Elevator QE

A guest post by Benjamin Cole

If you ever farted loudly on a crowded elevator, then you know the reaction of most economists to the idea that national debts should be monetized through central bank quantitative easing (QE), aka “printing money.”

Until recently, monetizing national debts was the most foul of topics, usually dismissed with words like “debauchery,” “debasement,” or “depravity.” Red-light district street winos had more moral fiber than to print money to pay national debts.

But now conservative University of Chicago economist John Cochrane has flatulence in the lift too. In his blog, The Grumpy Economist, has Cochrane’s suggested that the United States government pay off its entire debt through QE.

The elevator doors have also just admitted Martin Wolf, Financial Times econo-pundit extraordinaire, with his new book The Shifts and The Shocks. In this tome, Wolf says national governments should run permanent fiscal deficits, financed by permanent money printing, or QE.

It’s getting crowded in here!

Surely, this is one of the most remarkable developments in the history of modern economic thought. Who ever thought “serious economists” (pardon the oxymoron) would breezily toss off the idea of regularly monetizing national debts?

And whoever thought that serious economists—and me!—might be right?

The Japan Story

Japan applied a modest QE program 2002-2006, one that won gushy praise from John Taylor, the Stanford scholar, arch-conservative and inventor and defender of the “The Taylor Rule.” In 2006 Taylor wrote, “The key to the [Japanese] recovery has been…the quantitative easing of monetary policy,” in a paper entitled Lessons from the Recovery from the ‘Lost Decade’ in Japan: The Case of the Great Intervention and Money Injection.

Of course, Japan’s QE was just what Milton Friedman told the Bank of Japan to do, in his seminal 1998 essay for the Hoover Institution, Reviving Japan.

The modest 2002-2006 Japan QE program was associated with a relief from that nation’s post-1992 deflation-perma-gloom. Nor did the 2002-2006 BoJ QE result in much inflation.

Given what happened after 2006, it seems a case could be made that Japan should have never stopped QE—that the Cochrane-Wolf idea of permanent QE is worthy. Now, of course, the BoJ is trying QE again, and at least Japanese stock and property markets like it.

The U.S. Story

As readers of this space probably know, in the U. S. blogosphere there is an ongoing war (usually of attrition, rather than elucidation) over whether QE rescued the U.S. economy, or whether QE did nothing, or whether the U.S. economic recovery has been retarded by insufficient federal deficits.

My take is that the Market Monetarists have won this blog-war, and that the U.S. economy has grown because of QE and a normal tendency to recover. Bigger QE would have been better, with a clear statement from the Fed that the boost in the money supply would be permanent. In short, the Fed dithered and lacked resolve—much like the BoJ’s timid 2002-2006 QE program.

The even-worse, headache-inducing European econo-scene is due to the European Central Bank’s incredibly ill-timed concerns about inflation, and lack of expansionist resolve, and lack of aggressive QE.

Looking Forward

So, what if Wolf and Cochrane (and me!) are right?

What if QE is a useful tool to pay off national debts, and stimulate the economy? Then what are we to make of the Federal Reserve, as led by the FOMC and Chief Janet Yellen, moving now to quash QE?

My best guess is that the Fed, FOMC and Yellen are making a huge mistake, with terrible consequences for the economy and the national budget and taxpayers. The risks, my friends, are not in extending QE but in ending QE.

The risk of halting QE is Japanitis, and the island nation has yet to demonstrate it can escape perma-gloom. We can hope the BoJ’s current QE program works—but they now have to overcome decades of recession psychology. Who wants to invest in a perma-recession and deflation?

Blinded By A Phantom?

Yet FOMC members remain resolute in their fixation on inflation.

If FOMC members can’t find inflation with a microscope, then they use a telescope and scan the horizons for the slightest clue. And if inflation-scaremongering is not convincing—you know the Cleveland Fed Index of 10-Year Inflation Expectations is now below 2 percent—then there is always the rear view mirror, and the ever-handy horror stories of Weimar Republic.

But the question Yellen should raise to the FOMC at their next (secret, closed-door) meeting is this: “Are we so sure we will not just have to reverse course, like the BoJ, and go back to QE within a few years? While, in the meantime, millions of citizens pay the price in less employment and profits?”

