Words beat weapons

Lars has a very interesting post “The Cuban missile crisis never happened (or at least the stock markets didn’t care)“:

According to the history books one of the scariest events during the Cold War was the so-called Cuban missile crisis, where according to the history books the world was on the brink of nuclear Armageddon.

However, the history books might be wrong – at least if you look at what happened to the US stock market during the crisis. If we indeed were on the brink of the third world war we would certainly have expected the US stock market to drop like a stone.

What really happened, however, was that S&P500 didn’t drop – it flat lined during the 13 days in October 1962 the stand-off between the US and the Soviet Union lasted. That to me is pretty remarkable given what could have happened.

The early 1960s were a period of geopolitical turmoil, what with the escalation of the cold war, the “Cuban question”, the first innings in Vietnam, space race and presidential assassination.

The picture illustrates Lars´ conjecture about the stock market. For example, the day before President Kennedy´s assassination the S&P closed at 71.62 points, falling to 69.61 points or 2.8% on the fatal day (a Friday). On Monday the 25th of November 1963 the market remained closed and by the closing of the next day it had climbed to 72.38 points!

The “Missile crisis” played out during 13 days in the second half of October 1962, There´s even a good movie about it “Thirteen Days”. But it had started several weeks earlier when on September 4th President Kennedy issued a public warning against the introduction of offensive weapons into Cuba. The stock market was wobbly in face of the uncertainty, but it certainly did not believe the threats and counter threats would end in nuclear confrontation.

What the stock market really reacted to was President Kennedy´s famous press conference attacking the steel industry. Over a period of 10 weeks the market dropped 24%. Why?

A short answer is that unlike the President´s assassination, Kennedy´s speech signaled the possibility of a major institutional break: Executive interference in firm´s pricing policies!

Thirteen Days

So there you have it: for the stock market Words can be much more powerful than a show of Weapons!

The Easter bunny, once again, will not be visiting the long-term unemployed

Ben Casselman at FiveThirtyEight Economics has an interesting piece on long-term unemployment - The Biggest Predictor of How Long You’ll Be Unemployed Is When You Lose Your Job:

One characteristic distinguishes the long-term unemployed from the rest of America’s jobless. It isn’t how many hours they worked at their old job, or what industry they came from, or even their level of education.

Its bad timing.

A FiveThirtyEight analysis shows that by far the single biggest predictor of whether someone will be out of work for a year or more is the state of the economy when he or she loses his or her job.1 Over the past 15 years, a period spanning two recessions, a one-point increase in the unemployment rate increased an individual’s odds of remaining unemployed for at least a year by about 35 percent. No other characteristic — age, sex, race, marital status, education or occupation, among others — had even close to that big an effect.

Americans who had the misfortune of losing their jobs during the height of the most recent recession in 2009 were more than four times as likely to end up out of work for a year or longer than those who lost their jobs during the comparatively good economy of 2007. Extended unemployment benefits, which are often cited as a driver of the persistently high levels of long-term joblessness, don’t appear to be a major cause of the pattern.

More than 2.5 million Americans have been out of work for a year or more. That’s down from more than 4.5 million in 2010 but nonetheless represents a crisis of long-term unemployment that’s unprecedented in the U.S. since World War II. The plight of the long-term jobless has gotten renewed attention in recent weeks in part due to mounting evidence that they are being left out of the economic recovery.

After a long discussion (with data), they arrive at the following conclusion:

Taken together, these are discouraging findings. A weak economy can cause long-term unemployment, but a stronger economy can’t fix it. That suggests policymakers’ top priority needs to be preventing the kind of long, slow recovery that leads to high levels of long-term unemployment in the first place. A stronger economic rebound in recent years would likely have put many of the recession’s victims back to work before they became long-term unemployed. That lesson won’t do much to help today’s jobless, but it might help prevent a similar crisis in the future.

I´ll concentrate on their conclusion.

I have no beef with “a weak economy can cause long-term unemployment” (it sure can and does), but what exactly is meant by “but a stronger economy can´t fix it”?

That´s Alan Krueger´s view, not theirs. They really believe a stronger economic rebound would have done wonders.

