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To QE or not to QE

Published July 22, 2012 expectations , Hawtrey , Hayek , monetary policy 32 Comments

Steve Horwitz, one of my favorite contemporary Austrian economists – and he would be likely be one of them even if there were not such a dearth of Austrian economists to plausibly choose from — published an opinion piece in US News and World Report opposing another round of quantitative easing. His first paragraph focuses on the size of the Fed balance sheet and the (unenumerated) “new and unprecedented” powers that the Fed has accumulated, as if the size of the Fed balance sheet were somehow logically related to its accumulation of those new and unprecedented powers. But the size of the Fed’s balance sheet and the extent of the powers that it is exercising are not really the nub of Horwitz’s argument; it is the prelude to an argument that begins in the next paragraph

[P]revious rounds of quantitative easing have done little . . . to generate recovery. Of course it’s . . . possible that it’s because it wasn’t enough, but a tripling of the Fed’s balance sheet hardly seems like an insufficient attempt at monetary stimulus.

In other words, if QE hasn’t worked till now, why should we think that another round will be any more successful? But if the objection is simply that QE doesn’t matter, one might well respond that, in that case, there also doesn’t seem to be much harm in trying.

Horwitz then turns to the argument that some proponents (notably Market Monetarists) of additional QE have been making, which is that for about two decades the level of aggregate nominal spending in the economy or nominal gross domestic product (NGDP) was growing at an annual rate in the neighborhood of 5%. But since the 2008-09 downturn, the economy has fallen way below that growth path, so that the job of monetary policy is to bring the economy at least part of the way back to that path, instead of allowing it to lag farther and farther behind its former growth path. Horwitz raises the following objection to this argument.

[M]ost economic theories explaining why an insufficient money supply would lead to recession depend upon “stickiness” in prices and wages. Those same theories also indicate that, after a sufficient amount of time, people will adjust to that stickiness in prices and wages and the money supply will be sufficient again.

If that adjustment hasn’t taken place in almost four years, then perhaps it is not this “stickiness” that could perhaps be overcome by more monetary stimulus, but rather real resource misallocations that are causing delaying recovery. Those real misallocations cannot be fixed by more money. Instead, we need less regulation and more freedom for entrepreneurs to reallocate resources away from the mistakes of the boom, to where they are most valuable now.

I have three problems with this dismissal of monetary stimulus. First, Horwitz takes it as self-evident that a tripling of the Fed’s balance sheet is the equivalent of monetary stimulus. But that of course simply presumes that the demand of the public to hold the monetary base has not increased as fast or faster than the monetary base has increased. In fact, the slowdown in the growth of NGDP and inflation in the last four years suggests that the public has been more than willing to hold all the additional currency and reserves (the constituents of the monetary base) that the Fed has created. If so, there has been no effective monetary stimulus. But isn’t it unusual for the demand for the monetary base to have increased so much in so short a time? Yes, it certainly is unusual, but not unprecedented. In the Great Depression there was a huge increase in the demand to hold currency and bank reserves, and voices were then raised warning of the inflationary implications of rapidly increasing the monetary base. In retrospect, almost everyone (with the exception of some fanatical Austrian economists who tend to regard Professor Horwitz as dangerously tolerant of mainstream economics) now views the voices that were warning of inflation in the 1930s with the same astonishment as Ralph Hawtrey expressed when he compared such warnings to someone “crying fire, fire in Noah’s flood.”

Second, Horwitz may be right that most economic theories explaining why an insufficient money supply can cause unemployment rely on some form of price stickiness to explain why market price adjustments can’t do the job without monetary expansion. But price stickiness is a very vague and imprecise term covering a lot of different, and possibly conflicting, interpretations. Horwitz’s point seems to be something like the following: “OK, I’ll grant you that prices and wages don’t adjust quickly enough to restore full employment immediately, but why should four years not be enough time to get wages and prices back into proper alignment?” That objection presumes that there is a unique equilibrium structure of wages and prices, and that price adjustments move the economy, however slowly, toward that equilibrium. But that is a mistaken view of economic equilibrium, which, in the real world, depends not only on price adjustments, but on price expectations. Unless price expectations are in equilibrium, price adjustments, whether rapid or slow, cannot guarantee that economic equilibrium will be reached. The problem is that there is no economic mechanism that ensures the compatibility of the price expectations held by different economic agents, by workers and by employers. This proposition about the necessary conditions for economic equilibrium should not be surprising to Horwitz, inasmuch as it was set out about 75 years ago in a classic article by one of his (and my) heroes, F. A. Hayek. If the equilibrium set of price expectations implies an expected inflation rate over the next two to five years greater than the 1.5% it is now generally estimated to be, then the economy can’t move toward equilibrium unless inflation and inflation expectations are raised significantly.

Third, although Horwitz finds it implausible that price stickiness could account for the failure to achieve a robust recovery, he is confident that “less regulation and more freedom for entrepreneurs to reallocate resources away from the mistakes of the boom, to where they are most valuable now” would produce such a recovery, and quickly. But he offers no reason or evidence to justify a supposition that the regulatory burden is greater, and entrepreneurial freedom less, today than it was in previous recoveries. To me that seems like throwing red meat to the ideologues, not the sort of reasoned argument that I would have expected from Horwitz.

HT: Lars Christensen

It’s Déjà vu All Over Again

Published July 19, 2012 Eurozone crisis , monetary policy 12 Comments

On Thursday, it was Pascal Salin in the Wall Street Journal; now on Friday, as if not to be outdone, comes Nobel laureate Edmund Phelps in the Financial Times. Salin told us on Thursday that the cause of the eurocrisis is not the euro, but the profligacy of and bad management by the various governments now on the brink of insolvency; Phelps tells on Friday that the cause of the crisis is not Chancellor Merkel’s insistence on austerity measures and labor-market reforms, but the failure of the governments on the verge of insolvency to emulate the German model.

Chancellor Angela Merkel and Wolfgang Schäuble, her finance minister, are right to oppose fiscal and bank unions without political union. Without any teeth in such agreements, the nations now besotted with wealth, private and social, could use the loans and grants for financing more deficits and more entitlements – another round of corporatist excess – rather than for smoothing the way to fiscal responsibility.