Who is going to get on the elevator next?

Many still believe the Great Recession was the result of a “modeling error”

In “To exit the Great Recession, central banks must adapt their policies and models”, Marcus Miller and Lei Zhang summarize it thus::

During the Great Moderation, inflation targeting with some form of Taylor rule became the norm at central banks. This column argues that the Global Crisis called for a new approach, and that the divergence in macroeconomic performance since then between the US and the UK on the one hand, and the Eurozone on the other, is partly attributable to monetary policy differences. The ECB’s model of the economy worked well during the Great Moderation, but is ill suited to understanding the Great Recession.

And write:

As Wolfgang Münchau has pointed out,

“The ECB is failing to deliver on its inflation target not because it has run out of instruments but because it has based its policy on a poorly performing economic model. The ECB never expects inflation to deviate from the target of just under 2 per cent. Yet each month inflation undershoots, and the ECB is apparently taken by surprise.” (Münchau 2014).

It so happens that the model referred to, based on Smets and Wouters (2003), was built on the basis of Woodford’s analysis and fitted to pre-crisis European data. It worked well during the Great Moderation; but, as it had no financial sector, it failed completely to predict or rationalise the ensuing crisis.

In such models, the economy is inherently stable and, if left alone, will head for high output and target inflation. Could it be that the ECB, charged with managing the newly created euro, believed that it had found the philosopher’s stone – a technically sophisticated model built in line with the latest academic principles that would serve it in good times and in bad?

If so, it could be making a mistake about the nature of economics. As Gilboa et al. (2014) warn in their recent paper, economic models are not in general designed to incorporate universal laws of behaviour. They are often more like elaborate ‘case studies’ fitted to particular circumstances – to be employed with care elsewhere. Thus, as in Table 1 below, the choice of model and policy should be adjusted as best suits the regime. During the Great Moderation, for example, the ECB-style model with a Taylor rule could be appropriate, as shown in the top left; but this should be suspended during the Great Recession, in favour of QE, followed by forward guidance to exit, as shown in the bottom right.

Maybe there´s a “universal law” and that´s: “spending makes the world go around”. It was not because there was no financial sector in the model that made it “fail completely to predict or rationalize the ensuing crisis”. It was the colossal failure of monetary policy that brought the crisis about, just as it is the monetary timidity that is making the recovery so insipid and stretched.

For the recovery being insipid and stretched one reason may be the specter of inflation. David Glasner has a good discussion of this point, concluding:

Before anti-inflationism became a moral crusade, it was possible for people like Richard Nixon and Ronald Reagan, who were disposed to favor low inflation, to accommodate themselves fairly easily to an annual rate of inflation of 4 percent. Indeed, it was largely because of pressure from Democrats to fight inflation by wage and price controls that Nixon did the unthinkable and imposed wage and price controls on August 15, 1971. Reagan, who had no interest in repeating that colossal blunder, instead fought against Paul Volcker’s desire to bring inflation down below 4 percent for most of his two terms. Of course, one doesn’t know to what extent the current moral and ideological crusade against inflation would survive an accession to power by a Republican administration. It is always easier to proclaim one’s ideological principles when one doesn’t have any responsibility to implement them. But given the ideological current ideological commitment to anti-inflationism, there was never any chance for a pragmatic accommodation that might have used increased inflation as a means of alleviating economic distress.

Let´s see how “spending” has shaped the “world” (in this case the US economy over different “Great” epochs).

I´ll start with the epoch that came to be called “Great Inflation”. What caused it? The chart clearly illustrates that the growing trend in spending (NGDP) was followed by a upward trending inflation (sometimes obscured by price controls, sometimes enhanced by oil (supply) shocks).

Model error_1

The next charts illustrate the “Great Moderation” epoch and the “Great Recession”. Back in the day, I think it was Orphanides who coined the expression “opportunistic disinflation” to describe the fall in spending growth that brought inflation to the desired 2% trend. For the whole period, spending growth is quite stable and on the occasions it falters, real output and inflation “react”. The  “Great Recession” is the direct result of a monetary policy blunder that allowed spending to contract! Everyone suffers. Firms don´t sell so they don´t produce and don´t hire (and dismiss “excess labor”). Debtors’ don´t pay and banks (financial system) go “broke”. The Fed comes in throwing liquidity around to rescue the financial system because (as Bernanke knew from his academic work) they have an enormous capacity to propagate the monetary shock. QE1 marks the spending turnaround but it lacks “conviction”, maybe being constrained by the “moral crusade” discussed by Glasner. So the economy “limps” along. But we know that “limping” has side-effects on the “economic body”!