But is it really too late? No matter what people say, write and theorize, we´ll only know for sure if we (rather the policymakers) try.

The charts below may help give a feeling for the loss that´s been imposed on the economy by monetary procrastination.

I compare four different cycles for a period of twenty four quarters following the cycle peak. There´s one cycle in the 1970s (the oil-shock induced recession of 1973/75), one cycle in the 1980s (the Volcker “get-rid-of-inflation” induced recession of 1981/82) and two in the 2000s (the “growth-is-too-high” induced recession of 2001 and the “inflation-obsession” induced recession of 2007/09).

I´m just giving easily understandable “inducements”, but monetary policy errors of different nature was the real culprit, although I´ll not go into that to keep the focus on the plight of the long-term unemployed. In fact, as will become clear, it was only when monetary policy was “eased up” (by which I mean getting nominal spending (NGDP) to grow faster) that long-term unemployment subsided.

You´ll also see the behavior of long-term unemployment gives a good characterization of type of recovery: if it was V-shaped, U-shaped or L-shaped. For reasons that will become clear, the 2007 recession had a long “drop” and an also long “base”, mimicking the shape of an L.

I also show the behavior of inflation during the different cycles. The one in the 1970s is characterized by a jump in core inflation, something that “naturally” happens when there´s a significant negative supply shock (oil and commodity prices in this case). But that´s “natural” only in the case you already are in an inflationary environment and one in which the Fed has no credibility.

There was a significant rise in the price of oil in 2003/05 and again in 2007/08, but no jump, or even significant increase in core inflation. That´s because the Fed had earned credibility. By becoming obsessed with the inflationary effects of oil prices the Bernanke Fed got “trigger-happy”, with the consequence being the long drop in the vertical part of the “L”.

Observe that the recovery from the 1981 recession was strong (“V” shaped) with inflation on a downtrend, a sure sign that the Volcker Fed quickly earned credibility.

The recovery from the 2001 recession is mediocre. The recession itself was “shallow” but the Fed took its time to act. Only in the second half of 2003 did it become more “proactive”, introducing forward guidance (FG). Note how the NGDP trend becomes steeper and how long-term unemployment eases up from that point. Unfortunately the rise in nominal spending was not strong or quick enough to get something like the V-shaped recoveries obtained in the 1970s and 1980s. What is truly amazing is that this happened with the Fed being afraid of inflation getting too low! (Remember Bernanke´s 2002 “Helicopter Ben” speech?).

But that was just the “warm-up” for the real screw-up that would come a few years later and, which never ceases to amaze me, under the leadership of Mr. Ben (“Great Depression”) Bernanke! The QE´s augmented by thresholds and forward guidance cocktails were only effective in stopping the “spread of the cancer”, but there´s been no real remission.

Enough words. Let the pictures tell the story. For ease of comparison all the NGDP-Long-term Unemployment charts have the same scale both on the left side axis (NGDP) and right side axis (LTU-inverted scale). The same for the inflation charts. (Note: the top right hand side NGDP-LTU chart should read 2001-2007 (not 2006)).

Easter Bunny_1

Easter Bunny_2



There is “Scientology” and there´s also “Great Stagnationism”!

(Note: Both comprise a body of beliefs and related practices. For example: Scientology teaches that people are immortal beings who have forgotten their true nature.[9] Its method of spiritual rehabilitation is a type of counselling known as auditing, in which practitioners aim to consciously re-experience painful or traumatic events in their past in order to free themselves of their limiting effects.)

Yellen´s speech today, the first as Chair of the Federal Reserve has been extensively parsed. To minimize the risks of repeating what others have certainly written, what struck me was how, despite the subtext of her speech being how much the Fed is committed to support the recovery, that final goal is still far away:

In sum, the central tendency of FOMC participant projections for the unemployment rate at the end of 2016 is 5.2 to 5.6 percent, and for inflation the central tendency is 1.7 to 2 percent.2 If this forecast was to become reality, the economy would be approaching what my colleagues and I view as maximum employment and price stability for the first time in nearly a decade. I find this baseline outlook quite plausible.

In summary, the policy framework I have described reflects the FOMC’s commitment to systematically respond to unforeseen economic developments in order to promote a return to maximum employment in a context of price stability.

