Is the ECB acting purposefully?

As in “on purpose”:

The ECB seems to be in the background during this crisis – almost helpless due to Treaty obligations and dogmatic adherence to old monetary theories. This column argues that quite the opposite is true. The ECB is a full-blooded political actor engaging in a strategy aimed at forcing EU political leaders to embrace fiscal rectitude and a quantum leap forward in European integration.

And,” tan tan tan tan”:

  • Knowing that European political leaders cannot curb the ECB’s independence without violating their treaty obligations, Draghi took Eurozone politicians head on.

He scolded them for their lack of progress on reform, demanded action and called for “[s]olid public finances and structural reforms and…. a much more robust economic governance of the union going forward.” Mindful of the ECB’s role in the ouster of Silvio Berlusconi, Draghi’s words have unusual impact.

In short, the ECB is a central bank like no other. In this crisis it is a full-blooded political actor. As the sole institution that can affect financial markets, its influence goes beyond monetary policy and is unchecked by Eurozone politicians. As I explain below, the ECB is speeding toward a confrontation, not with Spain or Italy, but with France.

Reminds me of “The Euro and War”, on the cover of Foreign Affairs November-December 1997

Nominal Consumption Targeting?

Nathan Sheets, head of the Fed´s international division until August is now head of international economics at Citi:

In a new note he proposes a fairly dramatic communications option for the Fed – setting a target for the level of nominal consumption – which is definitely not the kind of thing you’re allowed to say in public when you work at the Federal Reserve Board.

Mr Sheets reckons that nominal consumption has several advantages over nominal GDP as a target:

  • It keeps the focus on consumer prices as the measure of inflation rather than the GDP deflator. That is closer to what consumers actually experience and to what the Fed does now thus reducing the communications challenge.
  • A stable path for consumption, rather than a stable path for GDP, is what consumers want and thus is closer to maximising their welfare.
  • Consumption is less volatile than GDP making it easier to target. Implied but not stated is that this would lead to less volatility in monetary policy.
  • Targeting consumption excludes components of GDP over which the central bank has no influence, notably government spending.
  • It might be easier to rally political support for stimulative policies in a crisis: “If politicians see that consumption is well below a sustainable level—meaning that their constituents are consuming less than they could be—this might help mobilize political support for stimulative monetary policies and perhaps also incentivize supportive fiscal policies.”

Seems to me that, as the idea of NGDPT, level targeting, has recently been all over the news and even mentioned in discussions within the FOMC, that Mr Sheets is just tossing an alternative, apparently similar idea “with several advantages” to get “noted”.

His so-called “advantages” over NGDP targeting are really “disadvantages”:

First problem: “It keeps the focus on consumer prices”. No, it doesn´t. It´s concerned with Nominal consumption. Prices and quantities will be whatever they will be. Additionally, consumer prices are a “bad” index.

Second problem: “A stable path for consumption…is what consumers want…”. OK, granted that consumers don´t like to be “all dressed up” one day and “naked” the next, but the particular stable LEVEL of consumption is the result of “optimizing decisions by the consumer”. So, to target a component of NGDP can get you into trouble. For example, the ratio of consumer expenditure to NGDP has not remained stable (stationary) over time. Note in the picture below that right about the time the “Great Moderation” began, the consumption-NGDP ratio begins to climb. Why? That´s the time that the economy became more stable and decision horizons were extended. In that case, if the Fed is targeting the level path of consumption, he´ll be interfering with private decisions and Reducing welfare (in addition to likely destabilize the economy).

Third problem; Since the start of the “Great Moderation” the volatilities of consumption and NGDP are the same! So the implication of a less volatile monetary policy from targeting consumption is also not true from this perspective.

Fourth problem: Government expenditures are determined through the political process. Imagine that society wants “more government”. If the Fed does not allow private consumption to fall, NGDP will begin to trend up, meaning higher inflation.

Fifth problem: the argument that it “might be easier to rally political support” is laughable!

So, all in all, a bad move.

