If this does not define “Depression”, what does?

The graphic below, from the Economist, gives a perfect summary of the world´s predicament. Of 34 advanced economies (EU + 7 others), 28 have a per capita GDP today that is smaller than 5 years ago. A Greek would probably say that Germany is a “vampire economy”, “feeding itself from others blood”. Australia not so, having kept its “own blood” (NGDP) flowing nicely. Mr. Bernanke, please note the US´s placement. Right there with Greece and Iceland! Please try to emulate Australia.

TALK of a Japanese style “lost decade” has abounded ever since the financial crisis took hold in 2008. The Economist has crunched the numbers and on the basis of seven indicators covering economic output, wealth and labour markets, the United States has already gone back in time some ten years. Its GDP per person, for example, was at a higher level than today back in 2005 and its main stockmarket index was higher in 1999. Of the countries considered, Greece has fared the worst. In economic terms, it is just entering the new millennium again. As a whole the rich world has been hardest hit by the financial crisis. Just six of the 34 “advanced” economies categorised by the IMF have GDP per person higher in 2011 than in 2007. Notable among them are Germany and Australia.


“Obsessions” are a formidable barrier to economic progress

In my last post I tried to show that in the 1960s the prevailing “obsession” with employment paved the way to the “Great Inflation” of the 1970s. In the 1970s, the employment “obsession” remained a “fixture of the policy landscape” under the Burns Fed. According to Robert Hetzel in his excellent piece Arthur Burns and Inflation:

Burns believed that the labor unions, through their exercise of monopoly power to push up wages, were blocking his attempt to lower ination and stimulate economic activity. He attacked the monopoly power of corporations and unions (U.S. Congress, 2/20/73, p. 414, and 8/21/74, p. 219, respectively):

“As for excessive power on the part of some of our corporations and our trade unions, I think it is high time we talked about that in a candid way. We will have to step on some toes in the process. But I think the problem is too serious to be handled quietly and politely.

. . . we live in a time when there are abuses of economic power by private groups, and abuses by some of our corporations, and abuses by some of our trade unions”.

More than anyone else, Burns had created widespread public support for the wage and price controls imposed on August 15, 1971. For Burns, controls were the prerequisite for the expansionary monetary policy desired by the political system—both Congress and the Nixon Administration. Given the imposition of the controls that he had promoted, Burns was effectively committed to an expansionary monetary policy. Moreover, with controls, he did not believe that expansionary monetary policy in 1972 would be inationary.

The outcome was that inflation “doubled up”, being the result of real shocks (that increased inflation and unemployment) and an expansionary monetary policy to mitigate the effect of the shocks on unemployment.

In the second half of the 1980s, 1990s and first half of the 2000s, inflation AND unemployment remained contained. In my interpretation this favorable combination came about because the Fed in fact stabilized nominal spending along a trend path. Then Bernanke took over and brought with him the “obsession” with inflation. The outcome was the “Great Recession” (“Lesser Depression” or “Second Great Contraction”). Four years on we are still a long way from escaping this predicament because, just as in the 1970s, the “obsession” that “caused” the “GR” is alive and well, as can be gleaned from this piece in the WSJ:

But a new survey of local businesses conducted by the Federal Reserve Bank of Atlanta, released Wednesday, suggests South-Eastern region business leaders may not share the Fed’s confidence about future inflation.

The survey of 168 firms found an average expectation inflation would hang close to the Fed’s target at 1.9% over the next 12 months. That was up a touch from the average expected annual gain of 1.8% uncovered in a similar survey a month ago, but it was still below the Fed’s preferred level for price increases of 2%.

The short run was not where the potential problem lies. Survey respondents predict inflation over the next five to 10 years to rise by 2.9%, a level that would problematic to the Fed. Of those who answered the question, the bias of regional companies clearly points to expectations that long term inflation risks are rising. Respondents said there was a 38% chance prices will rise between 1.1% to 3%, and a 29% chance of a gain between 3.1% and 5%. Those surveyed put a one in five chance on inflation rising by 5% or higher over the next five to 10 years.

So, yes: It´s “Hello Blackbird”! At least until someone like Christy Romer becomes Fed Chairperson.

The 60s X the 90s, “Golden Age” X “Great Moderation” – Who wins the “Economic Gold” (I could also call the “dispute” Obsession with Unemployment X Obsession with Inflation”.)

