“Misery Indices”

Via Stephen Gandel of The Curious Capitalist, I learn that Kathleen Madigan has thought up a new “Misery Index”, according to which, compared to now, the 1970´s was “bliss”!

So how does the economy measure up to the 1970s based on the misery index. Actually pretty well. The misery index hit 19.3 at the end of 1974, the year I was born. In 1980, the index averaged 21. Compare that to now and the economy looks positively rosy. Today the misery index would stand at 11. Good times, right. Maybe not.

But while the misery index may have been a good gauge of economic health in the 1970s. It isn’t the best measure of economic health at all times and misses the point today. One example, deflation is one of the worse things that can happen to the economy. Wages and income and asset values tumble, while debts stay the same. Bankruptcies galore. Yet, by the misery index, deflation would be a good thing, bringing the index down. And too little inflation, and the fear of deflation, has been one of the things that Bernanke has worried about.

That’s why Kathleen Madigan, over at the Wall Street Journal, has devised a new misery index that may do a better job of actually comparing today’s economic times to back then. While inflation is low, many think it will soon rise, and that along housing prices and the lack of jobs could be what is holding back the economy. So Madigan’s new misery index looks at the one year change in the jobless rate, gas prices and home prices. Based on those calculations, Madigan’s new misery index scores in at 20, up from 8.3 a year ago. She also finds that Phoenix is not the most miserable place, economy-wise, in the nation to live.

So how does our current economic times measure up to the 1970s? The earliest I could find for gas price data was 1979. At the end of that year, the new misery index would actually stand at -8. So a rating of positively groovy. That’s mostly due to the fact that housing prices rose 12 that year. The reading for 1980 would be 13.2%. So now were are talking some economic pain. But still that’s significantly less than Madigan’s misery index reads now. So I guess it’s time for me to recalibrate what I think the worst of economic times are. And I thought it was just the music that was better back then.

“High Misery” is news. So we can always devise indices to show higher present “misery”!

This reminded me of a panel showing rates and volatility I had recently made to illustrate a class I was giving. The first shows the “Inflation Saga” by periods from 1960 to 2010. The second shows the “Route to Nominal Spending Stability” by tenure of Fed Chairmen – from Burns to Bernanke (skipping W. G Miller who didn´t have time to “warm his seat”).

The whole thing is self explanatory, so I worry about feelings such as these described by David  Leonhardt, especially given the fact that NGDP growth is “travelling in the wrong direction” after falling into a “deep hole”:

One group of Fed officials and watchers worries constantly about the prospect of rising inflation, no matter what the economy is doing. Some of them are haunted by the inflation of the 1970s and worry it may return at any time. 

“This crazy world”

After reading this:

 It’s clear which way the Fed has erred recently. It has done too little. It stopped trying to bring down long-term interest rates early last year under the wishful assumption that a recovery had taken hold, only to be forced to reverse course by the end of year.

Given this recent history, you might think Fed officials would now be doing everything possible to ensure a solid recovery. But they’re not. Once again, many of them are worried that the Fed is doing too much. And once again, the odds are rising that it’s doing too little.

and this:

One of the reasons the Fed is concerned with inflation is its potential to reduce long-run growth. However, it’s not clear that moderate levels of inflation have this problem. Furthermore, the risks to growth are not one-sided. When unemployment is persistently high because of too much concern about inflation, this can also reduce long-run growth. The longer a person is unemployed, the more likely he or she will become permanently unemployable, or drop out of the labor force altogether. For younger workers there is evidence that a high unemployment rate at the time they accept their first job translates, on average, into lower lifetime income. The first permanent job – and the opportunities that may or may not come with it – is a very important determinant of lifetime earnings

this old tune by Paul Anka well captures the spirit of the moment!

“See saw”

It´s all “up for grabs”. Who´ll win? The “hardcore” or the “softcore”. When you reason from rates of change (be it prices or real growth) forgetting the depth of the hole you fell into, you´re bound to get it wrong. And that´s the major problem with IT: It has no “memory”.

