Ryan Avent´s “A theory of troubles” from a MM perspective

Recently, Ryan Avent at Free Exchange wrote a thought-provoking and ambitious post which he aptly titled “A theory of troubles”. The “troubles” flow from the “puzzles”, of which there has been no shortage of supply lately:

There are puzzles of wage stagnation and falling labour-force participation. There are savings glut puzzles and secular stagnation puzzles. The common thread linking the puzzles is that they almost always mean trouble of one sort or another.

Many stories have been presented to explain some of these phenomena (and others, as well, like rising inequality and the striking emergence of jobless recoveries). But not much effort has been made to tie these stories together into a broader narrative of what is happening to (primarily) rich economies and what might usefully be done about it. The nearest thing to an attempt is the secular stagnation narrative that, while not originating with him, has been popularised in recent months by Larry Summers. In this post I hope to tighten up and extend the arguments in Mr Summers’s story in pursuit of a broader theory of troubles.

I´ll be far less ambitious and will try only to understand the “emergence of jobless recoveries”. Maybe this will also help understand some of the other “puzzles”.

My argument will lean heavily on the (potential) efficacy of monetary policy and this is a point that RA, likely because he focuses on inflation, “misses out”:

Distributional issues are key in this narrative. If we assume that purchasing power is allocated via market wages, then the task facing central banks immediately becomes impossible. If they try to maintain low and stable inflation, then competition for low-skill work will place downward pressure on the wages of low-skill workers, but wages will be too rigid to provide employment for all willing workers.

… But in general, the benefits of growth will flow to high-income workers and owners of capital. Since they have low propensities to spend, central banks will find it difficult to generate adequate demand, except by nurturing unsustainable borrowing by workers with stagnant incomes. Central banks cannot have adequate demand and low inflation.

On the other hand, if central banks are willing and able to raise inflation rates, then real wages will be more flexible, and firms will be more willing to use labour to do tasks that could reasonably, or even easily, be automated. In this scenario the central bank succeeds in generating adequate demand; because low real wages encourage less substitution of capital for labour, a higher share of income flows to labour, to workers with a high propensity to spend. But adequate demand is incompatible with a low rate of inflation.  It may also be unsustainable, since many central banks will interpret the high inflation necessary to boost employment as evidence the economy is running at capacity.

What RA is saying, and this has been my longstanding view, is that persisting or even formally introducing an inflation target as the objective of monetary policy once inflation has been conquered (as is mostly the case, especially in advanced economies) can be “dangerous for the economy´s health”.

For example, if the central bank manages, as it mostly did during the period called “Great Moderation”, to maintain NGDP (or nominal spending) growing at a stable rate along a level growth path, the problem of rigid wages won´t manifest itself with any force. Why? Because the ratio of wages to NGDP will also be stabilized.

The upshot: don´t think in terms of higher or lower inflation (as a means to reduce wage rigidity), but focus on maintaining NGDP “hugging” a stable path.

What if a nominal shock disturbs the balance? Try to get NGDP back to the trend level as fast as possible. That´s one reason monetary policy (understood as keeping NGDP close to the trend level) shouldn´t react to real (say, productivity, or oil) shocks. If it does react (fearful of inflation, perhaps), given sticky wages, the wage NGDP ratio will rise and so will unemployment (while employment falls).

I hope the panel below helps to shed some light. The “leading” role in our script goes to employment. The other parts are all ones of “supporting roles”. Looking at the left side of the panel, we see that NGDP growth plays an important supporting role. The large drop in NGDP in the present cycle “translates” into a deep fall in employment, just as the slow NGDP recovery maps into the slow gains in employment.

Theory of troubles_1

But some other “force” (or supporting actor) must be “doing” something because, despite NGDP growth for the whole period being the same in the 1990 and 2001 cycles, the 2001 recovery was much more jobless that the 1990 recovery.

The top chart on the right hand side shows that productivity growth was much higher in the 2001 cycle than in the 1990 cycle.

Ryan Avent´s narrative touches on that point:

Productivity-rich recessions, and jobless recoveries, are a product of sticky wages.

Mark Bils, Yongsung Chang, and Sun-Bin Kim find that sticky wages push firms to wring more output from existing employees when confronted by a decline in demand. Productivity therefore rises during recessions—rising most in industries where wage rigidity is most binding—reducing the incentive to take on new workers despite relative wage flexibility among the unemployed.