With the crisis, all “Schools of Thought”, even the ones that were “dormant”, came alive. So let´s also be nostalgic and compare two decades that mostly got “rave revues” from just about everyone concerned with these things.

There are many similarities between the 1960s and the 1990s. They both started with a recession – the 1960/61 recession and the 1990/91 recession. Both were relatively mild and both recorded a drop of 1% in Real GDP at the trough.

President Kennedy was elected on November 1960 and immediately surrounded himself with a veritable “who´s who” of the intellectuals of the time as advisors and counselors. That was also true for the “economic team”, in particular the group that came to staff the Council of Economic Advisors (CEA).

This was a sea change from the Eisenhower presidency, where economists, with the exception of Arthur Burns, didn´t have much sway.  Walter Heller, Chairman of the first Kennedy Council (1961-64) even dubbed the period “The Age of the Economist”. In his 1966 book, New Dimensions of Political Economy, he recounts the following:

President Johnson underscored his esteem of economists at the swearing-in of James Duesenberry as new CEA member in early 1966. He predicted that the new Council member would “write a record here, as his colleagues… have written, that will excite the admiration of not only all their fellow Americans, but will excite the admiration of leaders in other governments throughout the world who frequently comment to me about the wisdom, the foresight, the stability of the United States of America and its policies”.

In the 1960s it was all “about Fiscal Policy”.  But Monetary Policy was not completely “forgotten”. From James Tobin, Counsel Member during 1961-62 we know that:

  1. The “new economics” (read “Keynesian economics) sought to liberate federal fiscal policy from restrictive guidelines unrelated to the performance of the economy.
  2. The Council sought to liberate monetary policy to focus it squarely on the same macroeconomic objectives that should guide fiscal policy.

In the 1960s the goal of policy was “full employment” in order to satisfy the requirement of the Employment Act of 1946, that put the responsibility for employment and inflation on the shoulders of the Federal Government. The CEA took that responsibility very seriously as can be gleaned from a reading of the yearly Economic Reports of the President published during the decade.

From the first ERP in 1962:

THE U.S. ECONOMY made substantial advances in 1961 toward the goals of the Employment Act: “maximum employment, production, and purchasing power.”

In spite of the significant gains of 1961, the economy at the turn of the year still fell short of the standards set forth in the Employment Act. Too many persons “able, willing, and seeking to work” were unable to find “useful employment opportunities.” Even at record levels, national production had not yet reached its potential at full employment; and the purchasing power of the American people—the command over goods and services represented by their incomes—was still too low.

From the 1969 ERP:

The large recent gains in output reflect the fact that over-all demand has caught up and kept up with the economy’s rising productive capacity. In the late 1950’s and early 1960’s, the Nation was sacrificing the opportunity to consume and invest a substantial amount of the output it was capable of producing. Potentially productive men and machines were idle because of inadequate demand for their services. At the recession trough in the first quarter of 1961, actual GNP was $50 billion (1958 prices) below the estimated potential output of the economy at a 4-percent unemployment rate. This “gap” was gradually reduced and finally closed in the last half of 1965. Since then, actual GNP has fluctuated in a relatively narrow range around its growing potential—exceeding it somewhat in the boom of 1966 and falling a little short during 1967.

The paragraphs above were written just to put the “employment/unemployment obsession in perspective. After all it´s been half a century and most of us were not (consciously) around. And that obsession has its roots in the events of the “Great Depression”.

We all now about the “inflation obsession” that has become the “rule” since the “Great Inflation” of the 1970s came to an end in the early 1980s, so I´ll not spend time on it, going straight to the comparative charts about which I´ll have some comments.

First up unemployment.

Followed by inflation (measured by the Core PCE).

And RGDP growth

The unemployment resemblance is “eerie” despite the fact that it was an “obsession” only in the 1960s. Maybe low/falling unemployment is consistent with low/falling inflation, contrary to the original Phillips Curve (remember that soon after 1969, unemployment AND inflation trended up).

In the 1960s inflation was low and stable in the first half of the decade and quickly climbed during the second half. In the 1990s it trended down continuously. Observe in the RGDP growth charts that growth was much more stable in the 1990s and ended the decade higher and even more stable while it came down in the second half of the 1960s, when inflation began to show it´s “ugly” face.

To these facts I´ll give a “Market Monetarist – NGDP Level Targeting” interpretation.