There are “outsiders” (not voting) like Bullard (St Louis), Lockhart (Atlanta) and Lacker (Richmond) who would feel better if QE2 had an “early termination”. The  “insiders” (voting) who feel the same include Plosser (Philadelphia) and Fisher (Dallas). Kocherlakota (Minneapolis) used to be dead set against but he just made a presentation in Marseille arguing:

“The bubble collapse has no impact on unemployment or output, given sufficiently accommodative monetary policy,” the bank president said, referring to an economic model in the text prepared for a speech today in Marseille.

But maybe he´s just talking about what should have been done. But since you didn´t do it, now “it´s too late” because inflation will “take off”.

“White knight” insiders include only New York´s Dudley (a permanent member and Vice Chairman) and Chicago´s Evans. Outsider Rosengren (Boston) is in this group.

Some of the “testimonies”:

1. Bullard:

March 28 (Bloomberg) — St. Louis Federal Reserve Bank President James Bullard said policy makers should review whether to curtail a plan to buy $600 billion in Treasury securities, noting that the U.S. recovery may not need that much stimulus.

“The economy is looking pretty good,” Bullard said to reporters in Marseille, France, on March 26. “It is still reasonable to review QE2 in the coming meetings, especially this April meeting, and see if we want to decide to finish the program or to stop a little bit short,” he said, referring to the second round of so-called quantitative easing.

2. Evans:

March 28 (Bloomberg) — Federal Reserve Bank of Chicago President Charles Evans said recent reports indicating a more sustainable economic expansion won’t alter the central bank’s plan to purchase $600 billion in U.S. Treasuries through June.

“Despite recent improvements to the outlook, we are not yet at that point” when “a change in the stance of monetary policy will be necessary,” Evans said today in the text of a speech in Columbia, South Carolina. “Slow progress” in lowering unemployment “and underlying inflation trends that are too low lead me to conclude that substantial policy accommodation continues to be appropriate.”

3. Rosengren

March 28 (Bloomberg) — Federal Reserve Bank of Boston President Eric Rosengren said that recent economic growth will not do much to lower the unemployment rate.

“While GDP, the growth in the economy, has been positive, it hasn’t been positive enough to make much of a dent on the unemployment rate,” Rosengren said today in a panel discussion hosted by the Boston Globe.

Note: The outsiders participate in the FOMC discussions and have an influence on decisions.

Good to hear…

that there are sane people still around. This is an interview with Adam Posen external BoE external MPC member:

The Bank of England‘s leading dove has predicted that inflation will tumble to 1.5% by the middle of next year as George Osborne‘s austerity drive and the underlying weakness of the economy stifle consumer spending.

In an interview with the Guardian, Adam Posen admitted he had sleepless nights over his call for more money to be pumped into the economy and said he would not seek re-election to Threadneedle Street’s monetary policy committee if his view turned out to be wrong.

Posen said: “If I have made the wrong call, not only will I switch my vote, I would not pursue a second term. They should have somebody who gets it right and not me. I am accountable for my performance. I’m holding my nerve because it is the right thing to do.”

Note: See this post on UK inflation

But “insane” people still travel in lofty circles. This is Charles Plosser:

Federal Reserve Bank of Philadelphia President Charles Plosser warned Friday of the risks of keeping monetary policy too easy in the face of an energy price shock.

“What creates inflation is monetary policy at the end of the day,” Plosser said.

Bloomberg News
Philadelphia Fed President Charles Plosser

Citing the jump in energy prices, Plosser said “the reason oil prices worry me is that there will be more pressure to keep monetary policy easier for longer” as some fear these price gains will hold back growth by reducing households’ spending power.

“That response is a response that will in my view” create inflation, and “we need to lean against that,” the policy maker said.

When economists lose their bearing…

It was when the gong announced the year 2009 had arrived. This happened during the AEA meeting on January 3-5. This NYT report on the meeting is enlightening:

SAN FRANCISCO — Frightened by the recession and the credit crisis that produced it, the nation’s mainstream economists are embracing public spending to repair the damage — even those who have long resisted a significant government role in a market system.

“We have spent so many years thinking that discretionary fiscal policy was a bad idea, that we have not figured out the right things to do to cure a recession that is scaring all of us,” said Alan J. Auerbach, an economist at the University of California, Berkeley, referring to the mix of public spending and tax cuts known as fiscal policy.

