Economists love turning dilemmas into ‘trilemmas’

Olivier Blanchard just released his thoughts on the recent “Rethinking Macroeconomics” seminar at the IMF. This paragraph caught my attention:

By implication, there is no agreement on how or even whether to integrate financial stability and macro stability in the mandate of central banks. Does it require a tweak to inflation targeting, or much more radical rethinking?  The intellectually pleasant position is to argue that macroprudential tools will take care of financial stability, so monetary policy can still focus on its usual business—  inflation targeting. I read, perhaps unfairly, Michael Woodford’s discussion at this conference to suggest that the crisis should lead us to shift from inflation targeting to nominal income targeting, without a major emphasis on financial stability. I am skeptical that this is the right answer. I think we have to be realistic about the role that macroprudential tools can play, and that monetary policy cannot ignore financial stability.

First it was the inflation-unemployment trade-off (or dilemma), then the variance of inflation-real growth variance trade-off. Now they want interest rates to take simultaneous ‘care’ (i.e. optimize) inflation, growth and financial stability (a ‘trilemma’)! Why ‘complicate’? Maybe because it gives rise to more papers!

It seems Mike Woodfords suggestion is to the point. Shift to NGDP targeting (level targeting) to ‘relive’ the 1987-07 period of nominal stability and develop macroprudential tools that help restrain financial ‘exuberance’. Two objectives – nominal stability and financial stability – and two instruments – monetary policy and macroprudential policy. As Tinbergen would say: “Obvious my dear Watson”.

They must hate “The Student”

It´s all the fault of Thomas Herndon, the Amherst graduate student that had the gall to fault R&R´s ‘beautiful masterpiece’. According to the OECD Chief-Economist, the Italian Carlo Padoan:

The euro zone is at risk of snatching defeat from the jaws of victory by abandoning efforts to cut budget deficits and fix long-standing economic problems, the Organization for Economic Cooperation and Development‘s chief economist warned Monday.

In an interview with the Wall Street Journal, Carlo Pier Padoan said euro-zone governments are close to stabilizing and even cutting their debts relative to economic output.

But he warned that governments facing resistance from voters as unemployment rates rise may halt their fiscal consolidations before they achieve that “remarkable result.”

“There is a risk that reform fatigue increases significantly, with governments facing very strong social resistance, and that happens at the wrong moment, because we are almost there,” Mr. Padoan said. “Our message is, we have done a lot in Europe, let’s not waste it.”

Mr. Padoan’s comments come as a growing number of European leaders are easing the austerity programs that have dominated policy across the continent in recent years, focusing instead on measures to promote growth.

That shift in policy was crystallized last week when European Commission President Jose Manuel Barroso said the policy of austerity no longer has the public backing needed to work.

Interestingly, in this case the tables are turned and it´s not that austerity doesn´t work but that it was abandoned too soon!

Which brings me once again to the picture of Merkel leading the ‘zombies’:

Silent movie

And to the lyrics of “We´re almost there”:

No matter how hard
The task may seem
Don’t give up our plans
Don’t give up our dreams

No broken bridges
Can turn us around
Cause what we’re searchin’ for
Will soon be found

Cause we’re almost there
Just one more step
(Cause we’re almost there)
Just one more step
(Just one more step)
Don’t give up
‘Cause we’re almost all almost there
(‘Cause we’re almost there)

Note: Between 200 and 2005 Mr. Padoan was at the IMF and responsible , among other small countries, for overseeing  Greece and Portugal!

“Economics can endanger your sanity”

This famous quote of Keynes:

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.

Needs to be amended. In times of crises, even living economists can be quite ‘dangerous’.

R&R 90% ‘tipping-point’ is a clear example. Less noticed is the ‘battle for fiscal supremacy’. That ‘battle’ is spearheaded by Paul Krugman and he never misses a chance to ‘disparage’ the views of others. So when Mike Konczal argued the market monetarist experiment had failed, Krugman quickly backed it up and Mark Thoma was also quick to second it.

One year ago, related to his Nobel win, Chris Sims was interviewed by the Gary Tapp at the Atlanta Fed:

Tapp: So, if I asked you to describe the main contribution of your work to the field of economic modeling and maybe relating back to the traditional model, how would you describe that?

