A Good Excuse = “A Book Excuse”

As John Taylor notes:

I’ve been writing about the reasons for weak recovery for two years, but the issue has heated up because of its relevance to the elections this fall.

His reasons were never very convincing, being dependent on what he calls “policy uncertainty” and he certainly does not emphasize monetary policy errors.

But he´s right about why the issue has heated up. He links to several pieces written recently. I´ll just single out the latest by Krugman who frames the issue in purely political terms:

People have been asking me for a while to respond to John Taylor’s claim that financial-crisis-induced recessions aren’t characterized by slow recovery. It’s a very convenient claim for Romney/Ryan, of course, because if true it eliminates the best excuse for lackluster performance under Obama.

I think Bill Woolsey got to the heart of the matter when he wrote:

Reinhart and Rogoff also show that a country receiving substantial foreign investment ends up in very bad shape when the investment flows are reversed.   When the foreigners stop rolling over their short term government bonds and bank deposits, then the net capital outflow is going to result in a reduction in real income.

Unfortunately, they and others have been misusing their work to provide excuses for the Federal Reserve’s poor performance over the last 4 years.   Rather than the true message that financial crises caused by a large sudden withdrawal of foreign investment is bad for both the foreign investors and the country losing the capital, they have turned this into a claim that a financial crisis necessarily results in a deep and persistent recession.

But as is well known, it´s election time and there´s the dictum: “It´s the economy, stupid

Note: This was my 1000th post in a little less than 26 months, averaging more than one a day! I´ll be mostly silent for the next few weeks to complete an ongoing collaborative project with a friend. But check-in once in a while.

Inflation in all shapes & sizes and for every taste

For some odd reason the 1966 Norman Jewison film  “The Russians are coming, the Russians are coming” came to my mind so I decided to type “Inflation is coming” on Google Trends. The result was interesting although not surprising. News with those words on the headline began to rise in March 2009 when QE1 was announced, peaked in May 2009 but remained elevated up to March 2010 when QE1 was discontinued, at which time it dropped to zero. It began to increase again after August 2010 when QE2 was hinted at the Jackson Hole Conference and peaked when QE2 was announced on the following November. After that it fell somewhat but kept a stable level, not showing any reaction to the announcement of Operation Twist or even to QE3. For the first half of October that headline has appeared zero times!

Maybe only a few ‘inflation obsessed’ like Philly Fed Plosser or Dallas Fed Fischer are still around, but not in enough numbers to generate “headlines”. Others will say that this is the moment of danger, when people become complacent.

I then decided to take a look at the ‘details’ of inflation. The Atlanta Fed has an ongoing “inflation project”, with lots of interesting CPI data. For example, they break down both headline CPI and Core CPI into their ‘flexible’ and ‘sticky’ components. They also calculate the median CPI inflation (the price change right at the middle of the distribution), among other things.

The charts below illustrate (in all, the dotted horizontal line indicates the 2% inflation target).

The first chart shows the Headline CPI and its flex and sticky components. The Flex CPI inflation is ‘flexible’ indeed, fluctuating widely. As the second chart shows that fluctuation follows closely on the heels of fluctuations in oil prices. Note that the Sticky Headline CPI remains close to the 2% target and for the past year is literally ‘sitting’ on it.

The third chart depicts the Core CPI and its Flex and Sticky components. Note that the Flex component of the Core CPI inflation fluctuates significantly, although much less than the Flex Headline CPI inflation (the charts are drawn on the same scale to facilitate comparisons). Here also, both the Core and its Sticky component have been ‘hugging’ the 2% target for more than one year.

The fourth chart illustrates the behavior of the Median CPI inflation. Again, the 2% target is an ‘attractor’.

The next chart shows the behavior of alternative measures of inflation expectations, for five and 10 years horizons. One is calculated by the Cleveland once a month on the release date of the CPI. The other is derived from the spread between regular and inflation protected treasuries. Maybe because it is available on a daily basis, the market shows a preference for the TIPS Spread. For my purposes here, I just want to highlight the fact that their qualitative reaction to major monetary policy moves (QEs and Operation Twist) is the same.