At about the same time, Brad DeLong wrote the same thing:

Economists who initially rejected the need for fiscal stimulus have warmed to the idea, too. Several months ago, Alan Viard, a Bush administration economist now at the American Enterprise Institute, thought the right size for a government spending bill was “probably zero.” He favored reliance on the Federal Reserve to slash interest rates and existing unemployment benefits to bolster the jobless. Now Viard shares the view that a stimulus package is needed, although he would prefer one limited primarily to tax cuts and direct benefits for victims of the recession, such as increased unemployment benefits. “Things have gotten so bad so quickly,” Viard said. “We have now lost 3.6 million jobs, a stunning loss. But what’s more horrifying is that half that loss has occurred in the last three months. This is a severe recession. There’s no doubt about it”…

The problem is that when you think out of fear you don´t think straight. The fear came from the quick and large drop in employment and increase in unemployment that took place in the last 6 months of 2008 (figure 1). In this setting, the “credit crisis” was a red herring that blinded most economists from thinking straight. This was further enhanced by the fact that monetary policy had become “ineffective” when short term rates dropped to “zero” by the end of 2008.

But all these things were really made worse by the seldom mentioned fact that the Fed allowed nominal spending (NGDP) to drop like a stone, something that was last seen in 1938 (figure 2)!

Just a little over two years on perceptions have changed dramatically. Many (maybe most) of those that championed fiscal “stimulus” in January 2009 are now in full force behind “austerity”:

There are many issues on which we don’t agree. Yet we find ourselves in remarkable unanimity about the long-run federal budget deficit: It is a severe threat that calls for serious and prompt attention.

In his NYT piece this weekend Mankiw brings the “future forward”:

The following is a presidential address to the nation — to be delivered in March 2026.

MY fellow Americans, I come to you today with a heavy heart. We have a crisis on our hands. It is one of our own making. And it is one that leaves us with no good choices.

But confusion still reigns. The Shadow Open Market Committee, a body that exists since 1973, convened on March 25. The Keynote speaker was Charles Plosser, a former “top gun” in the SOMC and now president of the Philadelphia Fed and FOMC voting member this year. The introduction to his speech is “biutiful”:

It is a pleasure to be here today with my old colleagues and friends. I spent the better part of 15 years as a member of the Shadow Open Market Committee and served as its co-chair with Anna Schwartz for part of that time. It was a valuable experience and I learned a great deal from our discussions and debates concerning policy.

When I accepted the position with the Federal Reserve Bank of Philadelphia in 2006, some of my colleagues thought that I had gone over to the dark side. I preferred to think of it as trying to help put the lessons of modern macroeconomics and monetary theory to work in the making of policy. That has turned out to be easier said than done for a number of reasons, not the least of which is the onset of the greatest financial crisis since the Great Depression. Some might think, based on temporal ordering or a test of Granger causality, that it was my arrival at the Fed that actually caused the crisis. Yet, we should be cautious in drawing conclusions about causation from such evidence. Personally, I prefer to think the crisis occurred despite my arrival at the Fed. But that is a story for another day

Michael Bordo, another SOMC member was forceful on the “prospects for inflation”:

The Great Recession of 2007-2009 is now over and the U.S. economy is expanding nicely as are most economies. The recovery from the recession reflects the operation of normal market forces and expansionary monetary policy by the Federal Reserve and other central banks. Many observers argue that the recovery in the U.S. is still anemic because the unemployment rate is still close to 9% and there is considerable economic slack. They argue that the Fed should continue on its expansionary track to insure that the recovery will be durable and strong.

The problem is that expansionary monetary policy by the Fed and by central banks around the world is creating incipient inflationary pressure which is already manifest in rising commodity prices and in headline inflation in both emerging and some advanced countries…

Arguing for “the other side” is former Fed Governor Laurence Meyer:

All of this has made some economists and lawmakers in the United States nervous. They fear that higher prices for commodities will translate into higher prices for all goods and services and that the Federal Reserve, by ignoring commodity prices, has become lax on inflation.

While the anxiety is understandable, the fears are misplaced. They result from a profound misunderstanding about whether food and energy prices today help predict overall inflation tomorrow.