HT David Levey

Monetary Policy is Discriminated

In a NYT article Robert Shiller laments the fact that fiscal policy will not come to the aid of the unemployed:

THE failure of the Congressional supercommittee to come up with any agreement on the budget deficit makes it even less likely that Congress will rise above its partisan divisions and act on behalf of the millions of out-of-work Americans.

Yet without government intervention, we may well have high unemployment and social discord for years to come. How did this disaster happen?

Probably the most important reasons for the failure to rescue the unemployed are intellectual, rather than purely political. First, there is a lack of scientific proof that government spending — fiscal stimulus — will do much to remedy unemployment. Second, there is a lack of appreciation of the human impact and social consequences of high, long-term joblessness.

Amazing that in a 1000 word essay dealing with the “Great Recession” induced hardship, the words money or monetary policy are not mentioned at all!

But let´s see. Do you think employment would have taken this plunge

If NGDP had not nose-dived

Due to the fact that monetary policy went haywire?

If so, maybe Shiller wouldn´t have had to remind us of Thomas Jefferson´s prediction:

The stakes are very high here, and they are not just economic. As anger rises in today’s economy, I’m reminded of Thomas Jefferson’s words about the danger of “angry passions” arising between the North and South over the question of extending slavery to the Missouri territory. In an 1820 letter, he wrote that “this momentous question, like a fire bell in the night, awakened and filled me with terror.” He went on to predict, from his observations of such rancor, the secession of the South that was to come 40 years later.

“Bashing the Conventional Wisdom”

Versions of this story have been told several times by market monetarists (MM). Given that “the other side” insists in pushing the “conventional wisdom”, I feel free to concoct yet another version of the MM story.

The New York Fed just came out with a study titled: “The Failure to Forecast the Great Recession”. The story told follows the “conventional script”:

The economics profession has been appropriately criticized for its failure to forecast the large fall in U.S. house prices and the subsequent propagation first into an unprecedented financial crisis and then into the Great Recession.

Note that there is no role for monetary policy in this “transmission process”. Actually, it´s worse because “excessively expansionary” monetary policy during 2002-05 is usually alleged to be a root cause of the house “bubble”.

The St Louis Fed has a convenient “Crisis Time-Line” in its site. The start date is February 2007. The events in first few months of the crisis are detailed below:

 February 27, 2007 | Freddie Mac Press Release

The Federal Home Loan Mortgage Corporation (Freddie Mac) announces that it will no longer buy the most risky subprime mortgages and mortgage-related securities.

April 2, 2007 | SEC Filing

New Century Financial Corporation, a leading subprime mortgage lender, files for Chapter 11bankruptcy protection.

June 1, 2007 | Congressional Testimony

Standard and Poor’s and Moody’s Investor Services downgrade over 100 bonds backed by second-lien subprime mortgages.

June 7, 2007

Bear Stearns informs investors that it is suspending redemptions from its High-Grade Structured Credit Strategies Enhanced Leverage Fund.

June 28, 2007 | Federal Reserve Press Release

The Federal Open Market Committee (FOMC) votes to maintain its target for the federal funds rate at 5.25 percent.

July 11, 2007 | Standard and Poor’s Ratings Direct

Standard and Poor’s places 612 securities backed by subprime residential mortgages on a credit watch.

July 24, 2007 | SEC Filing

Countrywide Financial Corporation warns of “difficult conditions.”

July 31, 2007 | U.S. Bankruptcy Filing

Bear Stearns liquidates two hedge funds that invested in various types of mortgage-backed securities.

August 6, 2007 | SEC Filing

American Home Mortgage Investment Corporation files for Chapter 11 bankruptcy protection.

August 7, 2007 | Federal Reserve Press Release

Fomc votes to maintain its target rate for the federal funds rate at 2.5%

August 9, 2007/BNP Paribas Press Release

BNP Paribas, France´s largest bank, halts redemption on three investment funds

That seems right because it´s exactly after February 2007 that the Case-Shiller HPI begins its downslide. Apparently Freddie Mac´s decision to no longer buy risky subprime mortgages was instrumental in “popping the bubble”.

