Quote of the day

At the NYT, Motoko Rich has a piece that harps on the now common argument: “If the economy is growing, why are people so gloomy”? Yes, I know that the Level of activity, not only the Growth rate matters, although journalists (and many economists) seem to forget that basic fact. But the title to this post refers to the comment made by Ian Shepherdson, chief US economist at High Frequency Economics, to Motoko:

“This recession, followed by sluggish recovery, is not the experience of pretty much anyone today,” Mr. Shepherdson said. “So for all intents and purposes nobody in America has any experience for an economy behaving like this. Economists don’t even understand it.”

He added: “So if people don’t really understand what’s going on in the economy, how can they frame reasonable expectations of where it’s going?”

Ball over to you, Chairman Bernanke!

“Summer fashions”

In the summer of 2010 the rage, as epitomized by this Kocherlakota speech, was that unemployment was mostly structural so that monetary policy would have little effect (my bold):

What does this change in the relationship between job openings and unemployment connote? In a word, mismatch. Firms have jobs, but can’t find appropriate workers. The workers want to work, but can’t find appropriate jobs. There are many possible sources of mismatch—geography, skills, demography—and they are probably all at work. Whatever the source, though, it is hard to see how the Fed can do much to cure this problem. Monetary stimulus has provided conditions so that manufacturing plants want to hire new workers. But the Fed does not have a means to transform construction workers into manufacturing workers.

Of course, the key question is: How much of the current unemployment rate is really due to mismatch, as opposed to conditions that the Fed can readily ameliorate? The answer seems to be a lot. I mentioned that the relationship between unemployment and job openings was stable from December 2000 through June 2008. Were that stable relationship still in place today, and given the current job opening rate of 2.2 percent, we would have an unemployment rate of closer to 6.5 percent, not 9.5 percent. Most of the existing unemployment represents mismatch that is not readily amenable to monetary policy.

More than one year on, the “shifting of the Beveridge Curve” (which relates the rate of job openings to unemployment) is confirmed, as can be observed from the figure below.

But to call this shift an evidence of “structural change” – unemployment mostly due to mismatch – is certainly exaggerated. Note that the B-C shift meshes well with the “downdraft” experienced in aggregate demand (nominal expenditures), which is very likely behind the common pattern seen in the Employment/POP ratio and in the level of job openings.

This summer it became de riguer to affirm that “regime uncertainty” is THE factor behind the absence of recovery in employment and in the economy more generally. Again, the indication is that monetary policy is powerless to reverse the situation.

This piece from Treasury Notes discusses compelling evidence to counteract the view that “regime uncertainty” is the key factor. One example:

Trends in Workforce, Capacity Utilization, and Business Investment

If regulatory uncertainty was the primary problem facing businesses, firms would prefer to use their existing capacity and current workers as much as possible, while avoiding building additional capacity until they are more certain about the contours of future regulation.

Specifically, if demand was strong but businesses were concerned about future regulations, they would increase the hours of the workers they already employ rather than hiring additional workers.  We have seen no evidence of this in the data: the average work week for private employees has been roughly flat for the past year.  Similarly, if demand were strong, firms could easily expand using existing capacity without taking on the cost and risk of added capacity.  However, the share of total potential industrial output in use remains 3 percent below its long-run average.  Low capacity utilization is inconsistent with concerns about future regulatory risk, but aligns with weak demand holding back current production.

At the same time, business investment has led economic growth over the last few years. Since the end of the first quarter of 2009, real investment in equipment and software has grown by 26 percent – about five times as fast as the economy as a whole.  However, businesses would not increase investment if they thought that future regulation posed a threat to their ability to operate profitably.

My take: Central Banks are conservative institutions and will fall behind any excuse that absolves them from taking bold action.

The ECB, no Chuck Norris

Nick Rowe has done four posts on the topic “Chuck Norris & Central Banks”. In his VoxEu column today Paul De Grawe shows that the ECB has been anything but:

Imagine an army going to war. It has overwhelming firepower. The generals, however, announce that they actually hate the whole thing and that they will limit the shooting as much as possible. Some of the generals are so upset by the prospect of going to war that they resign from the army. The remaining generals then tell the enemy that the shooting will only be temporary, and that the army will go home as soon as possible. What is the likely outcome of this war? You guessed it. Utter defeat by the enemy.