Finally, the last chart indicates that in the present cycle the stock market reacts favorably to increases in inflation expectations. That´s because the rise in inflation expectations signals a rebound in economic activity which affects the stock market positively (see Why the stock market loves inflation“).

Unfortunately the Fed is in practice constrained by the 2% inflation target (which, as the previous charts show, the market believes is binding). That precludes the Fed adopting something along the lines of a nominal spending (NGDP) target (level target) which, especially in the present situation, would be more effective in guiding agents expectations and therefore conducive to a much more robust recovery.

Expectations metamorphosis – 2

One month ago I showed this chart (expectations from the Cleveland Fed):

Then this chart:

And wrote:

After falling continuously, the short end of the inflation expectations curve “jumps” after June, with the long end remaining subdued. This transformation may be reflecting the chatter over the summer on the likelihood of “additional Fed action”.

I´m now curious to see the “mutation” which will show up next month. If the commitment pledged at the last FOMC meeting is believed, we should see the long end of the inflation expectations curve shift up, with the whole curve once more resembling a “Nike logo”, only at a higher level relative to the older ones.

But this is what transpired:

Inflation expectations fell for all horizons! That´s a bad omen for the success of QE3. The 5 year expected inflation from the TIPS spread is not very encouraging either:

Fire back on the “Big Lie” (that recoveries following financial crises induced recessions are slow)

John Taylor took sides with Bordo & Haubrich in a recent post. I butted in here. Now Reinhart and Rogoff fire-back, as reported by Jon Hilsenrath:

Rutgers University economic historian Michael Bordo and Cleveland Fed economist Joseph Haubrich studied just U.S. recessions going back to 1882 and found that U.S. recoveries following financial shocks tend to be rapid. Top economic advisers to Republican Mitt Romney have leaned on this research to argue that the culprit in the current slow recovery is Mr. Obama himself, not the financial crisis that preceded him. This line of research has taken issue with the Reinhart and Rogoff studies, arguing, among other things, that U.S. crises can’t be likened to financial crises that have happened elsewhere in the world — such as small developing markets – because their economic institutions are so different.

Now Reinhart and Rogoff are firing back. In a short paper they released this weekend, they fire back at the Bordo work. They see several flaws. One of their main arguments is that the Bordo work includes borderline financial shocks which weren’t full blown crises. Reinhart and Rogoff argue that if the paper focused on the four full blown U.S. crises of the past 150 years – in 1873, 1893, 1907 and the 1930s – they would get results similar to the broad swath of international crises the Harvard professors examined.

“The most recent US crisis appears to fit the more general pattern” they conclude, “The recovery process from severe financial crisis is more protracted than from a normal recession or from milder forms of financial distress.”

As argued in my earlier post, I favor a monetary explanation for the speed of the recovery. In this post I use the same strategy, only now I consider both the ‘downturn’ and the ‘upturn’ focusing only on the ‘four full blown U.S. crises’ identified by Reinhart and Rogoff: 1873, 1893, 1907 and 1930s. I start with the year real output peaked and end two years after the through year. The full periods are: 1873 – 1881, 1893 – 1896, 1907 – 1910 and 1929 – 1935.



What the charts show is that both the depth of the downturn and the swiftness of the upturn are related to what happens to nominal spending (NGDP). The 1907 – 1910 period is striking example. Note also that the 1873 – 1881 episode is very peculiar. Although NGDP dropped somewhat, there was never any drop in real output (a very ‘queer’ severe financial crisis). And when nominal spending takes off real output booms and by 1881 is almost 60% above its 1873 level!

The ongoing cycle clearly shows that more than the financial crisis from the burst of the housing bubble, what happens to nominal spending is what really matters. On yearly data, NGDP in 2008 is still above the 2007 level, so that despite the financial crisis, real output is supported. Things only go bad after nominal spending drops.

But the game of attributing responsibility to the president for the relatively weak recovery is misplaced. It´s the Fed´s fault (what Scott Sumner recently called “Fed Incompetence” ). Maybe Obama´s failure to fill up vacant Board seats for a long time had some effect, but surely that´s of second order importance.

