Austerity “distractions”

On the subject of “austerity”, Krugman “twists and turns”:

Right now the official unemployment rate is 7.3 percent. That’s bad, and many people — myself included — think it understates the true badness of the situation. On the other hand, there are some reasonable people (like Bob Gordon) arguing that at this point, possibly thanks to long-run damage from the Great Recession, “full employment” is now a number north of 6 percent. So there’s considerable uncertainty about just how depressed we are relative to potential. But we’re clearly still well below potential. And we’ve also had exactly the wrong fiscal policy given that reality plus the zero lower bound on interest rates, with unprecedented austerity. So, how much of our depressed economy can be explained by the bad fiscal policy?

To a first approximation, all of it. By that I mean that to have something that would arguably look like full employment, at this point we wouldn’t need a continuation of actual stimulus; all we’d need is for government spending to have grown normally, instead of shrinking.

Here’s a comparison of two series. One is actual government purchases of goods and services since the Great Recession began (this is at all levels; most of the fall has been state and local, but the Federal government could have prevented that with revenue sharing). The other is what would have happened if those purchases had grown as fast as they did starting in the first quarter of 2001, i.e., in the Bush years. (The chart is a better version of Krugman´s).

Austerity Distractions_1

As you can see, the gap is large and has been growing rapidly; it’s currently at about 400 billion 2009 dollars, or more than 2 1/2 percent of GDP. Given reasonable multipliers, this suggests that real GDP is somewhere between 3 and 3.75 percent lower than it would have been without the austerity. And given the usual Okun’s Law rule of half a point of unemployment per point of GDP, this in turn says that without the austerity we’d have an unemployment rate well under 6 percent, maybe even under 5.5 percent.

I don’t want to pretend to spurious precision here. Instead, I just want to make the point that given what we know and have learned about macro these past five years — and given the modest recovery that has taken place — we’re now at a point where, to repeat, to a first approximation the depressed state of the economy is entirely due to destructive fiscal policy.

The austerians have a lot to answer for.

It all sounds too good to be true. In particular, Krugman disregards monetary policy completely (we´re, after all, in a liquidity trap).

Below I reproduce my version of Krugman´s chart together with a chart of NGDP & Trend. Note that during the quarters from mid-2008 to mid-2009, while nominal spending tanked, real government spending was growing at an almost “normal” rate. But real growth plunged and unemployment soared. The adoption of QE1 was enough to reverse the spending trend despite the contraction of real government purchases!

Austerity Distractions_2

Now, imagine if a “regime shift” à la Christy Romer had been implemented in mid-2009, with the Fed´s target being a particular NGDP level. By now I´m pretty confident we would be progressing along the “continuance” path!

So, the answer to Krugman´s question: “So, how much of our depressed economy can be explained by the bad fiscal policy? Is: “To a first approximation, NONE of it”.

Related: “Just one of those things

The undying belief in the soothing powers of fiscal stimulus

Even in the face of a contractionary monetary policy that has so ‘offended’ Lars Svenson!

The FT reports:

Wednesday’s budget includes a fifth income tax credit under the centre-right worth SKr12bn, a higher income tax threshold for SKr3bn, and lower income tax for pensioners. The government estimates that the tax credit alone will create 13,000 new jobs.

“We’re doing what we promised and big numbers of wage earners are going to have more money in their pockets while [the Social Democrats] want to expand benefits,” Mr Reinfeldt said this week.

The government is forecasting growth of 1.2 per cent this year, rising to 2.5 per cent next year and 3.6 per cent in 2015.

Analysts at Nordea said the forecasts for both this year and 2015 looked optimistic. They added: “All in all, the budget will boost growth and the outlook for Swedish households in 2014 is bright. Also monetary policy will remain lenient. These factors, together with strong fundamentals in general, suggest that households’ demand for credit, consumption and houses will continue up.”

The Nordea analysts are wrong to think that the budget will boost growth on it´s own. Despite the five previous income tax credits, it is tight monetary policy that´s “winning”!

Sweden Fiscal Stimulus

No matter the “eloquence” behind the defense, forward guidance is still a convoluted manner to do monetary policy

David Miles, an external member of the BoE´s MPC made an eloquent speech today in defense of forward guidance: “Monetary policy and forward guidance in the UK”. From the introduction:

I believe that the main reason why it is now useful to offer guidance on the future stance of UK monetary policy is to reduce the risk that people believe that monetary policy would be quickly tightened once output began to rise at more normal rates. The nature of the guidance is simple; the message from the MPC is this: So long as inflation pressures don’t start heading in the wrong direction, we will not tighten monetary policy until a recovery is strong enough and sustained enough that it has made a meaningful dent in unemployment so that it at least falls to 7 per cent.

