“Uncertainty”

That´s a word we´ve being hearing a lot lately. It´s viewed by many as the major “cause” of all ills. In the last paragraph of his “Accounting for the Great Recession” Lee Ohanian, a good representative of this view writes:

Uncertainty, in fact, may be a primary reason why the recession deepened and persisted into 2009, well after the worst of the financial crisis. High uncertainty raises the value of delaying decisions in many economic models, which can depress economic activity. Recent and ongoing research on the impact of uncertainty on economic activity suggests that it can indeed induce recessions; in one forthcoming theoretical article, for example, uncertainty about the accuracy of government pronouncements regarding macroeconomic strength can lead households to reduce the labor hours they supply.

But that begs the question: What gave rise to the “uncertainty”? The “uncertainty” is seen as emanating from the panoply of “interventions” by the government to “support” the economy. This portion of Greg Ip´s article for the WAPO is a good summary:

Liberals and conservatives in the United States have long differed on how much the government should meddle in individual markets, whether for energy or health care. But they have largely agreed that the government should have at least some role in smoothing out the ups and downs of the business cycle — what economists call “macroeconomic stabilization,” that is, containing inflation in good times and boosting employment in bad.

But this is the consensus that many Republicans in effect now reject. In their view, the government has no more role meddling in the business cycle than in any other market. “Many of our problems can be traced to a misguided belief by politicians that the American economy is something that can be controlled or micromanaged or influenced positively by government intervention and borrowing,” House Speaker John Boehner (R-Ohio) said in a speech in May. He went on to explain that “for job creators, the ‘promise’ of a large new initiative coming out of Washington is more like a threat. It freezes them. … The rash of ‘stimulus’ legislation passed by Congress in recent years has been one of those obstacles.”

Lee Ohanian writes that:

The 2007-09 U.S. recession differed considerably from earlier post-World War II recessions both in the behavior of key variables like output, consumption, investment and labor as well as in the possible factors that might account for fluctuations observed in these variables.

It sure did differ. But an “X-ray” can easily pinpoint where the “cancer” is located. The set of pictures below show the post-World War II growth in aggregate nominal spending, the rate of inflation (Headline CPI to 1957 and Core CPI thereafter) and the rate of unemployment.

I divide the 63 year history portrayed in five “periods”, each having particular “characteristics” which are briefly described in the pictures. The driving force of the whole process is naturally the growth of aggregate spending. It is likely, therefore, that that´s where we are likely to find the “tumor”. And that´s easily done. For the first time in the post-War history, in 2008 the growth of aggregate spending turned negative!

But what “caused” the tumor? It´s no good prescribing treatments (interventions) when the “doctors” cannot agree on a diagnosis (“cause”), since the “side-effects” of inappropriate treatment may well “kill” the patient.

One interesting aspect is that the “tumor” showed up right after the twenty years from 1987 to 2007 that the “economic organism” was the “healthiest” –showing low/declining inflation, declining unemployment and pretty stable nominal and real spending growth – a period that got nicknamed (by Bernanke himself, I think) “Great Moderation”. It appeared that, finally, economists had learned how to do “stabilization policy”. The next picture illustrates.

The irony is that Bernanke took the helm of the Fed after a stint as Fed Governor and head of the CEA, having been the person that many years before had described what the Fed “should do” once Greenspan was gone!

U .S. monetary policy has been remarkably successful during Alan Greenspan’s 121/2 years as Federal Reserve chairman. But although President Clinton yesterday reappointed the 73-year-old Mr. Greenspan to a new term ending in 2004, the chairman will not be around forever. To ensure that monetary policy stays on track after Mr. Greenspan, the Fed should be thinking through its approach to monetary policy now. The Fed needs an approach that consolidates the gains of the Greenspan years and ensures that those successful policies will continue—even if future Fed chairmen are less skillful or less committed to price stability than Mr. Greenspan has been.

 We think the best bet lies in a framework known as inflation targeting, which has been employed with great success in recent years by most of the world’s biggest economies, except for Japan. Inflation targeting is a monetary-policy framework that commits the central bank to a forward-looking pursuit of low inflation—the source of the Fed’s current great performance—but also promotes a more open and accountable policy-making process. More transparency and accountability would help keep the Fed on track, and a more open Fed would be good for financial markets and more consistent with our democratic political system.

Fast forward 10 years.