And the biggest about face in all this confusion is provided by Kocherlakota. Only a few months ago he was ranting that unemployment was structural and there was nothing monetary policy could do about it (actually, if I remember well he advocated an increase in the FF rate). At a conference in Marseille on March 25th it is reported that:

Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said monetary policy stimulus, when done on a sufficient scale, could stop a bursting asset price bubble from causing an increase in unemployment.

“The bubble collapse has no impact on unemployment or output, given sufficiently accommodative monetary policy,” the bank president said, referring to an economic model in the text prepared for a speech today in Marseille.

He is clearly saying that if only the Fed had not let spending take a nose dive…

The surprising fact is that Bernanke is very much aware of the need to get spending back up (not just the growth rate but the LEVEL). According to Christy Romer:

I’m teaching a course this semester on macro policy from the Depression to today. One thing I had the class read was Ben Bernanke’s 2002 paper on self-induced paralysis in Japan and all the things they should’ve been doing. My reaction to it was, ‘I wish Ben would read this again.’ It was a shame to do a round of quantitative easing and put a number on it. Why not just do it until it helped the economy? That’s how you get the real expectations effect. So I would’ve made the quantitative easing bigger. If you look at the Fed futures market, people are expecting them to raise interest rates sooner than I think the Fed is likely to raise them. So I think something is going wrong with their communications policy. They could say we’re not going to raise the rate until X date. Those would be two concrete things that wouldn’t be difficult for them to do. More radically, they could go to a price-level target, which would allow inflation to be higher than the target for a few years in order to compensate for the past few years, when it’s been lower than the target.

I rest my case.

Lessons not learned

In a recent post, Scott Sumner concludes by saying, in reference to Friedman´s “torch”:

1. Demand shocks drive the business cycle.

2.  Monetary policy is the best tool for demand stabilization.

3.  Monetary policy is very powerful at the zero bound.

So let´s check the “economist´s laboratory” – the Great Depression.

The first figure shows the huge drop in nominal spending (NGDP), a big demand shock. 

Was it monetary policy? Many argue that the monetary base started rising after 1930 and that short term interest rates were fast dropping to “zero “so MP could not be regarded as “tight”. Figures 2 and 3 show the base and short term rates.

But the fact is that NGDP kept on falling after 1930. Figure 4 indicates that the rise in the monetary base was not enough to offset the increased hoarding of cash and reserves (the drop in the money multipliers), so that both M1 and M2 kept falling significantly.

So did prices (PPI and the CPI) shown in figure 5. There is no escaping the conclusion: monetary policy was extremely tight.

Figure 6 illustrates that industrial production (monthly data) dropped precipitously after mid 1929 as did the stock market (S&P) and the P/E ratio (figure 7).

Then, suddenly everything reversed direction. What happened? On March 1933, FDR devalued the dollar, leaving the gold standard and releasing the “brake” on monetary expansion.

For 3 months things looked up. Industrial production had the highest 3 month growth in history, rising by almost 60% and deflation turned into modest inflation. Stock prices boomed in what turned out to be a very short bull market.

What interrupted the process? On July 1933, N.I.R.A – which sanctioned, supported, and in some cases, enforced an alliance of industries. Antitrust laws were suspended, and companies were required to write industry-wide “codes of fair competition” that effectively fixed prices and wages, established production quotas, and imposed restrictions on entry of other companies into the alliances – was implemented. Bad move. Two years later it was declared unconstitutional and shortly after replaced with the Wagner Act – which gave workers the right to form unions and bargain collectively with their employers. This certainly was a factor in keeping unemployment high, despite the gains in production.

In the figures we observe an almost perfect synchronization (no lags) between expansive monetary policy and gains in economic activity. N.I.R.A is the “elephant in the room”, once it´s gone, things “pick up” again.

Until, that is, the Fed intervenes by raising required reserves, from fear of inflationary dangers (reminds you of some people in power today?). As you would have guessed, production and stock prices tumble again. On April 1938 FDR managed to “convince” Marriner Eccles, Fed Chairman, to discontinue the restrictive monetary policy. Production went back up immediately. Not so stock prices. Maybe by this time the “winds of war” in Europe, coupled with a natural mistrust by the market after so many “interventions”, were strong enough to hold stocks back.