A key point here is that focusing just on the rate of growth of output is not a good guide to whether economic activity is running at a pace consistent with the control of inflation. Growth has to be seen in the context of the LEVEL of activity from which that growth comes. If that level of activity is significantly below a rate consistent with controlled inflation – as I believe is the case in the UK today – then it does not make sense to quickly return monetary policy to a more normal setting once growth moves to more normal rates.

David Mile´s speech commits the basic error of conflating monetary policy with interest rates. In that case, “not tightening monetary policy” is synonymous with “keeping interest rates low”. He differentiates himself by emphasizing the important context of “activity level”, but sows future confusion by specifying a particular level of unemployment.

The chart shows nominal spending (NGDP) and trend since the UK got its act together after extricating itself from the “road to the euro” in 1992. Of all the countries I´ve sampled, the UK had the most stable nominal growth, averaging close to 5%. The plunge in mid-2008 was also one of the most abrupt, happening without any “prior warning”.

The “level” David Miles should be concerned with is a “target level” for NGDP (T). That would be a much more clear and productive way of doing “forward guidance”.


Summer´s out but, unfortunately, Romer is not in

Matt Iglezias one week ago had it 100% correct in “Three Reasons Christina Romer Should Be Fed Chair”:

Former White House Council of Economic Advisors chair Christina Romer isn’t under consideration to run the Federal Reserve and never has been. There are reasons for this, and they’re not all terrible reasons. But there are three very good reasons that she ought to be a—if not the—leading contender for the job.

A few months ago I was also ‘rooting’ for her:

On Fed monetary policy today:

But the truth is even these moves [Qe´s] were pretty small steps. With its most recent action, the Fed has pushed the edges of its current regime. And I am sure that given the opposition in Congress and the difference of opinion within the FOMC, even those measures were a struggle.Nevertheless, the key fact remains that the Fed has been unwilling to do a regime shiftAnd because of that, monetary policy has not been able to play a decisive role in generating recovery. To paraphrase E. Cary Brown’s famous conclusion about fiscal policy in the Great Depression: monetary policy has not been a strong recovery tool in recent years not because it did not work but because it was not tried—at least not on the scale and in the form that was necessary to have a large impact.

Monetary Policy used to be a serious matter

In “Does the Fed have a communication problem, or do markets have a listening problem?” Neill Irwin gets it exactly right:

Fed watchers have become spoiled at the sheer volume of information the Fed now conveys about its actions. Detailed policy statements, forecasts for economic variables and future interest rates, news conferences — these are all new innovations in the past six years. It’s a far cry from the not-too-distant past, when investors had to try to figure out what the Fed would do by scoping out the thickness of Alan Greenspan’s briefcase.

In other words, now that we can see more of the inner workings of Fed policymaking, we see the reality: They’re making it up as they go along, like the rest of us.

Maybe like too much booze, too much information can make you giddy!

Best kind of “forward guidance”: Keep mum

That´s what Stanley Fischer, until recently governor of the Bank of Israel, suggested:

The lesson, according to Stanley Fischer, the former head of the Bank of Israel, is the Fed would do better not to telegraph future policy decisions.

Fed officials have placed great store on these communications. By assuring the public that it will keep short-term interest rates low for several years, for instance, the Fed is sending signals aimed at holding down long-term rates to boost growth.

But Mr. Fischer said making such statements – known as forward guidance – can cause market confusion.

“You can’t expect the Fed to spell out what it’s going to do,” Mr. Fischer said. “Why? Because it doesn’t know.”

He added: “We don’t know what we’ll be doing a year from now. It’s a mistake to try and get too precise.”

And the “tapering talk” goes on following last week´s FOMC meeting. From St Louis Fed president Bullard:

St. Louis Fed President James Bullard said Friday that “a small taper is possible in October” and the decision not to move at the latest meeting was “borderline.”

“This was a close decision here in September,” he said on Bloomberg TV. “It’s possible you get some data that can change the complexion for the outlook and make the committee comfortable with a small taper in October.”

But Bill Dudley, NY Fed president, doesn´t think so:

The US economy still needs “very accommodative” policy before the Federal Reserve can tamp its brakes, William Dudley, the president of the Federal Reserve Bank of New York, said in the Big Apple this morning.

Then there´s “serial dissenter” Esther George of the KC Fed and “born again Christian” Kocherlakota of the Minneapolis Fed, who puts it ‘epically’:

To achieve its goals, the FOMC has taken some historically unprecedented monetary policy actions in recent years. But the U.S. economy is recovering from the largest adverse shock in 80 years—and a historically unprecedented shock should lead to a historically unprecedented monetary policy response. Indeed, the FOMC’s own forecasts suggest that it should be providing more stimulus to the economy, not less.