And again the “inflation solution”:

Taken together, these observations imply that in the presence of moderate inflation, real wages will be more flexible and productivity will flip back to falling, rather than rising, amid weak demand. That brings us back to the motivating example of the Britain versus America comparison, where that implication seems to have verified.

Note, however, that the NGDP gap (relative to its “Great Moderation” trend) was almost non-existent in the 1990 cycle and widened in the 2001 cycle (the stand alone chart takes away the 2007 gap because it distorts the picture).

Theory of troubles_2

In the 2001 cycle, therefore, the wage NGDP ratio rose, so “firms wring more output from existing employees when confronted by a decline in demand.” Only when nominal spending rises more strongly does employment pick up.

The present cycle is somewhat “special”. The NGDP gap widened off the charts, so, due to wage stickiness, the wage NGDP ratio must have increased considerably. As the chart shows, it did! Nevertheless, productivity behaved no differently from the 1990 cycle. Demand and output fell by an inordinate amount (so there is no incentive to “wring out more output from remaining employees”) and so has employment, which is crawling back at the rate allowed by the rise in nominal spending, that has been far short from what´s needed to narrow the gap. Only now, 24 quarters after the start of the cycle, the wage NGDP ratio inched below what it was in late 2007!

Theory of troubles_3

Takeaways: Focusing on inflation is the wrong “strategy”. Allowing more than moderate falls in NGDP leads to jobless recoveries. If large drops in NGDP occur (as in 2008-09) and monetary policy is “timid”, “job loss” recoveries ensue. Importantly, an NGDP level target will go a long distance in “neutralizing” nominal wage rigidities.

And everything becomes a “puzzle” because the existing models do not account for them! Policymakers say they have done all they could, but unfortunately we are in a “secular stagnation”, which has become the “new normal”!

The Report Everyone Forgot About. Even Me.

A guest post by Benjamin Cole

The U.S. Bureau of Labor Statistics tracks “unit labor costs,” and back on February 6, they came out with their latest report.  Usually I look for this report, but this time I missed it.

The news?

We are in deflation, when it comes to labor costs.

Here is the take-away:

“Unit labor costs in nonfarm businesses decreased 1.6 percent in the

fourth quarter of 2013, as the 3.2 percent increase in productivity

was larger than a 1.5 percent increase in hourly compensation. Unit

labor costs fell 1.3 percent over the last four quarters. “

I have been scrolling around the Internet trying to get a handle on what fraction labor is of total business costs. My memory was that 40 years ago it was about 60 to 80 percent, and that seems to be right today, although I could not find a definitive source, if there is one.

Suffice it to say it would be a strange world in which we had sustained inflation, but sustained deflation in labor costs.

According to the St. Louis Fed, unit labor costs are up 1.7 percent since the first quarter…of 2007. (data)


Now six years does not a lifetime make, but we are talking about a nation in which labor costs have been dead in the water for six years, and are now sinking.

Has anyone at the Fed, or in the frantic crowd of inflation-hysterics, read these BLS reports?

What would it take for the Fed to announce they are well undershooting their inflation targets, that we have deflation in unit labor costs—so prospects for higher inflation are shrinking—but corrective action is planned?

Despite ‘forward guidance,” I think the market and economy have correctly read between the lines: The Fed is not targeting 2 percent inflation. They may be targeting 1 percent inflation. Or if FOMC members Richard Fisher and Charles Plosser have their way, zero percent inflation (as measured).

And so the glacial recovery continues….

Forfeiting the Taylor Rule ‘caused’ the downfall!

This is the view of John Taylor who weighed-in on the “Macro Models/New Keynesian Models” debate:

There’s a good debate going on about the usefulness of macro models, and in particular whether the so-called New Keynesian models let us down or even helped bring on the financial crisis and the Great Recession.

This weekend Noah Smith argues that the new Keynesian models were built for the “last war” and thus missed macro-financial connections or the zero interest rate bound needed to understand the Great Recession and slow recovery. Simon Wren-Lewis writes that the models omitted key factors by focusing too much on rational expectations and other micro-foundations which “crippled the ability of New Keynesians to understand subsequent real world events.” And back last summer Paul Krugman in Macroeconomists at War wondered if these models were being used much at all, saying “It would be interesting to know how many graduate departments were in fact teaching New Keynesian macro in 2008. My guess is that a fair number weren’t.” Underling the debate is an implicit view that New Keynesian models deserve much of the blame for the poor economic performance in recent years, and should be “taken to the woodshed” as Chris House put it.