It is entirely possible, even likely, that wage reductions and labor-market liberalization would be beneficial for all European countries. But that is not the issue. France and Italy and other European countries can choose their own budgetary and labor-market policies. Those choices imply costs and consequences. High taxes and unproductive government expenditures will tend to depress growth rates. If France and Italy choose to grow at a slower rate than Germany, they have the right, as sovereign countries, to do so. The choice of a reduced rate of growth need not entail insolvency, and it is not Germany’s job to impose a higher rate of growth on France and Italy than they want. Except for Greece, which is a special case, the potentially insolvent countries in Europe are facing insolvency not because of their budgetary and labor-market policies, but because of a sharp slowdown since 2008 in rate of growth in nominal GDP in the Eurozone as a whole (averaging just 0.6% a year since the third quarter of 2008). Why has nominal GDP not increased as rapidly since 2008 as it did before 2008? Some of us think that that it has something to do with policies followed by the European Central Bank, policies that by and large are determined by the country in which the ECB is domiciled. (Can you guess which country that is?)

But for some reason – I can’t imagine what it would be — in the 670 words in his piece in the Financial Times, Professor Phelps, in discussing the causes of the Eurozone crisis and in defending Chancellor Merkel’s role in the crisis, didn’t mention the European Central Bank even once. Go figure.

There’s No Euro Crisis; It’s an ECB crisis

Published July 18, 2012 Eurozone crisis , monetary policy 9 Comments

Pascal Salin is a distinguished French economist. I met him many years ago at a conference and subsequently corresponded with him. He was also a contributor to Business Cycles and Depressions: An Encyclopedia which I edited. His op-ed in Thursday’s Wall Street Journal is a cut above the usual fare in the Journal‘s opinion section.

Salin correctly points out that there is no reason why a default by one government should have an adverse effect on another government just because the two governments are using the same currency. And certainly Professor Salin is also right in observing that joint European responsibility for the debts incurred by individual European governments is not logically entailed by the existence of a common currency. And I think he is very much on target when he makes the further point that the crisis is being used by those with a political agenda of creating a more centralized European super-state despite the apparent opposition to such a state by most Europeans.

The “euro crisis” is a pure political construction. It is a splendid opportunity for many politicians to impose some of their longstanding goals on everyone else. For instance, before the introduction of the euro, many politicians who called themselves Europeans considered monetary union a stepping stone to political union. I was opposed to the euro before its creation, precisely because I feared that the currency’s stewards would take this arbitrary link between the monetary system and national policies as a pretense to further centralize political decisions.

Politicians now argue that “saving the euro” will require not only propping up Europe’s irresponsible governments, but also centralizing decision-making. This is now the dominant opinion of politicians in Europe, France in particular.

But despite those valid points, I am afraid that Salin misses the key point, simply ignoring the indefensible role that the European Central Bank has played in this awful mess. Salin argues as if the difficulties of European governments in repaying their debts were entirely the result of their own profligacy and bad management, though I would not suggest that the governments in question are entirely blameless. But he says not a word about stagnation in European nominal GDP growth, as if nominal GDP were determined independently of monetary policy. In fact, since the bottom of the downturn in the second quarter of 2009, nominal GDP in the Eurozone has grown at an annual rate of 2.3%, slowing to a rate of 0.84% from Q2 2011 to Q1 2012. Cyprus, Italy, Netherlands, Portugal, and Spain have all experienced contractions in NGDP in the last three quarters. That is an unconscionable performance.

The New York Times reported on Wednesday that the IMF is now warning of a sizable deflation risk in the Eurozone. Guess what? The deflation has already started. If it’s not showing up in the official price indices, that’s probably because of improperly constructed prices indices (perversely counting increases in VAT as price increases). The problem is not that some European countries won’t pay their debts; the problem is that a deflationary ECB monetary policy is preventing them from earning the income with which to pay their debts. Talk about blaming the victim.

Bernanke Testifies; Says Nothing

Published July 17, 2012 monetary policy 6 Comments

Fed Chairman Ben Bernanke testified before the Senate Banking Committee today, presenting the Fed’s semiannual Monetary Policy Report to the Congress; he said nothing. That is to say, he said nothing that would provide any insight into the reasoning that is guiding him and his colleagues on the FOMC in their decisions about monetary policy.

Bernanke dryly presented the basic facts about the current status of the US economy and what he, somewhat laughably, refers to as a recovery. But even he acknowledges its weakness, while disclaiming any responsibility for that weakness.

However, those more hermeneutically astute than I in teasing out the hidden or obscure meanings from Bernanke’s pronouncements found in his reference to the risk of deflation a hint that Bernanke and other like-minded members of the FOMC are poised to launch a new round of quantitative easing, but are waiting for more evidence of deflation risk before inviting the criticism of opponents of monetary easing (both inside and outside the Fed). That is the optimistic spin on Bernanke’s testimony.

Here is the semantic commentary of hermeneutist Kathy Lynn.

Fed Chairman Ben Bernanke’s testimony before the Senate triggered widespread volatility in currencies. When Bernanke first spoke, the U.S. dollar soared against all the major currencies because Quantitative Easing was not mentioned as a possible tool to stimulate the economy. Based on his prepared remarks, Bernanke is clearly frustrated with the pace of recovery, but he deliberately stopped short of mentioning more QE, because he knew that doing so would spark speculation of action in August, a decision that they were not prepared to make.

However, as the question and answer session began, it quickly became clear that Bernanke would not be able to avoid discussing his plans for monetary policy, and more specifically Quantitative Easing. About 20 minutes into the Q&A session, Bernanke admitted that they have a range of possibilities for more easing, including more QE, using the discount window and cutting the interest rate on excess reserves. Their challenge right now is figuring out whether the “loss of momentum in the economy is enduring.” However, as the evidence shows, there is “frustratingly slow” progress on joblessness and a modest risk of deflation. This means that while August is out, QE3 is still an option for September.