The charts below show the behavior of Nominal Spending (NGDP) and a linear trend (estimated from, respectively, 1957 to 1965 and 1987 to 1995). It “fits the facts like a tailor-made glove”.

When did inflation “rear its ugly head” in the 1960s? Soon after spending “took off”. In the 1990s spending evolved along a constant growth trend. Unemployment AND inflation came down.

So, in a sense, the “obsession in the 1990s was with a constant level growth trend for spending. The “obsession” with inflation came “on board” with Bernanke and just as the unemployment “obsession” gave rise to the “Great Inflation”, the inflation “obsession” opened the door to (the final name ruling is still pending):

  1. The Great Recession
  2. The Lesser Depression
  3. The Second Great Contraction

Oh, almost forgot, I think the 1990s wins the “gold” hands down!

The guys back in the 1960s understood it better: There´s no Fiscal “Stimulus” without Monetary “Stimulus”

I was just reading this post by Laura D´Andrea Tyson:

The output gap reflects a deficit of more than 12 million jobs – the number of jobs needed to return to the economy’s peak 2007 employment level and absorb the 125,000 people who enter the labor force each month. Even if the economy grows at 2.5% in 2012, as most forecasts anticipate, the jobs deficit will remain – and will not be closed until 2024.

The US does indeed face a long-run fiscal deficit, largely the result of rising health-care costs and an aging population. But the current fiscal deficit mainly reflects weak tax revenues, owing to slow growth and high unemployment, and temporary stimulus measures that are fading away at a time when aggregate demand remains weak and additional fiscal stimulus is warranted.

So, how should the US economy’s jobs deficit, investment deficit, and long-run fiscal deficit be addressed?

Policymakers should pair fiscal measures to ameliorate the jobs and investment deficits now with a multi-year plan to reduce the long-run fiscal deficit gradually. This long-run plan should increase spending on education, infrastructure, and research, while curbing future growth in health-care spending through the cost-containment mechanisms contained in Obama’s health-reform legislation.

Approving a long-run deficit-reduction plan now but deferring its starting date until the economy is near full employment would prevent premature fiscal contraction from tipping the economy back into recession. Indeed, enactment of such a package could bolster output and employment growth by easing investor concerns about future deficits and strengthening consumer and business confidence.

Painful choices about how to close the long-run fiscal gap should be decided now and implemented promptly once the economy has recovered. But, for the next few years, the priorities of fiscal policy should be jobs, investment, and growth.

What a waste. No mention of monetary policy at all. Would it be because MP is “working double-time” to keep inflation close to the 2% target?

Scott Sumner has an illuminating discussion on Krugman and austerity:

So I read the UK austerity critics as saying:

Because you guys are too stupid to raise your inflation target to 3%, or to switch over to NGDP targeting, fiscal austerity will fail.  We believe the solution is not to be less stupid about monetary policy, but rather to run up every larger public debts.

Is that right?  Is that what critics are doing?

Now go back 50 years and see what the guys that “invented” the “output gap” concept thought (and this from the pen of non other than 1981 Nobel Laureate James Tobin, member of the CEA in 1961-62):

  1. The “new economics” (read “Keynesian economics) sought to liberate federal fiscal policy from restrictive guidelines unrelated to the performance of the economy.
  2. The Council sought to liberate monetary policy to focus it squarely on the same macroeconomic objectives that should guide fiscal policy.

Yes, they went too far in pursuing policies (fiscal and monetary) to close the gap. The charts below show Arthur Okun´s output gap from the Economic Report of 1969 (Okun was then Chairman) and the CBO based counterpart. It appears that the 1964 tax cut was “overkill” as a stabilization tool.

The “Output Gap” is a barren concept

And it has been widely “debated” recently. See here, here and here (and links therein).

Market Monetarists prefer to tackle the question of “gap” from the nominal or spending perspective. After all, that´s what stabilization policy can influence or control. So I present the chart below with three “ingredients”:

  1. Actual nominal spending (NGDP)
  2. A linear trend from 1987 to 2005
  3. The CBO “Potential NGDP”

There are a few “descriptions” in the chart, so you can make up your own story. But the “bottom line” is that there is a “spending gap”. It may be “high” or “low”, or somewhere in between so monetary policy is “shy”.

Two “Economic Popstars”, one “Libertarian”, the other “Progressive” talk to Playboy 39 years apart. Milton Friedman in 1973, four years into the “Great Inflation” and Paul Krugman in 2012, four years into the “Lesser Depression”.