And concludes:

I do not see the evidence that these models led policy makers astray or were a cause of the financial crisis. To the contrary I have argued that the general policy recommendations of these models—which generally took the form of particular monetary policy rules for the interest rate instrument—were not followed by policy makers in the years leading up to the crisis though they followed them during the Great Moderation. Ignoring the recommendations was the problem rather than the recommendations themselves. These models did not fail in their recommendations. Rather the policymakers failed to follow the recommendations.

That is just another way of saying that rates “too low for too long” were the cause of the house price boom and bust which morphed into the financial crisis giving rise to the “Great Recession”.

And as has become standard, the Fed avoided a second “Great Depression “ by, in the words of none other than Robert Lucas, “acting boldly as lender of last resort, just as it should have done in 1930s, but failed to do so”.

The chart below reproduces a chart in Taylor´s linked piece. He argues (through simulations) that by disrespecting the rule, the Fed caused havoc!

Model Wars_1

The next chart indicates that house prices had been going up since 1997 irrespective of what interest rates were.

Model Wars_2

A simpler version of the “rule”, devised by Mankiw, (which considers only core inflation and unemployment completely disregarding “natural rates” and “targets”) mimics Taylor´s counterfactual pretty well.

Model Wars_3

So, no matter your approach, rates were “too low for “too long”.

But note that the economy was not reacting to the persistent drop in rates that began in early 2001. In effect the chart below is a great example of the dictum: “low rates reflect the fact that monetary policy had been tight and high rates that it had been loose”. We see that low (falling) rates are associated with a negative (increasing) NGDP gap and high (rising) rates with a positive (shrinking) NGDP gap.

Model Wars_4

When did things began to change? When the Fed introduced forward guidance at the August 2003 FOMC meeting. The NGDP gap closes and, as the next chart shows, unemployment begins to fall (being the “mirror image” of the spending gap).

Model Wars_5

What was happening to inflation at the time? As the next set of charts show, headline inflation was “dancing to the beat of the oil and commodity price drums”, while core inflation remained pretty tame (although more often than not on the low side of 2%) all along.

Model Wars_6

As Scott Sumner said recently:

We should welcome an “abrupt policy adjustment.”  It’s much better to get to full employment in one year and then abruptly adjust policy to keep NGDP rising along a 4.5% trend line, than it is to have a gradual recovery that asymptotically approaches full employment over many years.  Which has been the actual policy since 2009, in case anyone didn’t notice.

In 2003, when the Fed decided to amend a situation that was infinitely more benign than the present one, it did so forcefully. But, despite the drop in unemployment and inflation (core) remaining very close to the “desired” level, to this day monetary policy is faulted!

One consequence of that misdiagnosis is that at present “expansionary monetary policy” (understood as actions that shrink the spending gap) is a taboo! Bubbles will inflate and a new crisis will ensue!

Update 2/22): While I was looking for the 2000s equivalent of Mussas´”Monetary Policy in the 1980s” and Mankiw´s “Monetary Policy in the 1990s”, I found this post by James Hamilton in 2011: “Monetary policy since 2000”.

JH concludes:

This provides an interesting confirmation of the theme of a talk by Stanford Professor John Taylor also given at the conference. Taylor argued that a shift away from the policies followed in the 1990s was one factor contributing to the excessive housing boom and subsequent problems. My personal view is that Taylor overstates the contribution of low interest rates, and that poor regulation of the shadow banking system was a more important cause of the problem.

Nevertheless, I agree that the lax monetary policy of 2003-2005 was a mistake.

To which Mark Sadowski responds in the comments with his usual attention to details:

Li, Li and Yu estimate their model using an outcomes based Taylor Rule and the GDP deflator for the inflation rate. Poole (2007) estimated an outcomes based Taylor Rule using headline CPI and found that the Fed was unusually accomodative from about 2000 on. Orphanides and Wieland (2007) on the other hand estimated an expectations based Taylor Rule that used the the inflation measures that the Fed has actually been targeting and found no deviation during the 2000s.

The Fed switched from GDP deflator to headline CPI in 1988 and then to headline PCE in 2000 and finally core PCE in 2004. So the regime change that Li, Li and Yu are detecting in 2000 is most likely a combination of the fact that the Fed’s behavior seems better modeled by an expectations based Taylor Rule and that the Fed switched it’s measure of inflation in the 2000s.