Additional discussion by Ezra Klein and John Taylor

Doug Irwin has a good take on market monetarism

I believe the ‘core paragraphs’ of Doug Irwin´s FT comment are these two (my bold):

Some US economists have been pushing for more fiscal stimulus because they believe that, with interest rates close to zero, monetary policy is out of ammunition. If interest rates are already so low, they cannot be cut further to stimulate business investment. These economists make the error of taking lower rates as the main channel by which monetary policy affects the economy. Friedman and market monetarists believe that monetary policy is never out of ammunition and that further actions can help the economy by increasing asset prices, which improves households’ and businesses’ financial position.

Market monetarism draws lessons from the Depression to demonstrate that cutting interest rates is not vital in promoting economic recovery. After 1933, when interest rates were at extremely low levels, US monetary policy promoted a strong recovery because gold inflows allowed the monetary base to expand. This did not further reduce interest rates, but the economy recovered nonetheless without significant inflation. We know this because when the Treasury began in 1937 to sterilise the gold inflows, halting growth in the monetary base, interest rates did not soar but the economy suffered a massive relapse in the sharp recession of 1937-38.

Lars Christensen also commented

The Big Lie: Recoveries following financial crises induced recessions are slow

John Taylor doesn´t agree and cites a paper by Bordo and Haubrich. He puts up this revealing chart showing growth in real output in the first four quarters of recoveries.

In other writings, Taylor argues that what´s keeping the economy ‘tied down’ is bad economic policy which is causing uncertainty. I prefer to think it´s mostly bad monetary policy. So I check how nominal spending (NGDP), something closely controlled by the Fed, behaved in the two years following the year of the recession through that are identified by Bordo & Haubrich as ‘financial crises recessions’. I leave out the 1914-16 recovery because that was mostly due to WWI spending and distorts the comparison.

I also note by a dashed line the cumulated real growth after the recession ended in 2009. It´s easily the weakest real and nominal recovery of all. Taylor correctly notes that after the 1990/91 recession recovery wasn´t strong due to the fact that the recession was very shallow, so there was not much ‘catch-up’ to do.

The Fed can make the speed of the nominal recovery be pretty much whatever it wants – with much being translated into a real recovery. More, it could well have avoided the depth of the fall. But it´s nice to have a popular excuse for why recovery is progressing at a snail´s pace.

Update: Scott Sumner says:

The central bank determines the total level of spending.  No society can ever run out of the ability to manufacture more spending, unless the central bank runs out of paper and ink.

In an op-ed at the WSJ Michael Bordo summarizes his research with Haubrich:

There’s a belief among policy makers that serious recessions associated with financial crises are necessarily followed by slow recoveries—like the one we’ve experienced since mid-2009. But this widespread belief is mistaken. To the contrary, U.S. business cycles going back more than a century show that deep recessions accompanied by financial crises are almost always followed by rapid recoveries.

From Dean Baker, a great quote pertinent to the topic:

We are so far lost in economic debates that we are not even at the point of arguing whether the earth goes around the sun of vice-versa. We can’t even agree that the sun rises in the east.

If you ask a stupid question, don´t expect other than a stupid answer. That´s what you get when the elusive concept of “price stability” overwhelms all else.

David Altig has a take at Macro Blog:

All of the five questions that Chairman Ben Bernanke addressed in his October 1 speech to the Economic Club of Indiana rank high on the list of most frequently asked questions I encounter in my own travels about the Southeast. But if I had to choose a number one question, on the scale of intensity if not frequency, it would probably be this one: “What is the risk that the Fed’s accommodative monetary policy will lead to inflation?”

The Chairman gave a fine answer, of course, and I hope it is especially noted that Mr. Bernanke was not dismissive that risks do exist:

“I’m confident that we have the necessary tools to withdraw policy accommodation when needed, and that we can do so in a way that allows us to shrink our balance sheet in a deliberate and orderly way. …

“Of course, having effective tools is one thing; using them in a timely way, neither too early nor too late, is another. Determining precisely the right time to ‘take away the punch bowl’ is always a challenge for central bankers, but that is true whether they are using traditional or nontraditional policy tools. I can assure you that my colleagues and I will carefully consider how best to foster both of our mandated objectives, maximum employment and price stability, when the time comes to make these decisions.”