Despite that fact, the next picture indicates that unemployment remained low.

At least until nominal spending began to fall in mid 2008.

And why does nominal spending drop? Here´s where the MM viewpoint comes into play. The next picture shows that when the crisis began, velocity started to fall (money demand to rise). This was offset by an increase in the growth of money supply. As a result, nominal spending (NGDP) continued to rise and unemployment remained contained. When, despite the continued fall in velocity, money supply growth reversed, nominal spending growth turned negative and the recession became “Great”, worsening the ongoing financial crisis (Lehman) from the fall in house prices.

In this sense, the “Great Recession” is a monetary phenomenon. And we shouldn´t forget that the “depressive state” in which the economy remains more than two years after the official end of the recession is also due to the failure of monetary policy to give the needed boost to aggregate demand.

At the end of the note the author writes:

However, the biggest failure was the complacency resulting from the apparent ease of maintaining financial and economic stability during the Great Moderation. Perhaps most important, as noted by some analysts as early as the 1990s, these adverse consequences of the Great Moderation were most likely to arise from the actions, judgments, and decisions of financial market participants.

I gather from that that every once in a while policymakers have to “surprise the markets” lest it becomes “complacent”!

Creditism and the “Great Recession”

Yesterday Lars Christensen put up a post in which he linked to a post by Kurt Shuler who writes:

During the financial crisis of 2008-09, many central banks expanded the monetary base. In some countries, the base remains high; in the United States, for instance it is roughly triple its pre-crisis level. Such an expansion, unprecedented in peacetime, has convinced many observers that a bout of high inflation will occur in the near future. That leads us to the lesson of the day:

To talk intelligently about the money supply, you must also consider the demand for money. Starting from a situation where supply and demand are in balance, the supply can triple, but if demand quadruples, money is tight. Similarly, the supply can fall in half, but if demand is only one-quarter its previous level, money is loose.

Related to that is this from the Cato Handbook for policymakers:

In the choice of monetary rules, the Fed should aim at those that minimize the need for forecasting, such as Carnegie-Mellon economist Bennett McCallum’s nominal final demand rule or the variant of that rule proposed by William Niskanen in this Handbook (Chapter 36). An even simpler rule is to freeze the monetary base and let private firms supply currency in response to market demand, as proposed by Milton Friedman.

And this from Milton Friedman´s The Fed´s Thermostat:

Admittedly, this is an oversimplification. The accumulation of empirical evidence on monetary phenomena, improved understanding of monetary theory, and many other phenomena doubtless played a role. But I believe they were nowhere near as important as the shift in the theoretical paradigm. The MV=Py key to a good thermostat was there all along.

If we write MV=Py as BuV=Py, where B is the monetary base and u the base multiplier, we can “link” the concept of “freezing the base” to the idea of targeting NGDP (Py). In this case the multiplier (u) changes to compensate for changes in velocity (V) in order to keep Py growing along a stable path.

Interestingly, a little over 5 years ago Lawrence White published this post in which he comments a letter written by Friedman to Mankiw:

Regarding the base freeze proposal, Mankiw comments:

I would have thought that the experience of the 1930s argues against such a rule. If I recall correctly, most of the decline in the monetary aggregates during that period was attributable not to high-powered money but to inside money and the money multiplier. If we abolished the Fed and kept high-powered money constant, it seems that a similar set of events could potentially unfold.

Do we need to keep the Fed around because the money multiplier might collapse again? Mankiw is right that the money multiplier declined sharply in the 1930s, but why did it? The proximate cause of the collapse in the 1930s was bank runs and fear of more bank runs. The underlying reason for the bank runs was geographic and note-issue restrictions that make US banks unnecessarily fragile. There were no bank runs and no money-multiplier collapse in Canada in the 1930s, which had neither restriction.

