Why monetarist victory is necessary: so central banks cannot hide

A guest post by Lorenzo

In the debate about how to think about the Great Inflation of the 1970s, Milton Friedman‘s policy advice–constant growth in a targeted monetary aggregate–turned out to be misplaced. Indeed, the failure of the Thatcher Government‘s monetary aggregate targeting led to the popularisation of Goodhart’s Law:

Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.

Ironically, the point Milton Friedman had originally made (pdf) in his critique of the use of the Phillips Curve for policy purposes–that such a use will change people’s expectations, and thus their behaviour, rendering the relationship between inflation and unemployment no longer useful for policy purposes–turned out to also apply to his own policy advice to target monetary aggregates being based, as it was, on the notion that monetary turnover (velocity) was relatively stable (or could be made so by quantitative targeting).

Victory (to a point)

Nevertheless, the wider macroeconomic victory of Milton Friedman–the acceptance that inflation is always and everywhere a monetary phenomenon–was a necessary step in the taming of inflation. Why? Because once the monetary nature of inflation was accepted, the responsibility of central banks for inflation became clear, incorporated in what is sometimes called the new neoclassical synthesis.  So the problem simply became a matter of finding a way to operationalise the responsibility of central banks. Such a way was found with inflation targeting. (Pioneered by, of all places, New Zealand under Reserve Bank of New Zealand Governor Don Brash.)

In other words, accepting that inflation was a monetary phenomenon gave the central banks no place to hide.

There were two problems which flowed from this. First, what became most widely accepted was narrow inflation targeting, where maintenance of price stability (typically defined as 2% inflation a year) became the only, or dominant, policy target of the central bank.

The second is that, in the wider economics profession, the dominant macroeconomics became New Keynesian economics, where the incorporation of monetarist notions is often glossed over: they do not play much part in David Romer’s 1993 paper (pdf), for example. The frequent use of Dynamic Stochastic General Equilibrium (DSGE) Models, which have some problems incorporating money and monetary effects, rather exacerbated this. Brad DeLong, conversely, makes explicit (pdf) the importance of what he calls Classic Monetarism in New Keynesianism.

Burdensome responsibility

Given the way central banks now pride themselves on–indeed, sometimes seem to define their role as–“taming” inflation, it is easy to forget how resistant many central banks were to the notion that inflation was their responsibility. And a major appeal of narrow inflation targeting is precisely that it minimises the responsibilities of central banks.

Which is why a new (market) monetarist victory is necessary. For the crucial step in flattening the business cycle is to gain acceptance that the intensity of the business cycle is also a monetary phenomenon: that central banks control the level of aggregate demand. Once that is accepted, the responsibility of central banks for stabilising the path of total spending on goods and services is clear, and it is just a matter of finding ways to operationalize that responsibility.

Given Scott Sumner’s very reasonable hypothesis that central banks (particularly the US Federal Reservetend to follow the macroeconomic consensus of the mainstream economics profession, this means the debate within said profession is very important; though still as part of the wider policy debate.

While central banks are not held accountable for the effects of what they do, and do not do, achieving a stable (macro)economic framework for people to go about the business of their lives is going to be a happy accident when it should be what policy makers—and specifically central bankers—are held accountable for.

How John H. Cochrane Quit Worrying and Learned to Love the (Monetary) Bomb

A guest post by Benjamin Cole

For the past few years, conservative University of Chicago prof and blogger John H. Cochran has written skeptically about quantitative easing (QE). By his own statement, Cochrane even “collected” anti-QE missives for dissemination on his excellent blog, The Grumpy Economist.

So imagine the surprise when Cochrane recently sojourned to Stanford University’s Hoover Institution—a hardened redoubt of monetary asceticism—and professed his love for QE!

Not only that, Cochrane announced he was enamored of the Federal Reserve Board’s gigantic $4.3 trillion balance sheet—and, of course, the Fed booty hoard can’t be created or even maintained without a lot of QE.

Cochrane’s new swoon is no fleeting infatuation, he insisted. Indeed, he rhapsodized that the Fed’s Big Balance Sheet is a desirable permanent feature of monetary policy of the future.

“A huge [Fed] balance sheet, with [commercial bank] reserves that pay market interest, is a very desirable configuration of monetary affairs,” John Cochrane told fellow Hooverites, including the Monetary Rules King and host John Taylor, the famed Stanford economist.