“Price stability” must mean 2% inflation because that´s exactly the average over the past twenty years of both the Headline PCE and PCE-Core!

And Bernanke is pretty cocky to say he´s confident …Why, then, did he let things get so bad to start with? Why should I believe him when he says he can get it right? But I do! I´m pretty confident that if inflation goes above the 2.25% that Kocherlakota said was his “threshold” the FOMC will come ‘pounding down’ full force. That´s exactly what they did in 2008 when they got squeamish about the possible impacts of oil and commodities.

David Altig throws in his ‘wisdom’:

In each case, policy actions were generally taken in periods when the momentum of inflation expectations was discernibly downward. A simple-minded conclusion is that FOMC actions have been consistent with holding the bottom on inflation expectations. A bolder conclusion would be that as inflation expectations go, so eventually goes inflation and, had these monetary policy actions not been taken, the Fed’s price stability objectives would have been jeopardized.

Perhaps more pertinent to the current policy discussion, inflation expectations have, in fact, moved up following the latest policy action—which I guess people are destined to call QE3. But unlike the periods around QE1, QE2, and Twist, QE3 was not preceded by a period of generally falling longer-term breakeven inflation rates. So this time around there will be another, and perhaps more challenging, chance to test the proposition that monetary accommodation is consistent with price stability. As for previous actions, however, I’m pretty comfortable arguing the case that the price stability mandate was not only consistent with accommodation, it actually required it.

Get real. People are by now pretty sure Bernanke (FOMC) will not let inflation come down ‘too far from 2%, so no one will be expecting that, let alone the market as a whole. So the only way inflation could go is up. But the market also understands that inflation cannot detach itself ‘too far’ from 2%.

And that means all the ‘forward guidance’ being spread around is for nothing.

Update (10/11): Ed Dolan also comments:

So there is the paradox: The bigger the Fed’s balance sheet grows, the more it has to emphasize the efficacy of its exit strategy, but the more it talks about the exit strategy, the less real kick it gets out of further increases in its balance sheet.

How do we break out of this trap? Next question, please.

Swedish lessons for all

Anders Aslund has written an essay which he titled “A Swedish Lesson for Ed Balls”:

 To Brits, Sweden with its tightly regulated social welfare state is often a byword for socialism. But in the last two decades the country has been transformed. today it offers a flexible and dynamic European model with ever falling public expenditure, lower taxes, economic growth and budget surpluses.

It can easily be generalized as “lessons for all”.

This is interesting because in his recent appearance on “This Week”, Krugman countered Mary Matlin´s assertion that “this is the worst recovery” saying this is what´s to be expected following a “financial crisis recession”. And cites Sweden in the early 1990s.

But let´s take a closer look and compare Sweden and the UK. The first chart shows that in the early 90s spending (NGDP) crashed in both countries. That may have something to do with the blow-up in the real estate market and banks in Sweden, but let´s leave that aside. They never regained the prior trend path of spending, but that´s because that spending path was associated with high inflation – of 8% on average during the 1980s in both countries.

Now take a look at the real output trend path and actual real output. Sweden took a long time reverting to the trend, reaching it in 2007, just before the international crisis erupted. But note that the UK never even tried to get back to the original trend path, remaining on a parallel lower path before shifting down following the crisis. Sweden, on the other hand appears set to regain the original trend level path.

As Aslund notes, Sweden after 1990 went through deep structural reforms, a difficult job after more than two decades of rampant socialist policies. Many of those were supply side reforms, allowing growth to rise so as to get back to the original trend path.

One indication is seen on the next chart. While since 1993 government expenditure has been on a downtrend in Sweden, more recently it has gone up significantly in the UK. Despite all the “austerity” talk in the UK, Sweden has been much more “austere”. During the crisis, mostly due to automatic stabilizers, government spending in Sweden went up by 3.2% of GDP. In Britain it went up by a whopping 7%. Since 2009 in Sweden it has dropped back to the initial level, but in Britain it is still more than 5% above. But that hasn´t helped British growth, which has remained well below Sweden´s.