The ECB has been behaving like the generals. When it announced its programme of government bond buying it made it known to the financial markets (the enemy) that it thoroughly dislikes it and that it will discontinue it as soon as possible. Some members of the Governing Council of the ECB resigned in disgust at the prospect of having to buy bad bonds. Like the army, the ECB has overwhelming (in fact unlimited) firepower but it made it clear that it is not prepared to use the full strength of its money-creating capacity. What is the likely outcome of such a programme? You guessed it. Defeat by the financial markets.

Update: Still, according to De Grawe, what the europeans are doing is substitute “Chuck Norris” for “Puff, the magic dragon”:

The result of this failure of the ECB to be a lender of last resort has been that a surrogate institution, the EFSF/ESM, had to be created that everybody knows will be ineffective. It has insufficient firepower and has an unworkable governance structure where each country keeps its veto power. In times of crisis it will be paralysed. As markets know this, its credibility will be weak.

To hide these shortcomings European leaders are now creating the fiction that by some clever leveraging trick the resources of the EFSF/ESM can be multiplied, allowing the ECB to retire to its Panglossian garden of inflation targeting. European leaders should know, however, that leverage creates risk, very large risks. These appear with full force when liquidity crises erupt. Thus when the leverage trick will be most needed, it will fail as it will show how risky the positions are of those who have guaranteed the leverage construction. Governments which now enjoy AAA creditworthiness will take the full blow of a 100% loss on their equity tranches and will lose their creditworthiness in one blow. The whole risky construction will collapse like other clever financial constructions of the recent past.

Academics have the reputation of living in an ivory tower far away from the realities of the world. My impression is that instead of the academics, it is the European leaders who have been living in an ivory tower. Disconnected from the economic and financial realities, they have created an institution that does not work and will never do so properly. Now they are creating a financial gimmick that, in their fantasies, they expect to solve the funding problems of major Eurozone countries. It is time for the European leaders to step back into the real world.

Straight from “Calvin´s Pulpit”

And this is from the BIS, Central Bank to Central Bankers:

Not all recessions are born equal. The typical recession during the first decades following World War II in advanced economies was triggered by a monetary tightening to fight inflation or balance-of-payments crises. The upswing was relatively short and, with financial systems heavily regulated, the recession did not trigger a major financial crisis or involve large debt and capital overhangs. Even when debt burdens were large and financial strains emerged, higher inflation and rising nominal asset values reduced them over time.

The current recession is quite different. The preceding boom was much more prolonged, the

subsequent debt and asset price overhang much larger, the financial sector much more seriously affected, and inflation much lower before and after. The Japanese experience of the early 1990s is the closest parallel. There is considerable cross-country evidence that banking crises tend to be preceded by unusually strong credit and asset price booms (see below), that those crises go hand-in-hand with permanent output losses (BCBS (2010)) and that subsequent recoveries tend to be slow and protracted  (eg Reinhart and Rogoff (2009), Reinhart and Reinhart (2010)). In all probability this reflects a mixture of an overestimation of potential output and growth during the boom, the corresponding misallocation of resources, notably capital, the headwinds of the  subsequent debt and real capital stock overhangs, and disruptions to financial intermediation. Fiscal expansions in the wake of the crises can add to these problems, by piling government debt on top of private debt and sometimes threatening a sovereign crisis.

All this reduces the effectiveness of monetary policy in dealing with the bust and exacerbates its unwelcome side-effects. These become apparent once the easing is taken too far after averting the implosion of the financial system. The economy needs balance-sheet repair, but very low interest rates together with ample central bank funding and asset purchases delay the recognition of losses and the repayment of debt.

Too much capital has been accumulated in the wrong sectors, but the easing tends to favour investment in the very longlived assets in excess supply (eg construction). The bloated financial sector needs to shrink, but the easing numbs the incentives to do so and may even encourage punting. The financial sector needs to generate healthy earnings, but as short-term interest rates approach zero and the yield curve flattens, they compress banks’ interest margins unless banks take on more interest-rate and, possibly, sovereign risk; and as long-term rates decline, they can generate strains in the insurance and pension fund sectors. Thus, as the easing continues, it raises the risk of perpetuating the very conditions that make eventual exit harder. A vicious circle can develop.