It is very welcome news that a return to these conditions has finally appeared in the medium-term outlook of many forecasters. But it will be much better news when this objective is reached. My colleagues on the FOMC and I will stay focused on doing the Federal Reserve’s part to promote this goal.

Let´s look at some statistics. The average span of expansions between 1945 and 1982 was 31 months. If we take the end of 2016 as coinciding with the end of this expansion, it will have been going on for 90 months or almost three times longer than the average length of expansions in the 1945-82 period!

But note that the average length of expansions during the Great Moderation – 1983 -07 – was 92 months (with a maximum of 120 months in the 1991-01 expansion).

That meshes well with the thought being put forth that we are in a “Great Moderation” 2.0, where growth (both nominal and real) and inflation volatilities are just as low as during the “Great Moderation” 1.0.

If so that also implies that policymakers have “chosen” to keep the economy trapped in what is being called a “Great Stagnation”, a path that is distancing itself quarter by quarter from a more suitable and attainable level path. And given path-dependency, there will come a time when the “Great Stagnation” will become not the “new” but simply the “normal” state of affairs.

I never tire to illustrate this scenario because it´s the best pointer to where we´re going!

Yellens First

By the end of 2016 inflation and unemployment may be hugging their respective “ideals”. But the economy itself will be a whole different animal from what it was in the post-war to 2007, and particularly, despite similar volatilities, very different from what it was during the GM 1.0.

Jürgen Stark looks only at Germany, but does so with ‘rose-tinted’ glasses

Writing in the FT “Doomsayers risk a self-fulfilling prophecy”:

It is likely we are living in an extended period of price stability. This is good news. It boosts real disposable income and will eventually support private consumption. Inflation expectations are well anchored, and there is no evidence households and companies are delaying purchases because of negative expectations. Warnings about outright deflation and calls for ECB action are misguided and irresponsible. The longer this discussion continues, and the more intense it becomes, the more likely the risk of a self-fulfilling prophecy.

He´s looking at and thinking only of Germany! I won´t even bother with the conceptual errors (like the real income boosting property of price stability/low inflation).

Why do I believe he´s “Germany-centered”? The charts tell the story. While Germany has been back on trend for some time, the “others” languish. It is also clear that the ECB is EXCLUSIVELY concerned with inflation, at least when its (even slightly) above trend, but much more cavalier when it´s some ways below! Unemployment has zero weight.

Jurgen Stark_1

Jurgen Stark_2

Jurgen Stark_3

Jurgen Stark_4

All that is pretty well known. Nevertheless, over the past two years (remember Draghi´s “whatever it takes” in July 2012?) the ECB says it´s being highly “accommodative” and is debating further “accommodation” (that´s one reason people like Stark are voicing a contrary opinion). But all that “accommodation” does not seem to be working!

Also, how long will Germany manage to “hold-out”?

Svensson is disgusted with the Riksbank

In his blog he writes “Deflation in Sweden: Questions and answers”:

Sweden has deflation, that is, negative inflation…What has caused the deflation, what are its consequences, could Sweden end up in a similar situation as Japan, and what can be done about the problem?

What has caused the deflation?

The deflation has been caused by the Riksbank´s tight monetary policy since the summer of 2010. The majority of the executive board chose in the summer of 2010 to start increasing the policy rate, which was then at 0.25 percent. The policy rate was increased at steady and fast rate to 2 percent in the summer of 2011. The increases started, in spite of the forecast in the summer of 2010 for inflation the next few years lying below the inflation target and the forecast for unemployment lying far above a long-run sustainable rate.

My summary of the Riksbank´s monetary policy is damning to the policymakers (see the charts)

Up to mid-2010 they were doing the ‘right thing’. In fact, they appeared to follow in the footsteps of Australia and in any case were much more proactive than the Fed, BoE or ECB. These were setting a ‘bad example’ by allowing NGDP to remain comfortably below trend and showing no desire to “try for the gold”. Unfortunately, Sweden decided to follow their example!

