Archive for the 'Little Depression' Category

Larry Summers v. John Taylor: No Contest

It seems that an announcement about who will be appointed as Fed Chairman after Janet Yellen’s terms expires early next year is imminent. Although there are sources in the Administration, e.g., the President, indicating that Janet Yellen may be reappointed, the betting odds strongly favor Jerome Powell, a Republican currently serving as a member of the Board of Governors, over the better-known contender, John Taylor, who has earned a considerable reputation as an academic economist, largely as author of the so-called Taylor Rule, and has also served as a member of the Council of Economic Advisers and the Treasury in previous Republican administrations.

Taylor’s support seems to be drawn from the more militant ideological factions within the Republican Party owing to his past criticism of Fed’s quantitative-easing policy after the financial crisis and little depression, having famously predicted that quantitative easing would revive dormant inflationary pressures, presaging a return to the stagflation of the 1970s, while Powell, who has supported the Fed’s policies under Bernanke and Yellen, is widely suspect in the eyes of the Republican base as a just another elitist establishmentarian inhabiting the swamp that the new administration was elected to drain. Nevertheless, Taylor’s academic background, his prior government service, and his long-standing ties to the US and international banking and financial institutions make him a less than ideal torch bearer for the true-blue (or true-red) swamp drainers whose ostensible goal is less to take control of the Fed than to abolish it. To accommodate both the base and the establishment, it is possible that, as reported by Breitbart, both Powell and Taylor will be appointed, one replacing Yellen as chairman, the other replacing Stanley Fischer as vice-chairman.

Seeing no evidence that Taylor has a sufficient following for his appointment to provide any political benefit, I have little doubt that it will be Powell who replaces Yellen, possibly along with Taylor as Vice-Chairman, if Taylor, at the age of 71, is willing to accept a big pay cut, just to take the vice-chairmanship with little prospect of eventually gaining the top spot he has long coveted.

Although I think it unlikely that Taylor will be the next Fed Chairman, the recent flurry of speculation about his possible appointment prompted me to look at a recent talk that he gave at the Federal Reserve Bank of Boston Conference on the subject: Are Rules Made to be Broken? Discretion and Monetary Policy. The title of his talk “Rules versus Discretion: Assessing the Debate over Monetary Policy” is typical of Taylor’s very low-key style, a style that, to his credit, is certainly not calculated to curry favor with the Fed-bashers who make up a large share of a Republican base that demands constant attention and large and frequently dispensed servings of red meat.

I found several things in Taylor’s talk notable. First, and again to his credit, Taylor does, on occasion, acknowledge the possibility that other interpretations of events from his own are possible. Thus, in arguing that the good macroeconomic performance (“the Great Moderation”) from about 1985 to 2003, was the result of the widespread adoption of “rules-based” monetary policy, and that the subsequent financial crisis and deep recession were the results of the FOMC’s having shifted, after the 2001 recession, from that rules-based policy to a discretionary policy, by keeping interest rates too low for too long, Taylor did at least recognize the possibility that the reason that the path of interest rates after 2003 departed from the path that, he claims, had been followed during the Great Moderation was that the economy was entering a period of inherently greater instability in the early 2000s than in the previous two decades because of external conditions unrelated to actions taken by the Fed.

The other view is that the onset of poor economic performance was not caused by a deviation from policy rules that were working, but rather to other factors. For example, Carney (2013) argues that the deterioration of performance in recent years occurred because “… the disruptive potential of financial instability—absent effective macroprudential policies—leads to a less favourable Taylor frontier.” Carney (2013) illustrated his argument with a shift in the tradeoff frontier as did King (2012). The view I offer here is that the deterioration was due more to a move off the efficient policy frontier due to a change in policy. That would suggest moving back toward the type of policy rule that described policy decisions during the Great Moderation period. (p. 9)

But despite acknowledging the possibility of another view, Taylor offers not a single argument against it. He merely reiterates his own unsupported opinion that the policy post-2003 became less rule-based than it had been from 1985 to 2003. However, later in his talk in a different context, Taylor does return to the argument that the Fed’s policy after 2003 was not fundamentally different from its policy before 2003. Here Taylor is assuming that Bernanke is acknowledging that there was a shift in from the rules-based monetary policy of 1985 to 2003, but that the post-2003 monetary policy, though not rule-based as in the way that it had been in 1985 to 2003, was rule-based in a different sense. I don’t believe that Bernanke would accept that there was a fundamental change in the nature of monetary policy after 2003, but that is not really my concern here.

At a recent Brookings conference, Ben Bernanke argued that the Fed had been following a policy rule—including in the “too low for too long” period. But the rule that Bernanke had in mind is not a rule in the sense that I have used it in this discussion, or that many others have used it.

Rather it is a concept that all you really need for effective policy making is a goal, such as an inflation target and an employment target. In medicine, it would be the goal of a healthy patient. The rest of policymaking is doing whatever you as an expert, or you as an expert with models, thinks needs to be done with the instruments. You do not need to articulate or describe a strategy, a decision rule, or a contingency plan for the instruments. If you want to hold the interest rate well below the rule-based strategy that worked well during the Great Moderation, as the Fed did in 2003-2005, then it’s ok, if you can justify it in terms of the goal.

Bernanke and others have argued that this approach is a form of “constrained discretion.” It is an appealing term, and it may be constraining discretion in some sense, but it is not inducing or encouraging a rule as the language would have you believe. Simply having a specific numerical goal or objective function is not a rule for the instruments of policy; it is not a strategy; in my view, it ends up being all tactics. I think there is evidence that relying solely on constrained discretion has not worked for monetary policy. (pp. 16-17)

Taylor has made this argument against constrained discretion before in an op-ed in the Wall Street Journal (May 2, 2015). Responding to that argument I wrote a post (“Cluelessness about Strategy, Tactics and Discretion”) which I think exposed how thoroughly confused Taylor is about what a monetary rule can accomplish and what the difference is between a monetary rule that specifies targets for an instrument and a monetary rule that specifies targets for policy goals. At an even deeper level, I believe I also showed that Taylor doesn’t understand the difference between strategy and tactics or the meaning of discretion. Here is an excerpt from my post of almost two and a half years ago.

Taylor denies that his steady refrain calling for a “rules-based policy” (i.e., the implementation of some version of his beloved Taylor Rule) is intended “to chain the Fed to an algebraic formula;” he just thinks that the Fed needs “an explicit strategy for setting the instruments” of monetary policy. Now I agree that one ought not to set a policy goal without a strategy for achieving the goal, but Taylor is saying that he wants to go far beyond a strategy for achieving a policy goal; he wants a strategy for setting instruments of monetary policy, which seems like an obvious confusion between strategy and tactics, ends and means.

Instruments are the means by which a policy is implemented. Setting a policy goal can be considered a strategic decision; setting a policy instrument a tactical decision. But Taylor is saying that the Fed should have a strategy for setting the instruments with which it implements its strategic policy.  (OED, “instrument – 1. A thing used in or for performing an action: a means. . . . 5. A tool, an implement, esp. one used for delicate or scientific work.”) This is very confused.

