Deep down, economists are mean “SOB´s”

Miles Kimball and Noah Smith elaborate on the upheavals at the Minneapolis Fed I “:The shakeup at the Minneapolis Fed is a battle for the soul of macroeconomics—again”:

The Saltwater macroeconomists believed that recessions were economic failures, and that monetary policy was important in fighting them. Led by Michael Woodford, they adopted the tools and language of the Freshwater economists, and managed to convince many of their Freshwater brethren to reluctantly agree that monetary policy can, in fact, boost the economy.

“By adopting the tools and language of the freshwater economists…” means that “money” was taken out of the picture. It´s “Interest & Prices”. To me that´s one of the reasons (together with the inflation target ‘obsession’) that the economy remains depressed more than four years on.

A few months later, at the end on 2008, America tumbled into its biggest economic slump since the Great Depression, soon followed by much of the rest of the world. Freshwater macroeconomists were left scratching their heads. How could this calamity represent the efficient outcome of a well-functioning economy? But the Saltwater New Keynesians—who included Fed chairman Ben Bernanke—had an answer: the economy had malfunctioned, and America needed the Fed to get us out of the hole. Bernanke and the Fed responded first by extraordinary measures to contain the financial crisis that was the immediate source of trouble, then lowering interest rates to zero and beginning an unprecedented campaign of Quantitative Easing.

See, since there´s no “money”, the economy, not monetary policy, had malfunctioned!

In any case, speculating on the reasons for what ultimately might boil down to simple personality conflicts is not our purpose here. Nor do we seek to offer any judgment on Kocherlakota’s personnel decision, which could have far-reaching impacts on the relationship between central banks and universities and the type of employment contracts offered by Fed banks. Instead, we want to highlight the tectonic shifts in economics itself. From that perspective, the shakeup may turn out to be part of the understandable rebalancing of macroeconomics in the Saltwater direction, as economists try to comprehend the Great Recession and figure out how to avoid an encore.

God forbid! Because the ‘liquidity trap’ idea also reduces to (almost) nothing any role for monetary policy. And a “Great Stagnation” is becoming the ‘thing of the future’!

PS I wrote a short post on Kocherlakota´s decision. In a private exchange I said this:

I hate when people go on a “conversion” trip and do what he´s trying to do. The Minneapolis Fed has a long and important research history. Just as the St Louis Fed was the “house of monetarism”, the MN Fed was the “house of RBC”.I think the freedom to pursue research is important and NK is trying to stifle that freedom (“it´s either my way or the highway”!)

HT Travis V

All central banks, in practice, are acting alike!

Recently, both Simon Wren-Lewis and Paul Krugman have singled Sweden as a country where the central bank has moved from targeting inflation to worrying about ‘deflating’ bubbles:


And in one country, Sweden, the independent central bank has kept interest rates above the ZLB, even though prices have been literally falling. While the central bank cut short rates to 0.25 in 2009, during 2010 they were increased to 1%, and during 2011 to 2%. They have since been cut to 1%, but the central bank does not want to cut any further despite prices being flat or falling throughout 2013. Yet the central bank has a clear target for inflation of 2%.

The reason the Swedish central bank – the Riksbank – is overriding its inflation target were clearly set out in a speech given by Kerstin af Jochnick, First Deputy Governor of the Sveriges Riksbank, in January 2013. The Riksbank is concerned that low interest rates will exacerbate a housing bubble. The discussion is interesting for at least two reasons. The first is that the Riksbank is not primarily concerned about the impact of any bursting bubble on the financial sector itself. It is not worried about a second financial crisis. Instead it is worried about the impact a bursting bubble might have on households (creating another balance sheet recession) and overseas confidence.


The Riksbank raised rates sharply even though inflation was below target and falling, and has only partially reversed the move even though the country is now flirting with Japanese-style deflation. Why? Because it fears a housing bubble.