When the dust settled, investors realized that nothing Bernanke said today removed the risk of additional stimulus and for the currency market this means there is no justification for a dollar rally. If anything, Bernanke’s concerns about deflation should tell us that the central bank remains in easing mode. FOMC member Pianalto spoke after Bernanke’s testimony, and she confirmed that the economy needs “highly accommodative monetary policy.”

Bernanke’s noncommittal comments on QE3 are consistent with the central bank’s strategy of biding their time until there is unambiguous evidence that another round of asset purchases is necessary. Two more months of job growth less than 100k and another month of negative retail sales could do the trick.

I hope that she’s right. And perhaps that is why the S&P 500, after falling about 8 points in the first hour of trading, later recovered to close up about 10 point on the day.

Perhaps, in view of recent discussions about the Hodrick-Presoctt filter, a useful question to put to Bernanke at the press conference after the next FOMC meeting would be: “Chairman Bernanke, what is your estimate of the current gap between current output and potential output?” If he acknowledges the existence of a gap, a follow-up question might: “Given the Fed’s dual mandate, what obligation, if any, do you believe that the FOMC has to take action to reduce that gap?”

George Selgin Asks a Question

Published July 11, 2012 expectations , Keynes , monetary policy , monetary theory , selgin , W. H. Hutt 18 Comments

I first met George Selgin almost 30 years ago at NYU where I was a visiting assistant professor in 1981, and he was a graduate student. I used to attend the weekly Austrian colloquium headed by Israel Kirzner, which included Mario Rizzo, Gerry O’Driscoll, and Larry White, and a group of very smart graduate students like George, Roger Koppl, Sandy Ikeda, Allanah Orrison, and others that I am not recalling. Ludwig Lachmann was also visiting NYU for part of the year, and meeting him was a wonderful experience, as he was very encouraging about an early draft of my paper “A Reinterpretation of Classical Monetary Theory,” which I was then struggling to get into publishable form. A few years later, while I was writing my book Free Banking and Monetary Reform, I found out (I can’t remember how, but perhaps through Anna Schwartz who was on George’s doctoral committee) that he was also writing a book on free banking based on his doctoral dissertation. His book, The Theory of Free Banking, came out before mine, and he kindly shared his manuscript with me as I was writing my book. Although we agreed on many things, our conceptions of free banking and our interpretations of monetary history and policy were often not in sync.

Despite these differences, I watched with admiration as George developed into a prolific economist with a long and impressive list of publications and accomplishments to his credit. I also admire his willingness to challenge his own beliefs and to revise his views about economic theory and policy when that seems to be called for, for example, recently observing in a post on the Free Banking blog that he no longer describes himself as an Austrian economist, and admires that Austrian bete noire, Milton Friedman, though he has hardly renounced his Hayekian leanings.

In one of his periodic postings (“A Question to Market Monetarists“) on the Free Banking blog, George recently discussed NGDP targeting, and raised a question to supporters of nominal GDP targeting, a challenging question to be sure, but a question not posed in a polemical spirit, but out of genuine curiosity. George begins by noting that his previous work in arguing for the price level to vary inversely with factor productivity bears a family resemblance to proposals for NGDP targeting, the difference being whether, in a benchmark case with no change in factor productivity and no change in factor supplies, the price level would be constant or would rise at some specified rate, presumably to overcome nominal rigidities. In NGDP targeting with an upward price trend (Scott Sumner’s proposal) or in NGDP targeting with a stationary price trend (George’s proposal), any productivity increase would correspond to price increases below the underlying price trend and productivity declines would correspond to price increases above underlying the price trend.

However, despite that resemblance, George is reluctant to endorse the Market Monetarist proposal for rapid monetary expansion to promote recovery. George gives three reasons for his skepticism about increasing the rate of monetary expansion to promote recovery, but my concern in this post is with his third, which is the most interesting from his point of view and the one that prompts the question that he poses. George suggests that given the 4.5-5.0% rate of growth in NGDP in the US since the economy hit bottom in the second quarter of 2009, it is not clear why, according to the Market Monetarists, the economy should not, by now, have returned to roughly its long-run real growth trend. (I note here a slight quibble with George’s 4.5-5.0% estimate of recent NGDP growth. In my calculations, NGDP has grown at just 4.00% since the second quarter of 2009, and at 3.82% since the second quarter of 2010.)

Here’s how George characterizes the problem.

My third reason stems from pondering the sort of nominal rigidities that would have to be at play to keep an economy in a state of persistent monetary shortage, with consequent unemployment, for several years following a temporary collapse of the level of NGDP, and despite the return of the NGDP growth rate to something like its long-run trend.

Apart from some die-hard New Classical economists, and the odd Rothbardian, everyone appreciates the difficulty of achieving such downward absolute cuts in nominal wage rates as may be called for to restore employment following an absolute decline in NGDP. Most of us (myself included) will also readily agree that, if equilibrium money wage rates have been increasing at an annual rate of, say, 4 percent (as was approximately true of U.S. average earnings around 2006), then an unexpected decline in that growth rate to another still positive rate can also lead to unemployment. But you don’t have to be a die-hard New Classicist or Rothbardian to also suppose that, so long as equilibrium money wage rates are rising, as they presumably are whenever there is a robust rate of NGDP growth, wage demands should eventually “catch down” to reality, with employees reducing their wage demands, and employers offering smaller raises, until full employment is reestablished. The difficulty of achieving a reduction in the rate of wage increases ought, in short, to be considerably less than that of achieving absolute cuts.

U.S. NGDP was restored to its pre-crisis level over two years ago. Since then both its actual and its forecast growth rate have been hovering relatively steadily around 5 percent, or about two percentage points below the pre-crisis rate.The growth rate of U.S. average hourly (money) earnings has, on the other hand, declined persistently and substantially from its boom-era peak of around 4 percent, to a rate of just 1.5 percent.** At some point, surely, these adjustments should have sufficed to eliminate unemployment in so far as such unemployment might be attributed to a mere lack of spending. How can this be?

There have been a number of responses to George. Among them, Scott Sumner, Bill Woolsey and Lars Christensen. George, himself, offered a response to his own question, in terms of this graph plotting the time path of GDP versus the time path of nominal wages before and since the 2007-09 downturn.