Let’s be very specific. The Fed, for better or for worse – I think for worse — has made a strategic decision to set a 2% inflation target. Taylor does not say whether he supports the 2% target; his criticism is that the Fed is not setting the instrument – the Fed Funds rate – that it uses to hit the 2% target in accordance with the Taylor rule. He regards the failure to set the Fed Funds rate in accordance with the Taylor rule as a departure from a rules-based policy. But the Fed has continually undershot its 2% inflation target for the past three [now almost six] years. So the question naturally arises: if the Fed had raised the Fed Funds rate to the level prescribed by the Taylor rule, would the Fed have succeeded in hitting its inflation target? If Taylor thinks that a higher Fed Funds rate than has prevailed since 2012 would have led to higher inflation than we experienced, then there is something very wrong with the Taylor rule, because, under the Taylor rule, the Fed Funds rate is positively related to the difference between the actual inflation rate and the target rate. If a Fed Funds rate higher than the rate set for the past three years would have led, as the Taylor rule implies, to lower inflation than we experienced, following the Taylor rule would have meant disregarding the Fed’s own inflation target. How is that consistent with a rules-based policy?

This is such an obvious point – and I am hardly the only one to have made it – that Taylor’s continuing failure to respond to it is simply inexcusable. In his apologetics for the Taylor rule and for legislation introduced (no doubt with his blessing and active assistance) by various Republican critics of Fed policy in the House of Representatives, Taylor repeatedly insists that the point of the legislation is just to require the Fed to state a rule that it will follow in setting its instrument with no requirement that Fed actually abide by its stated rule. The purpose of the legislation is not to obligate the Fed to follow the rule, but to merely to require the Fed, when deviating from its own stated rule, to provide Congress with a rationale for such a deviation. I don’t endorse the legislation that Taylor supports, but I do agree that it would be desirable for the Fed to be more forthcoming than it has been in explaining the reasoning about its monetary-policy decisions, which tend to be either platitudinous or obfuscatory rather than informative. But if Taylor wants the Fed to be more candid and transparent in defending its own decisions about monetary policy, it would be only fitting and proper for Taylor, as an aspiring Fed Chairman, to be more forthcoming than he has yet been about the obvious, and rather scary, implications of following the Taylor Rule during the period since 2003.

If Taylor is nominated to be Chairman or Vice-Chairman of the Fed, I hope that, during his confirmation hearings, he will be asked to explain what the implications of following the Taylor Rule would have been in the post-2003 period.

As the attached figure shows PCE inflation (excluding food and energy prices) was 1.9 percent in 2004. If inflation in 2004 was less than the 2% inflation target assumed by the Taylor Rule, why does Taylor think that raising interest rates in 2004 would have been appropriate? And if inflation in 2005 was merely 2.2%, just barely above the 2% target, what rate should the Fed Funds rate have reached in 2005, and how would that rate have affected the fairly weak recovery from the 2001 recession? And what is the basis for Taylor’s assessment that raising the Fed Funds rate in 2005 to a higher level than it was raised to would have prevented the subsequent financial crisis?

Taylor’s implicit argument is that by not raising interest rates as rapidly as the Taylor rule required, the Fed created additional uncertainty that was damaging to the economy. But what was the nature of the uncertainty created? The Federal Funds rate is merely the instrument of policy, not the goal of policy. To argue that the Fed was creating additional uncertainty by not changing its interest rate in line with the Taylor rule would only make sense if the economic agents care about how the instrument is set, but if it is an instrument the importance of the Fed Funds rate is derived entirely from its usefulness in achieving the policy goal of the Fed and the policy goal was the 2% inflation rate, which the Fed came extremely close to hitting in the 2004-06 period, during which Taylor alleges that the Fed’s monetary policy went off the rails and became random, unpredictable and chaotic.

If you calculate the absolute difference between the observed yearly PCE inflation rate (excluding food and energy prices) and the 2% target from 1985 to 2003 (Taylor’s golden age of monetary policy) the average yearly deviation was 0.932%. From 2004 to 2015, the period of chaotic monetary policy in Taylor’s view, the average yearly deviation between PCE inflation and the 2% target was just 0.375%. So when was monetary policy more predictable? Even if you just look at the last 12 years of the golden age (1992 to 2003), the average annual deviation was 0.425%.

The name Larry Summers is in the title of this post, but I haven’t mentioned him yet, so let me explain where Larry Summers comes into the picture. In his talk, Taylor mentions a debate about rules versus discretion that he and Summers had at the 2013 American Economic Association meetings and proceeds to give the following account of the key interchange in that debate.

Summers started off by saying: “John Taylor and I have, it will not surprise you . . . a fundamental philosophical difference, and I would put it in this way. I think about my doctor. Which would I prefer: for my doctor’s advice, to be consistently predictable, or for my doctor’s advice to be responsive to the medical condition with which I present? Me, I’d rather have a doctor who most of the time didn’t tell me to take some stuff, and every once in a while said I needed to ingest some stuff into my body in response to the particular problem that I had. That would be a doctor who’s [sic] [advice], believe me, would be less predictable.” Thus, Summers argues in favor of relying on an all-knowing expert, a doctor who does not perceive the need for, and does not use, a set of guidelines, but who once in a while in an unpredictable way says to ingest some stuff. But as in economics, there has been progress in medicine over the years. And much progress has been due to doctors using checklists, as described by Atul Gawande.

Of course, doctors need to exercise judgement in implementing checklists, but if they start winging it or skipping steps the patients usually suffer. Experience and empirical studies show that checklist-free medicine is wrought with dangers just as rules-free, strategy-free monetary policy is. (pp. 15-16)

Taylor’s citation of Atul Gawande, author of The Checklist Manifesto, is pure obfuscation. To see how off-point it is, have a look at this review published in the Seattle Times.

“The Checklist Manifesto” is about how to prevent highly trained, specialized workers from making dumb mistakes. Gawande — who appears in Seattle several times early next week — is a surgeon, and much of his book is about surgery. But he also talks to a construction manager, a master chef, a venture capitalist and the man at The Boeing Co. who writes checklists for airline pilots.

Commercial pilots have been using checklists for decades. Gawande traces this back to a fly-off at Wright Field, Ohio, in 1935, when the Army Air Force was choosing its new bomber. Boeing’s entry, the B-17, would later be built by the thousands, but on that first flight it took off, stalled, crashed and burned. The new airplane was complicated, and the pilot, who was highly experienced, had forgotten a routine step.

For pilots, checklists are part of the culture. For surgical teams they have not been. That began to change when a colleague of Gawande’s tried using a checklist to reduce infections when using a central venous catheter, a tube to deliver drugs to the bloodstream.

The original checklist: wash hands; clean patient’s skin with antiseptic; use sterile drapes; wear sterile mask, hat, gown and gloves; use a sterile dressing after inserting the line. These are all things every surgical team knows. After putting them in a checklist, the number of central-line infections in that hospital fell dramatically.

Then came the big study, the use of a surgical checklist in eight hospitals around the world. One was in rural Tanzania, in Africa. One was in the Kingdom of Jordan. One was the University of Washington Medical Center in Seattle. They were hugely different hospitals with much different rates of infection.

Use of the checklist lowered infection rates significantly in all of them.

Gawande describes the key things about a checklist, much of it learned from Boeing. It has to be short, limited to critical steps only. Generally the checking is not done by the top person. In the cockpit, the checklist is read by the copilot; in an operating room, Gawande discovered, it is done best by a nurse.

Gawande wondered whether surgeons would accept control by a subordinate. Which was stronger, the culture of hierarchy or the culture of precision? He found reason for optimism in the following dialogue he heard in the hospital in Amman, Jordan, after a nurse saw a surgeon touch a nonsterile surface:

Nurse: “You have to change your glove.”

Surgeon: “It’s fine.”