Model error_2

Now, look at the monetary “punch” applied by FDR during the “Great Depression; and how he intervenes again when monetary policy (spending) goes “off-track” in 1937.

Model error_3

It seems that in “sickness and in health” it is the behavior of spending (determined by monetary policy) that “calls the shots”.  The economy is really inherently stable, not by being left alone but by being guided by the appropriate monetary policy, in particular a policy that keeps spending growing adequately.

Deflation can be “good” or “bad”, it depends on the circumstances. Once again, don´t reason from a price change

David Andolfatto has a recent post where he questions the “evils of deflation”:

Everyone knows that deflation is bad. Bad, bad, bad. Why is it bad? Well, we learned it in school. We learned it from the pundits on the news. The Great Depression. Japan. What, are you crazy? It’s bad. Here, let Ed Castranova explain it to you (Wildcat Currency, pp.160-61):

Deflation means that all prices are falling and the currency is gaining in value. Why is this a disaster? … If you hold paper money and see that it is actually gaining in value, it may occur to you that you can increase your purchasing power–make a profit–by not spending it…But if many people hold on to their money, this can dramatically reduce real economic activity and growth…

In this post, I want to report some data that may lead people to question this common narrative. Note, I am not saying that there is no element of truth in the interpretation (maybe there is, maybe there isn’t). And I do not want to question the likely bad effects that come about owing to a large unexpected deflation (or inflation).  What I want to question is whether a period of prolonged moderate (and presumably expected) deflation is necessarily associated with periods of depressed economic activity. Most people certainly seem to think so. But why?

The first example I want to show you is for the antebellum United States (and shows a version of this chart):

Deflation Evil_1

Following the end of the U.S. civil war, the price-level (GDP deflator) fell steadily for 35 years. In 1900, it was close to 50% of its 1865 value. In the meantime, real per capita GDP grew by 85%. That’s an average annual growth rate of about 1.8% in real per capita income. The average annual rate of deflation was about 2%. I wonder how many people are aware of this “disaster?”

People should know that there are “good” and “bad” deflations. In the picture above we see that the real output-price outcome was the result of a shifting AS curve (positive productivity shock).

The next picture gives an example of “bad” deflation, the result of a contraction in AD. In 1933 the opposite occurs when FDR delinked from gold and monetary policy was expansionary, allowing real output to grow strongly with minor impact on prices (given all the “slack” generated by the GD).

Deflation Evil_2

The Great Inflation is the prototype example of inflation “running wild” due to excessively expansionary monetary policy.

Deflation Evil_3

So, in some cases deflation is really a “disaster”.

And in this day and age of inflation targeting, allowing inflation to fall below target (and letting the price level remain permanently below the “inflation target associated price level”) is tantamount to monetary tightening. More expansionary monetary policy would result in the “counterfactual per capita income”. In this case we don´t have deflation but “inadequate inflation” (in reality, inadequate nominal spending), which can also be (very) bad.

Deflation Evil_4

Freshwater meets Saltwater

The other day John Cochrane showed his “freshwater colors” answering to Krugman:

My worries about inflation do not come from monetary policy. I’ve been as outspoken on the view that monetary policy is ineffective at the zero bound as the most solid Keynesian.  In the WSJ,  “Reserves that pay market interest are not inflationary. Period.” If you bothered to read anything before venting, you’d know that.

Milton Friedman “turned in his grave”!

Now they only have to agree on the FTPL.

Plossers, Fishers and Georges are less prevalent among the “public”

The Federal Reserve Bank of San Francisco has a new study out: “Assessing Expectations of Monetary Policy”:

An ongoing concern has been that the public might misconstrue the Fed’s forward guidance about future monetary policy and underappreciate the extent to which short-term interest rates may vary with future news about the economy. Evidence based on surveys, market expectations, and model estimates show that the public seems to expect a more accommodative policy than Federal Open Market Committee participants. The public also may be less uncertain about these forecasts than policymakers.