What would Greenspan have said? Most likely what he did say:

The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal.

Manufacturing Activity and Central Bank actions

Markit´s PMI survey is a favorite of central banks and financial institutions. The panel below shows both the global (comprised of 32 countries) and the Eurozone and Japan PMI´s. Trichet´s rate increase ‘folly’ of April and June 2011 as well as Draghi´s “ECB will do whatever it takes” of July 2012 are marked. So is the “Abe effect” in Japan.

PMI Euro-Japan

Location is defining

Recently I visited Kansas City. One thing I learned was that the Kansas City Fed building faces the WWI Museum. Maybe that explains the behavior of both former president Thomas Hoenig and Esther George who is set on beating her predecessor´s record of successive dissents at FOMC meetings. They are constantly being reminded of ‘ancient wars’!

The WSJ reports:

The Federal Reserve‘s decision this week to keep up its bond purchases risks a spike in interest rates and clouds the credibility that is needed for future policy to be effective, a Fed official warned Friday.

As the lone dissenter of the Fed’s policy decision Wednesday, Kansas City Fed President Esther George explained she is worried the Fed’s ongoing efforts to stimulate the economy fail to take into account the economic progress already made and raise future costs. Ms. George has now cast a dissenting vote at each of the Fed’s six policy meetings this year.

“Waiting for more evidence at this point, in the face of economic growth, unnecessarily discounts the progress we’ve seen, unnecessarily discounts the costs of this tool,” the central banker said in a speech before the Manhattan Institute for Policy Research in New York.

Such costs include potentially sharp market disruptions when the Fed does pull the tapering trigger and excessive inflation because the Fed waited too long to pull back. And those costs may not be worthwhile when the economy is seeing little added benefits from monetary stimulus.

She cannot think of an alternative, more effective way, of doing monetary stimulus. She´s still stuck inside the trenches in the Somme!

“Forward Guidance” is like a primitive GPS

Robin Hardin at the FT: “Fed’s QE surprise shows problems of forward guidance”:

The sense of surprise at the US Federal Reserve on Wednesday is a reminder that we are still in the PalmPilot era of forward guidance about monetary policy: the technology exists, but it is clunky, temperamental and some way off the iPad level of usability that everybody expects.

Even if the Fed wanted to tie policy to its ultimate objectives more closely, perhaps by saying rates will stay low even if inflation runs above target for a while, it is hard to promise that, because a future leader might interpret the mandate in a different way. “I mean, we’re already, obviously, stretching the bounds of credibility to talk about specific projections for 2016,” Mr Bernanke told reporters.

And concludes, reminiscent of Mark Carney´s December 2012 speech, that:

The only way to resolve these problems at a deep level is by changing the objective to the level of prices or nominal gross domestic product. With such a goal, a central bank has to make up for growth or inflation missing during a downturn, so promises will be credible and the duration of a stimulus easier to predict.

Switching goals in the middle of a downturn would be difficult and risky. A change of objective, however, is the only way to an iPad technology of forward guidance.

HT Giles Wilkes

WeaK Signals

Miles Kimball suggested, via Twitter, a reread of a year old post by Ezra Klein (“Here’s why everyone is so excited about what the Fed did yesterday).  Ezra´s main argument, referring to last September´s intro of QE3 was:

The way the Fed’s plan works — if it works — is that buying all these bonds will drive down long-term interest rates, which will give businesses and investors more incentive to spend now as opposed to sitting on their money waiting for later. It will make mortgages even cheaper, which should accelerate the housing market’s recovery.

But the other part of the plan, and this part is really important, is that Bernanke just sent a signal to businesses and investors and the market and everyone else that the Fed is going to use its powers in a big, unusual way to get the economy moving. That’s a hugely important statement to make.

Let´s see how that panned out. The charts (weekly data) illustrate with the 10yr Treasury rate and the S&P 500 index.


First thing to note is that long term rates were never “driven down” and actually mostly went up (see this post by Scott Sumner on “Interest rates and the face/vase problem“)). Stocks which had already been trending up continued to do so. But note that the “taper talk” increased the volatility.

All in all, it appears the signal sent by Bernanke was not very powerful, so it´s no mystery, reproducing yesterday´s chart, that the Fed has been “following growth down”.

Queer Policy

And as the next chart indicates, it will likely continue to do so!


The following chart gives a hint to the reason, showing that NGDP is “content” to remain on a “flight plan” far below any reasonable trend level.