Uneasy Money

John Taylor has had a long and distinguished career both as an academic economist and as a government official and policy-maker.  He is justly admired for his contributions as an economist and well-liked by his colleagues and peers as a human being.  So it gives me no pleasure to aim criticism in his direction.  But it was pretty disturbing to read Professor Taylor’s op-ed piece (“A Slow-Growth America Can’t Lead the World”) in today’s Wall Street Journal, a piece devoid of even the slightest attempt to make a reasoned argument rather than assemble a hodge podge of superficial bromides about the magic of the market and the importance of fiscal discipline and sound monetary policies.  It is almost surprising that Taylor failed to mention motherhood, apple pie, and American flag while he was at.  Even more disturbing, Taylor proceeds, with no hint of embarrassment, to trash the half-hearted attempts by the Federal Reserve to use monetary policy to promote recovery even though the Fed’s policies are similar to, though much less aggressive than, the “quantitative easing” that he applauded the Japanese government and the Bank of Japan for adopting from 2002 to 2004 to extricate Japan from a decade-long period of deflation and slow growth starting in the early 1990s.

Taylor begins by attacking President Obama’s policies, strongly suggesting that those policies are responsible for the weak economic recovery.

At the most recent [G-20] meeting a year ago in Seoul, the G-20 rejected [President Obama’s] pleas for a deficit-increasing Keynesian stimulus and instead urged credible budget-deficit reduction and a return to sound fiscal policy.  And on that trip he had to defend the activist monetary policy of the Federal Reserve against widespread criticism that its easy money was damaging to emerging-market countries, causing volatile capital flows and inflationary pressures.

With a weak recovery – retarded by new health-care legislation and financial regulations, an exploding debt, and threats of higher taxes – the U.S. is in no position to lead as it has in the past.

Taylor then invidiously compares Obama’s failure in Seoul with the good old days after World War II when America called the shots.

By contrast, in the years after World War II, the U.S. led the world in promoting economic growth through reliance on the market and the incentives it provides, the rule of law, limited government, and more predictable fiscal and monetary policy.

This tendentious characterization of post-war economic policy overlooks the many sectors of the US economy then subject to strict regulation of prices and other aspects of their business operations, the powerful position of labor unions, and top marginal income tax rates as high as 92%, falling to 70% only after the Kennedy tax cuts were enacted in 1964.  High marginal tax rates and powerful labor unions were the norm in all developed countries in the 1950s and 1960s, so economic reality was far from the free-market utopia one might have imagined based on the comic-book picture offered by Taylor.  But that comic-book picture inspires Taylor to draw the following grand geopolitical lesson from the history of the last 65 years. 

As the U.S. has moved away from the principles of economic freedom – instead promoting short-term fiscal and monetary interventionism with more federal government regulations – its leadership has declined.  Some, even in the U.S., may cheer the decline, but it is not good for the world or the U.S.

Warming to his area of special expertise, monetary policy, Taylor continues by expounding on the evils of “monetary interventionism”

In the case of monetary policy . . . decisions on interest rates by foreign central banks are influenced by interest-rate decisions at the Federal Reserve because of the large size of the U.S. economy.  If the Fed holds its interest rate too low for too long, then central banks in other countries will have to hold rates low too, creating inflation risks.  If they resist, capital flows into their countries seeking higher seeking higher yields, thereby jacking up the value of their currencies and the prices of their exports.

But Professor Taylor has not always taken such a negative view of “monetary interventionism.”  In 2006, he wrote a background paper for the International Conference of the Economic and Social Research Institute Cabinet Office of the Government of Japan (September 14, 2006) entitled (I swear) “Lessons from the Recovery from the “Lost Decade” in Japan:  The Case of the Great Intervention and Money Injection.”