One cannot help wondering about what would have happened if the bull market that began in early 1933 had continued unabated. One implication is that the economic recovery, both in the US and abroad, would have been much more intense, possibly diminishing the likelihood of war!

Flash forward. In 2008 there was a steep drop in nominal spending and interest rates dropped to “zero”. Inflation (not prices) dropped significantly (figure 8).

In March 2009 the Fed introduced “quantitative easing” (QE1). Nominal spending reversed and so did stock prices (figure 9). Later, in 2010, just “talk” of QE2 was sufficient for a rebound in stock prices.

But monetary policy has not been forceful enough to get spending to converge to some acceptable trend level. “Opposition” to monetary stimulus is everywhere. It didn´t help that early on there was an almost undivided attention given to fiscal stimulus, that has come back to “haunt” policymakers. So we have two “elephants in the room” this time around. There is the deficit/debt path concern and, most importantly, the fear of a rebound in inflation.

To give a very current example, today (March 25th) the Shadow Open Market Committee convenes. Below is a preview of committee member Michael Bordo “Policy Brief” presentation:

The Prospects for Inflation Ahead
Most observers today argue that since core inflation is considerably below the implicit inflation target of 2%, and unemployment and the output gap are still too high, that inflation is not an important worry for policy makers. Yet commodity prices are rising and headline inflation is also rising. It will likely take a long time for headline inflation to feed into core inflation through the conventional mark up channels but once it does it will be hard to dislodge as the experience of the Great Inflation taught us.

He really didn´t “learn” anything!

Ponnuru´s “Not Enough Money” in pictures

Yesterday I sent an article by Ramesh Ponnuru, titled “Not Enough Money” that was published in the latest issue of National Review Online (NRO) to Scott Sumner. Scott did a post on it. Than I remembered sometime in the second half of 2009 I had put in picture form a panel that I called “Tight Money”, that is a good illustration of Ponnuru´s arguments. So this post has no more words but may help “visualize” Ponnuru´s story. (When needed click on the picture for a larger view). (I couldn´t link to the Ponnuru´s piece so it´s pasted after the picture panel)

NOT ENOUGH MONEY (Ramesh Ponnuru – NRO April 4 2011)


T o economists reading this essay in 2010, perhaps the most remarkable single fact to note about monetary policy at the end of the interwar period”— the author, Columbia University economist Charles Calomiris, is of course also talking about the end of the Great Depression—“is that its architects were, for the most part, quite pleased with themselves. Far from learning about the errors of their ways during the interwar period, Fed officials congratulated themselves on having adhered to appropriate principles, and to the extent that they were self-critical, it was because they thought that they had been too expansionary.”

Almost all economists today agree that monetary policy during the Depression, especially its early stages, was disastrously tight, indeed that this contractionary policy is the principal reason the Depression became Great. But perhaps we should not judge the central bankers of America in the 1930s too harshly. For one thing, as Calomiris notes, smart economists are still arguing about the precise nature of the Fed’s policy mistakes. He himself presents evidence against the received view that the Federal Reserve precipitated the “recession within a recession” of 1937 by raising banks’ reserve requirements and thus discouraging lending.

More important—and more disturbing—is that it is not at all clear that we have learned from the mistakes of the 1930s. Those central bankers believed that money was easy because interest rates were low and the monetary base (the supply of money under the Fed’s control) had expanded. They worried that further easing would reduce confidence in the dollar. British economist R. G. Hawtrey, writing in the late 1930s, described the climate of opinion in his country at the start of the decade: “Fantastic fears of inflation were expressed. That was to cry ‘Fire! Fire!’ in Noah’s Flood.” The economy was actually deflating, not inflating. Under the influence of the “real-bills doctrine,” some central bankers believed that the money supply should respond only to traders’ need for credit. Anything else would only fuel speculative excess.

Today’s inflation hawks employ the same reasoning that those firefighters did. And they are not wholly wrong. Easier money can lead to a destabilizing run on the currency. Inflation can be associated with low real interest rates and an expanded monetary base. But not always: Not in the 1930s, and almost certainly not today, either. The late Milton Friedman, perhaps the most famous inflation hawk of his generation, spotted the fallacy in his analysis of 1990s Japan: Low interest rates can also be a symptom of an excessively tight monetary policy that has choked off opportunities for growth. A looser policy, by increasing expectations of future economic growth, could actually raise real interest rates.