Deflation in Sweden_1

Deflation in Sweden_2

Deflation in Sweden_3

Missing the forest for the trees

Gavyn Davies at the FT writes about what´s becoming one of the most noxious views: That a “Great Moderation” is compatible with a “Great Stagnation”:

Before the financial crash in 2008, it was frequently claimed that the developed economies had permanently ended the cyclicality of prior eras. In fact, a name – the “Great Moderation” – was invented to describe the stable period from 1984-2008, when the variability of real GDP growth and inflation both fell markedly. Recessions did occur during these years, but they represented short and fairly shallow punctuations between extended periods of moderate expansion.

That was before the Great Recession of 2008-09, by far the deepest since the 1930s. The financial crash made the term “Great Moderation” seem hubristic, if not absurd, and for a while it was banished from the lexicon. But now it is back [in the guise of “Great Moderation”2.0 (GM2.0)]

This remark is outlandish:

The return to low volatility patterns has fuelled suggestions that the underlying causes of GM 1.0 have now re-asserted themselves, in which case the outlook would be for a further prolonged period of moderate expansion in output, with low inflation…Graph 3 shows that the present expansion would have to run for about 12 more quarters before it would match the median expansion during GM 1.0.

What almost everyone forgets is that the success of the GM 1.0 was grounded on two factors: One, on the Fed having attained nominal stability, and two, on having established the ‘proper’ initial level of nominal spending from which to progress.

As the chart indicates, only the first condition holds at present. There has been no effort to regain a higher trend level. To exonerate monetary policymakers from responsibility we are in an inevitable “Great Stagnation” (A “Great Moderation” within a “depressed” state).

Missing Forest

There was no breakdown in the “Musical Chairs Model”

In his recent post at Econlog – Germany´s mysterious recovery – Scott Sumner muses:

Initially I thought that the sharp fall in the German unemployment rate might have reflected falling German productivity and slow population growth. But that doesn’t explain the NGDP figures. Germany actually created far more jobs than America, despite lower NGDP growth.

The next step is to look at compensation per worker. I couldn’t find hourly compensation data for Germany (outside manufacturing) but if one compares total compensation to total employment it looks like compensation in Germany rose by just over 12% per worker. The US figures appear to be just under 13% per worker. So it does not look like the German employment miracle was caused by low wages.

So what is the explanation then? As far as I can tell, the only plausible explanation (at least in an accounting sense) is a breakdown in my “musical chairs model.” In this model the level of hours worked reflects the interaction of NGDP and (sticky) nominal wages. It is assumed that total labor compensation is a stable fraction of NGDP.

[The “musical chairs model: Think of recessions in terms of the game of musical chairs.  When the music stops several chairs are removed, and a few participants in the game end up sitting on the floor.  Slow NGDP growth combined with sticky wages is like taking away a few chairs; several unemployed workers end up “sitting on the floor” (i.e. unemployed), as there is not enough aggregate nominal income to support full employment at the existing nominal hourly wage level.]

But there was no breakdown in the MCM, so the German recovery is not “mysterious”. As Scott mentions, NGDP growth in the US from 2007.IV to 2013.IV – 16.3% (not 14.2%), or 2.6% per year – was higher than Germany´s 12.8%, or 2.0% per year.  But the point is that over that span of time NGDP in Germany grew very close to its trend growth rate of 2.2% while in the US it grew at less than half the trend growth rate of 5.4%.

Actually, while in the last quarter of 2007 Germany´s NGDP was above trend, in the US it was slightly below trend. In other words, in Germany there´s no ‘gaping hole’ to be filled, while in the US there is! The charts illustrate.

Mysterious German Recovery

Note: You can understand why the ECB (Germany focused) increased rates in April and June 2011. Germany was “back on trend”!

