We keep hearing…

that the Fed is not out of ammunition. The latest is from New York Fed Dudley:

“We are not out of ammunition,” Dudley said in the text of a speech prepared for delivery before a gathering at the United States Military Academy at West Point, New York.

That line is becoming a “standard” for a group of Fed officials that include Bernanke. My take:

  1. Either they “lost the key to the armory”, or
  2. They feel that´s the right way to “manage expectations”

And both reasons spell trouble.

Glenn Hubbard is consistently wrong

And has no idea of what he´s talking about when answering questions about NGDP targeting. In a recent Q&A:

Q. Are you concerned such a policy (NGDPT) wouldn’t work or maybe it works but then we face higher inflation expectations for a long time and it is self defeating long term?

GH. Actually, it’s a bit of both. In the near term, it’s hard for me to imagine that it would work much differently than what the Fed is currently doing, which isn’t exactly a booming success. And then in the longer term, I would worry about inflationary expectations becoming unhinged. And I think that’s something the Fed would find very difficult to reverse.

And now flashback 40 months to late July 2008(my bolds):

The current policy stance of holding the federal funds rate at 2% will keep monetary stimulus in place. With inflationary expectations not declining, this stimulus will almost surely raise inflationary expectations as the economy improves. This consequence can be seen already in surging commodity prices and the weakness in the foreign-exchange value of the dollar.

It is worrisome that the Fed’s own 2008 projections have risen over the year both for headline inflation (by about 1.5 percentage points) and core inflation (by about 0.2 percentage points). Furthermore, the Fed’s projections of receding inflation in 2009 and 2010 coming true will almost surely require increases in the federal funds rate.

A continuation of a negative real federal funds rate and the increase in money growth accompanying it raises the risk of increasing inflationary expectations, a costly mistake to fix.

As soon as he wrote, the floor fell off from under NGDP, the dollar began to climb against all currencies and oil and commodity prices began a strong downslide!

From the moment he wrote, all nervous about inflation expectations increasing – after all MP was “stimulative” with the FF at 2% – this is what happened to NGDP and 5 byearinflation expectations (monthly from the Cleveland Fed). Note that despite the climb in NGDP over the last couple of years it is weeeell below any reasonable trend level!

Now, imagine if the Fed had done what Hubbard thought was right back in July 2008; maybe a couple of trillion dollars less NGDP and unemployment at 15%? And he has the gall to say that what the Fed is currently doing is not a “booming success”?

Krugman has put a post today that shows why inflation expectations have not become “unhinged”. This is a version of his graph:

And this is Krugman:

I thought this slump would produce a “clockwise spiral” like the 80s recession, and for that matter like what happened in the 70s (not shown). That is, among other things, what textbook adaptive-expectations Phillips curves say should happen. So I thought we might well be into deflation by this point. Instead, while you can see a clockwise spiral, sort of, if you squint, it has been “scrunched” as if it’s bouncing off a hard surface at or near zero.

And that’s almost surely exactly what has happened. Downward nominal rigidity — the great difficulty of actually cutting wages and many prices — is now obvious. And research into PLOGs — prolonged large output gaps — shows that this is a general phenomenon.

I wonder, if all this was such a big surprise, what the heck was discussed in all the conferences over the last 12 years on “Monetary Policy in a Low Inflation Environment”? I bet Scott Sumner od David Beckworth were never invited!

HT David Beckworth

HT Benjamin Cole

Pearls of wisdom from long ago

Comenter Ryan Sanchez went on a “archeological digging expedition” and found a nice “treasure”. In Ryan´s words:

I was as looking over some old fed minutes from December 1982, interesting stuff, they debated targeting NGDP but decided it was too politically sensitive.

Here are some key quotes page 20 (selected by Ryan (all bolds mine)):

MR. MORRIS. I think we need a proxy–an independent intermediate target– for nominal GNP, or the closest thing we can come to as a proxy for nominal GNP, because that’s what the name of the game is supposed to be. If we have to target something that is not predictably related to GNP, which M1 has not been in the past two years, one of two things can happen. One is that we can do as we did in 1981 and say the M1 shift adjusted, which was our target, is coming in too low and we are just going to let it come in low–we’re not going to use it as a target de facto. I think that was the right decision. If we had tried to hit our targets for M1 in 1981, we obviously would have put too much money into the system. I think the targets have misled us this year. That is, up until October when we finally caught up with it, it seems to me that the monetary aggregates misled this Committee into following a much more restrictive policy than we intended. And that is reflected in a nominal GNP growth this year, which we’re now estimating at 3.6 percent, that I don’t think any of us a year ago would have [favored] as a target for nominal GNP. It seems to me that the best proxy for nominal GNP in this world of enormous change is the rate of growth of debt. Now, that may not be a perfect proxy, either. But we certainly don’t want to go back to interest rate targeting. Politically, I don’t think we could adopt a nominal GNP targeting approach even though theoretically that is what we ought to be doing. I don’t think we can do it. We need a proxy for nominal GNP.

