Needed for 2013, a paradigm change

Simon Wren Lewis joins the debate on the State of Macro.

How do you judge the health of an academic discipline? Is macroeconomics rotten or flourishing? Stephen Williamson is right that in one sense it is flourishing: many interesting avenues are being explored, and lots of interesting papers are getting written. Furthermore there is a common language. Of course there are pronounced local dialects, but there is mobility to, so having a freshwater dialect does not stop you giving a seminar that will be appreciated in a saltwater department, or indeed working in a saltwater department. So as an intellectual pursuit, one could claim that times have never been better for academic macro.

Society does fund some academics to engage in purely intellectual pursuits, but macroeconomics is not one of these. Yet much of the flourishing of ideas and research that is currently taking place has been inspired by recent events, and is directly or indirectly policy relevant. However having lots of ideas that are relevant to policy is not sufficient to make an academic discipline useful. It also needs to respond to the evidence in sorting out what ideas are helpful and what are not, so that it can be a progressive endeavour. In this respect, academic macroeconomics appears all over the place, with strong disputes between alternative schools.

Is this because the evidence in macroeconomics is so unclear that it becomes very difficult to judge different theories? I think the inexact nature of economics is a necessary condition for the lack of an academic consensus in macro, but it is not sufficient. (Mark Thoma has a recent post on this.) Consider monetary policy. I would argue that we have made great progress in both the analysis and practice of monetary policy over the last forty years. One important reason for that progress is the existence of a group that is often neglected – macroeconomists working in central banks.

Unlike their academic counterparts, the primary goal of these economists is not to innovate, but to examine the evidence and see what ideas work. The framework that most of these economists find most helpful is the New NeoClassical Synthesis, or equivalently New Keynesian theory. As a result, it has become the dominant paradigm in analysing monetary policy.

According to Scott Sumner the dominant paradigm is not very useful, in fact quite useless

Of course private industry doesn’t use DSGE models, they are useless.  The macroeconomy is incredibly complex; I recall McCallum once listing 10 types of wage/price stickiness.  Most models assume one type.  And most models fail to incorporate AD/AS interaction, as when adverse demand shocks reduce AS by leading policy-makers to extend unemployment insurance from 26 weeks to 99 weeks.  Most don’t know how to identify monetary policy shocks.  The DSGE models are incredibly simplistic.  I basically “retired” from mainstream macro several decades ago when I saw where things were going, and pursued my own research interests.

There are two possible uses for DSGE type models; identify the costs of macro instability, so that central banks can pick the optimal target, and identify the stance of monetary policy most likely to hit the policymaker’s target.  But the DSGE models cannot do either.  The optimal monetary policy stance is most efficiently resolved by targeting market forecasts of the goal variable.  And given the complexity of the macroeconomy, any attempt to use DSGE models to identify the optimal monetary policy goal will depend entirely on what assumptions are built into the model.

The real problem with mainstream macroeconomists is that they are too influenced by “framing effects” and had a giant brain freeze in late 2008.  Virtually the entire profession forgot that the central bank has the ability and responsibility to provide an adequate level of AD.  Only a fringe group of Aspergy-types looked beyond the framing effects, saw the real problem, and saw what needed to be done.  But the profession (freshwater and saltwater) failed us.  The central banks do pretty much what a consensus of elite macroeconomists think they should be doing. The profession “owns” the Great Recession, or at least that portion of it caused by inadequate AD. The profession has had the tools all along, but doesn’t seem to know how or when to use them.  Only 4 years later is it starting to wake up.

David Altig is also skeptical

According to David Altig:

What if, rather than some measure of nominal GDP, the 2004–06 Fed had instead been solely focused on the inflation rate? You can’t answer that question without operationalizing what it means to be “focused on the inflation rate,” but for the sake of argument let’s simply consider actual annualized PCE inflation over a two-year horizon. (In his press statementexplaining the Federal Open Market Committee’s (FOMC) latest decision, Fed Chairman Ben Bernanke suggested using a one- to two-year horizon for inflation forecasting horizon to smooth through purely transitory influences on inflation that the central bank would inclined to “look through.”) Here’s the record, with the period from 2004 through 2006 highlighted:

If you really do think that there was a policy mistake over the 2004–06 period—and in particular if you believe the FOMC during that should have adopted a more restrictive policy stance—I’m hard-pressed to see what advantage is offered by focusing on nominal GDP rather than inflation alone. In fact, you could argue that that the GDP part of the nominal GDP target would have added just about nothing to the discussion.

Lo and behold, Mr. Altig. Focusing on NGDP makes all the difference as an adaptation to your chart, including both the same calculation for the Core PCE and the estimate of the NGDP gap, indicates.