Bernanke´s October 15, 2010 speech is a “landmark”:

Although the attainment of price stability after a period of higher inflation was a landmark achievement, monetary policymaking in an era of low inflation has not proved to be entirely straightforward. In the 1980s and 1990s, few ever questioned the desired direction for inflation; lower was always better. During those years, the key questions related to tactics: How quickly should inflation be reduced? Should the central bank be proactive or “opportunistic” in reducing inflation? As average inflation levels declined, however, the issues became more complex. The statement of the Federal Open Market Committee (FOMC) following its May 2003 meeting was something of a watershed, in that it noted that, in the Committee’s view, further disinflation would be “unwelcome.” In other words, the risks to price stability had become two-sided: With inflation close to levels consistent with price stability, central banks, for the first time in many decades, had to take seriously the possibility that inflation can be too low as well as too high.

At another point of the speech:

Overall, my assessment is that the bulk of the increase in unemployment since the recession began is attributable to the sharp contraction in economic activity that occurred in the wake of the financial crisis and the continuing shortfall of aggregate demand since then, rather than to structural factors.

From these passages I surmise:

1. Bernanke is a die-hard inflation targeter (and symmetrically so)
2. Bernanke puts great weight on the “credit channel” of monetary policy

To him the “financial crisis” (meaning Lehman) started it all (and would have been much worse if the Fed hadn´t come out with all the “cannons” to “save the day…and the banks”).

On the day he made the speech, Stephanie Flanders of the BBC wrote:

Ben Bernanke declared war today – not on China, but on the possibility of deflation. He knows that a vicious cycle of slow growth, stagnant or falling prices and high unemployment poses a much greater threat to America’s way of life than China’s silly exchange rate.

And less than 20 days later, QE2 began.

But that´s the problem. Bernanke does not see the inconsistency of targeting inflation (avoiding deflation) and stabilizing the economy after a monetary error has been made and the previous stability jeopardized, giving way to the “Bernanke Depression”!

For him it was the “financial crisis”. But I subscribe to the “monetary disorder” that came about in mid 2008 when Bernanke and the Fed obsessed with “headline inflation” kept monetary policy “tight”. Remember that the FF rate was set at 2% at the April 2008 FOMC meeting and stayed at that level until October!

House prices began to fall in 2006 and problems with important financial institutions began taking place in early 2007. The date for the start of the financial crisis was “set” as early August 2007.

The start of the recession was set by the NBER as December 2007. At that moment, unemployment was 4.8%. By the second quarter of 2008 it was still “only” 5.3%, after which it climbed fast to a bit more than 10%.

The panel below provides evidence for the “monetary disorder” view of the recession (and worsening of the financial crisis).

During 2006-07, despite falling house prices and problems with residential construction employment and financial institutions, monetary policy was “stabilizing”, with money supply growth offsetting the decline in velocity (increase in money demand). The result was that nominal spending, which had returned to its trend level in late 2005 (see the Spending & Trend picture above) kept growing at its trend rate of around 5%. In 2008 the Fed, obsessed with rising oil and commodity prices, restrained money growth at the same time that velocity was falling fast! The result, as expected, was a steep drop (the steepest since 1938) in aggregate spending. The fast increase in unemployment and worsening of the financial crisis were the almost inevitable consequences.

By December 2008, interest rates were down to “zero” and all the talk was that monetary policy had run out of ammo. Even Bernanke said that fiscal policy had to come to the rescue to help prop up the real economy. The “divisions” and “distortions” only accentuated, helping give rise to the “tea party” movement and the “debt ceiling great debate”.

All in all a very sad and hurtful ending to the “Great Moderation”. And soon we´ll likely have a new expression in the economic lexicon: “downward-sticky unemployment rate”!

But many will argue it´s “structural”.

The “takeaway”: After more than 10 years of papers, conferences and speeches on the topic of “monetary policy in a low inflation environment”, policy makers should have learned that “inflation targeting can be hazardous to the economy´s health”. In 1933 FDR “adopted” a “price level target”. It was of great help, immediately reversing the downward trend in prices and economic activity. Bernanke could do even better by announcing a “spending level target (NGDP). Unfortunately, the odds are about 40 to 1 against it!

Update: From Jim Hamilton:

I would suggest that the more important and achievable goal for the Fed should be to keep the long-run inflation rate from falling below 2%. The reason I say this is an important goal is that I believe the lesson from the U.S. in the 1930s and Japan in the 1990s is that exceptionally low or negative inflation rates can make economic problems like the ones we’re currently experiencing significantly worse. By announcing QE3, the Fed would be sending a clear signal that it’s not going to tolerate deflation, and I expect that would be the primary mechanism by which it could have an effect. Perhaps we’d see the effort framed as part of a broader strategy of price level targeting.

He suggests “PLT”, but what really should be done is “stop talking about inflation/deflation”.