Sims: I think that what the Noble Prize people were singling out was that my work helped sort out the dispute between the monetarists and Keynesians. They, in part by introducing new approaches to statistical modeling in the ’60s and early ’70s, monetarists were claiming that the main source of business cycle fluctuations was bad monetary policy. The monetary authority was making mistakes, making the growth rate of money vary a lot, and all those variations resulted in recessions and booms, and if only we could force the monetary authority to stop messing with the economy and just keep money growth steady, the business cycle would be greatly reduced or even vanish.

And then the Keynesians were saying that can’t be true, but they didn’t have statistical models in which they could each put forward their position and ask, well, what did the data say? There were lots of attempts to do that, but with very awkward statistical modeling.

Over the course of about 10 years, things that I did and other people followed up on managed to sort out what the effects of monetary policy changes are and distinguish those from co-movements in money and prices and income that didn’t have anything to do with policy. There’s now pretty much a consensus on how monetary policy affects the economy, and on what the size of that effect is. The general conclusion is that it accounts for maybe somewhere between zero and 20 or 25 percent of the fluctuations we see, but if you try to trace out historically, you can’t blame any recession on monetary policy.

That´s a pretty strong statement, especially if you remember Friedman and Schwartz´s Monetary History and the research that followed up on it. By 1985, even the great Keynesian Paul Samuelson wrote in his famous textbook:

“Money is the most powerful and useful tool that macroeconomic policymakers have, and the Fed is the most important factor in making policy.”

But Thoma liked what Sims said so much that he helped spread the idea:

Now we need Chris Sims, or someone like him, to lead the charge against the idea that the problem with the economy is bad fiscal policy. Even better would be if they could overcome the objections to the use of fiscal policy in severe recessions — i.e. the type of recession that monetary policy alone cannot cure even if the interest rate is lowered to zero and non-traditional policies are put into place. In this case though, the empirical evidence is already mounting, what is needed are strong, respected voices to counter the objections to fiscal policy coming from the right (particularly, though not exclusively, objections to infrastructure investment). The politics of fiscal policy will always be a problem, but it would be less so if economists had the same unity on fiscal policy, particularly its ability to help the economy is severe recessions that they have on monetary policy.

I really don´t know what Thoma means by ‘unity’. There´s the long standing joke that if you gather 7 economists you´ll likely hear 8 different opinions!

While Chris Sims may be a pretty competent econometrician/statistician with that statement he indicated his knowledge of economic history is nonexistent. Worse, if that was really the conclusion the application of his tools to history provided, maybe the problem lies with the tools.

Is he implying that a 50% drop in nominal spending (NGDP), something the Federal Reserve, through monetary policy, is able to closely control had nothing to do with the “Great Depression”?

Or that the ‘reversal of fortune’ engineered by Roosevelt’s monetary actions in early 1933 had nothing to do with the recovery that followed?

Or that the decades-long Japanese slump had nothing to do with the monetary policy practiced by the BoJ, despite a ‘war-like’ increase in government spending and debt?

It´s a ‘circus’

And you have to applaud the ‘magician’:

Am I (and others on my side of the issue) that much smarter than everyone else? No. The key to understanding this is that the anti-Keynesian position is, in essence, political. It’s driven by hostility to active government policy and, in many cases, hostility to any intellectual approach that might make room for government policy. Too many influential people just don’t want to believe that we’re facing the kind of economic crisis we are actually facing.

I know, the critics will respond that I’m the one who’s being political — but again, look at how the debate has run so far.

The point is not that I have an uncanny ability to be right; it’s that the other guys have an intense desire to be wrong. And they’ve achieved their goal.

Update: From one of the ‘magician´s assistants‘:

I’ve was making this argument long before the crisis hit, I was among the first to say that monetary policy would not be enough to solve our problems, aggressive fiscal policy would also be needed, and nothing that’s happened during the recession has changed my mind. I eventually tired of the debate and assumed everyone was tired of hearing me say we needed more fiscal stimulus — arguing with monetarists won’t change any minds anyway and policymakers weren’t about to do more fiscal stimulus – – so I moved on to other things (mostly talking about the need for job creation through more aggressive policy of any type)

Who logically concludes:

Krugman is right.

Krugman takes a stab at market monetarists

From “Monetarism Falls Short”:

Now, there won’t and can’t be any current-events test of MMT until we get out of the slump, because standard IS-LM and MMT are indistinguishable when you’re in a liquidity trap. But as Mike Konczal points out, we are in effect getting a test of the market monetarist view right now, with the Fed having adopted more expansionary policies even as fiscal policy tightens.