From 1987 to 2007 there was the “Great Moderation”, a state of affairs in which NGDP grew at a stable rate along a level path. Did “freeze the base” play a role?

The picture below is illustrative.

In it we see that after 1986 reserves remained essentially “constant” – note the Y2K and 9/11 “blips”. But the Monetary Base increased significantly, from 252 billion when Greenspan became Chairman to 804 billion when he passed the job over to Bernanke. That´s not consistent with any notion of “freeze”. But note that, since reserves remained relatively constant over the period, all the increase in the monetary base came from the rise in the currency in circulation component. In an age of ATM´s, debit cards and other technological improvements that economize on currency, it is clear that most of that increase in currency went abroad (including going into the “pockets of shady characters”). From those considerations, I believe we can approximate the notion of “freeze the base” with “frozen reserves”.

Since NGDP evolved along a stable path from 1987 to 2007, given that reserves were “frozen”, the multiplier must have changed to compensate changes in velocity (money demand). The following picture shows that for much of the time that´s exactly what happened.

Note, for example, that between early 2003 and early2006 although velocity increases the multiplier doesn´t fall. During those years, therefore, NGDP grows above “trend”. But that´s exactly what was required to bring NGDP back to the level trend from which it had deviated following the 2001 recession. The next picture indicates that starting in 2003, NGDP began the “trip back to trend”, which had been attained by the time Bernanke became Chairman. (NGDP data monthly from Macroeconomic Advisors)

And the following graph indicates what happened after mid 2008. The Fed let the multiplier tank at the same time that velocity was dropping (money demand rising strongly). This was “engineered” by payment of interest on reserves, which “saved” the banks but “destroyed” the real economy (in particular employment), with NGDP taking a “dive”.

Why did this happen? From another viewpoint: Would it have happened under Greenspan? Maybe personalities are important “causal factors”. In the closing paragraphs of chapter 18 – “The Role of Creditism in the Great Recession” – of his new book – Money in a Free Society -, Tim Congdon argues:

To summarize, the monetary (or monetarist) view of banking policy is in sharp contrast to the credit (or Creditist, to recall Bernanke´s term) view. Contrary to the plethora of misguided academic papers, the monetary view contained – and of course still contains – a clear account of how money affects spending and jobs…

The debate about quantitative easing, and the larger debate between creditism and monetarism to which it is related, will rage for years to come. Much will depend on events and personalities, as well as on ideas and journal articles. But there is at least an argument that Bernanke´s creditism was the mistaken theory which, by a remorseless logic of citation, repetition and emulation, spread around the world´s universities, think tanks, finance ministries and central banks and led to the Bedlam of late 2008…

The academic prestige attached to the lending-determines-spending doctrine and other credit-based macroeconomic theories is puzzling. [As noted earlier], Bernanke and Gertler include in their 1995 article the observation that comparison of actual credit magnitudes with macroeconomic variables was not a valid test of their theory. One has to wonder why. They claimed that bank lending was determined within the economy and so was “not a primitive force”…Bernanke and Gertler must have known that the relationship between credit flows and other macroeconomic variables were weak or non-existent, casting doubt on their whole approach.

In the spirit of Thanksgiving…

…a conservative is befuddled. This is from David Frum, ousted from AEI for not “towing the party line”:

can’t shrug off this flight from reality and responsibility as somebody else’s problem. I belonged to this movement; I helped to make the mess. People may very well say: Hey, wait a minute, didn’t you work in the George W. Bush administration that disappointed so many people in so many ways? What qualifies you to dispense advice to anybody else?

Fair question. I am haunted by the Bush experience, although it seems almost presumptuous for someone who played such a minor role to feel so much unease. The people who made the big decisions certainly seem to sleep well enough. Yet there is also the chance for something positive to come out of it all. True, some of my colleagues emerged from those years eager to revenge themselves and escalate political conflict: “They send one of ours to the hospital, we send two of theirs to the morgue.” I came out thinking, I want no more part of this cycle of revenge. For the past half-dozen years, I have been arguing that we conservatives need to follow a different course. And it is this argument that has led so many of my friends to demand, sometimes bemusedly, sometimes angrily, “What the hell happened to you?” I could fire the same question back: “Never mind me—what happened toyou?”