CHAIRMAN VOLCKER. What is that political objection?

MR. MORRIS. Well, let’s say the President comes out in January and says we are going to have 12 percent nominal GNP growth, and you go up before the congressional committee in your Humphrey-Hawkins testimony the next month and say we’re going to finance a 9 percent nominal GNP growth. It seems to me it is not well suited to the needs of the central bank to be that far out on a limb.

CHAIRMAN VOLCKER. How far do you think we can go in that regard by saying we’re going to project a 9 percent credit growth or 9 percent M2 growth or something that is inconsistent with the 12 percent [nominal GNP growth]?

MR. MORRIS. I would merely submit that we’ve been getting away with this on the money supply for a number of years. I’m quite amazed that we have. But I think it’s very clear that the intermediate target should not be politically sensitive. And the wonderful thing about the rate of growth in the money supply, for all of its problems, is that it was never a politically sensitive item such as the unemployment rate, or interest rates, and so on. Nominal GNP, if we were to use that as a target, would be a politically sensitive target, and we ought to avoid it for that reason. But we need a proxy for it.

Another from page 40:

VOLCKER. I do think we’re going to be forced into a more explicit rationale, whatever we do, in terms of the nominal GNP. I’m not saying we have to target nominal GNP very directly, and there are obviously dangers in that, but I do suspect that we’re going to be drawn out on that subject much more heavily than we have been in the past. I think there is a real danger in that because it does overemphasize what we in practice can do. I think there’s great overemphasis now on what monetary policy can do either in terms of nominal GNP or interest rates. And it’s very dangerous. It’s partly just a matter of frustration. Nobody else can think of anything else to do so they say that the monetary authority must have control over all these things and if they press the right button everything is going to come out right. The presumption is that there’s a right button to press; I’m not sure there is. Some problems don’t have that simple an answer. I suspect we’re in one of those periods, and we ought to devote some attention to arguing that we’re not all that omnipotent. I myself would accept what some people have mentioned: That we keep an eye on such things as exchange rates or maybe even more importantly the price trend and the price forecast but that we not formally target them.

Mr Morris (alternate Board Member and for 20 years – 1968-88 president of the Boston Fed) was on the right track. Volcker seems reluctant to commit (to a TARGET). But in the end, look how things turned out over the next 5 quarters. Amazing!

And this is what went on during the next 3 years up to the end of Volckers tenure

A “soft and smooth landing”. And Greenspan “nurtured” the “gift received”

Update: Bill Woolsey has interesting comments on the points discussed in the meeting.

The economics of the EZ problems is “path dependent”

Ryan Avent links to Matt Yglesias:

But a sense of identity surely matters. Mr Yglesias closes by writing:

Americans, whether in San Francisco or in Kentucky, generally conceive of ourselves as all living in one country. We act either on behalf of narrow personally selfish claims or else broad idealistic concerns about what’s right and proper for the country as a whole. But if that spirit broke down, the whole national economy would have a very different feel.

Both posts worth reading

Apologies for my darken mood today

This is Ryan Avent at Free Exchange:

German Chancellor Angela Merkel has made some headlines today for a speech to her party calling for a “New Europe”, complete with much closer political and economic ties. It is difficult to know how to interpret her remarks, however, particularly against the backdrop of her recent rubicon-crossing suggestion that there might be a future in which Greece is outside the euro zone, and the rumours that some core economies are at least entertaining the idea of a new core Europe, presumably free of peripheral troublemakers.

It is difficult to see how the cycle of austerity, economic contraction, contagion, and financial retrenchment can be broken without the promise of substantial ECB support for sovereign debts. A large fiscal commitment by core economies to a new bail-out fund could potentially work in combination with much more monetary stimulus from the ECB; a return to growth is crucial. But as the crisis grows in scope, the maths get worse; you have an ever larger pool of troubled economies relying on financing from an ever smaller pool of “safe” economies. A big French fiscal commitment, for instance, might well move it decisively from the “safe” to the “troubled” camp. When you have more euro-zone economies in trouble than out of it, there’s no way to put together a fiscal package to fix the mess.