Here’s George’s take on the graph:

Here one can clearly see how, while NGDP plummeted, hourly wages kept right on increasing, albeit at an ever declining rate. Allowing for compounding, this difference sufficed to create a gap between wage and NGDP levels far exceeding its pre-bust counterpart, and large enough to have been only slightly reduced by subsequent, reasonably robust NGDP growth, notwithstanding the slowed growth of wages.

The puzzle is, of course, why wages have kept on rising at all, despite high unemployment. Had they stopped increasing altogether at the onset of the NGDP crunch, wages and total spending might have recovered their old relative positions about two years ago. That, presumably, would have been too much to hope for. But if it is unreasonable to expect wage inflation to stop on a dime, is it not equally perplexing that it should lunge ahead like an ocean liner might, despite having its engines put to a full stop?

However, after some further tinkering, George decided that the appropriate scaling of the graph implied that the relationship between the two time paths was that displayed in the graph below.

As a result of that rescaling, George withdrew, or at least qualified, his earlier comment. So, it’s obviously getting complicated. But Marcus Nunes, a terrific blogger and an ingenious graph maker, properly observes that George’s argument should be unaffected by any rescaling of his graph. The important feature of the time path of nominal GDP is that it dipped sharply and then resumed its growth at a somewhat slower rate than before the dip while the time path of nominal wages has continued along its previous trend, with just a gentle flattening of the gradient, but without any dip as occurred in the NGDP time path. The relative position of the two curves on the graph should not matter.

By coincidence George’s first post appeared the day before I published my post about W. H. Hutt on Say’s Law and the Keynesian multiplier in which I argued that money-wage adjustments — even very substantial money-wage adjustments — would not necessarily restore full employment. The notion that money-wage adjustments must restore full employment is a mistaken inference from a model in which trading occurs only at equilibrium prices. But that is not the world that we inhabit. Trading takes place at prices that the parties agree on, whether or not those prices are equilibrium prices. The quantity adjustments envisaged by Keynes and also by Hutt in his brilliant interpretation of Say’s Law, can prevent price-and-wage adjustments, even very large price-and-wage adjustments, from restoring a full-employment equilibrium. Hutt thought otherwise, but made no effective argument to prove his case, relying simply on a presumption that market forces will always put everything right in the end. But he was clearly mistaken on that point, as no less an authority that F. A. Hayek, in his 1937 article, “Economics and Knowledge,” clearly understood. For sufficiently large shocks, there is no guarantee that wage-and-price adjustments on their own will restore full employment.

In a comment on Scott’s blog, I made the following observation.

[T]he point [George] raises about the behavior of wages is one that I have also been wondering about. I mentioned it in passing in a recent post on W. H. Hutt and Say’s Law and the Keynesian multiplier. I suggested the possibility that we have settled into something like a pessimistic expectations equilibrium with anemic growth and widespread unemployment that is only very slowly, if at all, trending downwards. To get out of such a pessimistic expectations equilibrium you would need either a drastic downward revision of expected wages or a drastic increase in inflationary expectations sufficient to cause a self-sustaining expansion in output and employment. Just because the level of wages currently seems about right relative to a full employment equilibrium doesn’t mean that level of wages needed to trigger an expansion would not need to be substantially lower than the current level in the transitional period to an optimistic-expectations equilibrium. This is only speculation on my part, but I think it is potentially consistent with the story about inflationary expectations causing the stock market to rise in the current economic climate.

George later replied on Scott’s blog as follows:

David Glasner suggests “the possibility that we have settled into something like a pessimistic expectations equilibrium with anemic growth and widespread unemployment…To get out of such a pessimistic expectations equilibrium you would need either a drastic downward revision of expected wages or a drastic increase in inflationary expectations.”

The rub, if you ask me, is that of reconciling “pessimistic expectations” with what appears, on the face of things, to be an overly optimistic positioning of expected wages.

I am not sure why George thinks there is a problem of reconciliation. As Hayek showed in his 1937 article, a sufficient condition for disequilibrium is that expectations be divergent. If expectations diverge, then the plans constructed on those plans cannot be mutually consistent, so that some, perhaps all, plans will not be executed, and some, possibly all, economic agents will regret some prior decisions that they took. Especially after a large shock, I see no reason to be surprised that expectations diverge or even that, as a group, workers are slower to change expectations than employers. I may have been somewhat imprecise in referring to a “pessimistic-expectations” equilibrium, because what I am thinking of is an inconsistency between the pessimism of entrepreneurs about future prices and the expectations of workers about wages, not a situation in which all agents are equally pessimistic. If everyone were equally pessimistic, economic activity might be at a low level, but we wouldn’t necessarily observe any disappointed buyers or sellers. But what qualifies as disappointment might not be so easy to interpret. But we likely would observe a reduction in output. So a true “pessimistic-expectations” equilibrium is a bit tricky to think about. But in practice, there seems nothing inherently surprising about workers’ expectations of future wages not adjusting downward as rapidly as employers’ expectations do. It may also be the case that it is the workers with relatively pessimistic expectations who are dropping out of the labor force, while those with more optimistic expectations continue to search for employment.

I don’t say that the slow recovery poses not difficult issues for advocates of monetary stimulus to address. The situation today is not exactly the same as it was in 1932, but I don’t agree that it can be taken as axiomatic that a market economy will recover from a large shock on its own. It certainly may recover, but it may not. And there is no apodictically true demonstration in the whole corpus of economic or praxeological theory that such a recovery must necessarily occur.

Murdoch Tends to Corrupt

Published July 10, 2012 expectations , inflation , monetary policy 26 Comments

Allan Meltzer has had a long and distinguished career as an economist and scholar, making many notable contributions to monetary economics at both the theoretical and empirical levels, also writing valuable and highly regarded contributions to the history of economics and economic history, especially his 1989 book on Keynes and his recent monumental two-volume history of the Federal Reserve System. Meltzer has the added virtue of being a UCLA-trained economist, where as a student he began his long collaboration with his teacher Karl Brunner. So I take no pleasure in writing this post about what can only be described as an embarrassment, namely, the abysmal op-ed article (“What’s Wrong with the Federal Reserve?”) Meltzer wrote in today’s Wall Street Journal about the Fed and current monetary policy.