Nurse: “No, it’s not. Don’t be stupid.”

In other words, the basic rule underlying the checklist is simply: don’t be stupid. It has nothing to do with whether doctors should exercise judgment, or “winging it,” or “skipping steps.” What was Taylor even thinking? For a monetary authority not to follow a Taylor rule is not analogous to a doctor practicing checklist-free medicine.

As it happens, I have a story of my own about whether following numerical rules without exercising independent judgment makes sense in practicing medicine. Fourteen years ago, on the Friday before Labor Day, I was exercising at home and began to feeling chest pains. After ignoring the pain for a few minutes, I stopped and took a shower and then told my wife that I thought I needed to go to the hospital, because I was feeling chest pains – I was still in semi-denial about what I was feeling – my wife asked me if she should call 911, and I said that that might be a good idea. So she called 911, and told the operator that I was feeling chest pains. Within a couple of minutes, two ambulances arrived, and I was given an aspirin to chew and a nitroglycerine tablet to put under my tongue. I was taken to the emergency room at the hospital nearest to my home. After calling 911, my wife also called our family doctor to let him know what was happening and which hospital I was being taken to. He then placed a call to a cardiologist who had privileges at that hospital who happened to be making rounds there that morning.

When I got to the hospital, I was given an electrocardiogram, and my blood was taken. I was also asked to rate my pain level on a scale of zero to ten. The aspirin and nitroglycerine had reduced the pain level slightly, but I probably said it was at eight or nine. However, the ER doc looked at the electrocardiogram results and the enzyme levels in my blood, and told me that there was no indication that I was having a heart attack, but that they would keep me in the ER for observation. Luckily, the cardiologist who had been called by my internist came to the ER, and after talking to the ER doc, looking at the test results, came over to me and started asking me questions about what had happened and how I was feeling. Although the test results did not indicate that I was having heart attack, the cardiologist quickly concluded that what I was experiencing likely was a heart attack. He, therefore, hinted to me that I should request to be transferred to another nearby hospital, which not only had a cath lab, as the one I was then at did, but also had an operating room in which open heart surgery could be performed, if that would be necessary. It took a couple of tries on his part before I caught on to what he was hinting at, but as soon as I requested to be transferred to the other hospital, he got me onto an ambulance ASAP so that he could meet me at the hospital and perform an angiogram in the cath lab, cancelling an already scheduled angiogram.

The angiogram showed that my left anterior descending artery was completely blocked, so open-heart surgery was not necessary; angioplasty would be sufficient to clear the artery, which the cardiologist performed, also implanting two stents to prevent future blockage.  I remained in the cardiac ICU for two days, and was back home on Monday, when my rehab started. I was back at work two weeks later.

The willingness of my cardiologist to use his judgment, experience and intuition to ignore the test results indicating that I was not having a heart attack saved my life. If the ER doctor, following the test results, had kept me in the ER for observation, I would have been dead within a few hours. Following the test results and ignoring what the patient was feeling would have been stupid. Luckily, I was saved by a really good cardiologist. He was not stupid; he could tell that the numbers were not telling the real story about what was happening to me.

We now know that, in the summer of 2008, the FOMC, being in the thrall of headline inflation numbers allowed a recession that had already started at the end of 2007 to deteriorate rapidly, pr0viding little or no monetary stimulus, to an economy when nominal income was falling so fast that debts coming due could no longer be serviced. The financial crisis and subsequent Little Depression were caused by the failure of the FOMC to provide stimulus to a failing economy, not by interest rates having been kept too low for too long after 2003. If John Taylor still hasn’t figured that out – and he obviously hasn’t — he should not be allowed anywhere near the Federal Reserve Board.

Advertisements

Milton Friedman, Monetarism, and the Great and Little Depressions

Brad Delong has a nice little piece bashing Milton Friedman, an activity that, within reasonable limits, I consider altogether commendable and like to engage in myself from time to time (see here, here, here, here, here , here, here, here, here and here). Citing Barry Eichengreen’s recent book Hall of Mirrors, Delong tries to lay the blame for our long-lasting Little Depression (aka Great Recession) on Milton Friedman and his disciples whose purely monetary explanation for the Great Depression caused the rest of us to neglect or ignore the work of Keynes and Minsky and their followers in explaining the Great Depression.

According to Eichengreen, the Great Depression and the Great Recession are related. The inadequate response to our current troubles can be traced to the triumph of the monetarist disciples of Milton Friedman over their Keynesian and Minskyite peers in describing the history of the Great Depression.

In A Monetary History of the United States, published in 1963, Friedman and Anna Jacobson Schwartz famously argued that the Great Depression was due solely and completely to the failure of the US Federal Reserve to expand the country’s monetary base and thereby keep the economy on a path of stable growth. Had there been no decline in the money stock, their argument goes, there would have been no Great Depression.

This interpretation makes a certain kind of sense, but it relies on a critical assumption. Friedman and Schwartz’s prescription would have worked only if interest rates and what economists call the “velocity of money” – the rate at which money changes hands – were largely independent of one another.

What is more likely, however, is that the drop in interest rates resulting from the interventions needed to expand the country’s supply of money would have put a brake on the velocity of money, undermining the proposed cure. In that case, ending the Great Depression would have also required the fiscal expansion called for by John Maynard Keynes and the supportive credit-market policies prescribed by Hyman Minsky.

I’m sorry, but I find this criticism of Friedman and his followers just a bit annoying. Why? Well, there are a number of reasons, but I will focus on one: it perpetuates the myth that a purely monetary explanation of the Great Depression originated with Friedman.

Why is it a myth? Because it wasn’t Friedman who first propounded a purely monetary theory of the Great Depression. Nor did the few precursors, like Clark Warburton, that Friedman ever acknowledged. Ralph Hawtrey and Gustav Cassel did — 10 years before the start of the Great Depression in 1919, when they independently warned that going back on the gold standard at the post-World War I price level (in terms of gold) — about twice the pre-War price level — would cause a disastrous deflation unless the world’s monetary authorities took concerted action to reduce the international monetary demand for gold as countries went back on the gold standard to a level consistent with the elevated post-War price level. The Genoa Monetary Conference of 1922, inspired by the work of Hawtrey and Cassel, resulted in an agreement (unfortunately voluntary and non-binding) that, as countries returned to the gold standard, they would neither reintroduce gold coinage nor keep their monetary reserves in the form of physical gold, but instead would hold reserves in dollar or (once the gold convertibility of sterling was restored) pound-denominated assets. (Ron Batchelder and I have a paper discussing the work of Hawtrey and Casssel on the Great Depression; Doug Irwin has a paper discussing Cassel.)

After the short, but fierce, deflation of 1920-21 (see here and here), when the US (about the only country in the world then on the gold standard) led the world in reducing the price level by about a third, but still about two-thirds higher than the pre-War price level, the Genoa system worked moderately well until 1928 when the Bank of France, totally defying the Genoa Agreement, launched its insane policy of converting its monetary reserves into physical gold. As long as the US was prepared to accommodate the insane French gold-lust by permitting a sufficient efflux of gold from its own immense holdings, the Genoa system continued to function. But in late 1928 and 1929, the Fed, responding to domestic fears about a possible stock-market bubble, kept raising interest rates to levels not seen since the deflationary disaster of 1920-21. And sure enough, a 6.5% discount rate (just shy of the calamitous 7% rate set in 1920) reversed the flow of gold out of the US, and soon the US was accumulating gold almost as rapidly as the insane Bank of France was.