The difference in their relative performance in the present cycle  is due to what´s happened to spending growth in both countries. That´s illustrated in the next chart. Note that both countries remained close to the low inflation spending path to which they had ‘transferred’ after the early 90s adjustment, but while Sweden is well on the way back, Britain is still distancing itself from it!

Obviously, monetary policy in Sweden has been much better than in Britain. Lars Svensson, Bernanke´s Princeton colleague, is on the Board over there. Maybe he should be invited to cross the Atlantic!

Even “better” examples of relative success than Sweden are Australia – some will quickly say its because of commodity prices – and Poland, not known as a ‘commodity country’. In both, NGDP never faltered.

HT: David Levey

Are there recession types, akin to blood types?

It appears so. Reinhart & Rogoff have even written a book about how recoveries are slow after recessions induced by financial crises. Richard Koo has written about balance sheet recessions and how monetary policy effectiveness is weak and fiscal stimulus has to come to the rescue.

On the other hand, Nick Rowe has argued that “recessions are always and everywhere a monetary phenomenon”, i.e. they have all the same origin. How they progress may differ, and depends on how monetary policy acts, but that´s not the same as classifying them by “types”.

In a recent episode of ABC´s This Week, Paul Krugman contested Mary Matlin´s portrayal of the present recovery being the worst ever. In a post today PK illustrates with a chart showing that “financial crisis-type recessions” don´t recover as fast as “normal-type” recessions.

In fact, Mary Matlin was just borrowing Ed Lazear´s image of the worst recovery ever, which he wrote about six months ago:

How many times have we heard that this was the worst recession since the Great Depression? That may be true—although the double-dip recession of the early 1980s was about comparable. Less publicized is that our current recovery pales in comparison with most other recoveries, including the one following the Great Depression.

Bernanke himself has classified the Great Depression as the result of a financial crisis in his classic 1983 AER article “Nonmonetary effects of the financial crisis in the propagation of the Great Depression”.

The next chart shows that 10 quarters into the different recoveries the present one is really by far the worst. The indicator used is nominal GDP (or nominal spending) because that´s what the Fed closely influences. And in both 1933 and 1982 it was monetary policy that made the difference. That´s what´s lacking today.


Due to the Great Recession, have the “young” suddenly “aged”?

Calculated Riskwants us to believe that MOST of the decline in the participation has been due to the aging of the population:

I’ve written extensively on the reasons for the decline in the participation rate. Unfortunately some people haven’t been paying attention. Two key points: • Some of the recent decline in the participation rate has been to due to cyclical issues (severe recession), but MOST of the decline in the overall participation rate over the last decade has been due to the aging of the population. There are also some long term trends toward lower participation for younger workers pushing down the overall participation rate. • This decline in the participation rate has been expected for years. Here are three projections (two from before the recession started). The key to these projections is that the decline in the participation rates was expected.

I have difficulty reconciling that statement with the following observations, followed by the corresponding charts:

  1. Overall Labor force participation peaked at around 67.1% in early 1997 and maintained that level through early 2001. After falling to 66.1% in late 2003, that level was maintained through mid-2008, after which point the “Great Recession” “incredibly accelerated the aging rate of the population”.
  2. Curiously, given CR´s interpretation, employment among those 55 and up has been rising steadily since 1996. The Great Recession only provoked a short lull in the level of employment in that age group. I know that if population is aging the number of people above 55 is increasing. But so is the corresponding employment level, i.e. it is not inducing a fall in the participation rate.
  3. That´s not the case with the prime age work force, those between the ages of 25 and 54. The employment level in that age group dropped like a stone after mi-2008. Many likely are not participating at the moment, but that´s not because they “aged”.
  4. The participation rate among the really aged, those above 65 has surprisingly increased despite the rise in their number (data only after mid-2008 available). Again, this is not consistent with the big drop in the overall participation rate since mid-2008.