Related: “There´s nothing wrong with market monetarism

Interest rate/inflation targeting swan song

The St Louis Fed Regional Economist has an interesting article: The Ups and Downs of Inflation and the Role of Fed Credibility. Although they likely don´t realize it, it reads like “last rites” to the present system. I´ll skip to the end:

Looking forward

There is a great deal of uncertainty about future monetary policy because the outlook for interest rates, inflation and real economic growth is inconsistent with the Fisher equation. The low interest rate outlook is inconsistent with 2 percent inflation expectations and a normal recovery. A normal recovery will lead to rising real interest rates and should make the nominal interest rate higher than the 2 percent coming from the inflation objective. The uncertainty arises because there are dramatically different ways that the inconsistency can be resolved. Consider three alternative scenarios:

  1. The Fed loses credibility, and we return to 1970s-style inflation. This is the concern of some FOMC members who have dissented on a regular basis. In this scenario, real interest rates continue to be low, but inflation expectations and the 10-year rate begin to rise rapidly. The Fed is forced to raise the fed funds rate as inflation accelerates. This seems an unlikely outcome, at least in the next year or two.
  2. The Fed maintains credibility, and people expect 2 percent inflation to continue indefinitely. The Fed is successful in engineering a recovery with a gradual rise in interest rates. Interest rates rise enough to prevent a loss of credibility, but not so much as to cause another recession. This is the outcome that is considered most likely by private and government economic forecasters.
  3. The Fed decides to keep rates exceptionally low until the economic data clearly demonstrate that the economy is at full employment. The problem with this scenario is that neither the Fed nor private-sector economists are able to predict turning points. The economy is likely to be well beyond ordinary measures of full employment before the data reveal that the threshold has been met. The Fisher equation suggests that keeping nominal rates low while the economy recovers will put downward pressure on inflation. In this scenario, interest rates and inflation stay well below normal for a long time. This outcome is more likely if forward guidance sets a lower threshold on the inflation target.

The reason it is so hard to predict which of these scenarios might play out is that the result depends so much on what people think will happen. Inflation expectations are the key. A surge in inflation expectations leads to the first scenario above. Expectations anchored at 2 percent will support the second scenario. Expectations of falling inflation or even of deflation are likely to lead to the third outcome, which is a concern because it looks so much like the Japanese economy from 1995 to the present.

Solution: Think outside the “monetary policy is interest rate policy/inflation target” box. Think a new target that will coordinate expectations in the right direction, avoiding both scenarios 1&3 and making an outcome like scenario 2 much less convoluted and safer. Think NGDPLT!

If you don´t want to be so ‘daring’, think “Australian-style monetary policymaking“.

Barry Eichengreen jumps on the “higher inflation target bandwagon”

He sets out to discuss reasons for the observed fall in interest rates over the last three and a half decades. His final point turns to Yellen´s argument:

Still others, like the Fed’s current leader, Janet Yellen, suggest that investment and interest rates are depressed as a result of the damage done to the economy and the labor force during the Great Recession. Specifically, the skills and morale of the long-term unemployed have been eroded. Detached from the labor market, they lack incomes to spend; and, stigmatized by long-term unemployment, they are not regarded as attractive employees.

As a result, firms see inadequate demand for their products, and a shortage of qualified workers to staff their assembly lines. The result is low capital spending, one of the striking anomalies of the current recovery, which in turn can explain other troubling aspects of the recovery, from slow growth to low interest rates.

This argument has considerable merit. But, though it can explain why capital spending has been weak and interest rates have been low for the last three years, it cannot account for why capital expenditure has been insufficient to prevent rates from trending down for more than three decades. Here, the only explanation still standing is the shift in the composition of activity away from capital-intensive forms of production, like manufacturing, to less capital-intensive activities, like services.

Finally, central banks should set a higher inflation target, which would give them more room to cut nominal interest rates in response to a future slowdown. This is not something that a new Fed chair, anxious to establish her anti-inflation bona fides, can say out loud. But that is what her arguments imply.

Amazingly, it seems only a few can reason outside the straightjacket of inflation targeting. I would have thought an economic historian would have an alternative in mind.

If the problem is, according to Yellen, “inadequate demand”, and that´s true given what happened to nominal spending in 2008, there are more suitable alternatives than “increase the inflation target”, especially since for the last 30 years many central banks have ‘ferociously’ combated inflation and even seem to have reduced the de facto inflation target level of late. At least that´s one may naturally conclude from the observation that most countries have an inflation which is below the target (see chart from St Louis Fed showing the difference between actual and target inflation).


What Yellen´s argument implies is that aggregate demand has to rise, and the most efficient method to do it is having the Fed change the target to an NGDP-Level target.