And the results aren’t looking good for the monetarists: despite the Fed’s fairly dramatic changes in both policy and policy announcements, austerity seems to be taking its toll. I would add that the UK experience provides a similar lesson. Mervyn King advocated fiscal consolidation – I’d say that he shares equal responsibility with Cameron/Osborne for Britain’s wrong turn — but more or less promised (pdf) that he would and could offset any adverse effects on growth with monetary policy. He didn’t and couldn’t.

The last words in the quote above should be “He could but didn´t”.

From my last post it´s clear that the Fed´s changes in both policy and policy announcements have not been dramatic enough. I am not trying to use Krugman´s usual argument that back in 2009 fiscal policy didn´t work because it was ‘not expansionary enough’.

According to Christy Romer:

Exactly what the Fed hasn’t been willing to do is something nearly as dramatic as what Roosevelt did. They have not been wanted to change their goals or operating procedures in a way that might seriously rock the boat of public expectations. So, what they have been doing is pushing the boundaries of their current regime, not changing the regime.

And says:

From the perspective of today’s discussion, what is most important about adopting a nominal GDP target is that it would be a pretty clear regime shift—a very different way of conducting and talking about monetary policy. And, so like Roosevelt’s actions, it might have more impact on expectations than the incremental changes the Fed has been following so far.

And what did FDR get? The charts illustrate. See how things dramatically change after March 1933. And how things go into reverse following the monetary contraction in early 1937, when required reserves were raised and the Treasury began to sterilize gold inflows.

Krugman on MM_01

Krugman on MM_02

Krugman on MM_03

And Christy Romer goes on:

The place where we might be seeing a country try to follow the Depression lesson is actually Japan. Japan went through what the United States experienced in 2008 almost 20 years earlier. Back in the 1980s, their economy was the envy of the world. But they had a bubble and bust in their housing market that wreaked havoc on their financial system and caused a prolonged downturn. Japan hit the zero lower bound on interest rates in the late 1990s, and just sort of got stuck in a trap of low growth and steady price declines. Unlike almost every other advanced country in the world, Japan has had deflation for almost 15 years. But, like our Federal Reserve, the Bank of Japan has not wanted to take dramatic action.

But no one, not even Krugman, can say they were ‘timid’ with fiscal stimulus. The charts illustrate.

Krugman on MM_1

Krugman on MM_2

But real growth didn´t materialize:

Krugman on MM_3

And the reason is, as argued by Christy Romer, not only that the Bank of Japan has not wanted to take dramatic action  but that it has adopted increasingly tight monetary policy as shown by Japan´s NGDP history! And that´s the reason fiscal stimulus has not been helpful at all!

Krugman on MM_4

In his wrap-up Krugman ‘hedges’:

I’m not claiming that there is nothing the central bank can do; but as I’ve tried to explain before, monetary policy can, for the most part, gain traction under current circumstances only by changing expectations about future actions (and changing them a lot). Meanwhile, fiscal policy has a direct, current effect on the economy, which easily trumps attempts to move the economy by changing the Fed’s messaging.

Sorry, guys, but as a practical matter the Fed – while it should be doing more – can’t make up for contractionary fiscal policy in the face of a depressed economy.

OK, so he agrees with Christy Romer that a monetary policy regime shift is required. But he ignores (as a practical matter) the lessons of both ‘old’ and ‘new’ history that indicate:

  1. A monetary policy regime shift can ‘do the job’ (FDR) and,
  2. Monetary policy can and does neutralize the effects of even dramatically expansionary fiscal policy (Japan)

Note: Time goes by and Austrians keep humming the same tune. From a 1935 article in the Sydney Morning Herald on Lionel Robbins we read:

One of the most powerful obstacles to world recovery is the increasing intensity of  Government interference and trade restrictions, is the opinion of Professor Lionel Robbins, of the London School of Economics.

According to Professor Robbins, a return of business confidence is essential to recovery but an antecedent to this is some measure of monetary stabilization, with the ultimate aim of a restoration of the gold standard. That, however, would be a gradual process to be achieved only when new exchange parities had been definitely established and international trade and investment had once more become active. This will necessitate, of course, a removal of the existing trade restrictions. The gold standard, however, must be one functioning with the untrammeled use of the bank rate and unrestricted gold movements, and not on the present “managed currency” basis.