Describing his involvement in 2001, while Under-Secretary of the Treasury for International Affairs in the Bush Administration, in the formulation and execution of Japanese monetary policy, Taylor writes:

[I]n March 2001, the Bank of Japan announced that it would follow the new type of monetary policy, which it called “quantitative easing” and under which it would pump up the money supply in Japan until deflation ended.  I was ecstatic when I heard this announcement.  Since 1994 I had been an adviser to the Bank of Japan, a position I had to resign from when I joined the Bush Administration and I had recommended many times that the Bank of Japan focus on increasing the money supply as a means to end their deflation, and many other economists had recommended the same thing.

Now it’s true that inflation in the US as measured by the CPI has been running in the 3-4% range over the past year, but average inflation over the past 3 years has averaged only about 1% and expected inflation over a two-year time horizon has been consistently below 2% for the last year.  So the recent rise in inflation seems to be a transitory phenomenon while GDP growth remains very slow and unemployment very high.  With inflation, after a short blip, again falling and expected to remain very low for years, it is not at all clear that our situation is much different from the situation in Japan in 2001.  Yet Taylor wrote in 2006 that he had been ecstatic when he heard that the Bank of Japan “would pump up the money supply in Japan until deflation ended,” while now protesting his unqualified opposition to a not entirely dissimilar, though certainly less aggressive, policy by the Federal Reserve.

Taylor goes on to describe how the Japanese exited from their “monetary intervention.”

During the fall and winter evidence of a sustainable recovery in Japan mounted, and I thought that the sooner the recovery became clear, the soon Japan could exit from its intervention.  On December 5, 2003, I gave a speech in New York asserting that Japan was on the road to recovery.  It was still a little risky to declare victory that early, but fortunately I was right and the economy had indeed turned the corner.  Michael Phillips of the Wall Street Journal  wrote a piece entitled “U.S. Sees Reason to be Optimistic on Japan Growth” on the morning of my talk saying:  “The Bush Administration believes the Japanese economy may finally have turned the corner after more than a decade of little or no growth.  In a speech to be delivered today, the Treasury Department’s top international official, John Taylor, will credit the Koizumi government’s market changes and the Bank of Japan’s accommodating monetary policy for giving impetus to the country’s laggard economy. . . The upbeat comments from the Undersecretary of the Treasury for International Affairs represent a sharp shift in Washington’s long pessimistic view of Japan’s fortunes.”

In today’s Journal, however, the possibility that “monetary intervention” could give “impetus the [U.S]’s lagging economy” seems never even to have crossed Professor Taylor’s mind.

Some countries . . . are complaining that the Fed is exporting inflation with its near-zero interest rate and massive purchases of long-term government debt. . . And when global inflation picks up, as it has started to do in many emerging markets, it feeds back into more inflation in the U.S. through higher prices of globally traded commodities.  With unemployment already high, the result would be stagflation – slow growth, high inflation, steady unemployment – as we saw in the 1970s.

I guess we are just supposed to forget, along with Professor Taylor, about “accommodating monetary policy giving impetus to the country’s laggard economy.”  Oh my what a difference four or five years make.  Things do change, don’t they?

HT:  Benjamin Cole

Over the weekend I received a comment on my post about Clark Johnson’s new paper from someone who disputed Johnson’s assertion that it is a myth that the Fed has been following an expansionary monetary policy since the 2008 financial crisis. Here is the relevant part of the comment:

The Fed cannot fix the economy by changing “expectations” because they have no tools to follow through. Just saying that they should “change expectations” is not enough. I cannot change expectations of the whole economy, because I have no tools to follow through, the same applies to the Fed.

Even though I disagree with the commenter that the Fed cannot affect expectations, I understand and sympathize with the commenter’s skepticism that Fed could actually do so. As I have written here before, I don’t think that our current theory of fiat money explains very well how the value of a fiat money (i.e., the inverse of a comprehensively defined price level) is determined. Without such a theory, it is hard to specify the exact mechanism or channel by which a central bank can control the price level. Nevertheless, it seems clear that an essential element in that mechanism is control, though perhaps limited and imperfect, over the price-level expectations of economic agents.