On the question of whether policy was too accomodative one has too look at the results. If you believe that core inflation is a better measure of inflation inertia as I do then you’ll note that core PCE stayed within a narrow range of 1.5%-2.4% throughout 2000-2008. And GDP only went above potential in 2006-2007 and then only by a very modest amount. Similarly unemployment was below the natural rate only from March 2006 through November 2007 and never by more than 0.4 points.

So, no I don’t think Fed policy was excessively accomodative during the 2000s.

In the final analysis monetary policy should not have been held hostage to policing an asset bubble, even if it did contribute, which I sincerely doubt.

Beware: Faith will be your downfall!

Robert Samuelson ends his piece “Economists in the darkthus:

The faith in economics was, in many ways, the underlying cause of both the financial crisis and Great Recession — it made people overconfident and careless during the boom — and the basic explanation for the weak recovery, as stubborn caution displaced stubborn complacency. To regain relevancy, economists are searching for a new light bulb — or better use of the old one. Meanwhile, most are still sitting in the dark.

This sort of reasoning has, unfortunately, become commonplace. Scott Sumner has a post today at Econlog which discusses the “obviousness” of causes. It´s amazing how even academics quickly forget (or take down) what they wrote in textbooks. It´s also amazing to see how malleable ABCT is. It always finds a way to “fit the facts” – “overconfidence” or “complacency” on the way up and “stubborn caution” or “liquidationism” behind the weak recovery.

If you look at monetary policy as the “boat´s helmsman”, responsible for steering the boat´s course and fiscal policy as the “master of ceremony”, responsible for keeping an environment that is favorable to long term growth, you will see that:

  1. The “helmsman” “veered wildly off course” in 2008 and,
  2. The “master of ceremony” has unabashedly “polluted” the environment

End result: the “boat” is lost in a sea of “pollution”.

It´s that simple!

Old Wars and debates rekindled

Krugman elaborates on a post by Noah Smith:

For what was the next war? Contra what many people say, it was not the financial crisis. That crisis was a surprise, but not because we had no room for such things in our philosophy. Bank runs have been pretty well understood for a long time; the only thing was that few economists were aware of the institutional changes that had created the shadow banking system. Once you realized what had happened, that jumping haircuts on repo were the functional equivalent of a run on deposits, things fell into place.

And policy responded pretty effectively, too: the financial crisis may have come as a shock, but it was more or less contained by the spring of 2009.

No, the real war involved dealing with a persistently depressed economy, with monetary policy constrained by the zero lower bound. And I just don’t see an intellectual failure there. A number of Keynesians — yours truly, Eggertsson, Woodford, Svensson, whatshisname — Bernanke, that’s it! — and more had studied the issue. The models rolled out to make sense of the ongoing slump elaborated on but didn’t fundamentally change the approaches many of us had been working on since the late 1990s. And the predictions those models made, about interest rates, inflation, the output effects of fiscal policy, were both counterintuitive to many people and reasonably on target.

I just don’t see this as a story of economists unprepared to deal with new events. Personally, I’ve found the past five years, since we hit the zero lower bound, remarkably comfortable in intellectual terms: I’ve had to learn a few new things, but by and large this was the calamity I’ve been preparing for since 1998.

Now, you might ask why, in that case, we haven’t solved the problem. But the answer there has nothing to do with lack of economic understanding; it has to do with ideologues who made up new doctrines on the fly (like expansionary austerity or doom by 90 percent debt) to justify policies that made no sense in the standard models. If politicians turn to climate deniers, that’s not a reflection on climate science; if they turn to crank macroeconomics, that’s not a reflection on Keynesianism.

Bottom line: I am not a French general!

You might say policy responded to the financial crisis – by not allowing a domino effect on failing banks. But the financial crisis itself, at least its intensity and scope, was the result of bad monetary policy on the run up to the crisis.

Just as Bernanke was prepared (from his academic research on the Great Depression) to avoid a Great Depression-like financial failures, Krugman says the persistently depressed state of the economy is the “calamity I´ve been preparing for since 1998”.

That reminds me of Douglas Irwin´s argument that:

The intellectual response to the Great Depression is often portrayed as a battle between the ideas of Friedrich Hayek and John Maynard Keynes. Yet both the Austrian and the Keynesian interpretations of the Depression were incomplete. Austrians could explain how a country might get into a depression (bust following a credit-fueled investment boom) but not how to get out of one (liquidation). Keynesians could explain how a country might get out of a depression (government spending on public works) but not how it got into one (animal spirits). By contrast, the monetary approach of Gustav Cassel has been ignored. As early as 1920, Cassel warned that mismanagement of the gold standard could lead to a severe depression.