I´m not exagerating. Take a look at this op-ed:

Update: The Economist has a discussion

Update2: As does Scott Sumner

Update 3: David Beckworth discusses the topic

Update 4: David Glasner goes straight for the jugular:

Here is the internal contradiction – the Sumner critique, if you will – implicit in the Keynesian fiscal-policy prescription. Can fiscal policy work without increasing the rate of inflation or inflation expectations? If monetary policy alone cannot work, because it cannot break through the inflation targeting regime that traps us at the 2 percent inflation ceiling, how is fiscal policy supposed to work its way around the 2% inflation ceiling, except by absolving monetary policy of the obligation to keep inflation at or below the ceiling? But if we can allow the ceiling to be pierced by fiscal policy, why can’t we allow it to be pierced by monetary policy?

Perhaps K&K can explain that one to us.

X-raying the patient

The patient is at the doctor. He appears to be weak and anemic. Other doctors pass by and each gives a different diagnosis. Some say it’s the environment the patient lives under, that increases uncertainty and makes the patient anxious. Others say he´s not being ‘spoon-fed’ by his caretaker and still others say different things like he´s ‘paying’ for past ‘sins’ of ‘profligacy’ and now must ‘purge’ the excesses.

Along comes a doctor that has the initials “SS” in his white jacket. He looks at the patient and immediately says: “He needs to change his diet”. More ‘green salad and fibers’ are recommended.

Just to be on the safe side SS asks for an X-ray and remembers he has imaging exams from a previous bout of weakness that the patient manifested, which was cured by a change in diet. On the previous occasion the ‘green salad and fibers’ was packaged under the label ‘forward guidance’ and SS recalled it had worked just fine.

The X-rays are done and compared to the ‘old’ ones. This is the story they tell:












X-ray6After doing a detailed reading of the images the doctor tells the patient. Try to keep your diet of ‘green salad and fibers’ as stable as you can. It will remain the best antidote in the event you are clobbered on the head by falling home prices or in case you experience an upper-cut to your jaw from rising oil prices. Note that the level or amount of ‘green salad and fibers’ is key. Increasing the dosage by just a little – such as using the amounts under the label Q1 – is not enough. It will stop the anemia but won´t get you ‘up and running’.   

A ‘catlike economy’

A short summary of how dysfunctional economic reasoning really is.

Last week the International Monetary Fund hosted a conference of some of the world’s top macroeconomists to assess how the most intense crisis to have shaken the industrialized economies since the Great Depression has changed the profession’s collective understanding of how the world economy works.

Two things struck me about the conclave. The first was hearing George Akerlof, a Nobel-winning economist from Berkeley, take to the lectern to compare the crisis to a cat stuck in a tree, afraid to move.

The second was realizing how, after five years of coping with the consequences of the disaster, there is still so much uncertainty about what policies are needed to prevent another financial shock from tipping the world economy into the abyss again a few years down the road.

We don’t have a sense of the final destination,” said Olivier Blanchard, chief economist of the monetary fund. “Where we end I really don’t have much of a clue.”

Footnote: Olivier Blanchard, chief economist of the I.M.F. said economists don’t know “what financial stability actually means.”

And they thought ‘economic stability’ meant low and stable inflation. That´s not it. They have to progress and realize that economic stability means NOMINAL stability.

Additional Evidence for the Fed´s “Dereliction of Duty”

This post is an elaboration on this important post by David Beckworth (who has returned to blogging at ‘full blast’ after a long sojourn (one month away from blogging must be the equivalent to 1 year sabbatical)). David writes:

The fall of household dollar income expectations and its failure to fully recover is stunning. It suggests that the now lower expected future income growth is depressing current household spending, a point forcefully made by Mariacristina De Nardi, Eric French, and David Benson of the Chicago Fed. Digging into the data, they find that expected nominal income growth deteriorates across all age groups, educational levels, and income levels over the past few years. This is not some sectoral-specific development, it is a systemic nominal problem. They also find that the collapse in expected dollar income growth explains much of the decline in aggregate consumption since the crisis erupted.

But there is more. The figure also indicates that real debt burdens are higher than many households expected prior to the crisis. Look at the dashed line. It shows the average expected dollar income growth rate over the ‘Great Moderation’ period was 5.3%. Now imagine it is early-to-mid 2000s and you are taking out a 30-year mortgage and determining how much debt you handle. An important factor in this calculation is your expected income growth over the next 30 years. If you were average, then according to this data you would be forecasting about 5% growth rate. But that did not happen. Household dollar incomes declined and are expected to remain low. Nominal debt, however, has not adjusted as quickly leaving higher than expected real debt burdens for households.

David has updated his post to accommodate a comment by Nick Rowe, showing that income growth expectations precede nominal (NGDP) spending growth.