Then I read this morning on Scott Sumner’s blog the following quotation from a news item in the New York Times:

WASHINGTON — The Federal Reserve made a rare promise on Tuesday to hold short-term interest rates near zero through at least the middle of 2013, in a sign that it has all but written off the chances of an expansion strong enough to drive up wages and prices. . . .

By its action, the Fed is declaring that it, too, sees little prospect of rapid growth and little risk of inflation. Its hope is that the showman’s gesture will spur investment and risk-taking by convincing markets that the cost of borrowing will not rise for at least two years.

The Fed’s statement, with its mix of grim tidings and welcome aid, contributed to wild market oscillations as investors struggled to make sense of the economy and the path ahead.

The juxtaposition of my commenter’s skepticism about the ability of the Fed to affect expectations with the news item quoted by Scott suggests to me (or, to be more precise, reinforces for me) the following observations about expectations:

1. Expectations are partly autonomous, partly induced by policy rules or by policy announcements made by policy makers;
2. Expectations sometimes affect outcomes;
3. Expectations can therefore be self-fulfilling (referred to by Karl Popper as the Oedipus effect);
4. Expectations are often contagious;
5. Expectations can be cyclical (even exhibiting bubble-like characteristics);
6. Expectations sometimes are, and sometimes are not, consistent with equilibrium
7. There may be multiple equilibria corresponding to various sets of expectations;
8. Keynes’s famous characterization (General Theory, chapter 12) of the stock market as a beauty contest has an important kernel of truth to it and does not presume that traders act irrationally;
9. There is no clear distinction between expectations and fundamentals, because expectations are fundamentals.

If these observations about expectations are right, then conventional rational expectations (DSGE) models, which assume a unique equilibrium determined by fundamentals, are flawed at the most basic level, because they exclude a priori the existence of multiple potential equilibria. If there are many possible equilibria, each corresponding to a particular set of expectations, economic policy can affect outcomes by altering expectations, leading to the realization of a different equilibrium from the one that would have been realized under the old set of expectations. What real business cycle theorists identify as productivity shocks could just as easily be regarded as expectational shocks, possibly induced by policy choices. Put another way, by affecting expectations, monetary policy can affect not only the expected rate of inflation, it can affect the real rate of interest, so that the standard interpretation of the Fisher equation, in which expected inflation is added to an unvarying real rate of interest, is valid only on the assumption that there is a unique real equilibrium independent of the expected rate of inflation. But if there are multiple possible equilibria, whose realizations depend on what rate of inflation is expected, the observed nominal rate is not simply the sum of expected inflation and a uniform real rate, because the real rate is not uniform with respect to the expected rate of inflation.

This is what Keynes meant when (General Theory, p. 219) he rejected the concept of a unique natural rate (which in his terminology corresponded to the Fisherian real rate), because there is a different real rate corresponding to each level of employment. In fact, it is even more complicated than that because in Keynesian terminology, the real marginal efficiency of capital may shift as the expected rate of inflation changes. But we can save that complication for another time.

The S&P 500 rose 3.4% today, closing at 1284.59, the highest close since August 1. And not coincidentally, the breakeven TIPS spread – a slightly upward biased estimate of inflation expectations — on a constant maturity 10-year Treasury rose 9 basis points to 2.18%, the highest the TIPS spread has been since mid-August.

At the end of September, after a miserable third quarter, in which both stock prices and inflation expectations dropped sharply, there was a great deal of hand-wringing (some of it my own, see here, here and here) about the prospects for stock prices and the possibility of another bear market.  The economy had performed badly since the start of 2011, and the FOMC in its September meeting had held out little hope for further easing of monetary policy, the attempt to flatten the yield curve by lengthening the maturity of Fed holding being widely regarded as meaningless and ineffectual.  In addition, the determined resistance of three regional Fed bank presidents, Plosser, Fisher and Kocherlakota, to any further easing of monetary policy combined with the overt hostility of prominent Republican politicians to monetary easing seemed to have tied the hands of Chairman Bernanke.