This is Friedman and this is Krugman

The concluding question for each

PLAYBOY: So you’re hopeful?

FRIEDMAN: Not completely. You have to consider the ideological climate. The spirit of the times has gone against freedom and continues to go against it. There are still intellectuals who believe that concentrated power is a force for good as long as it’s in the hands of men of good will. I’m waiting for the day when they reject socialism, communism and all other varieties of collectivism; when they realize that a security blanket isn’t worth the surrender of our individual freedom even if it can be provided by government. There are faint stirrings and hopeful signs. Even some of the intellectuals who were most strongly drawn to the New Deal in the Thirties are rethinking their positions, dabbling just a little with free-market principles. They’re moving slowly and taking each step as though they were exploring a virgin continent. But it’s not dangerous. Some of us have lived here quite comfortably all along.

PLAYBOY: Arcade Fire delivers hope, but Wall Street failed us. The Rubin crowd failed us. Greenspan failed us. Who are the nonmusical heroes we can look forward to? Who’s going to save the United States of America?

KRUGMAN: Heroes who could be in a position to move stuff any time soon, I don’t see. The fact is the Great Depression ended largely thanks to a guy named Adolf Hitler. He created a human catastrophe, which also led to a lot of government spending. As you know, I’m famous for worrying about space aliens. It looks like it has to be some forcing event. Obviously you don’t operate on that basis, so what people like me will do is keep hammering on this stuff and hopefully it will eventually break through. The safety net has been enough to avoid mass suffering, to muffle it. People are exhausting their savings. This is where you start to wonder how much individuals really do matter. Maybe there is somebody on the political scene who will emerge. I don’t know where that comes from. But the big lesson I’ve taken from 10 years of punditry is that the story is never over. Who knows where we might be in four or five years?

The Strange Saga Of Richard Fisher, FOMC Member – The Inspector Clouseau of Central Bankers (A guest post by Benjamin Cole)

Once again I´m pleased to host a guest post by, as David Glasner put
it, “our esteemed Benjamin Cole” This time Benjamin applies his
journalistic talents on a profile of Dallas Fed President Richard
Fisher. Read and enjoy.

The images of the Federal Reserve Board building in Washington, D.C. are suitably august, graced by stolid Roman pillars, marble floors and handsome sculptures of giant-sized eagles.  It is a place of reserve and solemnity.  Well, except for one recent Federal Open Market Committee member.

In the longish-haired and effusive Dallas Fed President Richard Fisher, FOMC member in 2010, the prospect has instead been for florid homilies about the scourge of inflation, while—unknown the public—his personal money managers were using multi-million dollar chunks of Fisher’s $20-million booty-hoard to periodically “super-short” the S&P 500.

For example, in mid-May 2010 Fisher’s managers bought at least $3,050,000 worth of shares of an ETF identified on Fisher’s disclosure statements as “Proshares Double Inverse S&P 500.”

In English, that means if the S&P goes down, Fisher’s ETF shares go up, way up.  As the Fed’s “disclosure” forms are marvelously general, Fisher actually could have been short by many, many millions of dollars.  Fisher marked the category  “more than $1 million” on May 16, 2010.  On that day his managers went super-short more than $1 million, but no bottom limit was specified on that deep drill into the Wall Street Netherworld.

In radio-talk-show vernacular, Fisher’s personal money manager was placing Gong Show-scale bets against America while Fisher sat on a board that makes national monetary policy.

While Fisher—a financial-industry hotshot himself—contends he was not kept apprised of his money manager’s gyrations, these facts can hardly be comforting to the American public, nor are Fisher’s investment machinations the sort of comportment one associates with central bankers.  Worse, Fisher is a deeply skilled Wall Street veteran, a former star at Brown Bros. Harriman, and founder of the successful Dallas-based Fisher Capital Management.

The case put to the public is this: Fisher’s personal money manager, of his own initiative and volition, just decided to go ape-shat super short by a few millions in mid-May, without even so much as a secret handshake from Fisher.  The public may well wonder, and that sort of uncertainty is corrosive to good governance, especially of the monetary variety.