I show an alternative chart that I hope better describes the income growth expectations and NGDP outcomes.  To reduce ‘noise level’ in the household income expectations data I used a six-month moving average. The expectations series is also aligned to the NGDP ‘gap’ series (where the ‘gap’ is the difference between NGDP and the trend level). The NGDP series is a monthly series from Macroeconomic Advisors.

Note how the ‘zero gap’ aligns with the 5% long-term average nominal income growth that David emphasizes. And by the time Lehman ‘happened’ both NGDP and income growth expectations were well below their ‘normal’ levels, an indication that Lehman may not have been the ‘cause’ of the financial crisis but the ‘consequence’ of the Fed mistakes.

Income Expectations

PS There´s a new Chicago Fed paper: “Expected Income Growth and the Great Recession


Back at David´s comment section there has been a hot debate on ‘causality’. According to Nick Rowe:

Mark and Alex: this sounds interesting. But we might want to distinguish between:

1. Which caused which over the whole time period?

2. Which caused which in one particular episode (like the recent recession)? (Harder to test of course, except by the eyeball method?)

The theory that changes is ENGDP *always* cause changes in NGDP wouldn’t make sense, unless expectations were totally irrational, or totally self-fulfilling in a world of multiple equilibria?

I think there´s a simple story. Something happens (maybe house prices stop rising and then began to drop) and people turn slightly less optimistic, retrenching a little. This retrenching shows up in lower aggregate spending, so people retrench some more. This goes on while the Fed is showing it´s worried about inflation (from oil prices) and signaling that there´s a growing chance of policy being tightened. People ‘retrench’ some more and spending drops a bit more and so on and so forth. House prices continue to fall and delinquencies grow. The financial system starts to feel the heat. The first to go under are the mortgage houses, but there are linkages in the ‘financial chain’… all the way to Lehman, which was big in real estate.

Since the Fed´s major (only?) concern is inflation and feels ‘threatened’, it does not offset the fall in velocity that´s been going on under its nose. Suddenly, there´s a ‘tipping point’ and ‘all hell breaks loose’.

“Dereliction of duty” refers to the Fed not offsetting the fall in velocity, in other words, it allowed, by its inaction, the shock to propagate. I strongly believe that the “Great Moderation” came about because, even if implicitly, the Fed was concerned with nominal stability. That, and not an inflation target, should be the overriding concern of the monetary authority.

‘Roadmap of the Great Depression with sign posts’

The Mises Institute has a veritable festschrift on what they call the Hoover-Roosevelt   Depression with emphasis on the works of Austrians, with an interesting allusion to Lee Ohanian:

The conclusion of Ohanian’s paper is quite—one is tempted to say “hardcore”—Rothbardian.

I wonder if Ohanian will appreciate that ‘compliment’!

As it could be expected wrongheaded government policy was to blame. But there´s no mention of the recovery that began in March 1933 and is associated, as Christina Romer, following Temin and Wigmore who follow Sargent says, was due to a ‘regime shift’, in this case to FDR´s decision to ‘delink’ from gold. NIRA was certainly a ‘recovery stopper’.

The chart below gives the ‘roadmap with sign posts’. I wonder if the July 1932 ‘bottom’ is associated with FDR´s nomination acceptance speech on July 2, 1932.

Mises Inst

Never reason from ‘output gaps’

Normally Tim Duy is a very sober ‘Fed watcher’, commenting on the likelihood of the Fed deciding one way or the other, etc. But in this post I could picture him typing with ‘trembling hands’ and ‘quivering chin’, all the time thinking “this is not the world I live in”.

Has the pursuit of low inflation brought us to a point where we can maintain the Fed’s dual mandate only at the presence of financial instability?   That unless we allow for somewhat higher inflation, we are making a deliberate choice to follow only “inflation-neutral” measures of the output gap and ignore “finance-neutral” measures?  And, importantly, might it not be the case that the costs of somewhat higher inflation are in fact less than the costs associated with the financial instabilities that seem to be part and parcel of the current low-inflation regime?

Bottom Line:  If Kocherlakota is correct and monetary policy can only pursue the dual mandate in the context of financial – and, by extension – macroeconomic instability, then we really need to consider which part of the dual mandate needs to be loosened to reduce the reliance on financial instability.  My fear is that if Fed policy makers were asked this question, they would unanimously answer that it is the full-employment portion of the mandate that should be jettisoned.

My oh my!