In such a “revenge seeking” environment nothing can really work since any initiative will be torpedoed by one party or the other or, as in the “failure” of the “super committee”, by both!

Which conclusion is more appealing?

Paul Solman at The Business Desk contemplates a “scorched earth”:

So what’s going on? Well, rather obviously, investors are a lot more worried about the credit of Greece – or Spain or Italy – than ours. Investors are also more worried about stock investments. Investors are also more worried about almost any other asset into which they might put their money.

Investors also seem pretty sure that U.S.inflation is not going to be a problem anytime soon. If inflation scared them, they’d hardly let the United States lock in an interest rate of less than 2 percent for an entire decade.

So then why isn’t it plausible to draw the following conclusion: that U.S. interest rates have been going in the “wrong” direction because investors are scared that the U.S. is going to reduce its debt and deficits, and such a reduction might horse-collar the world economy?

But that’s not the only answer, or even the “best” one.

Alternatively: US interest rates have been going in the “wrong” direction because investors are scared that the Fed is not going to try and bring NGDP to a reasonable level, and maintaining NGDP too low, while the ECB is doing the same, will (not might) horse-caller the world economy.

Kocherlakota: An unending source of posts

There´s much I feel is quite wrong in this Kocherlakota speech (although I´m sure Steve Williamson would vehemently “applaud”). But I´ll concentrate on the last part – “Going forward”.

After mentioning the Fed´s success in “meeting its price stability mandate over the past four years and that the Fed´s actions have helped keep unemployment from rising higher” (this last “accomplishment” is a beauty), and that the Fed does have tools remaining bla bla bla.., Kocherlakota says:

However, the FOMC should do more than simply decide at each meeting whether or not to buy more assets or to keep interest rates low for longer. Any current decision is based on the FOMC’s forecast of the future, and no forecast can be perfect. The Committee should provide a public contingency plan—that is, provide clear guidance on how it will respond to a variety of relevant scenarios. For example, the Committee recently projected that in 2011, core inflation will be 1.9 percent and that it will fall back in 2012 and 2013 to around 1.7 percent. Suppose hypothetically that core inflation, and the outlook for core inflation, has risen to 3 percent by the end of 2013, while unemployment has fallen to between 8 percent and 8.5 percent. A public contingency plan would allow the public to know what the Committee intends to do in that eventuality.

Sounds pretty complicated to me. Much simpler to state a specific target, say a NGDP level target, and strive to keep the economy evolving as close to it as possible. If for any reason it drops below or climbs above, everyone knows what the Fed´s action is going to be: put the economy back on the target path.

He then goes on to say:

I believe that public contingency planning will have many benefits. Let me mention two. First, in recent statements and speeches, I have described why the FOMC actions in August and September seemed inconsistent with the evolution of the macroeconomic data in 2011. This kind of inconsistency is much less likely to occur once the FOMC has formulated an explicit public contingency plan. Second, I’ve heard from businesses that policy uncertainty is curbing their incentive to hire or invest. Similarly, I’ve heard from consumers that policy uncertainty is curbing their incentive to spend. A public FOMC contingency plan can help reduce the level of policy uncertainty being created by the Fed.

I can´t figure out how “contingency planning” will reduce “policy uncertainty”. This doubt I expressed becomes clear when he says:

No contingency plan can ever be definitive. Inevitably, the FOMC will learn things that it did not expect to learn. And so there may be conditions that force the FOMC to deviate from a chosen plan. However, having a public plan, and couching its decisions against the backdrop of that plan, will enhance Federal Reserve transparency, credibility, accountability and consistency.