However, sometimes it really is darkest just before the dawn.  The widespread expressions of despair about the future of the economy in the absence of any new measures taken by the Fed coupled with strong statements by Fed vice-chairman Janet Yellen, and by Presidents Charles Evans of the Chicago Fed and William Dudley of the New York Fed seemed to provide markets with renewed hope that the possibility  of further easing had still not yet been definitively taken off the table.

Hopes for monetary easing received a further boost on October 14, when Goldman Sachs released a staff report supporting a shift in Fed policy toward targeting nominal GDP as advocated by Scott Sumner and other Market Monetarists.  Thanks to revived hopes for monetary easing, the TIPS spread on the constant maturity 10-year Treasury has risen by 43 basis point since the end of September.

The chart below plots the daily change (measured in basis points) in the TIPS spread on the constant maturity 10-year Treasury and the percentage change in the S&P 500. Here is yet further evidence that the strongly positive correlation between inflation expectations and stock prices since early 2008 identified in my January 2011 paper (and discussed in earlier blog posts here and here) continues to hold.

A recent blog post by Daniel Nielson questions whether central banks can accomplish anything by targeting NGDP, because they have no credible means of achieving their objectives, but market measures of inflation expectations obviously are responding even to scraps of new information about changes in monetary policy.

I was thumbing through my copy of Hayek’s wonderful collection of essays, Studies in Philosophy, Politics, and Economics, and perused his (heavily underlined) essay, “Full, Employment, Planning, and Inflation,” originally published in the Institute of Public Affairs Review, Melbourne, vol. IV, 1950. The essay is an argument against the adoption of Keynesian (including monetary) policies to maintain full employment, warning that increasing aggregate demand to achieve the maximum attainable level of employment would lead not only to chronic inflation, but also to a mismatch between the distribution of demand and the distribution of labor. The inevitable mismatch between the demand for and supply of labor would cause unemployment to rise despite inflation, inviting the imposition of direct controls and the piecemeal implementation of central planning.

I will make two observations in passing. First, it is obvious from the discussion that although Hayek believed that there was a connection between expansionary monetary policy aimed at maintaining full employment (actually he meant “over-full” employment), he viewed the connection as indirect, clearly not identifying the conduct of monetary policy with central planning as such. Second, Hayek, already in 1950, had anticipated the essence of the argument for a vertical long-run Phillips Curve.

The main point of this post, however, is to focus on a few other gems about monetary policy from Hayek’s essay. Here is one:

Full employment has come to mean that maximum of employment that can be brought about in the short run by monetary pressure. This may not be the original meaning of the theoretical concept, but it was inevitable that it should have come to mean this in practice. Once it was admitted that the momentary state of employment should form the main guide to monetary policy, it was inevitable that any degree of unemployment which might be removed by monetary pressure should be regarded as sufficient justification for applying such pressure. That in most situations employment can be temporarily increased by monetary expansion has long been known. If this possibility has not always been used, this was because it was thought that by such measures not only other dangers were created, but that long-term stability of employment itself might be endangered by them. What is new about present beliefs is that it is now widely held that so long as monetary expansion creates additional employment, it is innocuous or at least will cause more benefit than harm.

Hayek here seems to be intimating a fairly hard-line stance against the use of monetary policy to increase employment. But two paragraphs later he adds an important qualification.

That so long as a state of general unemployment prevails, in the sense that unused resources of all kinds exist, monetary expansion can only be beneficial [my emphasis], few people will deny. But such a state of general unemployment is something rather exceptional, and it is by no means evident that a policy which will be beneficial in such a state will also always and necessarily be so in the kind of intermediate position in which an economic system finds itself most of the time, when significant unemployment is confined to certain industries, occupations or localities.