This was exactly the scenario against which Hawtrey and Cassel had been warning since 1919. They saw it happening, and watched in horror while their warnings were disregarded as virtually the whole world plunged blindly into a deflationary abyss. Keynes had some inkling of what was going on – he was an old friend and admirer of Hawtrey and had considerable regard for Cassel – but, for reasons I don’t really understand, Keynes was intent on explaining the downturn in terms of his own evolving theoretical vision of how the economy works, even though just about everything that was happening had already been foreseen by Hawtrey and Cassel.

More than a quarter of a century after the fact, and after the Keynesian Revolution in macroeconomics was well established, along came Friedman, woefully ignorant of pre-Keynesian monetary theory, but determined to show that the Keynesian explanation for the Great Depression was wrong and unnecessary. So Friedman came up with his own explanation of the Great Depression that did not even begin until December 1930 when the Fed allowed the Bank of United States to fail, triggering, in Friedman’s telling, a wave of bank failures that caused the US money supply to decline by a third by 1933. Rather than see the Great Depression as a global phenomenon caused by a massive increase in the world’s monetary demand for gold, Friedman portrayed it as a largely domestic phenomenon, though somehow linked to contemporaneous downturns elsewhere, for which the primary explanation was the Fed’s passivity in the face of contagious bank failures. Friedman, mistaking the epiphenomenon for the phenomenon itself, ignorantly disregarded the monetary theory of the Great Depression that had already been worked out by Hawtrey and Cassel and substituted in its place a simplistic, dumbed-down version of the quantity theory. So Friedman reinvented the wheel, but did a really miserable job of it.

A. C. Pigou, Alfred Marshall’s student and successor at Cambridge, was a brilliant and prolific economic theorist in his own right. In his modesty and reverence for his teacher, Pigou was given to say “It’s all in Marshall.” When it comes to explaining the Great Depression, one might say as well “it’s all in Hawtrey.”

So I agree that Delong is totally justified in criticizing Friedman and his followers for giving such a silly explanation of the Great Depression, as if it were, for all intents and purposes, made in the US, and as if the Great Depression didn’t really start until 1931. But the problem with Friedman is not, as Delong suggests, that he distracted us from the superior insights of Keynes and Minsky into the causes of the Great Depression. The problem is that Friedman botched the monetary theory, even though the monetary theory had already been worked out for him if only he had bothered to read it. But Friedman’s interest in the history of monetary theory did not extend very far, if at all, beyond an overrated book by his teacher Lloyd Mints A History of Banking Theory.

As for whether fiscal expansion called for by Keynes was necessary to end the Great Depression, we do know that the key factor explaining recovery from the Great Depression was leaving the gold standard. And the most important example of the importance of leaving the gold standard is the remarkable explosion of output in the US beginning in April 1933 (surely before expansionary fiscal policy could take effect) following the suspension of the gold standard by FDR and an effective 40% devaluation of the dollar in terms of gold. Between April and July 1933, industrial production in the US increased by 70%, stock prices nearly doubled, employment rose by 25%, while wholesale prices rose by 14%. All that is directly attributable to FDR’s decision to take the US off gold, and devalue the dollar (see here). Unfortunately, in July 1933, FDR snatched defeat from the jaws of victory (or depression from the jaws of recovery) by starting the National Recovery Administration, whose stated goal was (OMG!) to raise prices by cartelizing industries and restricting output, while imposing a 30% increase in nominal wages. That was enough to bring the recovery to a virtual standstill, prolonging the Great Depression for years.

I don’t say that the fiscal expansion under FDR had no stimulative effect in the Great Depression or that the fiscal expansion under Obama in the Little Depression had no stimulative effect, but you can’t prove that monetary policy is useless just by reminding us that Friedman liked to assume (as if it were a fact) that the demand for money is highly insensitive to changes in the rate of interest. The difference between the rapid recovery from the Great Depression when countries left the gold standard and the weak recovery from the Little Depression is that leaving the gold standard had an immediate effect on price-level expectations, while monetary expansion during the Little Depression was undertaken with explicit assurances by the monetary authorities that the 2% inflation target – in the upper direction, at any rate — was, and would forever more remain, sacred and inviolable.

Just How Infamous Was that Infamous Open Letter to Bernanke?

There’s been a lot of comment recently about the infamous 2010 open letter to Ben Bernanke penned by an assorted group of economists, journalists, and financiers warning that the Fed’s quantitative easing policy would cause inflation and currency debasement.

Critics of that letter (e.g., Paul Krugman and Brad Delong) have been having fun with the signatories, ridiculing them for what now seems like a chicken-little forecast of disaster. Those signatories who have responded to inquiries about how they now feel about that letter, notably Cliff Asness and Nial Ferguson, have made two arguments: 1) the letter was just a warning that QE was creating a risk of inflation, and 2) despite the historically low levels of inflation since the letter was written, the risk that inflation could increase as a result of QE still exists.

For the most part, critics of the open letter have focused on the absence of inflation since the Fed adopted QE, the critics characterizing the absence of inflation despite QE as an easily predictable outcome, a straightforward implication of basic macroeconomics, which it was ignorant or foolish of the signatories to have ignored. In particular, the signatories should have known that, once interest rates fall to the zero lower bound, the demand for money becoming highly elastic so that the public willingly holds any amount of money that is created, monetary policy is rendered ineffective. Just as a semantic point, I would observe that the term “liquidity trap” used to describe such a situation is actually a slight misnomer inasmuch as the term was coined to describe a situation posited by Keynes in which the demand for money becomes elastic above the zero lower bound. So the assertion that monetary policy is ineffective at the zero lower bound is actually a weaker claim than the one Keynes made about the liquidity trap. As I have suggested previously, the current zero-lower-bound argument is better described as a Hawtreyan credit deadlock than a Keynesian liquidity trap.

Sorry, but I couldn’t resist the parenthetical history-of-thought digression; let’s get back to that infamous open letter.

Those now heaping scorn on signatories to the open letter are claiming that it was obvious that quantitative easing would not increase inflation. I must confess that I did not think that that was the case; I believed that quantitative easing by the Fed could indeed produce inflation. And that’s why I was in favor of quantitative easing. I was hoping for a repeat of what I have called the short but sweat recovery of 1933, when, in the depths of the Great Depression, almost immediately following the worst financial crisis in American history capped by a one-week bank holiday announced by FDR upon being inaugurated President in March 1933, the US economy, propelled by a 14% rise in wholesale prices in the aftermath of FDR’s suspension of the gold standard and 40% devaluation of the dollar, began the fastest expansion it ever had, industrial production leaping by 70% from April to July, and the Dow Jones average more than doubling. Unfortunately, FDR spoiled it all by getting Congress to pass the monumentally stupid National Industrial Recovery Act, thereby strangling the recovery with mandatory wage increases, cost increases, and regulatory ceilings on output as a way to raise prices. Talk about snatching defeat from the jaws of victory!

Inflation having worked splendidly as a recovery strategy during the Great Depression, I have believed all along that we could quickly recover from the Little Depression if only we would give inflation a chance. In the Great Depression, too, there were those that argued either that monetary policy is ineffective – “you can’t push on a string” — or that it would be calamitous — causing inflation and currency debasement – or, even both. But the undeniable fact is that inflation worked; countries that left the gold standard recovered, because once currencies were detached from gold, prices could rise sufficiently to make production profitable again, thereby stimulating multiplier effects (aka supply-side increases in resource utilization) that fueled further economic expansion. And oh yes, don’t forget providing badly needed relief to debtors, relief that actually served the interests of creditors as well.