But here comes in Fisher’s somewhat lovable Inspector Clouseau side:  The super-short positions were super-duds.  With exquisite timing, the Fisher team nearly chose the exact market bottom, and there was a slow mixed grind upward from there for the rest of the year, and indeed, mostly ever since.   Fisher’s super-short Netherworld shock troops declared ignominious defeat in October 2010, and retreated to higher ground, perhaps losing 15 percent on the position.  Hey, only a half-mil or mil or so down the tubes. Timing, comedians will tell you, is everything.  And Fisher is a funny man.

Fisher’s Waterloo in the ETF short-world has become the sort of drama one expects from the extroverted Fisher. As President of the Federal Reserve Bank of Dallas, Fisher has never been shy about delivering strident public commentary that is or was at odds with the stewardship (failed or otherwise) of Chairman Ben Bernanke.  While freedom of expression is generally a positive, Fisher’s limelight gushing has presented a media image of a FOMC board riven by diametrically opposed divisions—just when the United States economy needed forthright and bold monetary leadership.  Regime certainty is what actors in the economy crave, but the Fisher Follies during the Great Recession have instead suggested the FOMC board is in multi-headed chronic confusion. A blind dog in a meathouse has more perceived directional resolve than our Fed.

And Fisher, despite leaving the FOMC in 2012 (he is still Dallas President), is not letting up: On Feb. 3, 2012, Reuters ran an article headlined, “Fed Still Divided as Fisher Sees No Need For QE3.”  That’s our Richard Fisher.

Yet Fisher, as with his personal money manager’s ill-fated super-short downhill rollercoaster ride, has been consistently wrong in his monetary policy positions. Why is Fisher always wrong?  It is an odd condition. Fisher’s IQ must be off the charts, and his handsome career is one success after another.  His academic credentials are solid gold, studded with Harvard economics degrees and an MBA from Stanford.  On paper, Fisher can’t miss.

But in real life, Fisher is afflicted with a myopia borne of his favorite time-piece, that of a broken clock unearthed circa 1978.  Fisher has inflationitis fever, burning hotter than Romeo for Juliet.  Like a financial Inspector Clouseau, Fisher has a simple theory for every bit macroeconomic evil-doing: Inflation did it, has done it, or will do it.

Fisher has a peevish fixation on inflation, even as the United States has posted the lowest inflation rates since WW II, even as unit labor costs have been falling for several years straight, even as commercial real estate is selling for half-price all across the United States, even as the United States Nominal GDP is perhaps 13 percent below where it should or could be.

Let’s take early 2008, a year that went down in infamy in Economic History as one of the most frightening GDP plunges of all time.  Not a year to worry about inflation, but rather a year to try to keep the economy from a death gurgle.

No matter to Fisher. As the year unfolded, Fisher was adamantly pettifogging against inflation and suggesting an upward price spiral was imminent.  Fisher’s best piece of advice was in June 2008, delivering insights to the prestigious Council of Foreign Relations in New York City. According to the Wall Street Journal, Fisher told the assembled notables that “though the economy still faces a period of slowdown, or “anemia,” and smaller businesses in particular are likely to feel some pinch from a tighter credit environment…the U.S. will skirt recession.”

Fisher’s prediction, of course, was as wrong as a pickled onion on a banana split.  The second half of 2008 was especially black, and by the fourth quarter the US economy was suffering from an “anemia” that was contracting the GDP at a horrific 10 percent annual rate. Fisher seems to have the knack for a timing that is precise, accurate and exactly incorrect.

Nevertheless, Fisher, who has a personal wealth of at least $20 million and a near-sinecure as President of the Dallas Fed, bravely assured listeners that he was in the trenches with them in the fight against inflation: “I prefer the word “anemia” because I think we’re going to have anemic economic growth for a longer cycle,” intoned Fisher. “I’m not sure how long.  I will pay that price personally if the price of that is that we don’t increase inflation….”

Fisher, in the best Clouseau-like style, is nothing if not enviably serene and self-confident even as he blunders across the economic landscape.  Indeed, Fisher seems blissfully unaware or unconcerned that the Fed, over-responding to global commodities inflation in 2008, helped steer the United States economy into near-collapse by the second half of 2008, and helped wreak commercial carnage globally as well.

“I have a reputation for being the most ‘hawkish’ participant in the deliberations of the Federal Open Market Committee, and I have a record that substantiates that reputation, having voted five times against further accommodation during the commodity-driven price boom of 2008,” Fisher inexplicably but proudly admitted to a Tokyo audience in April, 2009.  “I consider inflation an evil spirit that rots the core of economic prosperity and must never, ever be countenanced.”