So Hayek here acknowledges that monetary policy can be effective in times of widespread unemployment of all kinds throughout the economy, i.e., (to use a more conventional idiom than Hayek used) when aggregate demand is deficient. Some people may regard our current levels of unemployment as not “unexceptional,” but nearly three years of 9-10% unemployment will hardly qualify as an “intermediate position” in the minds of most people. Hayek continues:

Of a system in a state of general unemployment it is roughly true that employment will fluctuate in proportion with money income, and that if we succeed in increasing money income we shall also in the same proportion increase employment. But it is just not true that all unemployment is in this manner due to an insufficiency of aggregate demand and can be lastingly cured by increased demand. The causal connection between income and employment is not a simple one-way connection so that by raising income by a certain ratio we can always raise employment by the same ratio.

Sixty years ago Hayek was arguing against an extreme version of Keynesian doctrine that viewed increasing aggregate demand as a panacea for all economic ills. Hayek did not win the battle himself, but his position did eventually win out, if not completely at least in large measure. Today, however, an equally extreme version of Hayek’s position seems to have become ascendant. It denies that increasing aggregate demand can, under any circumstances, increase employment. I don’t know what Hayek would think about all this if he were alive today, but I suspect that he would be appalled.

A staple argument of right-wing opponents of monetary expansion to increase prices and nominal income is that, given high unemployment, inflation will not increase nominal wages, so that increasing prices must reduce real wages. This response is classic faux populism at its worst, as practiced with consummate hypocrisy by the Wall Street Journal editorial page.

What makes this argument so disreputable is not just the obviously insincere pretense of concern for the welfare of the working class, but the dishonest implication that employment in a recession or depression can be increased without an, at least temporary, reduction in real wages. Rising unemployment during a contraction implies that real wages are, in some sense, too high, so that a falling real wage tends to be a characteristic of any recovery, at least in its early stages. The only question is whether the falling real wage is brought about through prices rising faster than wages or by wages falling faster than prices. If the Wall Street Journal and other opponents of rising prices don’t want prices to erode real wages, they are ipso facto in favor of falling money wages.

Here is how Ludwig von Mises, with his unique gift for understatement, put it in his magnum opus, Human Action (3^rd ed., p. 789), explaining the connection between real wages and unemployment in the Great Depression.

In the boom period that ended in 1929 labor unions succeeded in almost all countries in enforcing wage rates higher than those which the market, if manipulated only by migration barriers, would have determined. These wage rates already produced in many countries institutional unemployment of a considerable amount while credit expansion was still going on at an accelerated pace. When finally the inescapable depression came and commodity prices began to drop, the labor unions, firmly supported by the governments, even by those disparaged as anti-labor, clung stubbornly to their high-wages policy. They either flatly denied permission for any cut in nominal wage rates or conceded only insufficient cuts. The result was a tremendous increase in institutional unemployment. (On the other hand, those workers who retained their jobs improved their standard of living as their hourly real wages went up.) The burden of unemployment doles became unbearable. The millions of unemployed were a serious menace to domestic peace. The industrial countries were haunted by the specter of revolution. But the union leaders were intractable, and no statesman had the courage to challenge them openly.

In this plight the frightened rulers bethought themselves of a makeshift long since recommended by inflationist doctrinaires. As unions objected to an adjustment of wages to the state of the money relation and commodity prices to the height of wage rates. As they saw it, it was not wage rates that were too high; their own nation’s monetary unit was overvalued in terms of gold and foreign exchange and had to be readjusted. Devaluation was the panacea.

Mises actually describes the situation fairly accurately, if allowance is made for his political extremism and insane anti-inflationism, as if devaluation, in the face of 5 to 10% annual deflation from 1930 to 1933, were the problem not the solution. So if the Wall Street Journal and other opponents of monetary expansion to raise prices and nominal GDP don’t want rising prices to erode real wages, they need to explain how employment is supposed to expand after a depression without a fall in real wages. If they can’t do that, then, by the laws of arithmetic, they, like their hero Ludwig von Mises, must be in favor cutting nominal wages.