So my problem with the open letter to Bernanke is not that the letter failed to recognize the existence of a Keynesian liquidity trap or a Hawtreyan credit deadlock, but that the open letter viewed inflation as the problem when, in my estimation at any rate, inflation is the solution.

Now, it is certainly possible that, as critics of the open letter maintain, monetary policy at the zero lower bound is ineffective. However, there is evidence that QE announcements, at least initially, did raise inflation expectations as reflected in TIPS spreads. And we also know (see my paper) that for a considerable period of time (from 2008 through at least 2012) stock prices were positively correlated with inflation expectations, a correlation that one would not expect to observe under normal circumstances.

So why did the huge increase in the monetary base during the Little Depression not cause significant inflation even though monetary policy during the Great Depression clearly did raise the price level in the US and in the other countries that left the gold standard? Well, perhaps the success of monetary policy in ending the Great Depression could not be repeated under modern conditions when all currencies are already fiat currencies. It may be that, starting from an interwar gold standard inherently biased toward deflation, abandoning the gold standard created, more or less automatically, inflationary expectations that allowed prices to rise rapidly toward levels consistent with a restoration of macroeconomic equilibrium. However, in the current fiat money system in which inflation expectations have become anchored to an inflation target of 2 percent or less, no amount of money creation can budge inflation off its expected path, especially at the zero lower bound, and especially when the Fed is paying higher interest on reserves than yielded by short-term Treasuries.

Under our current inflation-targeting monetary regime, the expectation of low inflation seems to have become self-fulfilling. Without an explicit increase in the inflation target or the price-level target (or the NGDP target), the Fed cannot deliver the inflation that could provide a significant economic stimulus. So the problem, it seems to me, is not that we are stuck in a liquidity trap; the problem is that we are stuck in an inflation-targeting monetary regime.

 

Exposed: Irrational Inflation-Phobia at the Fed Caused the Panic of 2008

Matthew O’Brien at The Atlantic has written a marvelous account of the bizarre deliberations of the Federal Open Market Committee at its meetings (June 25 and August 5) before the Lehman debacle on September 15 2008 and its meeting the next day on September 16. A few weeks ago, I wrote in half-seriousness a post attributing the 2008 financial crisis to ethanol because of the runup in corn and other grain prices in 2008 owing to the ethanol mandate and the restrictions on imported ethanol products. But ethanol, as several commenters pointed out, was only a part, probably a relatively small part, of the spike in commodities prices in the summer of 2008. Thanks to O’Brien’s careful reading of the recently released transcripts of the 2008 meetings of the FOMC, we now have a clear picture of how obsessed the FOMC was about inflation, especially the gang of four regional bank presidents, Charles Plosser, Richard Fisher, James Lacker, and Thomas Hoenig, supported to a greater or lesser extent by James Bullard and Kevin Warsh.

On the other hand, O’Brien does point out that two members of the FOMC, Eric Rosengren, President of the Boston Fed, and Fredric Mishkin of the Board of Governors, consistently warned of the dangers of a financial crisis, and consistently objected to and cogently punctured the hysterical inflation fears of the gang of four. It is somewhat, but only somewhat, reassuring that Janet Yellen was slightly more sensitive to the dangers of a financial crisis and less concerned about inflation than Ben Bernanke. Perhaps because he was still getting his feet wet as chairman, Bernanke seems to have been trying to articulate a position that could balance the opposing concerns of the FOMC membership, rather than leading the FOMC in the direction he thought best. While Yellen did not indulge the inflation phobia of the gang of four, she did not strongly support Rosengren and Mishkin in calling for aggressive action to avert the crisis that they clearly saw looming on the horizon.

Here are some highlights from O’Brien’s brilliant piece:

[FOMC Meeting] June 24-25, 2008: 468 mentions of inflation, 44 of unemployment, and 35 of systemic risks/crises

Those numbers pretty much tell you everything you need to know about what happened during the disastrous summer of 2008 at the Fed

Rosengren wasn’t nearly as concerned with 5 percent headline inflation—and with good reason. He reminded his colleagues that “monetary policy is unlikely to have much effect on food and energy prices,” that “total [inflation] has tended to converge to core, and not the opposite,” and that there was a “lack of an upward trend of wages and salaries.”

In short, inflation was high today, but it wouldn’t be tomorrow. They should ignore it. A few agreed. Most didn’t.

Mishkin, Fed Governor Donald Kohn, and then-San Francisco Fed chief Janet Yellen comprised Team: Ignore Inflation. They pointed out that core inflation hadn’t actually risen, and that “inflation expectations remain reasonably well-anchored.” The rest of the Fed, though, was eager to raise rates soon, if not right away. Philadelphia Fed president Charles Plosser recognized that core inflation was flat, but still thought they needed to get ready to tighten “or our credibility could soon vanish.” Fed Governor Kevin Warsh said that “inflation risks, in my view, continue to predominate as the greater risk to the economy,” because he thought headline would get passed into core inflation.

And let us not forget Richard Fisher of the Dallas Fed who provided badly needed comic relief.

And then there was Dallas Fed chief Richard Fisher, who had a singular talent for seeing inflation that nobody else could—a sixth sense, if you will. He was allergic to data. He preferred talking to CEOs instead. But, in Fisher’s case, the plural of anecdote wasn’t data. It was nonsense. He was worried about Frito-Lays increasing prices 9 percent, Budweiser increasing them 3.5 percent, and a small dry-cleaning chain in Dallas increasing them, well, an undisclosed amount. He even half-joked that the Fed was giving out smaller bottles of water, presumably to hide creeping inflation?

By the way, I notice that these little bottles of water have gotten smaller—this will be a Visine bottle at the next meeting. [Laughter]

But it was another member of the Gang of Four who warned ominously:

Richmond Fed president Jeffrey Lacker suggested, that “at some point we’re going to choose to let something disruptive happen.”

Now to the August meeting:

[FOMC Meeting] August 5, 2008: 322 mentions of inflation, 28 of unemployment, and 19 of systemic risks/crises.

Despite evidence that the inflationary blip of spring and summer was winding down, and the real economy was weakening, the Gang of Four continued to press their case for tougher anti-inflation measures. But only Rosengren and Mishkin spoke out against them.

But even though inflation was falling, it was a lonesome time to be a dove. As the Fed’s resident Cassandra, Rosengren tried to convince his colleagues that high headline inflation numbers “appear to be transitory responses to supply shocks that are not flowing through to labor markets.” In other words, inflation would come down on its own, and the Fed should focus on the credit crunch instead. Mishkin worried that “really bad things could happen” if “a shoe drops” and there was a “nasty, vicious spiral” between weak banks and a weak economy. Given this, he wanted to wait to tighten until inflation expectations “actually indicate there is a problem,” and not before.

But Richard Fisher was in no mood to worry about horror stories unless they were about runaway inflation:

The hawks didn’t want to wait. Lacker admitted that wages hadn’t gone up, but thought that “if we wait until wage rates accelerate or TIPS measures spike, we will have waited too long.” He wanted the Fed to “be prepared to raise rates even if growth is not back to potential, and even if financial markets are not yet tranquil.” In other words, to fight nonexistent wage inflation today to prevent possible wage inflation tomorrow, never mind the crumbling economy. Warsh, for his part, kept insisting that “inflation risks are very real, and I believe that these are higher than growth risks.” And Fisher had more”chilling anecdotes”—as Bernanke jokingly called them—about inflation. This time, the culprit was Disney World and its 5 percent price increase for single-day tickets.