This kind of fits the H.L. Mencken definition of Puritanism: “The haunting fear that someone, somewhere, may be happy.” But here’s the thing: if we really are in the Summers/Krugman/Hansen world of secular stagnation, things like this are going to happen all the time. The underlying deficiency of demand will call for pedal-to-the-medal monetary policy as a norm. But bubbles will happen — and central bankers, always looking for reasons to snatch away punch bowls, will use them as excuses to tighten.

But has the US acted any different (as a practical matter)? For example, Gavyn Davis writes: “The separation principle drives the Fed towards tapering”:

…These personnel changes will create their own uncertainty. But, in addition, the Fed’s monetary strategy is clearly in a state of flux, with its approach to tapering having developed markedly in recent weeks. A new “separation principle” seems to be emerging, and it explains why the FOMC seems eager to begin winding down its asset purchases in the near future, while relying even more heavily than before on “lower for longer” guidance on forward short rates. This could have important ramifications for markets.

… Furthermore, Fed Governor Jeremy Stein has argued that asset purchases might well cause more distortions to asset prices via the reach for yield than the distortions which are caused by lower short rates. With the benefits of asset purchases in terms of economic activity being less, and the costs in terms of market bubbles being greater, it is not surprising that the Fed is opting increasingly for the forward short rate weapon.

Even if ‘procedures’ are different in the two countries, the ‘background noise’ is the same: A fear of bubbles!

It´s not surprising that the outcomes have been similar as the set of charts for both Sweden and the US illustrate.

Fear of Bubbles_1


Fear of Bubbles_2

Note that up to end 2010 Sweden was performing better than most, with NGDP on the route back to trend. But ‘bubble fear’ butted in!

In the US, QE1 was only enough to stop the fall in NGDP. QE3 plus thresholds has clearly not been effective (in a positive sense, not just as relative to a counterfactual). NGDP growth has flattened a bit over the past year and inflation has fallen significantly.

In the US related charts “T” stands for a level target for NGDP. What if instead of “targeting instrument settings” the Fed had targeted a level of NGDP? That´s the counterfactual I prefer.

John Taylor: Problem is cyclical, not structural

Taylor leaves it vague:

There is no longer debate that the labor market performance in this recovery–and the recovery itself–is unusually weak.  The debate is now over why. I have argued that it is the economic policy.

Research by Christopher Erceg and Andrew Levin is providing solid evidence that the decline in the labor force participation rate since 2007 has been due to cyclical factors–the recession and slow recovery–rather than to demographic factors.  In other words, the fact that such a large number of people have dropped out of the labor force is associated with the weak economy rather than to their reaching their retirement years–or some other typical demographic trend.  Because the unemployment rate does not count the people who dropped out of the labor force it no longer gives a good reading of the state of the labor market. The unemployment rate would be much higher without this large decline in labor force participation.

In the latest version of their paper Chris and Andy estimate how large the US unemployment rate would be without this abnormal decline in the labor force, and they produced this amazing chart which summarizes their findings:

Not just policy_1

Taylor talks vaguely about “policy”. To MMs, it´s very much about inadequate monetary policy.

I reproduce Taylor´s chart on the change of the employment population ratio following the recoveries from the 1981/82 recession and the 2007-09 recession. I add a chart that depicts the change in the E/Pop ratio during the downturns that preceded them.

Not just policy_2

Note that in the 2007-09 downturn the labor market situation got really bad (in relative terms) after mid-2008.

Would that be linked to what happened to NGDP, which tanked at that point? The next chart shows for both the downturns and the recoveries the behavior of NGDP. It seems it´s not just “policy” gone wrong, but specifically monetary policy going “off track”!

Not just policy_3

Kocherlakota: “Born again Christian”

“It is a term associated with salvation in Christianity. Individuals who profess to be born again often state that they have a personal relationship with Jesus Christ.”

That can be “dangerous”, especially to people who shared your prior beliefs.

It appears Kocherlakota is on a “purging crusade”:

Last month, the bank fired economist Patrick Kehoe and demoted Kei-Mu Yi from his position as senior vice president and research director to a job as special policy adviser. Monetary adviser Ellen McGrattan won’t be retained when her contract comes up for renewal.