The odds for a pleasant end to the situation continue to grow longer, in other words. Policymakers elsewhere are making ready for the fall. Federal Reserve officials are preparing to conduct a new round of stress tests on American banks with a euro-area collapse in mind. And Treasury officials are looking at big American banks and urging them to cut back their exposure to Europe. The recent failure of MF Global thanks to euro bets gone bad seems to have created a sense of urgency among regulators. These preparations are good news for American investors, who watched in 2007 and 2008 as the American government lagged two and three steps behind the rapid progression of the financial crisis. They are very bad news for Europe. As other economies prepare for euro disaster, their selling will accelerate Europe’s decline.

The clock keeps ticking down. Eventually, the buzzer will sound and the game will be over.

To RA it´s the “clock and buzzer”. I had the “music stopping”.

Question: If there´s a break-up in the EZ, in which camp will France end up? The “north camp” or the “South camp”? (and why, obviously)

“The German Solution”

It´s almost unbelievable. The FT reports:

The president of Germany’s powerful Bundesbank has firmly rebuffed international demands for decisive intervention in the bond markets by the European Central Bank to combat the eurozone debt crisis, warning that such steps would add to instability by violating European law.

Bundesbank president Jens Weidmann told the Financial Times that only politicians could resolve the crisis, and he rejected the idea of using the ECB as “lender of last resort” to governments.

He also criticised actions taken by eurozone governments as “inconsistent”, and warned that their plans to involve private sector banks in rescue plans for Greece could add to the eurozone’s woes. Such private sector involvement, he said, could undermine market confidence in the eurozone’s crisis-fighting tools such as the rescue fund, the European financial stability facility.

Unfortunately, there´s no “confidence” left to be undermined!

Play “Criminal Minds” and draw a profile based on the “set look and tight lips” on this face:

The Euro: Views from the trenches

This post gathers in one place material that could be helpful for those that wish to have a view of the “long march” of the “Euro project” and how many of the problems that have developed over time had been considered years before it came into being.

The first, which can be construed as an example of “bad timing” – “The euro: It can’t happen, It’s a bad idea, It won’t last – US economists on the EMU, 1989 – 2002” – is a “slap in the face” of those Americans that were critical of the single currency. It was written by Lars Jonung and Eoin Drea in January 2008, just before the “flood gates” opened up!

Abstract: The purpose of this study is to survey how US economists, those with the Federal Reserve System and those at US universities, looked upon European monetary unification from the publication of the Delors Report in 1989 to the introduction of euro notes and coins in January 2002.

Our survey of about 190 publications shows (a) that academic economists concentrated on the question “Is the EMU a good or bad thing?”, usually adopting the paradigm of optimum currency areas as their main analytical vehicle, (b) that they displayed considerable skepticism towards the single currency, and (c) that economists within the Federal Reserve System had a more pragmatic approach to the single currency than academic economists, focusing on the design and operations of the new European central bank system.

We find it surprising that economists living in and benefiting from a large monetary union like that of the US dollar were so skeptical of monetary unification in Europe. We explain the critical attitude of US economists towards the single currency by several factors: first, the strong influence of the original optimum currency area theory on US analysis, leading to the conclusion that Europe was far from a optimal monetary union, second, the implicit use of a static ahistoric approach to monetary unification, resulting in the failure to see monetary unification as an evolutionary process, third, the failure to identify the problems with alternative exchange arrangements other than a single European currency, and fourth, the misleading belief that the single currency for Europe was primarily a political project that ignored economic fundamentals, thus dooming the single currency to disaster.

The second, one of the pieces mentioned in Jonung´s and Drea´s article, is Martin Feldstein´s 1997 article originally published in Foreign Affairs which had the cover title of “The Euro and War”:

According to Martin Feldstein, Professor of Economics at Harvard University and President of the National Bureau of Economic Research, the Economic and Monetary Union could lead to conflict and eventually even to war. Instead of increasing intra-European harmony and global peace, the shift to EMU and the political integration that would follow would be more likely to lead to increased conflicts within Europe and between Europe and the United States.

The reasons, according to Feldstein, are that there would be important disagreements among the EMU member countries about the goals and methods of monetary policy and the European Central Bank

Especially the German stringent anti-inflationary policy and the French political interventionism could lead to disagreements. The tension between countries that are more concerned about unemployment than inflation and countries which remain adamant about fighting inflation could be exacerbated whenever the business cycle raised unemployment in a particular country or group of countries.