The FOMC was divided, but the inflation-phobes held the upper hand. Unwilling to challenge them, Bernanke appeased them by promising that his statement about future monetary policy after the meeting would be “be slightly hawkish—to indicate a slight uplift in policy.”

Frightened by what he was hearing, Mishkin reminded his colleagues of some unpleasant monetary history:

Remember that in the Great Depression, when—I can’t use the expression because it would be in the transcripts, but you know what I’m thinking—something hit the fan, [laughter] it actually occurred close to a year after the initial negative shock.

Mishkin also reminded his colleagues that the stance of monetary policy cannot be directly inferred from the federal funds rate.

I just very much hope that this Committee does not make this mistake because I have to tell you that the situation is scary to me. I’m holding two houses right now. I’m very nervous.

And now to the September meeting, the day after Lehman collapsed:

[FOMC meeting] September 16, 2008: 129 mentions of inflation, 26 of unemployment, and 4 of systemic risks/crises

Chillingly, Lacker and Hoenig did a kind of victory dance about the collapse of Lehman Brothers.

Lacker had gotten the “disruptive” event he had wanted, and he was pretty pleased about it. “What we did with Lehman I obviously think was good,” he said, because it would “enhance the credibility of any commitment that we make in the future to be willing to let an institution fail.” Hoenig concurred that it was the “right thing,” because it would suck moral hazard out of the market.

The rest of the Gang of Four and their allies remained focused like a laser on inflation.

Even though commodity prices and inflation expectations were both falling fast, Hoenig wanted the Fed to “look beyond the immediate crisis,” and recognize that “we also have an inflation issue.” Bullard thought that “an inflation problem is brewing.” Plosser was heartened by falling commodity prices, but said, “I remain concerned about the inflation outlook going forward,” because “I do not see the ongoing slowdown in economic activity is entirely demand driven.” And Fisher half-jokingly complained that the bakery he’d been going to for 30 years—”the best maker of not only bagels, but anything with Crisco in it”—had just increased prices. All of them wanted to leave rates unchanged at 2 percent.

Again, only Eric Rosengren seemed to be in touch with reality, but no was listening:

[Rosengren] was afraid that exactly what did end up happening would happen. That all the financial chaos “would have a significant impact on the real economy,” that “individuals and firms will be become risk averse, with reluctance to consume or invest,” that “credit spreads are rising, and the cost and availability of financing is becoming more difficult,” and that “deleveraging is likely to occur with a vengeance.” More than that, he thought that the “calculated bet” they took in letting Lehman fail would look particularly bad “if we have a run on the money market funds or if the nongovernment tri-party repo market shuts down.” He wanted to cut rates immediately to do what they could to offset the worsening credit crunch. Nobody else did.

Like Bernanke for instance. Here is his take on the situation:

Overall I believe that our current funds rate setting is appropriate, and I don’t really see any reason to change…. Cutting rates would be a very big step that would send a very strong signal about our views on the economy and about our intentions going forward, and I think we should view that step as a very discrete thing rather than as a 25 basis point kind of thing. We should be very certain about that change before we undertake it because I would be concerned, for example, about the implications for the dollar, commodity prices, and the like.

OMG!

O’Brien uses one of my favorite Hawtrey quotes to describe the insanity of the FOMC deliberations:

In other words, the Fed was just as worried about an inflation scare that was already passing as it was about a once-in-three-generations crisis.

It brought to mind what economist R. G. Hawtrey had said about the Great Depression. Back then, central bankers had worried more about the possibility of inflation than the grim reality of deflation. It was, Hawtrey said, like “crying Fire! Fire! in Noah’s flood.”

In any non-dysfunctional institution, the perpetrators of this outrage would have been sacked. But three of Gang of Four (Hoenig having become a director of the FDIC in 2012) remain safely ensconced in their exalted positions, blithely continuing, without the slightest acknowledgment of their catastrophic past misjudgments, to exert a malign influence on monetary policy. For shame!

How Monetary Policy Works

These are exciting times. Europe is in disarray, unable to cope with a crisis requiring adjustments in relative prices, wages, and incomes that have been rendered impossible by a monetary policy that has produced almost no growth in nominal GDP in the Eurozone since 2008, placing an intolerable burden on the Eurozone’s weakest economies. The required monetary easing by the European Central Bank is unacceptable to Germany, so the process of disintegration continues. The US, showing signs of gradual recovery in the winter and early spring, remains too anemic to shake off the depressing effects of the worsening situation in Europe. With US fiscal policy effectively stalemated until after the election, the only policy-making institution still in play is the Federal Open Market Committee (FOMC) of the Federal Reserve. The recent track record of the FOMC can hardly inspire much confidence in its judgment, but it’s all we’ve got. Yesterday’s stock market rally shows that the markets, despite many earlier disappointments, have still not given up on the FOMC.  But how many more disappointments can they withstand?

In today’s Financial Times, Peter Fisher (head of fixed income at BlackRock) makes the case (“Fed would risk diminishing returns with further ‘QE'”) against a change in policy by the Fed. Fisher lists four possible policy rationales for further easing of monetary policy by the Fed: 1) the “bank liquidity” rationale, 2) the “asset price” rationale, 3) the “credit channel” rationale, and 4) the “radical monetarist” rationale.

Fisher dismisses 1), because banks are awash in excess reserves from previous bouts of monetary easing. I agree, and that’s why the Fed should stop paying banks interest on reserves. He dismisses 2) because earlier bouts of monetary easing raised asset prices but had only very limited success in stimulating increased output.

While [the Fed] did drive asset prices higher for a few months, there was little follow-through in economic activity in 2011. This approach provides little more than a bridging operation and the question remains: a bridge to what?

This is not a persuasive critique. Increased asset prices reflected a partial recovery in expectations of future growth in income and earnings. A credible monetary policy with a clearly articulated price level of NGDP target would have supported expectations of higher growth than the anemic growth since 2009, in which asset prices would have risen correspondingly higher, above the levels in 2007, which we have still not reached again.

Fisher rejects 3), the idea “that if the Fed holds down long-term interest rates it will stimulate private credit creation and, thus, economic expansion.” Implementing this idea, via “operation twist” implies taking short-term Treasuries out of the market and replacing them with longer-term Treasuries, but doing so denies “banks the core asset on which they build their balance sheets,” thus impairing the provision of credit by the banking system instead of promoting it.

I agree.

Finally Fisher rejects 4), “the idea more central bank liabilities will eventually translate into ‘too much money chasing too few goods and services’ at least so as to avoid a fall in the general price level.” Fisher asks:

What assets would the Fed buy? More Treasuries? Would the Fed embark on such a radical course in a presidential election year?

Perhaps the Fed could buy foreign currencies, engineer a much weaker dollar and, thereby, stimulate inflation and growth. Would the rest of the world permit this? I doubt it. They would probably respond in kind and we would all have a real currency war. Nor is it clear the US external sector is large enough to import enough inflation to make a difference. If energy and commodity prices soared, would American consumers “chase” consumption opportunities or would they suppress consumption and trigger a recession? Recent experience suggests the latter. How much “chasing behaviour” would we get in a recession? Engineering a dollar collapse would be to play with fire and gasoline. It might create inflation or it might create a depression.