Fisher the preening hawk—but one wonders at the Tokyo response to that statement of virtue, or how quickly they deposited him at the Osaka airport for his trip home.  Fisher’s remarks are stupefying alone, but doubly so in context: In Japan, in a nearly continuously deflationary environment since 1992, industrial production has fallen 20 percent, the stock market has fallen 75 percent, and property markets are down 80 percent and still falling, while the yen has nearly doubled against the dollar. Tight money has been an epic, ruinous failure, only alleviated by Japan’s already high (but since largely frozen) living standard of 1992, and an exemplary society of personal sacrifice, cultural socialization, and stability.  Even so, the Bank of Japan has all but asphyxiated the nation. (By comparison, in the United States industrial output doubled from 1992 to 2008, and inflation usually ranged from 2 percent to 6 percent.)

Lesser lights to Fisher, from Milton Friedman, to Allan Meltzer, to John Taylor, to Ben Bernanke (oh, them?) have all told the Bank of Japan to print more money, and then print a lot more money, and to keep printing money to break their deflationary spiral.  But not Fisher.  He all but told the Japanese that a twenty-year-long deflationary recession is a worthy price to pay, while inflation may lurk.  And that as a FOMC member he voted against “accommodation” five times in 2008—just as too-tight money helped plunge the United States into the Great Recession, from which we still have not recovered.

Okay, so let’s go forward (even as we cringe) to a now-domestic Fisher speaking in hometown Dallas in September 2009.  While most employees and private-sector businesses were in a cold sweat from the near-death experience of the 2008-2009 financial collapse, Fisher reassured his neighbor Chamber of Commerce burghers thusly: “As to the long-term dangers of inflation posed by the expansion of the Federal Reserve’s balance sheet, I remain ever vigilant. I have been outspoken on the reduced need for monetary stimulus in the future.”  One can only imagine a Dallas hotelier, or office-building owner, banker or retailer musing about that reassurance: “Our building is now worth 50 cents on the dollar, but Fisher is discussing the fine points of fighting inflation.” Perhaps they were wondering if Fisher could be stationed more permanently in Japan.

But of course, Fisher, in best Clouseau fashion, is a man confident in his obsessions. While Fisher’s nearly innumerable public presentations from 2006-2011 always contained a fierce homage to inflation-fighting, in fact inflation has been deader than Jimmy Hoffa on a bad day.  According to the BLS, what a Ben Franklin would have bought in 2008 required a whole $104.48 in 2011, annual averages.  That’s a 4.48 percent increase in a three-year period.  You are talking less than a 1.5 percent annual increase in prices, as measured by the CPI.  It is a historically low rate of inflation, and below even the Fed’s questionably low 2 percent target—a target that obviously should be lifted to get the United States out of long-term recession-land.

No wonder wall Street Journal reporter Mark Gongloff recently wrote that Fisher, “has incorrectly seen inflation coming around every corner for the past several years.”

Oddly, one never hears Fisher bragging about success of Fed policy in suffocating inflation (and the economy), although that is closer to the reality.  Indeed, for the last four months the CPI has been dead flat or down for three. (And set aside arguments that even measuring inflation has become dubious, and that many believe the CPI over-counts inflation, due to rapidly evolving and improving goods and services).

Happily, as Fisher presented one of the true active menaces to prosperity in America, he is now off of the FOMC.  The Fisher role going forward, through his pulpit in Dallas, will be limited to confusing markets about the Feds resolve and direction and perhaps explaining why his personal money manager occasionally placed multi-million-dollar maxi-wagers against the S&P 500.

Of one thing you can be sure: Right now, Fisher is very, very determined to rout inflation.  And that Inspector Clouseau is on the job, and defending you.

Keynes General Theory didn´t make Christy Romer´s Book List on “Learning from the Great Depression”

In her Five Books Interview:

 When you asked me for my list of books, I debated about whether to put The GeneralTheory by John Maynard Keynes on the list. The General Theory is an incredibly important book, but it’s basically a theoretical explanation of how aggregate demand could affect output. It was Friedman and Schwartz who provided the empirical evidence that supported the theory. That’s why A Monetary History went to the top of my list.

Just a couple of comments on a very enlightening interview. Her third listed book is Bernanke´s essay collection on the Great Depression and in particular the essay “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression”. According to Christina it “has added to our understanding of financial downturns”:

 Bernanke’s focus on the non-monetary effects of financial crises turned out to be incredibly important. It started a whole literature on how credit matters, above and beyond what’s reflected in interest rates. He changed our view of how monetary policy affects the economy.