Meltzer immediately gets off to a bad start, from which he never recovers, with the following opening sentence.

By allowing its monetary policy to be influenced by elected politicians and market speculators, the Federal Reserve is putting its independence at risk.

Now you might have thought that a serious charge about the Fed’s conduct would require some supporting evidence that the Fed’s policy was being influenced by either politicians or speculators. Well, this is what seems to count as evidence for Professor Meltzer.

Consider the response to last week’s employment report for June—a meager 80,000 net new jobs created, and an unemployment rate stuck at 8.2%. Day traders and speculators immediately clamored for additional monetary easing. Even the president of the Federal Reserve Bank of Chicago joined in.

So the people that Professor Meltzer thinks are now controlling Fed policy are a bunch of day traders. This goes way past what even Ron Paul would say about who is controlling the Fed, i.e., international bankers (aka the Rothschilds). No, it’s a conspiracy of the day traders, apparently having co-opted the president of the Chicago Federal Reserve Bank. Talk about lowering the bar. But it gets worse. Let’s read on.

To his credit, Mr. Bernanke did not immediately agree. But he failed utterly to state the obvious: The country’s sluggish growth and stubbornly high unemployment rate was [sic] not caused by, nor could it [sic] be cured by, monetary policy.

OK, Professor Meltzer has discovered that the Fed is being controlled by a conspiracy of day traders working through the president of the Chicago Fed. Except that Bernanke and the FOMC (except for that guy from Chicago) did not go along with the conspirators! What then is the evidence that Fed policy is controlled by the day traders? Apparently, the failure of Bernanke to make an abject admission of the Fed’s impotence.

Now what is Professor Meltzer’s evidence for the Fed’s impotence? Let him speak for himself:

Market interest rates on all maturities of government bonds are the lowest since the founding of the republic.

This is astonishing. Allan Meltzer is widely regarded as a founding fathers (along with Milton Friedman and Karl Brunner) of modern Moneterism, one of whose basic tenets is that nominal interest rates are primarily determined by inflation expectations. Thus, low interest rates, as Milton Friedman always pointed out, are symptomatic of tight monetary policy that keeps inflation, and inflation expectations, low, as they are now. But somehow Professor Meltzer has now concluded, like the Keynesians that Monetarists once disputed, that low interest rates are symptomatic of easy money. Meltzer later invokes Friedman’s authority to support the proposition that monetary policy is an unreliable instrument for stabilizing short-term fluctuations in the economy, causing one to wonder whether his memory lapses are random or selective.

Professor Meltzer’s memory of recent economic history is also dubious. Discussing the Fed’s adoption of QE2 in the fall of 2010, he writes:

Consider also how, in the summer of 2010, the Fed allowed itself to be spooked by cries about a double-dip recession and deflation. It added $600 billion to banks’ reserves by buying up federal Treasurys and mortgage-backed securities. Today, $500 billion of those reserves remain on bank balance sheets, and most of the rest of the dollars are held by foreign central banks. Not much help to the U.S. economy. By early autumn 2010, it had become clear that fears of a double-dip recession and deflation were just short-term hysteria.

Actually, Chairman Bernanke only signaled in late August and early September 2010 that the Fed would engage in renewed quantitative easing, thereby producing an immediate market response. The renewed purchases did not begin until the autumn. What became clear in the autumn was not that recession and deflation fears were just short-term hysteria, but that quantitative easing prevented the slide into recession that had been anticipated by a sharp dive in the stock market in August 2010.

Meltzer asserts that the cause of the weak recovery is uncertainty about future tax rates, health-care costs, and the regulatory burden. One would expect that, as an accomplished empirical economist, Professor Meltzer would attempt to back up his assertion with evidence. But he apparently regards it as too self-evident a proposition to require any empirical support.

Professor Meltzer again displays a shockingly cavalier attitude toward empirical evidence with the following assertion:

Evidence is growing that many think higher inflation is in our future. One sign is the premium that investors pay to hold index-linked Treasury bonds that protect against inflation.

These claims about inflation expectations are not backed up by data of any kind, even though they are readily available. The only problem is that the data don’t support Meltzer’s claims. Breakeven TIPS spreads have edged up slightly in the last couple of weeks as fears of an imminent financial crisis in Europe have eased, but even at the 10-year time horizon the breakeven rate is barely above 2%, which is less than inflation expectations have been for most of the nearly four years since the onset of the financial crisis in 2008. And according to the estimates of inflation expectations by the Cleveland Fed, 10-year inflation expectations in June were at an all-time low, about 1.2%.

Although there is much more to criticize about this piece, it would be churlish to continue further. But I cannot help wonder why Professor Meltzer is so heedless of his reputation that he would allow his name to be attached to a piece of work so far below not just his own formerly high standards, but even below a standard of minimal competence. My only conjecture is that Rupert Murdoch is somehow responsible. Perhaps Murdoch has cast a demonic spell on Professor Meltzer. That seems as good an explanation as any.

Williamson v. Sumner

Published July 6, 2012 expectations , Fisher equation , Friedman , inflation , monetary policy 22 Comments

Stephen Williamson weighed in on nominal GDP targeting in a blog post on Monday. Scott Sumner and Marcus Nunes have already responded, and Williamson has already responded to Scott, so I will just offer a few semi-random comments about Williamson’s post, the responses and counter-response.

Let’s start with Williamson’s first post. He interprets Fed policy, since the Volcker era, as an implementation of the Taylor rule:

The Taylor rule takes as given the operating procedure of the Fed, under which the FOMC determines a target for the overnight federal funds rate, and the job of the New York Fed people who manage the System Open Market Account (SOMA) is to hit that target. The Taylor rule, if the FOMC follows it, simply dictates how the fed funds rate target should be set every six weeks, given new information.