Mr. Kocherlakota switched in 2012 from opposing some of the Fed’s easy-money policies to calling for more aggressive Fed action to spur economic growth and employmentThe move reflected a shift in his views on persistently high unemployment: He went from thinking the cause was largely structural (and thus could not be fixed with monetary policy) to thinking it was largely due to weak demand (which means it could be addressed through policies aimed at boosting demand).

Conservatives praise Kennedy

Economic Policies for the 21st century (e21) at the conservative Manhattan Institute, that also houses the SOMC (Shadow Open Market Committee) writes “KENNEDY: THE FIRST SUPPLY-SIDE PRESIDENT?:

“It is a paradoxical truth that tax rates are too high and tax revenues are too low and the soundest way to raise the revenues in the long run is to cut the rates now … Cutting taxes now is not to incur a budget deficit, but to achieve the more prosperous, expanding economy which can bring a budget surplus.”

– President John F. Kennedy (November 20, 1962)

President John F. Kennedy knew that in order for the economy to grow and generate jobs, Congress would need to lower tax rates. He believed in the simple principle that when people have more money, they spend it, generating additional economic activity and tax receipts. While he pushed for reform during his presidential campaign and throughout his presidency, the first of his proposed tax cuts were not passed until February 26, 1964, after his death.

Kennedy proved to be a visionary in fiscal policy. Not only did lower tax rates lead to higher tax revenues, which increased from $94 billion in 1961 to $153 billion in 1968, but lower rates resulted in a declining unemployment rate. This was due in part to additional consumer spending, as well as businesses spending the money they saved on capital investment and hiring more workers—while taking additional entrepreneurial risk.

Gross domestic product grew at 5.8 percent in 1964, 6.5 percent the following year, and 6.6 percent the year after that. Individuals benefitted from finding jobs and having confidence that the economy would continue to improve.

And show this chart:


Kennedy did not live to see his tax plan enacted. We will never know how far tax rates would have dropped under his leadership, but we do know that future presidents, such as Ronald Reagan and George W. Bush, followed his leadership on tax reform with similar results. The American people benefitted as well, and should thank the 35th President on the 50th anniversary of his assassination for promoting sensible policies to turn the economy around.

This is a very partial (and so incomplete) view of Kennedy and his times.

The 1960s view, informed heavily by the Great Depression, the ever-present threat was that of economic entropy, in the form of recession and possibly depression, and of business losses that discourage investing, thus becoming a self-fulfilling prophesy.  Economic gloom gathers mass, unless actively dispelled.  Anyone who had lived through the Great Depression, and then the World War II boom, would probably assent to that.

And even if an economist did not fear a self-generating recession, a buttressing view was that recessions marked a shortfall from potential, not a business cycle above and below an optimum output level. Why endure shortfalls?

In this context, monetary policy became a sidekick to White House planners and fiscal stimulus, according to Okun: “The stimulus to the economy also reflected a unique partnership between fiscal and monetary policy. Basically, monetary policy was accommodative while fiscal policy was the active partner. The Federal Reserve allowed the demands for liquidity and credit generated by a rapidly expanding economy to be met at stable interest rates”.

The charts below include the chart above and others that help put it into context:


It appears that potential output calculations by the economists at the CEA were too optimistic relative to potential output calculations made by the Congressional Budget Office (CBO) available today. In fact, by 1965, the year after the tax cut was enacted, the economy was beginning to overheat, and creating what may be called a “demand-pull” inflation. Both nominal spending and real output began to grow above potential levels. This is confirmed by what happened to inflation and unemployment, where the continuing fall in unemployment is indicative that the rise in inflation was not expected.

Regarding the Kennedy quote above, perhaps it is not too cynical to observe that in the case of tax cuts, or more federal spending, that the White House and members of Congress may have had constituents and lobbyists in mind, as much as macroeconomic policy.  To have deficits sanctioned as “good policy” may be akin to informing an alcoholic that drinking red wine is actually salubrious.