To see why changes in the monetary base are also an un – reliable guide to whether money is loose or tight, I’m afraid it’s necessary to look at an equation. Friedman and others familiarized us with the equation of exchange: MV=PY. What that means is that the money supply (M) times the speed with which money changes hands (V, for velocity) must equal the price level (P) times the size of the real economy (Y). If velocity holds constant and the money supply goes up, either prices must go up or the economy must expand or both.

If, on the other hand, velocity drops—if people have an increased desire to hold money balances—then either prices must drop or the economy must shrink or both. And prices, especially wages, are sticky. They won’t automatically and evenly fall in response to a shock. So at least some of the reduction in PY, and maybe a lot of it, will have to come from real economic contraction. What this suggests is that if velocity drops unexpectedly, stabilizing the economy will require increasing the money supply to make up for it. Another way of putting it is that if the demand for money balances increases, the money supply has to grow to accommodate it. If the Fed does not increase the money supply, its inaction in the face of changing economic conditions amounts to passive tightening.

The money supply is itself the product of the monetary base (B) and the “money multiplier” (m), which measures how changes in the base are being converted into changes in commonly used monetary assets such as checking and money-market accounts. So—I promise this is the last equation—BmV=PY. David Beckworth, a conservative economics professor at Texas State University who maintains a blog, has shown that at the height of the financial crisis in late 2008, velocity dropped significantly and the money multiplier fell off a cliff. The monetary base grew a lot too: The inflation hawks are right about that. But it grew enough to offset only the fall in the money multiplier. It didn’t offset the fall in velocity.

Beckworth’s interpretation: The Fed was increasing the base to save the financial system, not the economy overall. At the same time the Fed was injecting money into the financial system, it instituted a policy of paying banks interest on their reserves—a policy that made them less likely to lend out those reserves (and thus kept m down). That policy helped the banks’ solvency but not the economy. The financial system would almost certainly have benefited more from a broader policy: A rising tide lifts all banks. Both m and V remain well below their pre-crisis levels.

Beckworth is among those economists who argue that Fed policy should aim to stabilize the growth of nominal spending— roughly, the total value of the economy in current dollars, which is equal to PY (and therefore to MV and BmV). That policy is superior to trying to grow the base at a steady rate, a much-discussed idea in the past, because it allows the base to change in response to changes in the money multiplier and velocity. It is superior to trying to hold inflation constant because it allows the price level to respond to changes in productivity. It would create a stable environment in which economic actors could make their decisions and contracts.

Josh Hendrickson—an economist at the University of Toledo, and like Beckworth a right-leaning blogger—hass hown that the Fed did a pretty good job of stabilizing the growth of nominal income at roughly 5 percent per year during the “great moderation” that lasted from the mid-1980s until the current recession. (Although Beckworth notes that growth was slightly above trend during the housing boom, for which he faults the Fed.) Most debts—notably, most mortgage debts—are contracted in nominal terms, with no inflation adjustment. If people are used to 5 percent growth in nominal incomes each year and make their arrangements accordingly, then an unexpected drop will make their debt burdens heavier and also make them reluctant to make plans for a suddenly uncertain future.

That’s what happened during the recent crisis. Scott Sumner—yet another right-of-center econoblogger, this one based at Bentley University—often notes that in late 2008 and early 2009, we saw the sharpest fall in nominal income since 1938. In his view, much of what we think we know about the recession of 2007–09 is wrong. Not only has money not been loose since the crisis began, but tight money is the fundamental reason the recession was so severe and the recovery has been so halting. He argues that it was more fundamental than the housing bust, since residential-construction employment started falling long before the crisis hit.

An alternative theory of the crisis goes something like this: While a recession may have been inevitable, it was the Fed’s passive tightening that made it a disaster. The recession began in late 2007, although many observers knew it only after the fact. The Fed passively tightened mildly in mid-2008. In the fall of 2008, the financial crisis caused velocity (and the money multiplier) to drop dramatically—in part, perhaps, because political and financial leaders were scaring everyone. The Fed did not act aggressively enough to accommodate the increased demand for money balances, and what had been a mild recession became a severe one.