So, from the mid-1980s until 2008, everything seemed to be going swimmingly. Just as the inflation targeters envisioned, inflation was not only low, but we had a Great Moderation in the United States. Ben Bernanke, who had long been a supporter of inflation targeting, became Fed Chair in 2006, and I think it was widely anticipated that he would push for inflation targeting with the US Congress.

Thus, under the Taylor rule, as implemented, ever more systematically, by the FOMC, the federal funds rate (FFR) was set with a view to achieving an implicit inflation target, presumably in the neighborhood of 2%. However, as a result of the Little Depression beginning in 2008, Scott Sumner et al. have proposed targeting NGDP instead of inflation. Williamson has problems with NGDP targeting that I will come back to, but he makes a positive case for inflation targeting in terms of Friedman’s optimal-supply-of-money rule, under which the nominal rate of interest is held at zero via a rate of inflation that is the negative of the real interest rate (i.e., deflation whenever the real rate of interest is positive). Back to Williamson:

The Friedman rule . . . dictates that monetary policy be conducted so that the nominal interest rate is always zero. Of course we know that no central bank does that, and we have good reasons to think that there are other frictions in the economy which imply that we should depart from the Friedman rule. However, the lesson from the Friedman rule argument is that the nominal interest rate reflects a distortion and that, once we take account of other frictions, we should arrive at an optimal policy rule that will imply that the nominal interest rate should be smooth. One of the frictions some macroeconomists like to think about is price stickiness. In New Keynesian models, price stickiness leads to relative price distortions that monetary policy can correct.

If monetary policy is about managing price distortions, what does that have to do with targeting some nominal quantity? Any model I know about, if subjected to a NGDP targeting rule, would yield a suboptimal allocation of resources.

I really don’t understand this. Williamson is apparently defending current Fed practice (i.e., targeting a rate of inflation) by presenting it as a practical implementation of Friedman’s proposal to set the nominal interest rate at zero. But setting the nominal interest rate at zero is analogous to inflation targeting only if the real rate of interest doesn’t change. Friedman’s rule implies that the rate of deflation changes by as much as the real rate of interest changes. Or does Williamson believe that the real rate of interest never changes? Those of us now calling for monetary stimulus believe that we are stuck in a trap of widespread entrepreneurial pessimism, reflected in very low nominal and negative real interest rates. To get out of such a self-reinforcing network of pessimistic expectations, the economy needs a jolt of inflationary shock therapy like the one administered by FDR in 1933 when he devalued the dollar by 40%.

As I said a moment ago, even apart from Friedman’s optimality argument for a zero nominal interest rate, Williamson thinks that NGDP targeting is a bad idea, but the reasons that he offers for thinking it a bad idea strike me as a bit odd. Consider this one. The Fed would never adopt NGDP targeting, because it would be inconsistent with the Fed’s own past practice. I kid you not; that’s just what he said:

It will be a cold day in hell when the Fed adopts NGDP targeting. Just as the Fed likes the Taylor rule, as it confirms the Fed’s belief in the wisdom of its own actions, the Fed will not buy into a policy rule that makes its previous actions look stupid.

So is Williamson saying that the Fed will not adopt any policy that is inconsistent with its actions in, say, the Great Depression? That will surely do a lot to enhance the Fed’s institutional credibility, about which Williamson is so solicitous.

Then Williamson makes another curious argument based on a comparison of Hodrick-Prescott-filtered NGDP and RGDP data from 1947 to 2011. Williamson plotted the two series on the accompanying graph. Observing that while NGDP was less variable than RDGP in the 1970s, the two series tracked each other closely in the Great-Moderation period (1983-2007), Williamson suggests that, inasmuch as the 1970s are now considered to have been a period of bad monetary policy, low variability of NGDP does not seem to matter that much.

Marcus Nunes, I think properly, concludes that Williamson’s graph is wrong, because Williamson ignores the fact that there was a rising trend of NGDP growth during the 1970s, while during the Great Moderation, NGDP growth was stationary. Marcus corrects Williamson’s error with two graphs of his own (which I attach), showing that the shift to NGDP targeting was associated with diminished volatility in RGDP during the Great Moderation.

Furthermore, Scott Sumner questions whether the application of the Hodrick-Prescott filter to the entire 1947-2011 period was appropriate, given the collapse of NGDP after 2008, thereby distorting estimates of the trend.

There may be further issues associated with the appropriateness of the Hodrick-Prescott filter, issues which I am certainly not competent to assess, but I will just quote from Andrew Harvey’s article on filters for Business Cycles and Depressions: An Encyclopedia, to which I referred recently in my post about Anna Schwartz. Here is what Harvey said about the HP filter.

Thus for quarterly data, applying the [Hodrick-Prescott] filter to a random walk is likely to create a spurious cycle with a period of about seven or eight years which could easily be identified as a business cycle . . . Of course, the application of the Hodrick-Prescott filter yields quite sensible results in some cases, but everything depends on the properties of the series in question.

Williamson then wonders, if stabilizing NGDP is such a good idea, why not stabilize raw NGDP rather than seasonally adjusted NGDP, as just about all advocates of NGDP targeting implicitly or explicitly recommend? In a comment on Williamson’s blog, Nick Rowe raised the following point:

The seasonality question is interesting. We could push it further. Should we want the same level of NGDP on weekends as during the week? What about nighttime?

But then I think the same question could be asked for inflation targeting, or price level path targeting, because there is a seasonal pattern to CPI too. And (my guess is) the CPI is higher on weekends. Not sure if the CPI is lower or higher at night.

In a subsequent comment, Nick made the following, quite telling, observation:

Actually, thinking about seasonality is a regular repeated shock reminds me of something Lucas once said about rational expectations equilibria. I don’t remember his precise words, but it was something to the effect that we should be very wary of assuming the economy will hit the RE equilibrium after a shock that is genuinely new, but if the shock is regular and repeated agents will have figured out the RE equilibrium. Seasonality, and day of the week effects, will be presumably like that.

So, I think the point about eliminating seasonal fluctuations has been pretty much laid to rest. But perhaps Williamson will try to resurrect it (see below).