Not surprisingly, monetarists were not impressed with the 1960s style of macroeconomic policymaking, including the tax cuts (which later would become right-wing orthodoxy as the fuel for economic growth). In a debate with Walter Heller (President Kennedy´s first CEA Chairman) on “Monetary vs. Fiscal Policy” (1969), Milton Friedman argued:

“…So far as I know, there has been no empirical demonstration that the tax cut had any effect on the total flow of income in the US. There has been no demonstration that if monetary policy had been maintained unchanged…the tax cut would have been really expansionary on nominal income….”

The uninhibited expansionist fiscal and monetary policies of the 1960s—but especially the monetary—had telling effect, and inflation, and thus interest rates, began to rise by 1965. The next chart shows that when nominal spending “took off”, interest rates and inflation followed suit.


At that point the policymakers began to have doubts. According to Arthur Okun:

“In 1965 the nation was entering essentially uncharted territory. The economists in government were ready to meet the welcome problems of prosperity. But they recognized that they could not provide a good encore to their success in achieving high-level employment.”

And as Gardner Ackley, then CEA Chairman, put it a talk entitled the “The Contribution of Economists to Policy Formation” in December 1965:

“…The plain fact is that economists simply don´t know as much as we would like to know about the terms of trade between price increases and employment gains (i.e., the shape and stability of the Phillips Curve). We would all like the economy to tread the narrow path of balanced, parallel growth of demand and capacity utilization as is consistent with reasonable price stability, and without creating imbalances that could make continuing advance unsustainable. But the macroeconomics of a high employment economy is insufficiently known to allow us to map that path with a high degree of reliability…It is easy to prescribe expansionary policies in a period of slack. Managing high-level prosperity is a vastly more difficult business and requires vastly superior knowledge. The prestige that our profession has built up in the Government and around the country in recent years could suffer if economists give incorrect policy advice based on inadequate knowledge. We need to improve that knowledge.”

Some might say that even in 2013, and given macroeconomic policies of our era, we still very much need to improve our knowledge.

There´s no “secular stagnation”, it´s about misguided monetary policy

Larry Summer made a splash with his closing speech at the IMF Conference. That was probably his intention following him being denied the Fed Chair.

Several people have taken turns both critiquing and asserting his “secular stagnation” thesis. I think the most straightforward critique was Ryan Avent´s “The solution that cannot be named”:

I think it’s important and welcome for someone of Mr. Summers’ stature to point out how serious a problem the zero lower bound is and to note that it is not going away any time soon. But this discussion sorely needs a dose of real talk, and soon. Or nominal talk, I should say.

Just why the real natural rate of interest is so low is an interesting question. Maybe it’s down to a global savings glut, spurred by emerging-market reserve accumulation and exchange-rate management. Maybe it is a transitory symptom of widespread deleveraging. Maybe its roots are more structural in nature: a product of demographic or technological trends. I have my own suspicions, but the important thing to point out is that for the purpose of this discussion and this crisis it doesn’t matter.

The zero lower bound is a nominal problem. However low the real interest rate, an economy can keep nominal rates safely in positive territory by running a sufficiently high rate of inflation. Back in August, another eminent economist, Robert Hall of Stanford University, contributed a paper on the zero lower bound to the Kansas City Fed’s Jackon Hole conference, in which he estimated that the market-clearing real rate of interest is -4%. Now again, just why the real, natural rate of interest is currently -4% is an interesting question, but it’s irrelevant to the challenge of closing the output gap. All that matters there is that expected inflation is between 1% and 2% instead of near 4%. That’s the problem; that’s what’s keeping tens of millions of people out of work and hundreds of millions languishing in a perpetually weak economy: a couple of percentage points of inflation.

And central banks are entirely to blame for that.

My purpose is to illustrate the shortcoming of monetary policy that began almost as soon as Bernanke took over at the Fed. The set of three charts give, I think, a good visual of what went on since 1987.

Secular Stagnation_1

In his post Ryan Avent concludes:

The belief in the critical importance of low and stable inflation is more flexible than the gold standard was, and it is born of a better understanding of the workings of the macroeconomy. But it is a binding constraint on recovery and prosperity all the same. And the unwillingness to question its continued utility in the face of evidence that it is doing real harm looks all too similar to the intellectual fetters that led central bankers to persist in foolish policy in the early 1930s.