Unlike Keynes or Hayek, Cassel analyzed both how a country could get into a depression (deflation due to tight monetary policies) and how it could get out of one (monetary expansion).

Analogously, Market Monetarists (MMs) say that tight monetary policies (NGDP falling below trend) caused the Great Recession (and worsened the financial crisis) and that monetary expansion (taking NGDP back to trend) could get it out of it. In other words, if monetary policy had been geared to maintaining NGDP on trend things would have been very different. Bernanke´s financial failures would not have happened and nor would Krugman´s calamity (because for MMs, who advocate an NGDP Level Target, the ZLB is no constraint on monetary policy)!

A replay of recent charts illustrates:

Krugmans Calamity

Krugmans Calamity1

“Some questions do have answers”

In his recent post at Econlog Scott Sumner writes “Questions that have no answers”:

There are some questions that have no answers. One example is the question: “Was monetary policy too expansionary during the housing boom?” The only sensible answer is “it depends.” It’s not clear what the Fed was trying to do during this period. If we knew, we could evaluate whether the policy was too loose or too tight to achieve their policy goal.

…What are we to make of the 2% inflation rate? One could argue the Fed has been successful. After all, 2% is their target. But I believe that’s wrong for 3 subtle reasons.

His third reason:

3. The third problem with the Fed policy is that inflation is the wrong target, they should target NGDP growth, level targeting. It turns out that the NGDP growth rate that kept inflation right at 2% over the past 10 1/2 year was only 4%, well below the 5.4% rate of 1990-2007. And yet, at the very moment when they needed to downshift NGDP growth to 4% to keep inflation on target, the Fed upshifted to more than 6.5% NGDP growth during the housing boom of 2003-06.

The third mistake allows us to better understand the mild dispute between some market monetarists over whether Fed policy was too tight loose in 2003-06. David Beckworth says yes, growth was above 5%. Marcus Nunes says no, there was some catch-up from the 2001 recession, and it’s level targeting that matters.

In my view there is no answer to this question. If the Fed had continued along the level target path that Marcus suggests, then he would have been right, the policy would have been fine. Given the Fed wanted 2% inflation, Beckworth’s advice would have been better in retrospect. If the Fed went even further and switched to 4% NGDP growth in 2003, then the recovery would have been agonizingly slow, John Kerry would have won Ohio and the Presidency in 2004, and there would have been no Great Recession of 2008. It would have looked like a bad Fed policy in retrospect because of the very slow recovery. The policy would have been condemned by many people, but it would have been far superior to the actual policy.

I hope some illustrations help to clarify matters.

The first thing I want to take out of the way because it is irrelevant to the story is “the housing boom of 2003-06”. It´s really a housing boom of 1997-06 as the chart indicates, independent of what was happening to either interest rates or NGDP growth.


There is an almost universal consensus that monetary policy was “too easy” in 2003-06. My argument is that it was not. Let´s see:

1 NGDP growth tumbled following the 2001 recession


2 The NGDP gap widened up to mid-2003


3 Core inflation went down significantly below target while headline inflation after 2003 reflected oil and commodity price increases (to which Greenspan, correctly, did not react!)


The FOMC meeting of August 2003 introduced forward guidance (“rates will remain low for an extended period, followed later by “rates will rise at a measured pace”). Note that from that point NGDP growth picks up. To close the gap it has to grow more than the 5.4% trend growth rate.

By the time Greenspan was replaced with Bernanke the gap had closed.

This is what happened during Bernanke´s stewardship:

1 After initially remaining close to trend, NGDP growth tanks


2 The gap becomes gargantuan


3 It appears (1) and (2) above were the result of the Fed´s (mistaken) reaction to headline inflation


The rest is ‘history’.

Update: Karl Smith argues along the same lines

Elvis Presley and Inflation Are Dead.

Richard “Inspector Clouseau” Fisher, Dallas Fed President, Needs to Adjust.

And Change His 1970s Hairdo.

Can We Have National Demand-Pull Inflation in an Economy of Globalized Supply?

A guest post by Benjamin Cole

It ain’t the 1970s anymore, and Dallas Fed Prezzy Richard “Inspector Clouseau” Fisher should quit ranting about inflation. Especially in the United States. And consider a new hairdresser—the large hair look is out.


Deflation may be the next long-term threat.