These are concerns that have been expressed before, especially in astute and challenging comments by David Pearson to many of my posts on this blog. They are not entirely misplaced, but I don’t think that they are weighty enough to undermine the case for monetary easing, especially monetary easing tied to an explicit price level or NGDP target. As I pointed out in a previous post, Ralph Hawtrey addressed the currency-war argument 80 years ago in the middle of the Great Depression, and demolished it. FDR’s 40-percent devaluation of the dollar in 1933, triggering the fastest four-month expansion in US history, prematurely aborted by the self-inflicted wound of the National Recovery Administration, provides definitive empirical evidence against the currency-war objection. As for the fear that monetary easing and currency depreciation would lead to an upward spiral of energy and commodity prices that would cause a retrenchment of consumer spending, thereby triggering a relapse into recession, that is certainly a risk. But if you believe that we are in a recession with output and employment below the potential output and employment that the economy could support, you would have to be awfully confident that that scenario is the most likely result of monetary easing in order not to try it.

The point of tying monetary expansion to an explicit price level or spending target is precisely to provide a nominal anchor for expectations. That nominal anchor would provide a barrier against the kind of runaway increase in energy and commodity prices that would supposedly follow from a commitment to use monetary policy to achieve a price-level or spending target.  Hawtrey’s immortal line about crying “fire, fire” in Noah’s flood is still all too apt.

More on Inflation Expectations and Stock Prices

It was three and a half weeks ago (May 14) that I wrote a post “Inflation Expectations Are Falling; Run for Cover” in which I called attention to the fact that inflation expectations, which had been rising since early in 2012, had begun to fall, and that the shift had coincided with falling stock prices. I included in that post the chart below showing the close correlation between inflation expectations (approximated by the breakeven TIPS spread on 10-year constant-maturity Treasuries and 10-year constant-maturity TIPS).

Then I noted in two posts (May 24 and May 30) that since early in May, I had detected an anomaly in the usual close correlation between short-term and long-term real interest rates, longer-term real interest rates having fallen more sharply than shorter-term real interest rates since the start of May. That was shown in the chart below.

I thought it would now be useful to look at my chart from May 14 with the additional observations from the past three weeks included. The new version of the May 14 chart is shown below.

What does it teach us? There still seems to be a correlation between inflation expectations and stock prices, but it is not as close as it was until three weeks ago. I confirmed this by computing the correlation coefficient between inflation expectations and the S&P 500 from January 3 to May 14. The correlation was .9. Since May 14, the correlation is only .4. That is a relatively weak correlation, but one should note that there are other three-week periods between January 3 and May 14 in which the correlation between inflation expectations and stock prices is even lower than .4. Still, one can’t exclude the possibility that the last three weeks involve some change in circumstances that has altered the relationship between inflation expectations and stock prices. The chart below plots the movement in inflation expectations and stock prices for just the last three weeks.

One other point bears mentioning: the sharp increase in stock prices yesterday was accompanied by increases in nominal and real interest rates, for all durations. That is not an anomalous result; it has been the typical relationship since the early stages of the Little Depression.  Expected inflation implies increased nominal rates and increased borrowing costs.  Moreover, expected inflation has generally been positively correlated with real interest rates, expectations of increased inflation being correlated with expectation of increased real returns on investment.  So the conventional textbook theory that loose monetary policy increases stock prices and economic activity by reducing borrowing costs is simply not reflected in the data since the start of the Little Depression.

Expected Inflation and the S&P 500 Redux

On Monday I wrote a post with the chart below showing the close correlation since January of this year between the S&P 500 and expected inflation as (approximately) reflected in the spread between the constant maturity 10-year Treasury note and the constant maturity 10-year TIPS.  A number of other bloggers noticed the post and the chart.  One of those was Matthew Yglesias who coupled my chart with a somewhat similar one posted by Marcus Nunes on his blog on the same day as mine.

One commenter (“Fact Checker”) on Matthew’s blog criticized my chart accusing me of cherry picking.

The second graph is meaningless, as it does not work through time.

Here it is from 1990: http://research.stlouisfed.org/fredgraph.png?g=7gX
Again from 2000: http://research.stlouisfed.org/fredgraph.png?g=7gY
From 2005: http://research.stlouisfed.org/fredgraph.png?g=7gZ
From 2009: http://research.stlouisfed.org/fredgraph.png?g=7h0

And in another comment:

The S&P + inflation chart is reproduced below, with longer windows. And as you suggest there is no correlation in any time frame but the very short window cherry picked by MY.

Two points to make about his comment.  First, if Fact Checker had read Yglesias’s post carefully, or, better yet, actually read my post (let alone the original paper on which the post was based), he would have realized that my whole point is that the close correlation between expected inflation and stock prices is generally not observed, and that one would expect to observe the correlation only when deflation exceeds the real rate of interest (as it does now when slightly positive expected inflation exceeds the negative real real rate of interest).  So the fact that the correlation doesn’t work through time was precisely the point of my post.  Second, the graphs to which Fact Checker links use survey data by the University of Michigan of the inflation expectations of households.  I do not totally discount such data, but I regard survey estimates of expected inflation as much less reliable than the implicit market expectations of inflation reflected in the TIPS spread.

To show that the correlation I have found is reflected in the data since approximately the beginning of the downturn at the very end of 2007, but not before, here is a graph similar to the one I posted on Monday covering the entire period since 2003 for which I have data on the 10-year TIPS spread.

Before the beginning of 2008, there is plainly no correlation at all between inflation expectations and stock prices.  It is only at some point early in 2008 that the correlation begins to be observed, and it has persisted ever since.  We will know that we are out of this Little Depression when the correlation vanishes.

John Kay on Central Bank Credibility

Few, if any, newspaper columnists are as consistently insightful and challenging as John Kay of the Financial Times.  In his column today (“The dogma of ‘credibility’ now endangers stability”), Kay brilliantly demolishes the modern obsession with central-bank credibility, the notion that failing to meet an arbitrary inflation target will cause inflation expectations to become “unanchored,” thereby setting us on the road to hyper-inflation of Zimbabwean dimensions.  (Talk about a slippery slope!  If only central bankers and Austrians Business Cycle Theorists realized how much they had in common, they would become best friends.)

Here’s Kay:

The elevation of credibility into a central economic has turned a sensible point — that policy stability is good for both business and households — into a dogma that endangers economic stability.  The credibility the models describe is impossible in a democracy.  Worse, the attempt to achieve it threatens democracy.  Pasok, the established party of the Greek left, lost votes to the moderate Democratic Left and more extreme Syriza party because it committed to seeing austerity measures through.  Now the Democratic Left cannot commit to that package because it would lose to Syriza if it did.  The UK’s Liberal Democrats, by making such a deal, have suffered electoral disaster.  The more comprehensive the coalition supporting unpalatable policies, the more votes will go to extremists who reject them.

We got into this mess in 2008, because the FOMC, focused almost exclusively on rising oil and food prices that were driving up the CPI in the spring and summer of 2008, ignored signs of a badly weakening economy, fearing that rises in the CPI would cause inflation expectations to become “unanchored.”  The result was an effective tightening of monetary policy DURING a recession, which led to an unanchoring of inflation expectations all right, but in precisely the other direction!

Now, the ECB, having similarly focused on CPI inflation in Europe for the last two years, is in the process of causing inflation expectations to become unanchored in precisely the other direction.  Why is it that central bankers, like the Bourbons, seem to learn nothing and forget nothing?  Don’t they see that central bank credibility cannot be achieved by mindlessly following a single rule?  That sort of credibility is a will o the wisp.