Despite boldly declaring a new perspective, Cochrane became oblique on a few points, which he has not yet amplified, at least in writing or on his blog.

How Big a Fed Balance Sheet? 

Cochrane does not say if the Fed should add yet more to its QE-hoard of trillions in bonds. He provided no “Cochrane Rule,” such as “In normal times, the Fed balance sheet should be X percent of GDP.”

Indeed, Cochrane breezily asserts, “Fortunately the size of its balance sheet is also irrelevant. Interest-paying reserves are not inflationary. To the extent that the size of the balance sheet is correlated with stimulus or restraint, the sign is likely to change: raising interest rates via interest on reserves may come with an increase in the balance sheet.”

If you were in a bar, and translating that last sentence, you might say, “Cochrane says the Fed can fight inflation by buying Treasury bonds. By the trillions of dollars.”

Of course, that raises a question.

Can the Fed Pay Off the National Debt through QE?

This topic gets short shrift in Cochrane’s paper, and indeed in the entire economics profession. I think that is because it is embarrassing to admit that the hoariest and most evil red-letter cardinal macroeconomic sin of monetizing the national debt…is now thought a good idea.

It cannot be denied that the United States federal government has built up a mountain of debt starting with President Ronald Reagan (oddly exonerated by Cochrane, in a neat bit of intellectual gymnastics), running through the Bushes and reaching a zenith under President Obama. The national debt in relation to GDP is now back to post-WWII levels.

Cochrane points out that if interest rates rise, taxpayers are going to get whacked with hundreds of billions in added taxes, ceteris paribus. (Minor quibble: Cochrane assumes $18 trillion in federal IOUs, but in fact about $5 trillion of that is held in-house by federal agencies. The real debt outstanding is about $13 trillion.)

Yet, as jauntily expansive and prolific is Cochrane is on some topics, he becomes mute on the radical reduction or elimination of the national debt through QE.

But Cochrane did write that the national debt can be converted into the Fed balance sheet asset (QE) and consequent commercial bank reserves, and no worries—the Fed can pay interest on reserves by creating more reserves. By printing more money!

“Sure, the Fed can announce an interest rate on reserves, and can pay the interest by simply printing up new reserves when the time comes,” writes Cochrane.


There was a lot more to Cochrane’s presentation to the Hooverites, entitled Monetary Policy With Interest on Reserves, and I hope some serious readers out there tackle the paper (online), and opine in this space (with permission of Marcus Nunes), or theirs.

We can wonder if parts of Cochrane’s Brave New World of Monetary Economics are strokes of genius or insanity. I am leaning towards genius.

After all, the Fed has monetized trillions in federal debt already (driving inflation-hysterics into overflowing freshwater-area insane asylums) and yet inflation has ground to a near halt.

Moreover, there have been two little-noted yet published Fed studies of late that concluded even massive amounts of QE would not be inflationary.

Yi Wen, assistant veep and economist with the St. Louis Federal Reserve Bank, issued a paper entitled, Evaluating Unconventional Monetary Policies—Why Aren’t They More EffectiveWen posited that a four-fold increase in QE would stimulate the national economy enough to close the output gap (!), and would be disinflationary. Something about portfolio investors switching to cash, wrote Wen.

A four-fold increase in QE, btw, would wipe out the national debt, if directed at US IOUs. Wen’s views echo an earlier paper published last year by the NY Fed.


Well, there is a lot to ponder here. Here we have classic freshwater guys saying we can ramp up QE and wipe out the national debt, and throttle inflation.

You can have your cake, and eat it too, with a big dollop of ice cream, and keep trim along the way.

Why not give it a whirl?

“Stuff Happens”, or Why the Fiscalist Model Never Seems to Fit the Data

A guest post by Mark Sadowski

Krugman discusses some of the mistakes he has made through the years and concludes by discussing his failure to predict the recent relatively strong growth of the U.K. economy in the face of contractionary fiscal policy.