In the 2004-06 period monetary policy was “geared” to take nominal spending back to trend, which it succeeded in doing by the end of Greenspan´s tenure. The difference to Bernanke in 2007-08 was that Greenspan didn´t make monetary policy a “slave” of Headline inflation. By focusing on oil and commodity price increases in 2007-08 Bernanke “punched” nominal spending “right in the nose”. The “bleeding” was copious!

Noah is skeptical

Noahpinion has a laugh at the expense of MMs who think Abe could make a diference in Japan.

According to Noah.

Abe is mainly interested in social and cultural issues. He is the Japanese style of socio-cultural conservative, sort of a Newt Gingrich type . As prime minister in 2006-7, he enacted a law requiring public schools to teach “patriotism”,  mounted a vigorous denial of Japan’s WW2 “comfort women” sex-slavery, gave gifts to the nationalist Yasukuni Shrine (angering China), and pushed to de-emphasize Japan’s WW2 war guilt in school textbooks. His lifelong quest has been the revision of Japan’s “pacifist” constitution to allow Japan to have a normal military.

I of course don’t mean to imply that Abe’s cultural conservatism makes him unlikely to experiment with monetary policy (unlike in America, in Japan “hard money” is less of a conservative sacred cow). Instead, what I mean is that Abe really just does not care very much at all about the economy. I mean, of course he wants Japan to be strong, and of course he doesn’t want his party kicked out of power. But his overwhelming priority is erasing the legacy of World War 2, with the economy a distant, distant second.

And he may well be right, although we should not forget Bernanke s own about face since becoming Fed Chairman! But what is very wrong in Noah s post is the claim that

The LDP, which thrived in the 60s, 70s, and 80s, has always been a mercantilist outfit, weakening the currency to pump up exports, using the surplus from exports to support Japan’s corporatist social model in the so-called “two-tiered economy”. In Japan’s days as a high-quality low-cost export powerhouse, this worked marvelously and kept everyone happy, allowing the LDP to keep power for generations. The recent strength of the yen, however, has been looking like the final nail in that system’s coffin.

Just before the end of Bretton Woods in the early 1970s, the Yen was 360 to the dollar. Three months ago it bottomed at 75. Now it s at 83. In all those decades there was only a brief  3 year period – 1995 to 1998 – that the Yen, like every other currency, depreciated againt the dollar, driven by high productivity growth in the US and flight to safety from crises in Asia and Russia. So, if they have tried to weaken the currency through all those years they were pretty incompetent. Maybe this time it will be different.

Chart Update:

 

HT David Levey

Jeff Frankel gives out good Christmas advice

From Jeff Frankel:

The time is right for the world’s major central banks to reconsider the framework they use in conducting monetary policy. The US Federal Reserve and the European Central Bank are grappling with sustained economic weakness, despite years of low interest rates. In Japan, Shinzō Abe of the Liberal Democratic Party’s (LDP) was elected prime minister December 16 on a platform of switching to a new, more expansionary, monetary policy.  Mark Carney, the incoming governor of the Bank of England, has made clear that he is open to new thinking.

Monetary policymakers would do well to consider a shift toward targeting nominal GDP.   (Carney is evidently contemplating precisely this).  The switch could be phased in via two steps, without abandoning the established inflation anchor.

Sifting through the GDP components

CalculatedRisk tries an optimistic note:

Discussions of the business cycle frequently focus on consumer spending (PCE: Personal consumption expenditures), but the key is to watch private domestic investment, especially residential investment. Even though private investment usually only accounts for around 15% of GDP, the swings for private investment are significantly larger than for PCE during the business cycle, so private investment has an outsized impact on GDP at transitions in the business cycle.

And shows the chart below.

Note that during the recent recession, the largest decline for GDP was in Q4 2008 (a 8.9% annualized rate of decline).  On a three quarter center averaged basis (as presented on graph), the largest decline was 5.9% annualized.
However the largest decline for private investment was a 43% annualized rate!  On a three quarter average basis (on graph), private investment declined at a 35% annualized rate.

To a market monetarist what matters is the whole shebang, i.e. NGDP. In all situations investment is much more volatile than consumption. But if nominal spending evolves close to the level trend path, everything, investment AND consumption become much less volatile. And that was the main characteristic of the Great Moderation.

 

Calculated Risk further notes:

The key downside risk for the US economy in 2013 is too much austerity, too quickly.   However, barring a policy mistake (I expect a fiscal agreement), it seems unlikely there will be a sharp decline in private investment in 2013.   This is because residential investment is already near record lows as a percent of GDP and will probably increase further in 2013, and  that suggests the US will avoid a new recession in 2013.

But MMs know that the key downside risk is for monetary policy to stay on the sidelines and not compensate for any austerity brought on by the fiscal adjustments that might take place!