Inflation Expectations Are Falling; Run for Cover

The S&P 500 fell today by more than 1 percent, continuing the downward trend began last month when the euro crisis, thought by some commentators to have been surmounted last November thanks to the consummate statesmanship of Mrs. Merkel, resurfaced once again, even more acute than in previous episodes. The S&P 500, having reached a post-crisis high of 1419.04 on April 2, a 10% increase since the end of 2011, closed today at 1338.35, almost 8% below its April 2nd peak.

What accounts for the drop in the stock market since April 2? Well, as I have explained previously on this blog (here, here, here) and in my paper “The Fisher Effect under Deflationary Expectations,” when expected yield on holding cash is greater or even close to the expected yield on real capital, there is insufficient incentive for business to invest in real capital and for households to purchase consumer durables. Real interest rates have been consistently negative since early 2008, except in periods of acute financial distress (e.g., October 2008 to March 2009) when real interest rates, reflecting not the yield on capital, but a dearth of liquidity, were abnormally high. Thus, unless expected inflation is high enough to discourage hoarding, holding money becomes more attractive than investing in real capital. That is why ever since 2008, movements in stock prices have been positively correlated with expected inflation, a correlation neither implied by conventional models of stock-market valuation nor evident in the data under normal conditions.

As the euro crisis has worsened, the dollar has been appreciating relative to the euro, dampening expectations for US inflation, which have anyway been receding after last year’s temporary supply-driven uptick, and after the ambiguous signals about monetary policy emanating from Chairman Bernanke and the FOMC. The correspondence between inflation expectations, as reflected in the breakeven spread between the 10-year fixed maturity Treasury note and 10-year fixed maturity TIPS, and the S&P 500 is strikingly evident in the chart below showing the relative movements in inflation expectations and the S&P 500 (both normalized to 1.0 at the start of 2012.

With the euro crisis showing no signs of movement toward a satisfactory resolution, with news from China also indicating a deteriorating economy and possible deflation, the Fed’s current ineffectual monetary policy will not prevent a further slowing of inflation and a further perpetuation of our national agony. If inflation and expected inflation keep falling, the hopeful signs of recovery that we saw during the winter and early spring will, once again, turn out to have been nothing more than a mirage

Reading John Taylor’s Mind

Last Saturday, John Taylor posted a very favorable comment on Robert Hetzel’s new book, The Great Recession: Market Failure or Policy Failure? Developing ideas that he published in an important article published in the Federal Reserve Bank of Richmond Economic Quarterly, Hetzel argues that it was mainly tight monetary policy in 2008, not the bursting of the housing bubble and its repercussions that caused the financial crisis in the weeks after Lehman Brothers collapsed in September 2008. Hetzel thus makes an argument that has obvious attractions for Taylor, attributing the Great Recession to the mistaken policy choices of the Federal Open Market Committee, rather than to any deep systemic flaw in modern free-market capitalism. Nevertheless, Taylor’s apparent endorsement of Hetzel’s main argument comes as something of a surprise, inasmuch as Taylor has sharply criticized Fed policies aiming to provide monetary stimulus since the crisis. However, if the Great Recession (Little Depression) was itself caused by overly tight monetary policy in 2008, it is not so easy to argue that a compensatory easing of monetary policy would not be appropriate.

While acknowledging the powerful case that Hetzel makes against Fed policy in 2008 as the chief cause of the Great Recession, Taylor tries very hard to reconcile this view with his previous focus on Fed policy in 2003-05 as the main cause of all the bad stuff that happened subsequently.

One area of disagreement among those who agree that deviations from sensible policy rules were a cause of the deep crisis is how much emphasis to place on the “too low for too long” period around 2003-2005—which, as I wrote in Getting Off Track, helped create an excessive boom, higher inflation, a risk-taking search for yield, and the ultimate bust—compared with the “too tight” period when interest rates got too high in 2007 and 2008 and thereby worsened the decline in GDP growth and the recession.

In my view these two episodes are closely connected in the sense that if rates had not been held too low for too long in 2003-2005 then the boom and the rise in inflation would likely have been avoided, and the Fed would not have found itself in a position of raising rates so much in 2006 and then keeping them relatively high in 2008.

A bit later, Taylor continues:

[T]here is a clear connection between the too easy period and the too tight period, much like the connection between the “go” and the “stop” in “go-stop” monetary policy, which those who warn about too much discretion are concerned with. I have emphasized the “too low for too long” period in my writing because of its “enormous implications” (to use Hetzel’s description) for the crisis and the recession which followed. Now this does not mean that people are incorrect to say that the Fed should have cut interest rates sooner in 2008. It simply says that the Fed’s actions in 2003-2005 should be considered as a possible part of the problem along with the failure to move more quickly in 2008.

Moreover in a blog post last November, when targeting nominal GDP made a big splash, receiving endorsements from such notables as Christina Romer and Paul Krugman, Taylor criticized NGDP targeting on his blog and through his flack Amity Shlaes.

A more fundamental problem is that, as I said in 1985, “The actual instrument adjustments necessary to make a nominal GNP rule operational are not usually specified in the various proposals for nominal GNP targeting. This lack of specification makes the policies difficult to evaluate because the instrument adjustments affect the dynamics and thereby the influence of a nominal GNP rule on business-cycle fluctuations.” The same lack of specificity is found in recent proposals. It may be why those who propose the idea have been reluctant to show how it actually would work over a range of empirical models of the economy as I have been urging here. Christina Romer’s article, for instance, leaves the instrument decision completely unspecified, in a do-whatever-it-takes approach. More quantitative easing, promising low rates for longer periods, and depreciating the dollar are all on her list. NGDP targeting may seem like a policy rule, but it does not give much quantitative operational guidance about what the central bank should do with the instruments. It is highly discretionary. Like the wolf dressed up as a sheep, it is discretion in rules clothing.

For this reason, as Amity Shlaes argues in her recent Bloomberg piece, NGDP targeting is not the kind of policy that Milton Friedman would advocate. In Capitalism and Freedom, he argued that this type of targeting procedure is stated in terms of “objectives that the monetary authorities do not have the clear and direct power to achieve by their own actions.” That is why he preferred instrument rules like keeping constant the growth rate of the money supply. It is also why I have preferred instrument rules, either for the money supply, or for the short term interest rate.

Taylor does not indicate whether, after reading Hetzel’s book, he is now willing to reassess either his view that monetary policy should be tightened or his negative view of NGDP. However, following Taylor post on Saturday, David Beckworth wrote an optimistic post suggesting that Taylor was coming round to Market Monetarism and NGDP targeting. Scott Sumner followed up Beckworth’s post with an optimistic one of his own, more or less welcoming Taylor to ranks of Market Monetarists. However, Marcus Nunes in his comment on Taylor’s post about Hetzel may have the more realistic view of what Taylor is thinking, observing that Taylor may have mischaracterized Hetzel’s view about the 2003-04 period, thereby allowing himself to continue to identify Fed easing in 2003 as the source of everything bad that happened subsequently. And Bill Woolsey also seems to think that Marcus’s take on Taylor is the right one.

But, no doubt Professor Taylor will soon provide us with further enlightenment on his mental state.  We hang on his next pronouncement.


About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

Enter your email address to follow this blog and receive notifications of new posts by email.

Join 1,538 other followers

Follow Uneasy Money on WordPress.com