RA argues in terms of inflation (or expected inflation). But you don´t need to do so. Much better to frame things in terms of nominal spending or NGDP. The charts above should help convince some people.

Note: What gave rise to the oil shock of 2002-08, when oil price increased by a factor of 6?

One candidate is the demand pressure from Chinese imports which rose by a factor of 5 during the same period, which coincides with China becoming a member of the WTO! Chart below.

Secular Stagnation_2

Note 2: The chart below indicates that nominal and real rates have been trending down since inflation was “crushed” by Volcker and kept low and stable thereafter. So what?

Secular Stagnation_3


Update: The perils of interest rate targeting:

The Fed’s decision in the final month of 2008 to lower its overnight target rate to essentially zero percent appears to have “unwittingly committed the U.S. to an extremely long period at the zero lower bound similar to the situation in Japan, with unknown consequences for the macroeconomy,” Mr. Bullard said.

FOMC Minutes: “Love me, love me not”

The Minutes came out. The stock market didn´t appreciate it, at least immediately.

Bernanke´s concept of “open and transparent” monetary policy is really something!

On the Economic Outlook:

Although the incoming data suggested that growth in the second half of 2013 might prove somewhat weaker than many of them had previously anticipated, participants broadly continued to project the pace of economic activity to pick up.

After botching ‘communications’ in May/June of this year, they are now making an effort to be “clear”:

Participants broadly endorsed making the Committee’s communications as simple, clear, and consistent as possible, and discussed ways of doing so. With regard to the asset purchase program, one suggestion was to repeat a set of principles in public communications; for example, participants could emphasize that the program was data dependent, that any reduction in the pace of purchases would depend on both the cumulative progress in labor markets since the start of the program as well as the outlook for future gains, and that a continuing assessment of the efficacy and costs of asset purchases might lead the Committee to decide at some point to change the mix of its policy tools while maintaining a high degree of accommodation.

Given how they´re keen on “expecting” and “anticipating” economic improvement, and how eager to get of the bond buying horse, they say:

Participants reviewed issues specific to the Committee’s asset purchase program. They generally expected that the data would prove consistent with the Committee’s outlook for ongoing improvement in labor market conditions and would thus warrant trimming the pace of purchases in coming months.

Where “coming months” becomes “next month” to markets.

Although they have been saying they expect inflation to move up to target, they considered putting a lower bound to what would be acceptable inflation:

In general, the benefits of adding this kind of quantitative floor for inflation were viewed as uncertain and likely to be rather modest, and communicating it could present challenges, but a few participants remained favorably inclined toward it.

Maybe that´s best. Considering that inflation has been drifting down, if a floor is made official, as long as you are at or only slightly above the floor, the FOMC will feel it has done its job!

The FOMC has been doing a lot of “expecting” and “anticipating”

In his speech yesterday Bernanke stated:

Nearly eight years ago, when I began my time as Chairman, one of my priorities was to make the Federal Reserve more transparent–and, in particular, to make monetary policy as transparent and open as reasonably possible.

Let´s check out how he has performed relative to the “stable prices” mandate.

In the early months after the crash, the FOMC was still very much focused on headline inflation. That was certainly one of the reasons monetary policy was so tight going into the “Great Recession”:

In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate in coming quarters to levels consistent with price stability.(Oct 08).

In later occasions the FOMC doesn´t mention energy and commodity prices explicitly (maybe because they crashed):

With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time. (Nov 09)

Currently, the unemployment rate is elevated, and measures of underlying inflation are somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate. Although the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, progress toward its objectives has been disappointingly slow. (Dec 10)

Fantastic! They anticipated inflation would remain excessively low:

The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee’s dual mandate. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations. (Dec 11)

The Committee also anticipates that inflation over the medium term likely will run at or below its 2 percent objective. (Dec 12)

The Committee also anticipates that inflation over the medium term likely will run at or below its 2 percent objective. (Apr/May 13)

Suddenly they acknowledge that “too low” inflation could pose risks. But instead of doing something about that they start “anticipating” that it will move back up in the medium term (are they evoking the “Holy Ghost”?):

The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, but it anticipates that inflation will move back toward its objective over the medium term. (July 13)

In his latest speech Bernanke drops the risk part and only continues to “anticipate” that inflation will somehow rise:

The Committee additionally expected that inflation would be moving back toward its 2 percent objective over time. (Speech Nov 13)

The chart illustrates that they have for a long time “expected” and “anticipated” wrong. Lately, even, inflation has moved further down, not up as “anticipated”!