In his reply to Scott, Williamson reiterates his long-held position that the Fed is powerless to affect the economy except by altering the interest rate, now 0.25%, paid to banks on their reserves held at the Fed. Since the Fed could do no more than cut the rate to zero, and a negative interest rate would be deemed an illegal tax, Williamson sees no scope for monetary policy to be effective. Lars Chritensen, however, points out that the Fed could aim at a lower foreign exchange value of the dollar and conduct its monetary policy via unsterilized sales of dollars in the foreign-exchange markets in support of an explicit price level or NGDP target.

Williamson defends his comments about stabilizing seasonal fluctuations as follows:

My point in looking at seasonally adjusted nominal GDP was to point out that fluctuations in nominal GDP can’t be intrinsically bad. I think we all recognize that seasonal variation in NGDP is something that policy need not be doing anything to eliminate. So how do we know that we want to eliminate this variation at business cycle frequencies? In contrast to what Sumner states, it is widely recognized that some of the business cycle variability in RGDP we observe is in fact not suboptimal. Most of what we spend our time discussing (or fighting about) is the nature and quantitative significance of the suboptimalities. Sumner seems to think (like old-fashioned quantity theorists), that there is a sufficient statistic for subomptimality – in this case NGDP. I don’t see it.

So, apparently, Williamson does accept the comment from Nick Rowe (quoted above) on his first post. He now suggests that Scott Sumner and other NGDP targeters are too quick to assume that observed business-cycle fluctuations are non-optimal, because some business-cycle fluctuations may actually be no less optimal than the sort of responses to seasonal fluctuations that are general conceded to be unproblematic. The difference, of course, is that seasonal fluctuations are generally predictable and predicted, which is not the case for business-cycle fluctuations. Why, then, is there any theoretical presumption that unpredictable business-cycle fluctuations that falsify widely held expectations result in optimal responses? The rational for counter-cyclical policy is to minimize incorrect expectations that lead to inefficient search (unemployment) and speculative withholding of resources from their most valuable uses. The first-best policy for doing this, as I explained in the last chapter of my book Free Banking and Monetary Reform, would be to stabilize a comprehensive index of wage rates. Practical considerations may dictate choosing a less esoteric policy target than stabilizing a wage index, say, stablizing the growth path of NGDP.

I think I’ve said more than enough for one post, so I’ll pass on Williamson’s further comments of the Friedman rule and why he chooses to call himself a Monetarist.

PS Yesterday was the first anniversary of this blog. Happy birthday and many happy returns to all my readers.

The Bank for International Settlements Falls into a Hayekian Trap

Published June 27, 2012 Great Depression , Hayek , monetary policy 9 Comments

On April 9, 1975, F. A. Hayek, having recently received the Nobel Prize in economics, was invited to give a talk to a group of distinguished economists at the American Enterprise Institute in Washington DC. He was introduced by his old friend and colleague from Vienna, Gottfried Haberler. During his talk, Hayek pointed out that although a downturn can be triggered by microeconomic factors causing a lack of correspondence between the distribution of demand across products and industries and the distribution of labor across products and industries.

These discrepancies of demand and supply in different industries, discrepancies between the distribution of demand and the allocation of the factors of production, are in the last analysis due ot some distortion in the price system that has directed resources to false uses. It can be corrected only by making sure, first, that prices achieve what, somewhat misleadingly, we call an equilibrium structure, and second, that labor is reallocated according to these new prices.

Lacking such price readjustment and resource reallocation, the original unemployment may then spread by means of the mechanism I have discussed before, the “secondary contraction,” as I used to call it. In this way, unemployment may eventually become general.

In the subsequent discussion, Haberler asked Hayek to elaborate on the concept of a “secondary contraction,” and the appropriate policy response to such a phenomenon. Haberler asked:

I was very glad you said that you find some justification in the view that depressions are aggravated by a cumulative spiral and that there is such a thing as a secondary deflation. Don’t you think that it is possible to do something about that aggravation without recreating the fundamental maladjustments which, in your opinion, caused the depression.

Hayek replied:

I hope I implied this. The moment there is any sign that the total income stream may actually shrink, I should certainly not only try everything in my power to prevent it from dwindling, but I should announce beforehand that I would do so in the event the problem arose.

Later in the discussion, Haberler again pressed Hayek on his position regarding a downward deflationary spiral such as occurred in the 1930s. Hayek responded to Haberler as follows:

You ask whether I have changed my opinion about combatting secondary deflation. I do not have to change my theoretical views. As I explained before, I have always thought that deflation had no economic function; but I did once believe, and no longer do, that it was desirable because it could break the growing rigidity of wage rates. Even at that time I regarded this view as a political consideration; I did not think that deflation improved the adjustment mechanism of the market.

In a terrific commentary on the recent annual report of the Bank for International Settlements, Ryan Avent disposes of the arguments offered by the BIS for tightening current monetary policies.

I was especially struck by the following passage, quoted by Avent, from the report.

Although central banks in many advanced economies may have no choice but to keep monetary policy relatively accommodative for now, they should use every opportunity to raise the pressure for deleveraging, balance sheet repair and structural adjustment by other means.

Here, in another, slightly less ferocious, guise, is the deflationary argument that Hayek himself disavowed nearly 40 years ago: that secondary deflation could be used to “break the growing rigidity of wage rates,” or in updated BIS terminology could “raise the pressure for deleveraging, balance sheet repair and structural adjustment.”

Plus ca change, plus c’est la meme chose.