Put differently, when dealing with major financial busts monetary policy addresses the symptoms rather than the underlying causes of the slow recovery. It alleviates the pain, but masks the illness. It gains time, but makes it easier for policymakers to waste it.

And those thoughts are not the result of “statistical findings” as in the previous post, but are expressions of a “philosophy” -“liquidationism”- that has a long tradition!

“Damned Statistics”

According to Papell & Prodan, guestbloging  at Econbrowser, the economy will languish for a couple more years before it starts climbing out of the “hole” and will arrive at the final “destination” only in 2016!

They start from the hypothesis that the Second Great Contraction was “caused” by the financial crisis, which, according to research by Rogoff and Reinhart, entails  very “perturbing dynamics”.

But if you recognize that the present slump, like the “Great Depression” (or first great contraction) had its cause in grave monetary errors being committed, it is conceivable that “righting the errors” could jump start the process. Anyway it is very dangerous to depend heavily on statistical analysis to conclude that “there´s not much that can be done”. The very history of the GD, which was for long assumed to be the result of a big financial shock, shows how powerful monetary policy can be, for ill (1929-32) and good (1933-36), notwithstanding the “fiscal errors” (NIRA and such) made on the way.

This is their picture:

The WSJ has “deflated expectations” for the economy

As expected, after Goldman Sachs wrote favorably about NGDP level targeting, the subject would be picked up by the media. Today the WSJ has a critical and unfavorable appraisal. They mostly depend on the GS analysis and that can be misleading especially since they provide “precise” quantitative estimates of the required size of the Fed´s balance sheet and the required period for “zero” FF rates. In other words, they don´t subscribe to the “Chuck Norris” principle in the conduct of monetary policy elaborated by Nick Rowe (via Lars Christensen):

Central banks run monetary policy not so much by doing things, but by threatening to do things. If their threats are credible, we never observe them carrying out those threats, and we often observe them doing the exact opposite

A credible central bank is a bit like Chuck Norris. (Apologies to Lars Christensen for stealing his metaphor.) Chuck Norris simply looks at the target variable, and it moves to wherever he wants it to go. It looks like magic. But it works because nobody wants Chuck Norris to carry out his implicit threat. So he doesn’t need to.

The WSJ could do much better by reading Scott Sumner´s Retargeting the Fed, so I´ll not go into detailed comments on the “errors of interpretation” they make (I see Scott has done a post to answer back), and just elaborate on this specific argument (which really invalidates any attempt to get the economy back on track):

First, it is tempting, but probably mistaken, to assume the Great Recession came along and knocked the U.S. off an otherwise sustainable growth track. It wasn’t an external shock, but internal weakness, that led to the economy’s collapse.

Substitute “internal weakness” for “accumulated sins” and you get the “Calvinist/Puritanism view of economic ills. This quote is from Lars Christensen via Doug Irwin:

NYT quote Cassel: “The deeper psychological explanation of this whole movement…can without doubt be found in American Puritanism. This force assembled all its significant resources in what was considered a great moral attack on the diabolism of speculation. Each warning against deflation has stranded on fear on the part of Puritanism that a more liberal monetary policy might infuse new vigor in the spirit speculation.”

Let me, as usual, put some pictures up. In the first RGDP is shown from 1955 to 2011. In the picture, I “identify” 3 growth paths and a 4th which may, or may not, progress. From 1960 to 67 we have “Camelot”. Nice, but it brought up the seeds of the “Great Inflation”. The growth path (always drawn passing through the cycle peaks) shifts down but is maintained all the way to 2000. It seems that after 2000 “potential” output growth slowed and the real economy evolved along a lower growth path until, that is, early 2008 after which it dropped into an “air pocket”.

Maybe the Journal is partly right when it says thatthe economy’s real potential growth rate has been slowing for decades”. It´s just decade in the singular. So here we are at a point of decision. Will everyone involved be content with travelling along a much lower level path? (Or should “something” be done to make the traverse from path 4 to path 3? Or even, with the right supply side reforms, try to go back to path 1? In this case, research should be undertaken to measure how much of the fall in “potential” the Journal mentions was due to Bush Jr. policies – fiscal and war?).