As panic subsided, velocity stopped falling, and the economy then began to recover. But in mid-2010, the eurozone crisis resulted in a flight to the dollar. Increased demand for dollars again had a contractionary effect, and the Fed took months to respond to it. Finally, in the late summer, it began letting it be known that it would dramatically increase the money supply— an initiative called quantitative easing, or QE2, the first QE having been the injection of money into the financial system in late 2008—and then, in the fall, it followed through.

A number of justifications were offered for QE2. The most plausible was that if people expected it to move nominal income to a permanently higher path, asset values would increase to reflect this higher expected income stream. Both consumers and investors would then spend more money. The demand for money, in other words, would decline at the same time as the supply increased, restoring equilibrium.

As the market became convinced that the Fed planned to act, both expectations of inflation and expectations of real growth increased: the former indicated in the spreads between inflation indexed bonds and non-indexed bonds, the latter in real interest rates. Nominal income thus moved closer to trend, if not as much as it would have with a bolder Fed initiative. (An explicit announcement that the Fed is willing to do what it takes to restore the trend might itself change expectations enough to make great exertions by it unnecessary.) Stocks picked up too. QE2, though flawed, worked. It began to work even before being formally implemented.

Conservative politicians and conservative pundits none – the less blasted it. They seized on the rise in long-term interest rates as proof it was not stimulating the economy: the precise kind of confusion about the meaning of interest-rate changes that Friedman had warned against. They blamed QE2 for a boom in commodities prices, largely ignoring the role of rising Asian demand for those commodities. And they fretted about runaway inflation, even though, in the aftermath of QE2, the spreads mentioned above were forecasting inflation rates below 2 percent for years to come—a lower average inflation rate than in each of the last five decades.

The argument for stabilizing the growth of nominal income implies that if the Fed overshoots its target in one year it should undershoot it the next, and vice versa: The key is to keep to the targeted long-term trend. Any rational person would want as much of the growth in nominal income to be made up of real economic gains, and as little of it of inflation, as possible. But a modest uptick in inflation that helps to bring nominal income back to trend is better than staying below trend.

There is a reasonable argument—made by Beckworth, among others—that over time the Fed should gradually reduce the average growth of nominal income from 5 percent per year to something closer to 3 percent. The idea would be to move the economy to a lower average inflation rate, or even to a mild and gradual deflation. But such a move should neither be abrupt nor begin in the midst of a shaky recovery, let alone a crisis.

In warning about inflation, conservatives are crying “fire” in, if not Noah’s flood, at least a torrential rain. It may be that they are stuck not so much in the 1930s as in the 1970s—the time when conservatism forged much of its current outlook on economics, and a time when monetary restraint was badly needed. Conservatives also tend to think that loosening monetary policy is a kind of intervention in free markets, and therefore to be suspicious of it. But this is an error. Professor Hendrickson points out that in a system of free banking, with competitive note issue rather than a central bank, the desire for profit and the need for solvency would lead to the supply of banknotes roughly equaling the demand. In a fiat-money regime such as the one under which we, for better or worse, live, a central bank’s withholding of a sufficient supply of money is just as much of an intervention in the economy as its overproduction of it.

The economy, post-QE2, seems to be on the mend. But events overseas—a renewed eurozone crisis, or trouble in the Middle East—could again boost demand for dollars. If so, will the Fed accommodate that demand? Or will it be dissuaded by the vehement criticism its efforts to date have already drawn from conservatives? Congressional Republicans are at the moment blocking the confirmation of Peter Diamond, a Nobel Prize–winning economist, to the Federal Reserve’s board of governors because of their opposition to the inflation they believe is just around the corner.

We are not likely to see a second Great Depression. But it would be tragic if conservatives, moved by hostility to the Fed, led it to repeat, even on a smaller scale, the worst mistakes in its history.

