Archive for the 'Little Depression' Category

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.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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