That´s where NGDPT comes in. The next graph depicts NGDP from the early Great Moderation period. Again, it seems that after 2000 the growth path was lowered.  That reflects “good monetary policy”; one that lowered the nominal growth path to “accommodate” the lower “potential” output path, thus maintaining inflation on “target”!

The drop from path 2 to path 3 has obviously nothing to do with so called “internal weakness” but everything to do with monetary mistakes (that have been amply discussed by all MM´s).

If we can visually “identify” the level path we (at least) should be in – path 2, the sophisticated measuring tools available could give a pretty good numerical target for NGDP to allow the traverse from path 3 (the “bottom of the hole”) to path 2. Here again, the Journal is “too pessimistic”: “even if the Fed were to aim at a particular nominal GDP target, it isn’t clear policy makers could successfully hit it”. I bet they could!

Just hope this does not come to pass

NetNet gives us this thought:

With the market barely given enough time to digest the last easing drive, talk already is emerging that the Federal Reserve is getting ready to rev up the engine again.

“At the very minimum, we think that means the Fed will formally or informally tell the markets they are on hold until either an inflation or unemployment rate target is reached,” Pawlak wrote in an analysis for clients. “At the maximum, it means the likelihood of QE3 is much higher in our view than those in the markets and the general economy realize.”

There´s a much more effective and much less “traumatic” way of getting the economy to move upwards: Nominal Income Targeting (NGDPT)

Smart take from Paul De Grawe

Here´s the article in the FT:

The European financial stability facility is no substitute for the ECB. The fund will not be capable of acting quickly even if its resources are expanded by giving it access to the ECB’s liquidity. The reason is that its governance is based on unanimity rule and will paralyse it when quick action is required.

The ECB has no excuse not to act. In trying to keep its monetary virginity intact, the bank threatens to destroy the eurozone. If that happens, nobody will be able to profit from its virginity.

Pervasive “mental disorientation”

Florin Citu reproduces Rogoff´s interview to the McKinsey Quarterly. As FC states: “it is important to know what the great ones think”.

The Quarterly: You’ve advocated allowing inflation to increase as one kind of remedy. Can you explain?

Kenneth Rogoff: There are no quick fixes. But I do think that this is a period when we shouldn’t be worried about raising inflation slightly. Indeed, moderate inflation, I would say, is exactly the prescription for a Great Depression–type scenario or a Japan-type scenario. It lowers real interest rates, helps facilitate housing price adjustment (the real price still needs to come down in many places), and modestly shortens the typical long post-crisis deleveraging period. I’ve pushed the idea, for some time, that we’re in a Great Contraction, not in a typical recession, and one has to analyze the problem differently. Unfortunately, there is still a risk that this thing could get much, much worse. The biggest problem is the global overhang of debt. After publishing our book, Carmen Reinhart and I did a study that looked at the impact of public debt on growth. When debt gets over a certain level—a good marker is 90 percent of GDP—it is linked to lower growth.

Unfortunately, he has his “misguided obsessions”, and they can change quickly. This is Rogoff in July 2008:

Of course, today’s mess was many years in the making and there is no easy, painless exit strategy. But the need to introduce more banking discipline is yet another reason why the policymakers must refrain from excessively expansionary macroeconomic policy at this juncture and accept the slowdown that must inevitably come at the end of such an incredible boom. For most central banks, this means significantly raising interest rates to combat inflation. For Treasuries, this means maintaining fiscal discipline rather than giving in to the temptation of tax rebates and fuel subsidies. In policymaker’s zealous attempts to avoid a plain vanilla supply shock recession(!), they are taking excessive risks with inflation and budget discipline that may ultimately lead to a much greater and more protracted downturn.

And barely 7 months later, in February 2009:

Excess inflation right now would help ameliorate the problem. For that reason, it would be far better to have 5pc to 6pc inflation for a couple of years than to have 2pc to 3pc deflation,” he told the Central Banking Journal.

To me, that sort of “mental disorientation”on the part of the “great ones” and of policy makers, is an important reason behind the dismal state the economy is in!