As a devout Market Monetarist, I recognize the key role that monetary policy plays in inflation and economic growth. And, as a student of the writings of Marcus Nunes, I am educated on the role of the Federal Reserve Board and Chair Arthur Burns in the late 1970’s inflations, when Elvis Presley staged his first big comeback.

In that era of sideburns, big hair and sequined bell-bottomed pants, consumer prices in the United States sometimes rose by low double-digits (less often noted is that the U.S. economy grew by a real 20 percent in four years coming out of the 1973-75 recession, but set that aside).

Richard “Inspector Clouseau” Fisher must have been scarred deeply by the 1970s; he speaks continuously (and has for decades) about the perils of 1970s replay or even worse.

For the (enviably) uninitiated, Fisher earned the moniker “Inspector Clouseau” for voting to tighten Fed policy in 2008, just before the Great Bust, and then going super-short against the market in 2011, thus nearly calling the market bottom; the DJIA is up roughly 50 percent since Fisher went short. More recently, Fisher has seen clues to a pending inflationary flood in rare book prices, but the PCE deflator has trending towards zero instead. More follows…

Elvis Not Coming Back, Inflation Dead Too.

We may wish Elvis to return, but he won’t and inflation won’t either.


Though rarely noted in the current era of inflation-hysteria, the United States economy has been positively and radically transformed from the inflationary 1960s-70s.

•In the 1960s, about one-third of the private labor force was unionized. Today, that figure is 6.3 percent.

•In the 1960s, the transportation, finance and telecommunication industries were heavily regulated, including on price. Oldsters will remember pretty stewardesses (no price competition in airfares); one monopoly phone company per region (Ma Bell); Regulation Q (regulated interest rates on passbook accounts, the only form of liquid savings available to most Americans); and fixed (and expensive!) stockbroker commissions.

Importantly, trucking and rails were heavily regulated on price by the old ICC, all through the 1960s and 1970s.

•International trade was less than 10 percent of the U.S. economy in 1960s, meaning that foreign competition was much less of a force. Today trade makes up more than 25 percent of the U.S. economy, and is still rising. Imports are obviously rife, the “Made in USA” label a rarity in consumer products.

•Hard as it is to fathom today, the top federal tax rate was more than 90 percent for almost all of the 1960s and 1970s, crimping capital formation and thus new business formation. The venture capital community in the 1960s was miniscule. Start-ups were for oddballs.

•The 1960s and 1970s was the epoch of “Big,” as in “Big Steel,” and the “Big Three” (domestic automakers), “Big Oil,” and other gigantic enterprises with market heft, who often set prices for season and made the prices stick. There were only three national TV networks, and a few national print outlets.

The upshot? In the 1960s and 1970s, Fed Chief Arthur Burns was not all wrong.

As Burns contended, cutting demand by the monetary noose in the 1960s did not cut prices by much, as so much of the price structure was set in stone by regulations or union contracts, or by big oligopolistic enterprises, and all enabled by the lack of foreign competition.

Dampen demand, Burns correctly surmised, and you get recession.

And pumping up demand did boost output dramatically thanks to sticky prices and wages, as seen by the rapid 20 percent real recovery from the 1973-75 recession–although Burns ultimately overplayed his hand, and revved-up inflation.

Burns deserves a bad rap—but some consideration also. It was the 1970s, after all. Excess and ossification was in.

Today No Elvis, But Still Richard Fisher

Today, of course, the United States economy is much less inflation-prone than that of the 1960s and 1970s.

•The private sector is deunionized and labor toothless even where it exists.

•The range of product and services today in the United States subject to intense foreign competition has radically expanded. Capital, products and services flow into the U.S. to meet demand, and, until recently, so did labor. The Internet and international transportation systems have amplified the globalized economy.

•The problem in the United States today is not crimped capital formation caused by high tax rates and federal borrowing, but too much capital. The marginal tax rates may be too high, but they are half the 1960s and 1970s levels.

•Prices and rates are deregulated in transportation, communications and finance, a huge difference from the 1970s. Ma Bell? Today consumers are buying unlimited nationwide calling, text and Internet use for $5 a month. Others get  free shipping from Amazon.com.

•Retailing has been transformed, first by the globally sourcing Wal-Mart and competitors, then by 99-cent stores, and then by the Internet and Craigslist. Inefficient retailers are dying, and for the first time in history (thanks to Craigslist) it is viable to sell second-hand goods person-to-person, or even engage in easy-to-start “grey market” retailing.