My bet is on the “public”!

Wishful thinking cum confirmation bias

According to Market Insider: “Jobs bombshell raises questions of new weakness”:

August’s nonfarm payrolls growth of just 142,000 raises concerns that the economy is healing unevenly, but economists say the stunningly weak jobs report could be just a temporary setback in a stronger trend.

“I don’t believe it. … You can’t predict a weak number, but August tends to be weak consistently, and it tends to get revised up consistently,” said Mark Zandi, chief economist at Moody’s Analytics. “I think the trend is still north of 200,000. Every other data point is pointing to stronger growth, not weaker growth.”

That´s a mixture of wishful thinking and confirmation bias. The fact is that for the past three or four years the economy has been on a mediocre “even keel”. Mediocre in the sense that it hasn´t bothered to recoup almost anything from the losses of 2008-09.



And if “every other data point is pointing to stronger growth” why is the long term bond yield not reflecting expectations of either growth or inflation?


Singing “off-key”

Bill McBride at Calculated Risk keeps singing his preferred tune: “Much of Recent Decline in Labor Force Participation Rate due to “ongoing structural influences“:

For several years, I’ve been arguing that “most of the recent decline in the participation rate” was due to demographics and other long term structural trends (like more education). This is an important issue because if most of the decline had been due to cyclical weakness, then we’d expect a significant increase in participation as the economy improved. If the decline was due to demographics and other long term trends, then the participation rate might keep falling (or flatten out) as the economy improves.

My counterarguments (and Dave Shuler´s comment) from two years ago are still relevant:

  1. Overall Labor force participation peaked at around 67.1% in early 1997 and maintained that level through early 2001. After falling to 66.1% in late 2003, that level was maintained through mid-2008, after which point the “Great Recession” “incredibly accelerated the aging rate of the population”.
  2. Curiously, given CR´s interpretation, employment among those 55 and up has been rising steadily since 1996. The Great Recession only provoked a short lull in the level of employment in that age group. I know that if population is aging the number of people above 55 is increasing. But so is the corresponding employment level, i.e. it is not inducing a fall in the participation rate.
  3. That´s not the case with the prime age work force, those between the ages of 25 and 54. The employment level in that age group dropped like a stone after mi-2008. Many likely are not participating at the moment, but that´s not because they “aged”.
  4. The participation rate among the really aged, those above 65 has surprisingly increased despite the rise in their number (data only after mid-2008 available). Again, this is not consistent with the big drop in the overall participation rate since mid-2008.

Dave´s comment:

Sadly, Bill McBride is increasingly desperate to portray the present economic situation in a favorable light. You failed to highlight the most outrageous part of his post:

“If someone says the “actual” unemployment rate is much higher than reported because of the decline in the participation rate, they are unaware of a key demographic shift.”

Demography per se does nothing whatever to alter the labor force participation rate and there really is no way to reconcile his claims with increasing employment and participation rate among seniors.

Contrary to Mr. MacBride’s preferred narrative the reality is that seniors are working longer than they have in generations while the young incur educational debts that will reduce their other personal consumption expenditures below what has been expected for those of their age in generations.

An updated chart:


Missing the point

That´s, I think, what Simon Wren-Lewis does in “Unconventional Monetary Policy versus fiscal policy”:

One way of stimulating demand when interest rates are stuck at zero is to promise a combination of higher than ideal inflation and higher than ideal output in the future. (This can be done either explicitly or implicitly by using some form of target in the nominal level of something like nominal GDP. For those not familiar with how this works, see here.) The cost of this policy is clear: higher than ideal future inflation and output. Once again, these costs can be worth it because of the severity of the current recession, which is why nominal rates are stuck at zero. Whether these costs are greater or less than the cost of changing government spending is debatable: a paper by Werning that I discussed here suggests optimal policy may involve both.

The concept of ideal real output is elusive, to say the least. And we have no precise idea of how a rise in nominal spending (NGDP) will break down between real growth and inflation.

For 20 years the US economy was moving along a stable level path, with inflation close to target and real output growth close to “potential” (at least close to its long term trend).