This has had practical implications:

His work and the subsequent research it inspired made us realize how important it is in a financial crisis not to just prevent the money supply from falling, but also to make sure that credit keeps flowing. We learned from the Great Depression that when credit dries up it has devastating consequences.

That idea had a huge impact on the Federal Reserve’s behavior in the most recent crisis. In response to the financial crisis in the fall of 2008, the Fed not only followed the conventional central bank remedy – flood the system with liquidity and make sure there’s plenty of cash out there – but they also took extraordinary actions to keep credit flowing. When they saw credit markets were not functioning, the Fed was incredibly creative in finding ways to make sure that firms could get credit. For example, many businesses issue commercial paper to cover payroll and finance day-to-day operations. When that market stopped functioning and no one was willing to buy commercial paper, the Fed said, we’ll buy it.

But quite likely Bernanke´s “Credit View” had very “negative” implications. According to Scott Sumner:

Ben Bernanke published an influential article back in 1983, in which he argued that debt-deflation could worsen a depression by reducing bank intermediation.  He saw the reduction in intermediation as sort of “real shock,” which could not be completely addressed by easier money (otherwise his model would not have differed from Friedman and Schwartz’s.)

In 2008 he was given a chance few academics ever see—he was allowed to try out his theory on the US economy.  The Fed decided to focus on bailing out the banking system in the second half of 2008, rather than adopting an aggressive policy of monetary stimulus.  Indeed the famous interest on reserve program of October 2008 was implemented precisely to prevent the injection of funds into the banking system from ballooning the money supply and raising prices.  The Fed argued that without IOR the fed funds rate would have fallen close to zero.  (The ff target was in the 1.5% to 2.0% range at the time.)

Unfortunately, Bernanke’s theory is based on a misreading of the Great Depression.  The bank panics were problematic, but only because they led to monetary contraction.  The direct effects were trivial.  How do I know this?  Obviously I cannot be sure, but consider the following evidence:

1.  There were more than 600 bank failures each year during the Roaring Twenties, and yet the economy boomed.  Over 950 banks failed in 1926, a relatively prosperous year.

2.  The rate of bank failures did increase in the early 1930s, but they were mostly the same small rural banks that failed in the 1920s, and the share of deposits affected was a small fraction of the total banking system.

3.  There was one exception, during 1933 bank failures rose dramatically.  The deposits of failed banks were 11% of all deposits.  Much of the banking system was shut down for many months.

And what happened to the economy during this “mother of all bank panics?”  Prices and output soared (as I discussed in the previous post.)  This occurred because in 1933 (unlike 1930-32) the bank crisis was not allowed to lead to monetary contraction.

I would never argue that banking problems had zero impact on productivity, but the evidence from the booming 20s, and from 1933, suggests that as long as NGDP is growing, banking difficulties are not a major factor in the business cycle.  And we also know that banking problems don’t prevent NGDP from growing.  So it looks like Bernanke was relying on the wrong model of the business cycle, and fighting the wrong problem.

Towards the end of the interview, when the discussion turns to “The End of One Big Deflation” Christina Romer says:

What we learned from the Temin and Wigmore paper is that one way out of a recession at the zero lower bound is by changing expectations. To do that, often what is needed is a very strong change in policy – something economists call a “regime shift”. The most effective way to shake an economy out of a terrible downturn when we’re at the zero lower bound is an aggressive change in policy that makes people wake up, say “this is a new day” and change their expectations. What the Fed has done since early 2009 is much more of an incremental change.

I think that what the Fed needs instead is a regime shift. A number of economists have suggested that the Fed adopt a new framework for monetary policy, like targeting a path for nominal GDP. If the Fed adopted such a nominal GDP target, they would start in some normal year before the crisis and say nominal GDP should have grown at a steady rate since then. Compared with that baseline, nominal GDP is dramatically lower today. Pledging to get back to the pre-crisis path for nominal GDP would commit the Fed to much more aggressive policy – perhaps more quantitative easing and deliberate actions to talk down the dollar. Such a strong change in the policy framework could have a dramatic effect on expectations, and hence on the behavior of consumers and businesses.