Clark Johnson wrote a really excellent book, Gold, France and the Great Depression, 1919-1932 on the international monetary disorders that produced the Great Depression, published by Yale University Press in 1997. The work stems from his doctoral dissertation at Columbia Yale University. Although Johnson wrote his dissertation in the history department (at Yale), Robert Mundell (from the economics department at Columbia) was involved in supervising the dissertation, and the final product is obviously the work of a gifted and insightful historian/economist. Additionally, Johnson gives ample recognition to the sadly neglected contributions of Gustav Cassel and R. G. Hawtrey, who more than anyone else at the time and almost anyone else since, diagnosed and understood the monetary pathology that produced the Great Depression.

In a newly published paper (in the Miliken Institute Review), Johnson compares the monetary disorders producing the current Little Depression to the monetary disorders that produced the Great Depression some 80 years ago. He organizes his paper around six widespread myths about monetary policy, explaining how reality is almost exactly the opposite of the myths now paralyzing the implementation of effective monetary policy.

Myth #1: The Federal Reserve has followed a highly expansionary monetary policy since August 2008.

Myth #2: Recovery from recessions triggered by financial crises is necessarily slow.

Myth #3: Monetary policy becomes ineffective when short-term interest rates fall to close to zero.

Myth #4: The greater the indebtedness incurred during growth years, the larger the subsequent need for debt reduction and the greater the downturn.

Myth #5: When monetary policy breaks down, there is a plausible case for a fiscal response.

Myth #6: The rising prices of food and other commodities are evidence of expansionary monetary policy and inflationary pressure.

One of Johnson’s most important points is to challenge the notion that the near-term objective of monetary ease ought to be to reduce interest rates. The objective of monetary policy in current circumstances must be to raise prices and to increase inflation expectations. Doing so will increase estimates of profitability and encourage investment, causing interest rates to rise not fall. Focusing on reducing interest rates simply feeds into the pessimistic expectations that are holding down spending (both investment and consumption) inasmuch as expectations of low interest rates into the future can be validated only by low levels of economic activity or falling prices, both of which are deterrents to current spending and inducements to holding cash. Whether Johnson is right in endorsing Ronald McKinnon’s suggestion that the leading central banks cooperate to increase short-term interest rates immediately is not so clear, but he is almost certainly right to argue that the FOMC’s promise to keep interest rates low for an extended period of time was, whatever its intent, deflationary in effect. I would also quibble with his suggestion that rising commodities prices are entirely independent of monetary policy, even though he is correct to observe that rapid economic growth by China and other developing countries is an independent, and perhaps more important, factor in fueling increases in commodities prices. (And let’s not forget ethanol subsidies and mandates, either.)

At any rate, kudos to Clark Johnson for this timely contribution. Let’s hope that Johnson will provide further valuable insights on economic and monetary policy.

Update 10/28:  I made a few changes in the first paragraph in response to Clark Johnson’s comment.

See Scott Sumner’s post today about this piece about nominal GDP targeting by Kelly Evans.  Scott writes:

What’s happened to the Wall Street Journal?  They seem to be increasingly veering toward the Rick Perry school of monetary analysis.

And then:

I can’t imagine any reputable economist disagreeing with me on any of these three points, even if he or she hated NGDP targeting.  The WSJ is simply flat out wrong.

And again:

Don’t you love it how the WSJ switches over to Keynesian economics, just after they’ve trashed the idea that the economy needs demand stimulus.  Is there any model there?

But you really need to read Scott’s entire post to get the full flavor of his skewering of the Journal‘s “analysis.”

The only surprise here is that Scott actually seems to be surprised.  What an innocent!