A politically unified Europe would make it easier to enforce policies that would reduce structural unemployment but EU countries would also become collectively less able to compete with the rest of the world. The result would undermine the entire global trading system and create serious conflicts with the United States and other trading partners.
Since not all European nations would be part of the monetary and political union, there would be conflicts between the members and nonmembers of Europe, including the states of Eastern Europe and the former Soviet Union.

Furthermore, without the ability to use monetary policy to offset a decline in demand, governments would want to use tax cuts and increases in government outlays to stimulate demand and reverse cyclical increases in unemployment,. But the ‘Stability Pact’ tells governments that they cannot run fiscal deficits above three percent of GDP after the start of EMU. The most likely outcome of the shift to a single monetary union would therefore be the growth of substantial transfers from the EU to countries who have high unemployment rates. This would require a significant increase in tax revenues collected by the EU (a bigger EU-budget). The debates about how large the transfers should be and how the taxes should be collected would definitely lead to a lot of irritation and conflict according to Feldstein. The attempt to form a common military and foreign policy would be an additional source of conflict because they differ in their national ambition and in their attitudes and projecting force and influencing foreign affairs.

The monetary union is based on France’s aspiration for equality with Germany and Germany’s expectation for hegemony. Both vision drive their countrymen to support the pursuit of the project and both would lead to disagreements and conflicts when they could not be fulfilled. Smaller countries would also get frustrated as the union expands with at least six more countries of Eastern Europe. Current EU voting rules will give way to weighted voting arrangements in which the larger countries will have a predominant share of the votes.

A critical feature of the EU in general and EMU in particular is that there is no legitimate way for a member to withdraw. But if countries discover that EMU hurts their economies they might want to leave. The devastating American Civil War shows that a formal political union is no guarantee against a intra-European war.

The third is an article just published by the Center for European Reform. It confirms many of the worries by the early cementers and critics of the project. From the conclusion:

When the euro was launched, critics worried that it was inherently unstable because it was institutionally incomplete. A monetary union, they argued, could not work outside a fiscal (and hence a political) union. Proponents of the euro, by contrast, believed that a currency union could survive without a fiscal union provided it was held together by rules to which its member-states adhered. If, however, a rules-based system proved insufficient to keep the monetary union together, many supporters assumed (as faithful disciples of Jean Monnet) that the resulting crisis would compel politicians to take steps towards greater fiscal union.

Eurozone leaders now face a choice between two unpalatable alternatives. Either they accept that the eurozone is institutionally flawed and do what is necessary to turn it into a more stable arrangement. This will require some of them to go beyond what their voters seem prepared to allow, and to accept that a certain amount of ‘rule-breaking’ is necessary in the short term if the eurozone is to survive intact. Or they can stick to the fiction that confidence can be restored by the adoption (and enforcement) of tougher rules. This option will condemn the eurozone to selfdefeating policies that hasten defaults, contagion and eventual break-up.

If the eurozone is to avoid the second of these scenarios, a certain number of things need to happen. In the short term, the ECB must insulate Italy and Spain from contagion by announcing that it will intervene to buy as much of their debt as necessary. In the longer term, however, the future of the euro hinges on the participating economies agreeing at least four things: mutualising the issuance of their debt; adopting a pan-European bank deposit insurance scheme; pursuing macroeconomic policies that encourage growth, rather than stifle it (including symmetric action to narrow trade imbalances); and lowering residual barriers to factor mobility.

Pity Cassel “missed” the debate. He would have won “hands down”!

It is a great pity that we only hear about the Keynes-Hayek debate. Unlike those two towering figures, Cassel was consistent throughout. Economics, and the world economy, would have evolved very differently if Cassel´s “voice” had been given the same “air time”!

Doug Irwin´s paper on Cassel is a “bottomless pit” of quotable ideas from Cassel that resonate pristine into the present time. Take, for example, this Krugman post from earlier today:

Eric Rauchway finds an astonishingly timely quote about the Obama administration — said by Harry Dexter White in 1935:

There were, in meeting the crisis of the 1930s, two positions.

(a) Let the Government spend the minimum necessary to keep men alive and to prevent social disturbance; or
(b) Let the Government spend on such a large scale as to provide a positive powerful stimulus to recovery.

This second alternative is often formally embraced by those who in practice support the first position. That is, the actual scale of expenditures that they propose, while sufficient to bring about a serious derangement of the budget, is not sufficient to exert an adequate stimulus to recovery. In consequence, depression conditions tend to be frozen over a considerable period.