Merry Xmas and a profitable New Year to all

John Taylor mourns the five-year-anniversary of the end of the Great Moderation

In a recent post, Taylor writes:

Hundreds of research papers have been written on the nature and causes of the Great Moderation, which got started around 1983. While that research began long after the Great Moderation got underway (I published one of the earliest papers on it in 1998), we should not wait so long to start seriously researching the causes of the post-Great Moderation period, regardless of how this period is eventually named by economists.

In my view, the framework that Ben Bernanke used in a February 2004 paper to study the causes of the Great Moderation is a good one. It goes back to research that started before the Great Moderation. Bernanke characterized the Great Moderation as a reduction in (1) the variance of inflation and (2) the variance of real GDP. He used the following diagram (it is a replica of Figure 1 in his paper) in which these two measures are on the horizontal and vertical axes respectively. Using the diagram he represented the Great Moderation as a move from point A to point B. He showed that a primary cause was better monetary policy, and he represented this by showing that better policy brought the economy closer to the true policy tradeoff curve (TC2) rather than the occurrence of a shift in the curve (from TC1 to TC2) . I completely agree with that interpretation.

But what caused the end? I have updated Bernanke’s diagram by adding a point C and a line from point B to point C (in red), based on the empirical volatility measures in the table below for the three periods. Observe that the post-Great Moderation deterioration does not simply retrace the previous improvement. It is nearly vertical, reflecting that virtually all the deterioration is in the output variability dimension.
In my view monetary policy was a major factor in the end of the Great Moderation just as it was the major factor in the Great Moderation itself. I review the reasons for this view in this paper on central bank independence versus policy rules which I am presenting at the annual meeting of the American Economic Association next month.

In the paper he says:

It was through such considerations that Bernanke (2004), Taylor (1998, 2010), Meyer (2010) and others were led to consider changes in monetary policy as a major reason for the improved economic performance in the 1980s and 1990s. And in fact there were clearly identifiable changes in policy during this period, including the more rule like focus on price stability and the closer adherence to simple predictable policy rules starting with Paul Volker and continuing for much of Alan Greenspan’s term.

In my view, the same monetary policy considerations—working in reverse—are relevant for explaining the recent deterioration of performance.  Monetary policy became much less rule like, starting in my view in the period from 2003 to 2005 when the policy interest rate was held far below levels that would have pertained in the 1980 s and 1990s under similar conditions.

If he can insist on blaming rates “too low for too long” in 2003-05, I can insist it wasn´t. In fact, during that period monetary policy was the correct one. As soon as in August 2003 the FOMC said that:

The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. In contrast, the probability, though minor, of an unwelcome fall in inflation exceeds that of a rise in inflation from its already low level. The Committee judges that, on balance, the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.

The economy began to mend. By “mend” I mean NGDP began to rise towards trend and all the things we would be happy to see happen now – increase in RGDP growth, rapidly falling unemployment, rising long term rates, increase in stock prices and rising inflation expectations – happened then!

But note that “monetary policy was the correct one” given there was no explicit target stated. If, for example, that Fed had an explicit NGDP level target, quite likely interest rates would not have stayed “so low for so long”.  Differently from Taylor, I believe the problem lies not in the “Taylor rule” not being “practiced” but in the absence of an explicit nominal (preferably NGDP) level target.

Is ‘opacity’ best?

One must miss Greenspan when a senior Fed researcher has to try and ‘make transparency transparent’:

As a regular, satisfied customer of The Wall Street Journal‘s “Heard on the Street” feature, I was a bit distressed to read this, from an item titled “Bonds Beware Central Bank Regime Change“:

In the U.S., the Federal Reserve has announced that future monetary policy tightening will depend on a hard target for falling unemployment and a softer target for rising inflation expectations. That looks like a tilt toward growth as the priority over inflation.

When The Financial Times and The Wall Street Journal in quick sequence publish articles that seem to misinterpret Fed communications, I have to surmise that the message isn’t getting through and bears repeating and further explaining.

Earlier this week, in response to the alluded-to FT article, I addressed the charge of a “tilt toward growth as the priority over inflation,” noting that Fed Chairman Ben Bernanke clearly indicated in last week’s press conference that there has been no “change in our relative balance, weights towards inflation and unemployment….”

Greenspan, in his way, was ‘transparent’:

I guess I should warn you, if I turn out to be particularly clear, you´ve probably misunderstood what I´ve said.

But anyway, I´m surprised that Bernanke didn´t think pundits would arrive at exactly this sort of conclusion when he started putting numbers on unemployment and inflation objectives.