“Finally, Britain is growing much faster right now than I expected. Fundamental model flaw? I don’t think so. As Simon Wren-Lewis has pointed out repeatedly, the Cameron government essentially stopped tightening fiscal policy before the upturn, which means in effect that the “x” in my equation didn’t do what I thought it would. On top of that, there was a drop in private savings, which is one of those things that happens now and then. The point is that the deviation of British growth from what a standard Keynesian model would have predicted, while real, wasn’t out of line with the normal range of variation-due-to-stuff-happening; nothing there that warranted a major revision of framework.”

The UK’s Office of  Budgetary Responsibility (OBR) estimates of the impacts of fiscal austerity on the level of real GDP (RGDP) can be found in Chart 2.26 on Page 54.

If you read the surrounding text you’ll note the graph depicts the varying effects of each type of fiscal policy change, including both spending and revenue, on level RGDP by fiscal year. (Fiscal years in the UK run from April 1, through March 31.) The estimates in this chart are comprehensive and fully account for the lagged effects.

The chart shows that fiscal policy is estimated to have the following effects on level RGDP in percent by fiscal year.

FY         RGDP
2009-10 (+0.5)
2010-11 (-0.5)
2011-12 (-1.2)
2012-13 (-1.5)
2013-14 (-1.4)

Since these are level effects we need to convert them to changes.

FY         RGDP
2010-11 (-1.0)
2011-12 (-0.7)
2012-13 (-0.3)
2013-14 (+0.1)

Now let’s turn to the actual nominal GDP (NGDP) and RGDP growth and inflation as measured by the GDP implicit price deflator:


Estimates for 2014Q1 are not reflected in the above graph. Here are the resulting growth rates by fiscal year.

2010-11  4.6  2.0  2.6
2011-12  3.1  0.8  2.3
2012-13  1.4  0.3  1.1
2013-14  4.0  2.3  1.7

Note that when the OBR estimates that fiscal consolidation was most deleterious to economic growth, AD (NGDP) growth was actually at its fastest, and as fiscal consolidation was progressively decreased in each of the two subsequent fiscal years, both NGDP and RGDP growth nevertheless decreased. Note also that in the just completed fiscal year RGDP growth was faster than in any of the three previous fiscal years, but since NGDP growth was not as fast as it was in FY 2010-11 this is due more to the fact that inflation has slowed than it is to faster AD growth.

In other words, the timing of the economic effects of fiscal consolidation does not at all match the actual pattern of AD growth, suggesting that rather than the U.K. economy being in a liquidity trap, monetary policy has been fully offsetting fiscal consolidation. Moreover, the recent superlative RGDP growth is more due to a subsiding of negative aggregate supply (AS) shocks than it is to outstanding AD growth.

It seems to me, rather than simply shrugging and saying “stuff happens”, maybe it’s time that “stuff” (monetary policy and AS shocks) be incorporated into the fiscalist model.

Is Fiscalist Policy Advice Consistent with Their Research, and Just How Interested is Simon Wren-Lewis in Debt Stabilization?

A guest post by Mark Sadowski

In “Good and Bad Blog Debates” Simon Wren-Lewis claims that he and Jonathan Portes are really, really interested in debt stabilization.

“Now here he talks about ‘fiscalists’ rather than mentioning me by name, but anyone reading this post would assume that I was among the people he is talking about. Another fiscalist named in this debate is Jonathan Portes. Now it just so happens that Jonathan and I have just written a substantial paper, which is all about debt stabilisation! Whoops.

Here is the beginning of the abstract of the paper that Wren-Lewis and Portes have written:

“Theory suggests that government should as far as possible smooth taxes and its recurrent consumption spending, which means that government debt should act as a shock absorber, and any planned adjustments in debt should be gradual. This suggests that operational targets for governments (e.g. for 5 years ahead) should involve deficits rather than debt, because such rules will be more robust to shocks. Beyond that, fiscal rules need to reflect the constraints on monetary policy, and the extent to which governments are subject to deficit bias. Fiscal rules for countries in a monetary union or fixed exchange rate regime need to include a strong countercyclical element. Fiscal rules should also contain a ‘knock out’ if interest rates hit the zero lower bound: in that case the fiscal and monetary authorities should cooperate to formulate a fiscal expansion package that allows interest rates to rise above this bound…”