And this is Cassel (1933):

 “considering what governments have done and still do to deter private investment by high and arbitrary taxation, by all sorts of restrictions, national and international, and by bad monetary policy, it is, to say the least of it, curious that such mistakes should be exploited as a ground for widening the functions of governments as entrepreneurs

“Editing history”

The Euro crisis has reached a “tipping point”. Italy has been “marked to die” and that really spells the “death of the euro project”. Nick Rowe and Free Exchange have come up with potential last minute “games” that could be enacted to give additional “oxygen” to the “weak and sick” and, who knows, save the project. But even they do not put much faith in the success of the “trick”.

I wasn´t very surprised to see that with little editing, a few paragraphs of Doug Irwin´s just released paper on “Gustav Cassel´s analysis of the interwar gold standard”, give a perfect description of present day events:

…Many of these problems were mutually reinforcing and helped put the world economy Eurozone economies into a death spiral, but central banks the ECB did little to address the situation.  As Eichengreen showed, the gold standard euro constrained monetary policies and prevented countries from undertaking expansionary measures that could have ended the severe deflation recession. Politicians and central bankers clung to the “gold standard mentality” “euro mentality” which viewed the gold euro parity as an inviolable contract that had to be defended even at the cost of high unemployment (Eichengreen and Temin 2000).  The belief that deflation  internal devaluation was a necessary and inevitable adjustment from the preceding boom also provided an excuse to refrain from any significant policy response.

Among most economic historians, the gold standard euro standard interpretation has come to represent a “consensus view” of the Great Depression Great Eurozone Recession. The fact that countries not on the gold standard euro standard managed to avoid the Great Depression Great Eurozone Recession while countries on the gold standard euro standard did not begin to recover until they left it, provides strong evidence in support of this explanation.

The same “result” is obtained through analogy by David Glasner in his excellent “The economic consequences of Mrs Merkel”:

…Fast forward some four score years to today’s tragic re-enactment of the deflationary dynamics that nearly destroyed European civilization in the 1930s. But what a role reversal! In 1930 it was Germany that was desperately seeking to avoid defaulting on its obligations by engaging in round after round of futile austerity measures and deflationary wage cuts, causing the collapse of one major European financial institution after another in the annus horribilisof 1931, finally (at least a year too late) forcing Britain off the gold standard in September 1931…

… Now, it is Germany, the economic powerhouse of Europe dominating the European Central Bank, which effectively controls the value of the euro. And just as deflation under the gold standard made it impossible for Germany (and its state and local governments) not to default on its obligations in 1931, the policy of the European Central Bank, self-righteously dictated by Germany, has made default by Greece and now Italy and at least three other members of the Eurozone inevitable…

… If the European central bank does not soon – and I mean really soon – grasp that there is no exit from the debt crisis without a reversal of monetary policy sufficient to enable nominal incomes in all the economies in the Eurozone to grow more rapidly than does their indebtedness, the downward spiral will overtake even the stronger European economies. (I pointed out three months ago that the European crisis is a NGDP crisis not a debt crisis.) As the weakest countries choose to ditch the euro and revert back to their own national currencies, the euro is likely to start to appreciate as it comes to resemble ever more closely the old deutschmark. At some point the deflationary pressures of a rising euro will cause even the Germans, like the French in 1935, to relent. But one shudders at the economic damage that will be inflicted until the Germans come to their senses. Only then will we be able to assess the full economic consequences of Mrs. Merkel.

The figure below illustrates Glasner´s argument that the European crisis is a “NGDP crisis not a debt crisis”, with the ECB “targeting” Germany´s needs.

And to end this post “realistically”, there is this “cold” description of “Breaking up the euro” from Free Exchange:

…The technical challenges are not great. What is vastly under-estimated by advocates of euro exit is the financial and social chaos that would ensue both in the departed country and in the rest of the world. A euro break-up would not, as some seem to believe, be a slightly messier version of the ERM crisis of 1992-93. It would be a gigantic financial shockwave. Once departure by Italy were a serious prospect, there would be runs on its banks as depositors scrambled to move savings to Germany, Luxembourg or Britain, in order to avoid a forced conversion into the new weaker currency. The anticipated write-down of private and public debts, much of which is held outside Italy, would threaten bankruptcy of Europe’s integrated banking system.

There would be runs on other countries that might even consider leaving. A taboo would be broken. Credit would collapse. There would be a dash for cash (those €500 euro notes would come in handy). Businesses short of it would go under. Capital controls and restrictions on travel would be needed to contain the chaos. Once the recriminations start, the survival of the European Union and its single market would be under question. It’s all a frightening prospect.

But that doesn’t mean it won’t happen.