“Trickery” from The Economist

The Economist just published “The 12 charts of 2012”. Chart number 4 is:

In such lifeless company America’s economy looked almost vibrant (chart 3). Its housing market turned a corner in 2012 (chart 4), and its unemployment rate fell steadily. But the recovery is still very weak. The numbers of long-term jobless stayed high; export markets drooped.

In trying to associate the unemployment dynamics with house prices, the Economist bungles it.

Below the relevant charts.

1. Overall employment (NFP) & Residential Construction Employment

Note that overall employment continued to rise after residential construction employment began to drop.

1. 2. Residential Employment & House Starts

House starts peak in January 2006. Residential construction employment falls in tandem.

1. 3 The unemployment rate is NOT associated with house prices but clearly follows the lead of nominal spending (NGDP), only ballooning when spending tanks and falling with spending growth. But note that the LEVEL of employment is still low (and unemployment high) because NGDP is way below the ‘trend level’.

 

House prices fall, house starts drop, residential construction employment dips; but the overall economy is still doing ‘fine’. But when spending tanks all “hell breaks loose”.

Matthew Klein (MCK) could have talked to Ryan Avent (RA) before writing foolish things about NGDP Targeting

This is MCK:

THOSE who want central bankers to focus to changes in nominal incomes (NGDP or NGDI growth) rather than the pace of consumer price increases (CPI or PCE inflation) have made tremendous progress over the past few years, at least when it comes to persuading economists and pundits. Even policymakers seem to be increasingly interested in the idea. In the short term, a nominal income target, coupled with the notion of “catch-up growth,” would provide central bankers with much more leeway to engage in monetary stimulus, particularly by affecting people’s expectations. (The exact nature of how this works is unclear). In general, the theoretical appeal of a nominal income target is that it would do a better job than an inflation target at shielding the economy from supply shocks.

For example, shortages in essential commodities can cause the observed rate of inflation to accelerate while restraining real output growth. A central bank that focused on nominal incomes would avoid an excessively tight policy response compared to a central bank that targeted the rate of consumer price inflation. But a central bank with a nominal income target would also have to be tighter than one with an inflation target during a commodity glut or during a period when the world’s labour supply increased. Worryingly for the advocates of an NGDP target, this means that the emerging consensus may not be politically durable. People have gotten used to the idea of monetary tightening in response to faster inflation. How would they feel if, in the face of higher output growth but falling inflation, the central bank failed to ease, or even tightened, in order to stick to its NGDP target?

And he quotes Jerry Jordan´s doubts. But this is what Greenspan himself had to say at the time:

From the November 17 FOMC Transcript, Greenspan says:

“Let me put it to you this way. If you ask whether we are confirming our view to contain the success that we’ve had to date on inflation, the answer is “yes.” I think that policy is implicit among the members of this Committee, and the specific instruments that we may be using or not using are really a quite secondary question. As I read it, there is no debate within this Committee to abandon our view that a non-inflationary environment is best for this country over the longer term. Everything else, once we’ve said that, becomes technical questions. I would say in that context that on the basis of the studies,we have seen that to drive nominal GDP, let’s assume at 4-1/2 percent, in our old philosophy we would have said that [requires] a 4-1/2 percent growth in M2. In today’s analysis, we would say it’s significantly less than that. I’m basically arguing that we are really in a sense using [unintelligible] a nominal GDP goal of which the money supply relationships are technical mechanisms to achieve that. And I don’t see any change in our view…and we will know they are convinced (about “price stability”) when we see the30-year Treasury at 5-1/2 percent.”

MCK gets it very wrong in the highlighted sentence above. Just as the central bank would keep NGDP growing at the trend level rate if the economy were hit by a negative supply shock, it would also keep NGDP growth ‘on target’ if it were hit by a positive supply shock.

The chart below illustrates.

The positive supply shock shits the AS curve to the right.By keeping AD growing at the target level rate, the economy moves from point 1 to point 2, experiencing higher growth AND lower inflation. If it were targeting inflation, it would increase AD growth, but the result would be instability!

This actually happened in 1998. The positive productivity shock increased real growth and reduced inflation (core). First the Fed reduced rates (afraid of a fallout from LTCM). Then it increased rates because RGDP growth was “too high”. The result was nominal instability. The charts illustrate.

 

More recently, the FOMC reacted to the rise in headline inflation from oil/commodity shocks (a negative supply shock) and constrained AD growth. The result, given the weakened state of the economy from the fall in home prices, was instability on steroids, i.e. the “Great Recession”.

HT Josh Hendrickson, David Levey

The “Abe Effect”

Is ‘storming’ through Japan. The implication is that the stock market index correlates positively with inflation expectations while the exchange rate travels in the opposite direction.

 

 

We hope that Abe goes through with his ‘threats’!