As soon as you say that you are potentially expanding the “uncertainty space”, so it would not be of much help in reducing the “policy uncertainty that´s curbing incentives to spend and hire”. Importantly, FOMC actions in August and September that “seemed inconsistent with the evolution of the macroeconomic data in 2011” to Kocherlakota, may have seemed consistent (or inconsistent in an opposite sense) to other FOMC members. Again, “policy uncertainty wouldn´t be much reduced”.

Much easier, again, to state an explicit TARGET (hopefully not for inflation or unemployment) and pursue it “tenaciously”. And always remember that an NGDPT level target was quite successfully, even if unwittingly, pursued by Greenspan for 20 years. When the Bernanke Fed, full of “inflation hawks” “abandoned” it, the result was “depressive”.

A beautiful addition to the ranks of MM´s

Courtesy of David Levey, this is Diane Swonk on the FOMC minutes:

The group fell short, however, of endorsing a full-scale shift in its targets for both inflation and unemployment, as Chicago Fed President Charlie Evans (who dissented in favor of more stimulus) has proposed. A more likely scenario is that we see the Fed start to shape expectations via a more loose and conditional form of inflation and unemployment targeting. We saw a prelude to this when Chairman Bernanke laid out the Fed’s forecast, which shifted the outlook for unemployment to fall in any meaningful way out to 2014, from 2013.

The Fed also discussed nominal GDP targeting, which I prefer over Evans’s model. It just seems much more intuitive for markets to digest that the Fed is working to recoup losses endured during the recession, rather than raising the actual target on inflation. The Fed is struggling with a liquidity trap; there is a core consensus forming that the Fed must reassure the public and financial markets that it is committed to reflating the economy. The goal is to get consumers and investors to move out of the perceived safety of the Treasury market and make riskier, more productive investments in our future.

It´s good that Charles Evans “proposal” didn´t get traction. Last year he was all about PLT. Now he “votes” for a higher inflation target and lower unemployment, as if there were an “exploitable” Phillips Curve just waiting to be “manipulated”.

If the Fed is “struggling with a liquidity trap” it´s a “self inflicted struggle”. Bernanke knows that´s not an issue and even less a constraint (except in Krugman´s mind).Yes, the Fed “must quickly find a way to reassure the public and financial markets that it is committed”. Once again, for that to be effective it has to clearly state a TARGET. With that the “communications problem” essentially disappears.

Note: Now the ranks of NGDPT “freaks” has been adorned by a beautiful smile! And in addition to the beautiful smile, her credentials are impressive:

They haven´t done their homework properly

This is from the FOMC minutes of their last meeting (my bolds):

More broadly, a number of participants expressed concern that switching to a new policy framework could heighten uncertainty about future monetary policy, risk unmooring longer-term inflation expectations, or fail to address risks to financial stability. Several participants observed that the efficacy of nominal GDP targeting depended crucially on some strong assumptions, including the premise that the Committee could make a credible commitment to maintaining such a strategy over a long time horizon and that policymakers would continue adhering to that strategy even in the face of a significant increase in inflation. In addition, some participants noted that such an approach would involve substantial operational hurdles, including the difficulty of specifying an appropriate target level. In light of the significant challenges associated with the adoption of such frameworks, participants agreed that it would not be advisable to make such a change under present circumstances.

But note:

  1. Nothing heightens uncertainty more at present than the absence of an explicit TARGET
  2. If in the long run inflation is determined by money growth, if you specify a growth path for NGDP, how can you unmoor inflation expectations?
  3. Although financial stability is a separate issue, maintaining a stable path for NGDP avoids worsening any financial “instability” that can come about. In 2008, when NGDP tanked financial problems went up exponentially.
  4. How can the Committee make a credible commitment? Remember than even without an explicit TARGET the Committee was credible for more than 20 years!
  5. As in 2 above, if the path of NGDP is adhered to, how can a significant increase in inflation (not defined as a relative price change, but as a “continued increase in the general level of prices”) take place?

But it´s much easier to “fiddle with communication strategies”, even though without a TARGET they are just “empty words”.

Update: Scott Sumner has a more extensive discussion