That environment of nominal stability began to be lost soon after Bernanke took over as head of the BoG. In mid-2008 it was completely lost!

A NGDP level target is not something to do so as to have any particular break-down between inflation and growth, but to maintain nominal stability. Sometimes, for reasons unrelated to monetary policy (supply shocks), inflation might go up and real growth down. The best monetary policy can do in those situations (helping to avoid financial crises, for example), is to “keep the nominal boat on a steady course”.

The problem is that having veered so far off course for such a long time, we have no precise idea of the new right course to “place the boat on”. We know we are below the “ideal” course, but how far below? But that should not discourage policymakers and make them feel good with “this is the new normal” view that is becoming widespread.

Instead of stating numerical objectives for the rate of unemployment (a real variable) the Fed could set a target for the level of nominal spending and keep adjusting the target depending on how the economy behaves. We´ll know when the “ideal” level has been reached because market variables will tell us. From then on nominal growth will proceed in such a way so as to be consistent with the best view for potential output growth and level of desired inflation. In other words, nominal stability will have been regained.

Missing point

Fiscal policy? That should concentrate on providing the most friendly environment for long term growth.

Why not “change the label”

Tim Harford wastes time in – “Why inflation remains best way to avoid stagnation” . That “wine” has remained “unsold” on the shelves for more than 4 years. He writes:

People who were not born when the financial crisis began are now old enough to read about it. We have been able to distract ourselves with two Olympics, two World Cups and two US presidential elections. Yet no matter how stale our economic troubles feel, they manage to linger.

Given the severity of the crisis and the inadequacy of the policy response, it should be no surprise that recovery has been slow and anaemic: that is what economic history always suggested. Yet some economists are growing disheartened. The talk is of “secular stagnation” – a phrase which could mean two things, neither of them good.

…If secular stagnation is a real risk, we need policies to address it. One approach is to try to change the forces of supply and demand to boost the demand for cash to invest, while stemming the supply of savings, and reducing the bias towards super-safe assets.

There is a simple alternative, albeit one that carries risks. Central bank targets for inflation should be raised to 4 per cent. A credible higher inflation target would provide immediate stimulus (who wants to squirrel away money that is eroding at 4 per cent a year?) and would give central banks more leeway to cut real rates in future. If equilibrium real interest rates are zero, that might not matter when central banks can produce real rates of minus 4 per cent.

If all that makes you feel queasy, it should. As Prof Summers argues, unpleasant things have a tendency to happen when real interest rates are very low. Bubbles inflate, Ponzi schemes prosper and investors are reckless in their scrabble for yield.

One thing that need not worry anyone, though, is the prospect of an inflation target of 4 per cent. It will not happen.

What practical policy options remain? That is easy to see. We must cross our fingers and hope that Prof Summers is mistaken.

So why write about something you know will not happen?

Instead of “crossing your fingers and hope it doesn´t happen”, try a marketing ploy: Keep the wine and change the label. Try, for example, selling a spending level target labelled wine. It´s not “more inflation” people want. They want higher nominal income (spending).

When you hear the expression “sooner rather than later”, more likely than not it was uttered by Charles Plosser!

And this has been his “default” view since before the economy crashed. At a speech today:

… For these reasons, I would prefer that we start to raise rates sooner rather than later. This may allow us to increase rates more gradually as the data improve rather than face the prospect of a more abrupt increase in rates to catch up with market forces, which could be the outcome of a prolonged delay in our willingness to act.

And you could travel back more than six years without “wetting your feet” by stepping on the “sooner rather than later” stones spread across time. In July 2008:

In sum, this year and next will be quite challenging. The economy will grow this year but at a slow pace, and the unemployment rate is likely to get worse before it gets better. At the same time, inflation will be uncomfortably high for a while.

I am more optimistic about the outlook for 2009 and I expect we will see economic growth return to near its longer-term trend. But to prevent recent inflation from continuing(!) to plague the economy and to avoid a rise in inflation expectations, I believe the current very accommodative stance of monetary policy will need to be reversed, and depending on how economic conditions evolve, I anticipate that this reversal will likely need to begin sooner rather than later.

 But let´s concede that someone who´s consistently wrong has its uses!

Plosser strikes