“The man who shot Liberty Valance”

After presiding over the first depression since the 1930s, Bernanke is off to the speaking circuit. His pension is guaranteed to grow despite the meagre interest rates. For someone of his stature those things go for 50K to 100K a ‘pop’! And don´t forget the multimillion book deals.

And he´ll be hailed as a Hero!

Liberty Valance

I hope his ‘contemplation’ leads to a ‘mea culpa’ and an apology down the road.

When fiction and reality clash: The Bernanke legacy

Bernanke´s opening statement in his speech to the National Economics Club sounded like the opening paragraphs of a fairy tale:

Nearly eight years ago, when I began my time as Chairman, one of my priorities was to make the Federal Reserve more transparent–and, in particular, to make monetary policy as transparent and open as reasonably possible.

I believed then, as I do today, that transparency in monetary policy enhances public understanding and confidence, promotes informed discussion of policy options, increases the accountability of monetary policymakers for reaching their mandated objectives, and ultimately makes policy more effective bytightening the linkage between monetary policy, financial conditions, and the real economy [uau! A mouthful!!!]

Of course, responding to the financial crisis and its aftermath soon became the Federal Reserve’s main focus. As it has turned out, however, following the stabilization of the financial system, supporting our economy’s recovery from the deepest recession since the Great Depression has required a more prominent role for communication and transparency in monetary policy than ever before.

For the last 5 years monetary policy has not been transparent, it has been unconventional, so that public understanding and confidence are lacking. In fact elements of monetary policy are seen, simultaneously, as having little effect and being dangerous!

Please tell me where to go for an “informed discussions of policy options”, or show me how accountability of monetary policy makers has been increased if they have systematically missed ALL their mandated objectives.

Last, how come monetary policy has been made more effective if it´s mostly seen as having little effect beyond blowing bubbles and increasing financial risks?

In the last paragraph above, Bernanke is either being facetious or really has no inkling that before “responding” he (the Fed) played the role of the arsonist, greatly enhancing the fire which he later decided to, albeit timidly, respond.

Maybe I´m being too harsh. After all, Bernanke can say that by being “open and transparent” he was just assuring the populace that inflation would stay on target. But this just tells you how bad, deceiving and even criminal that particular target can be.

PS An example of “transparency and openness”:

In coming meetings, in evaluating the outlook for the labor market, we will continue to consider both the cumulative progress since September 2012 and the prospect for continued gains. We have seen meaningful improvement in the labor market since the latest asset purchase program was announced in September 2012. At the time, the latest reading on the unemployment rate was 8.1 percent, and both we and most private-sector economists were projecting only slow reductions in unemployment in the coming quarters. Recent reports on payroll employment had also been somewhat disappointing. However, since the program was announced, the unemployment rate has fallen 0.8 percentage point, and about 2.6 million payroll jobs have been added. Looking forward, we will of course continue to monitor the incoming data. As reflected in the latest Summary of Economic Projections and the October FOMC statement, the FOMC still expects that labor market conditions will continue to improve and that inflation will move toward the 2 percent objective over the medium term. If these views are supported by incoming information, the FOMC will likely begin to moderate the pace of purchases. However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s economic outlook. As before, the Committee will also continue to take into account its assessment of the likely efficacy and costs of the program.

Does the chart corroborate Bernanke´s opinion of a “meaningful improvement”?

Meaningful Improvement

About the fall in the unemployment rate, it doesn´t mean anything special when account is taken of the drop in the labor force since September 2012 (217K) and the reduction in labor force participation (from 63.6% in September 2012 to 62.8% in October 2013).