•”Big” is Dead. Big Steel, the Big 3 automakers, Big Aluminum etc. are dead, and surviving remnants struggle in global markets.

•There is a well-financed venture capital community today; almost no good idea goes unfinanced, and many so-so ones do.


The industrialized world has seen 30-year secular declines in inflation and interest rates, and Richard Fisher should seek a clue in that reality. Today, the United States is still on the cusp of ZLB, or zero lower bound. The trend lines say from here we go to deflation and the Japan scenario.

That might not daunt Fisher. He is the central banker who visited Japan in April 2009 and delivered a speech that included this: “I consider inflation an evil spirit that rots the core of economic prosperity and must never, ever be countenanced.” Did I mention Fisher said that in Japan?

But then Fisher also told the Council of Foreign Relations in New York City in 2008 that “though the economy still faces a period of slowdown…the U.S. will skirt recession.” He has boasted of having voted for the Fed to raise rates to fight the commodities inflation of 2008—the proximate cause of the Great Recession, by many lights.

Fisher aside, a more-relevant question today is, “Can the United States ever have a demand-pull inflation again, given globalized supply chains, superlative retailers and the Internet, and dead unions? Or will more demand (within reasonable ranges) only result in more output, sucking up supply globally?

I say more demand makes for more output, and let’s find out if I am right.


I will confess some nostalgia for the 1970s, when I could wear tight pants and dance disco. It makes me miss Elvis to think inflation is dead, and like Elvis, ain’t coming back.

But no worries. I can still download Richard “Inspector Clouseau” Fisher and check out his hairdos, or watch Elvis on youtube.

And, if we do not have inflation today, we can always look forward to tomorrow. In Fisher’s world (as some say about fusion power), inflation is a force of the future and always will be.

Spinning Tales

At the end of 2013, the Economic Policy Institute presented the “13 Most Important Charts of the Year”. One of those is below (on the left), purporting to show the “roots of American inequality”. The chart on the right hand side tells the same tale using slightly different data.

EPI Charts_1

Let me make a change in the deflator of hourly compensation. Instead of using consumption prices I use producer prices. That´s not an arbitrary change. When deciding on pay, the producer takes into account the productivity of the worker relative to the price he (the producer) will receive.

The tale changes significantly.

EPI Charts_2

At the end there is still a gap, but that starts in the mid-00s, not in the mid-70s!

Following the 2001 recession there was a long period that came to be called “jobless recovery”. Real wages stagnated while productivity continued to rise. As the bottom chart shows, profits rebounded strongly. The same happens (more intensely) following the 2008/09 crisis. Real compensation even drops somewhat (a “job-loss recovery”) while productivity rises.

This chart also gives a hint into the reasons for the corporate shenanigans (by the Enrons of this world) which the SEC unraveled in late 2001. Interestingly the SEC went back to 1997, which was identified as the starting point for the false income reporting by the corporations involved.

Notice, looking at the shaded area, that 1997 was the year in which real compensation began to climb strongly after spending some time stagnant while productivity rose. Profits drop. The executives whose pay was tied to stock performance ‘despaired’. Solution: cook the books to keep our pay level! Obviously most corporations had better governance than Enron et al.

I certainly hope “time will tell”

At the C.D. Howe Institute in Canada, Steve Ambler of the University of Quebec has a commentary titled: Price Level Targeting: A Post Mortem. I found his conclusion interesting:

However, the main reason that central banks have not experimented with PT is that they are too wedded to the ability to exercise discretion in the conduct of monetary policy. PT acts as a substitute for commitment in the sense of Kydland and Prescott (1977). IT is a regime that allows bygones to be forgotten and allows the central bank to decide on its optimal policy without regard to past economic conditions. Central bankers have resisted strongly academic studies demonstrating the superiority of rules-based approaches to monetary policy as imposing too much rigidity on the monetary policy process and robbing them of the flexibility to react to circumstances not accounted for in their forecasting models or in mechanical rules. The financial crisis was a special circumstance par excellence.

PT has disappeared recently from academic discussions and from central bank working paper series, and it has all but disappeared from discussions on the blogosphere. The main alternative monetary policy framework discussed actively today is nominal GDP targeting (NGDPT), which replaces a target price level path with a target path for nominal income. Nominal income becomes the long-run anchor for monetary policy rather than the price level.