And that folks puts Christy smack in the Market Monetarist camp. Yes, she mumbles about the relevance of “Fiscal Stimulus”, mostly on if there hadn´t been one the situation would be worse and that it was always “too small” anyway. But she indicates that what makes all the difference is the conduct of monetary policy.

The search for “structural” causes of unemployment goes on

Since it´s been hard to get aggregate evidence for “structural” causes of unemployment, David Andolfatto tries to do so at a more disaggregated level, comparing changes in job vacancy rates and changes in unemployment at the MSA (Metropolitan Statistical Area) level. As the bible says: “Search and Ye Shall Find”.  And Andolfatto is confident he did:

What does the second chart show? First, it is generally believed that unemployment rates across all major U.S. population centers increased during and since the past recession, and the chart corroborates this impression. It is also generally presumed that vacancy rates decline during an economic downturn, but the chart shows this is not necessarily the case. Roughly half of the sampled MSAs show the classic Beveridge relationship but the remainder do not. In this latter group, an increase in the unemployment rate is associated with an increase in the job vacancy rate. One inference that could be made here is that for this latter group, local unemployment rates are more the product of structural, rather than cyclical, factors.

Whether a recession is the product of cyclical or structural factors has some bearing on the optimal policy response. Monetary policy, in particular, is relatively well equipped to deal with an aggregate cyclical downturn. But it is not clear how monetary policy might be used to reduce local unemployment rates where recruiting intensity is high but the right kind of worker is hard to find. In these latter locations, localized fiscal policies may prove a direct and useful tool.

But if you click on the chart link above you´ll notice an “asymmetry”. Most of the MSAs where vacancy rates increase, this increase is very small, maybe insignificant. Note, for example the almost imperceptible vacancy rate increase in the New York, Louisville, Memphis and Nashville MSAs. Only the Detroit MSA has a vacancy rate increase that is a bit over 0.5 percentage point.

Things are very different in the bottom part of the chart where most MSAs experienced a strong drop in vacancy rates.

As the CBO recognizes, there´s always a structural element present in the process, but lack of demand remains the principal reason for the dire employment situation and if this goes on for long it will “create” structural problems down the line.

I find it strange that so much effort is dedicated to finding reasons for NOT using monetary policy. Maybe that´s because many have been indoctrinated on the “money always spells inflation” meme.

The Economic Report of the President 2012 – A report lacking character

This is the President Obama´s third “Economic Report of the President” and it´s still looking into the far past to “justify” a dismal present economic situation. One can only miss the “character” of the 1962 Economic Report, Kennedy´s first, where Arthur Okun introduces the concept of “output gap” which will guide “policy initiatives”, or the 1982 Economic Report, Reagan´s first, that starts off with describing an “Economic Policy for the 1980´s”:

At the same time that inflation was moderating, a far-reaching set of economic policies was being developed to provide a framework for growth and stability in the years ahead, reversing more than a decade of declining productivity growth and wide swings in economic activity.

In contrast, today´s Economic Report stresses the dismal condition of the labor market and anemic job growth during the recovery. But Mr. Krueger (CEA Chair) said the recession was less severe than economists might have predicted(!). He is still unaware that this is not a recession, being much closer to a “depression”. But he goes on trying to give “positive spins”:

The pace of the recovery has not been faster because of the severity of the financial and economic crisis and the unique nature of the problems that led to the crisis in the first place.  These problems included excess borrowing in the run-up to the financial crisis that subsequently caused massive deleveraging by households, a massive loss of wealth during the financial crisis that continues to constrain consumption and excess residential home building during the housing boom that continues to cause weakness in residential construction and the housing sector.

And the arguments below will make him a front runner for “The Spin Award of 2012”:

As has been the pattern in recent recoveries, job growth has lagged a resumption of economic growth. Job growth started in February 2010, 8 months after the official conclusion of the 2007–09 recession, versus 11 months after the end of the 1991 recession and 21 months after the end of the 2001 recession. From February 2010 through January 2012 (months 8 through 31 after the official end of the recession), private-sector employers added a net total of 3.7 million jobs. Over the comparable period of the recovery from the 1991 recession, businesses added 3.0 million jobs (from November 1991 to October 1993), and over the comparable period of the recovery from the 2001 recession, businesses added 1.1 million jobs (July 2002 to June 2004).

But this is the real comparable chart for the 1990/91, 2001 and 2007/09 recessions:

“Spin” as much as you like Mr. Krueger because the reality of the situation is clear even to the “blind”.