Anna Schwartz, RIP

Published June 25, 2012 Anna Schwartz , Friedman , monetary history , monetary policy , monetary theory 4 Comments

Last Thursday night, I was in Niagra Falls en route to the History of Economics Society Conference at Brock University in St. Catharines, Ontario to present a paper on the Sraffa-Hayek debate (co-authored with my FTC colleague Paul Zimmerman) when I saw the news that Anna Schwartz had passed away a few hours earlier. The news brought back memories of how I first got to know Anna in 1985, thanks to our mutual friend Harvey Segal, formerly chief economist at Citibank, who had recently joined the Manhattan Institute where I was a Senior Fellow and had just started writing my book Free Banking and Monetary Reform. When Harvey suggested that it would be a good idea for me to meet and get to know Anna, I was not so sure that it was such a good idea, because I knew that I was going to be writing critically about Friedman and Monetarism, and about the explanation for the Great Depression given by Friedman and Schwartz in their Monetary History of the US. Nevertheless, Harvey was insistent, dismissing my misgivings and assuring me that Anna was not only a great scholar, but a wonderful and kind-hearted person, and that she would not take offense at a sincerely held difference of opinion. Taking Harvey’s word, I went to visit Anna at her office at the NBER on the NYU campus at Washington Square, but not without some residual trepidation at what was in store for me. But when I arrived at her office, I was immediately put at ease by her genuine warmth and interest in my work, based on what Harvey had told her about me and what I was doing. About a year later when my first draft was complete and submitted to Cambridge University Press, I was truly gratified when I received the report that Anna had written to the editors at Cambridge about my manuscript, praising the book as an important contribution to monetary economics even while registering her own disagreement with certain positions I had taken that were at odds with what she and Friedman had written.

Over the next couple of years Anna and I actually became even closer when, after finishing Free Banking and Monetary Reform, I accepted an offer to edit a proposed encyclopedia of business cycles and depressions, an assignment that I later bitterly regretted accepting when the enormity of the project that I had undertaken became all too clear to me. After taking the assignment, I think that Anna was probably the first person that I contacted, and she agreed to serve as a consulting editor, and immediately put me in touch with two of her colleagues at the National Bureau, Victor Zarnowitz, and Geoffrey Moore. During my decade-long struggle to plan, execute, and see to conclusion this project, it was in no small part thanks to the generous and unstinting assistance of my three original consulting editors, Anna, Victor Zarnowitz, and Geof Moore. Over time, they were soon joined by other distinguished economists (Tom Cooley, Barry Eichengreen, Harald Hagemann, Phil Klein, Roger Kormendi, David Laidler, Phil Mirowski, Ed Nell, Lionello Punzo and Alesandro Vercelli) whose interest in and enthusiasm for the project kept me going when I wanted nothing more than to rid myself of this troublesome project. But without the help I received at the very start from Anna, and from Victor Zarnowitz and Geof Moore, the project would have never gotten off the ground. Sadly, with Anna gone, none of my original three consulting editors is still with us. Nor is another dear friend, Harvey Segal. I shall miss, but will not forget, them.

In a small tribute to Anna’s memory, I reproduce below (in part) the entry, written by Michael Bordo, on Anna Jacobsen Schwartz (1915 – 2012), from Business Cycles and Depressions: An Encyclopedia.

Anna Schwartz has contributed significantly to our understanding of the role of money in propagating and exacerbating business-cycle disturbances. Schwartz’s collaboration with Milton Friedman in the highly acclaimed money and business-cycle project of the National Bureau of Economic Research (NBER) helped establish the modern quantity theory of money (or Monetarism) as a dominant explanation for macroeconomic instability. Her contributions lie in the four related areas of monetary statistics, monetary history, monetary theory and policy, and international arrangements.

Born in New York City, she received a B. A. from Barnard College in 1934, an M.A. from Columbia in 1936, and a Ph.D. from Columbia in 1964. Most of Schwartz’s career has been spent in active research. After a year at the United States Department of Agriculture in 1936, she spent five years at Columbia University’s Social Science Research Council. She joined the NBER in 1941, where she has remained ever since. In 1981-82, Schwartz served as staff director of the United States Gold Commission and was responsible for writing the Gold Commission Report.

Schwartz’s early research was focused mainly on economic history and statistics. A collaboration with A. D. Gayer and W. W. Rostow from 1936 to 1941 produced a massive and important study of cycles and trends in the British economy during the Industrial Revolution, The Growth and Fluctuation of the British Economy, 1790-1850. The authors adopted NBER techniques to isolate cycles and trends in key time series of economic performance. Historical analysis was then interwoven with descriptive statistics to present an anatomy of the development of the British economy in this important period.

Schwartz collaborated with Milton Friedman on the NBER’s money and business-cycle project over a period of thirty years. This research resulted in three volumes: A Monetary History of the United States, 1867-1960, Monetary Statistics of the United States, and Monetary Trends in the United States and the United Kingdom, 1875-1975. . . .

The overwhelming historical evidence gathered by Schwartz linking economic instability to erratic monetary behavior, in turn a product of discretionary monetary policy, has convinced her of the desirability of stable money brought about through a constant money-growth rule. The evidence of particular interest to the student of cyclical phenomena is the banking panics in the United States between 1873 and 1933, especially from 1930 to 1933. Banking panics were a key ingredient in virtually every severe cyclical downturn and were critical in converting a serious, but not unusual, downturn beginning in 19329 into the “Great Contraction.” According to Schwartz’s research, each of the panics could have been allayed by timely and appropriate lender-of-last-resort intervention by the monetary authorities. Moreover, the likelihood of panics ever occurring would be remote in a stable monetary environment.

Yikes! Inflation Expectations Turned Negative Yesterday

Published June 22, 2012 expectations , inflation , monetary policy 17 Comments

In the wake of the FOMC’s decision Wednesday to ignore reality (and its own forecasts), the stock market dove yesterday. Inflation expectations, as approximated by the breakeven TIPS spread, also dove. And for the first time since March 2009, when the S&P 500 fell below 700, the implied breakeven TIPS spread on a one-year Treasury turned negative. I point this out just to illustrate the gravity of the current situation, not because there is a huge difference between the expectation of slightly positive inflation and slightly negative deflation.

Check out this chart for the one-year breakeven TIPS spread, this one for the 2-year, this one for the 5-year, and this one for the 10-year.

Chairman Bernanke has been reduced to defending the indefensible. Paul Krugman properly castigated the FOMC’s abdication of responsibility this week. Scott Sumner believes that Bernanke’s heart is in the right place, but his hands are tied, and is therefore unable to do what he knows in his heart ought to be done. If Scott is right, then Bernanke has only one honorable course of action: to resign and to explain that he cannot continue to serve as Fed Chairman, presiding over, and complicit in, a policy that he knows is mistaken and leading us to disaster.

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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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