Under NGDPT, deviations of nominal income from the target path are the only measure of the need for tightening or loosening, so it is potentially simpler. In contrast, under PT the need for tightening or loosening of monetary policy is measured not only by deviations of the price level from target but also on measures of the output gap, which is not directly observable. NGDPT with a level target is a framework in which bygones are not bygones and deviations from target must be corrected. In this respect, it is a rules-based approach to monetary policy similar to PT. Time will tell if NGDPT gains enough traction to overcome central bankers’ reluctance to accepting limits on their discretion. The active discussion concerning NGDPT will keep alive the debate over rules versus discretion.

Illustration: The Fed´s mistaken decision to strongly react to oil/commodity price shocks tanked NGDP. Since it has no level target for NGDP the economy remains depressed! (With discretion keeping inflation way below target)

Steve Ambler

Fed is quick to blame the weather!

Manufacturing output, the largest component of industrial production, fell 0.8% in January.

“Manufacturing output fell…partly because of the severe weather that curtailed production in some regions of the country,” the Fed said.

The Fed is an institution that exists to assign blame. As this old post argues:

Krugman has it right:

Worse, what Brad suggests — and it’s my impression, too — is that policy formation is being seriously distorted by unwillingness to acknowledge past error. People who opposed stronger action in the past continue to oppose strong action now, in part because that would be admitting, at least implicitly, that they were wrong before.

Farfetched? Certainly not. History suggests that kind of behavior or attitude has been adopted at least once before, in similar circumstances. In early 1937 the Fed jacked up required reserves. Prices and economic activity nose-dived. At the FOMC meeting of January 1937, Orphanides recounts (especially pages 9 to 14):

The section of the law which authorizes the Board to change reserve requirements for member banks states that when this power is used it shall be `in order to prevent injurious credit expansion or contraction.’ The significance of this language is that it places responsibility on the Board to use its power to change reserve requirements not only to counteract an injurious credit expansion or contraction after it has developed, but also to anticipate and prevent such an expansion or contraction. … In view of all these considerations, the Board believes that the action taken at this time will operate to prevent an injurious credit expansion and at the same time give assurance for continued progress toward full recovery. (Board Press Statement, January 30, 1937).

The Chairman, further clarified his reasoning in favor of the tightening in an article published in Fortune magazine in April. Raising the specter of 1929 once again, he stressed: Recovery is now under way, but if it were permitted to become a runaway boom it would be followed by another disastrous crash.

And the “clincher”:

Particularly enlightening is the reasoning offered by Williams (Board Member, Fed Chief-Economist and Harvard prof) as to why a reversal of the earlier tightening action would be ill advised.

We all know how it developed. There was a feeling last spring that things were going pretty fast … we had about six months of incipient boom conditions with 11rapid rise of prices, price and wage spirals and forward buying and you will recall that last spring there were dangers of a run-away situation which would bring the recovery prematurely to a close. We all felt, as a result of that, that some recession was desirable …We have had continued ease of money all through the depression. We have never had a recovery like that. It follows from that that we can’t count upon a policy of monetary ease as a major corrective. …

In response to an inquiry by Mr. Davis as to how the increase in reserve requirements has been in the picture, Mr. Williams stated that it was not the cause but rather the occasion for the change. … It is a coincidence in time. …

If action is taken now it will be rationalized that, in the event of recovery, the action was what was needed and the System was the cause of the downturn. It makes a bad record and confused thinking. I am convinced that the thing is primarily non-monetary and I would like to see it through on that ground.

There is no good reason now for a major depression and that being the case there is a good chance of a non-monetary program working out and I would rather not muddy the record with action that might be misinterpreted. (FOMC Meeting, November 29, 1937. Transcript of notes taken on the statement by Mr. Williams.)

The Federal Reserve made every effort to build a convincing case that the cause of the 1937 downturn could be more than accounted for by factors other than the monetary tightening and that policy action by the rest of the government and not by the Federal Reserve were needed to restore prosperity. \Causes of the recession,” a famous essay written at the Board by Lauchlin Currie (a close advisor to Chairman Eccles) at the time offered one of the most advanced non-monetary interpretations of events of its time and dismissed the possible role of monetary policy. Currie defended the 1937 tightening as follows:

There was, as previously remarked, inflationary sentiment in the air. …The rise in reserve requirements was regarded as a precautionary rather than a restrictive measure. …The action may have contributed to the removal of the fear or expectation of monetary inflation and an indenite rise in prices … If so, its effect was salutary… From this point of view, the criticism should be not that the action was taken, but rather that it was unduly delayed. (Currie 1980, 326-327.)