Highly deserving

Some posts merit the widest audience possible. That´s my justification for linking to this beautiful piece by Nick Rowe:

Keynesian unemployment makes sense in a monetary exchange economy, where money is what Hahn calls “essential” for trade. It makes no sense whatsoever in a barter economy, or where money is inessential.

Keynesian unemployment is an excess demand for the medium of exchange. It’s a coordination failure, because if all three spent the $20 to buy what they wanted, all three would find her purse is a widow’s cruse. The $20 reappears as soon as it is spent. But the widow’s cruse fails unless all three increase spending at once. And, in Nash Equilibrium, none of the three wants to do that. She prefers the $20 in her purse.

We buy newly-produced goods with money. A Keynesian recession is an excess supply of newly-produced goods, and a deficiency of Aggregate Demand. In a monetary exchange economy, a deficiency of Aggregate Demand, and an excess supply of goods, is an excess demand for money. Money is what we demand goods with.

So, what should we do Watson? But Holmes, that´s a no brainer!


Paul Krugman takes issue with a paper by Mankiw that argues “that fiscal expansion shouldn´t be the tool of choice even at the ZLB; that MP can still work if you can credibly make commitments about future MP”.

Krugman notes (a bit sarcastically):

Early in the present crisis, Greg publicly made exactly the argument his analysis implies: that the Fed needed to promise higher inflation, so as to get negative real interest rates.

As I understand it, he received furious pushback from readers. And in response to this pushback, he stuck to his guns, arguing repeatedly that inflation really was the right policy more or less dropped the subject.

And concludes extolling some of the “virtues” of fiscal expansions:

Now, the thing about fiscal expansion is that people don’t have to believe in it: if the government goes out and builds a lot of bridges, that puts people to work whether they trust the government’s commitment to continue the process or not. In fact, to the extent that there’s some Ricardian effect out there, fiscal policy works better, not worse, if people don’t believe it will continue.

The problem with Krugman´s argument is that you never know how much fiscal stimulus is enough. And that´s how he usually argues: “It didn´t work because it was too small”! And the public debt path has now become a problem…

On the other hand, Mankiw´s conclusion:

A sufficiently flexible and credible monetary policy is always sufficient to stabilize output following an adverse demand shock, even if the zero lower bound on the short-term interest rate binds.

Does not justify pages and pages of “Greek letters”. The problem is that monetary policy was at the root of the “adverse demand shock”. If so, that means that monetary policy was not sufficiently flexible (although it was credible).

The problem lies with inflation being the “target” (formal or informal) that guides monetary policy. And inflation easily becomes an “obsession”. Monetary policy then becomes difficult to implement, not because of the ZLB but because of the OB (“obsession bound”).

Mankiw says that a sufficiently flexible (and credible) monetary policy is always sufficient…But it has become clear that IT does not provide “flexibility”. Blanchard, among others, has proposed a higher IT so as to avoid the ZLB. The smack down on the proposals was “loud”.

Figure 1 indicates that MP was really not flexible. Otherwise, according to Mankiw AD would have been stabilized. In fact, it was MP, set according to an undisclosed target for an undisclosed index, which is behind the big “damage” to AD.

In figure 2 it is shown that the inflation “obsession” flares up as soon as inflation points up even if from a rock bottom level! In that case, AD will never be brought up back to some reasonable level…and unemployment will remain higher for longer. Never mind, that´s “structural” and MP is impotent to do anything about it!

Pictures of the Inflation “Menace”

The first graph shows alternative measures of “core” CPI inflation. Note: It´s a good thing that inflation turned up following QE2. In that sense, QE2 is working. More significantly, if most were happy with the inflation observed in 2005-2007, the present level of inflation is “bad”, especially because it is the result of a deep plunge in nominal demand (AD).

Figure 2 shows that there is “heat” and “light” concerning inflation. This comes from the Atlanta Fed Inflation Project. They calculate (both for the CPI and the CPI-Core) the rate of inflation for the “flexible” and “sticky” components. We observe it´s “dangerous” to pay undue attention to the “heat” generated by the flexible component. This may have been the BIG mistake made by the Fed in 2008!

Figure 3 illustrates the fact that when you are inside an inflation process, like in the 1970s, ALL prices move in the same direction. “Sticky” prices become “unstuck”, the hallmark of an ongoing inflation process.