I’ll grant that the main focus of the paper is on debt stabilization, but the underlying theme is the degree to which fiscal policy should be countercyclical, and under what circumstances fiscal rules should be relaxed in order to support monetary policy in its consensus assignment of aggregate demand stabilization. The paper specifically argues that the fiscal policy of countries in a monetary union, such as the Euro Area, needs to be strongly countercyclical. This is a reasonable suggestion if the currency area is largely devoid of an automatic fiscal transfer mechanism to absorb asymmetric shocks, which the Euro Area evidently does. It also argues that there needs to be ZLB “knockout” under which the focus of fiscal policy shifts away from debt stabilization to aggregate demand stabilization if policy interest rates are likely to fall to zero. This too is reasonable, if one approaches this subject from a Neo-Wicksellian perspective, but in the final analysis what the paper fundamentally addresses is how to make fiscal policy rules more flexible in the face of aggregate demand shocks.

I want to call attention to the following passage in Section 5.

“This strongly suggests that any fiscal rule for an economy within a monetary union or fixed exchange rate regime should contain an important countercyclical element. However, the same logic also suggests that the focus should be on the cyclical condition of the economy relative to the other union members, rather than some absolute measure of cyclicality. If, for example, there was excess demand in all union members, then the consensus assignment suggests this is best handled by monetary policy at the union level, and not by fiscal policy operating within all the union members.”

In my opinion, at least away from the ZLB, this passage should be interpreted in a perfectly symmetric fashion. That is, if there is deficient demand in all the monetary union members, then Wren-Lewis and Portes should believe that the consensus assignment suggests that this is also best handled by monetary policy at the union level, and not by fiscal policy operating within the monetary union members.

Recall that in early 2011 the Main Refinancing Operations rate (MRO) was 1.0%, and it was raised to 1.25% in April and then to 1.5% in July. Thus not only was the Euro Area not at the ZLB, it was moving away from the ZLB just before the second Euro Area recession started. Thus Wren-Lewis’ original statement that “the major factor behind the second Eurozone recession is not [controversial] : contractionary fiscal policy” seems to be very much at odds with this paper that he and Portes have just written.

Simon Wren-Lewis also believes that his homepage confirms beyond a shadow of a doubt his passion for debt stabilization.

“An unlucky error? No, it’s much worse. A quick look on my homepage will show you that much of my academic research since 2000 has been about debt stabilisation. Unlike MS, I do not think the subject is really dull. Issues like what the long run target for debt should be, how quickly we should get there, what happens to monetary policy when debt is not controlled by the fiscal authority, seem to me rather interesting.”

His homepage lists the research he has published since 2008 or for the last six and a half years. I have no intention of digging all the way back to 2000, or for the past decade and a half, to see everything that he has written since then. Yes, the period since 2008 may be somewhat biased in favor of countercyclical fiscal policy, due to the Great Recession, but I am not going to spend the time, and welcome others to repeat the analysis that I am about to do concerning his research since 2008.

There are 16 papers listed on Simon Wren-Lewis’ homepage. Given he agrees that the consensus assignment of fiscal policy is debt stabilization, he should also agree that all of his papers on fiscal policy should at least tangentially address this issue. So the question is not whether his papers ever touch on the subject of debt stabilization, but whether the main focus of these papers is debt stabilization.

According to my classification, there is one paper the main focus of which is the consensus assignment of monetary and fiscal policy, one paper the main focus of which is microfoundations, one paper the main focus of which is the effect of influenza on the UK economy, one paper the main focus of which is on both countercyclical fiscal policy and debt stabilization, two papers the main focus of which is monetary policy, two papers the main focus of which is debt stabilization, three papers the main focus of which is fiscal policy governance, and five papers the main focus of which is countercyclical fiscal policy. So, by my weighted average count, that’s 5.5 papers on countercyclical fiscal policy to 2.5 papers on debt stabilization.

There is some overlap between Simon Wren-Lewis’ research papers and his blog posts. In particular he identifies six blog posts that are connected to two of his papers. But given my experience reading his blog these past few years, and a casual search of his blog by keyword, the bias of his posts towards countercyclical fiscal policy, and away from debt stabilization, is even more extreme than his research.

In short, be careful what you ask for.

Simon Wren-Lewis Needs Help Figuring out what “Nothing” and “Zero” Mean, and the Real Asymmetry between Monetarists and Fiscalists

A guest post by Mark Sadowski

Simon Wren-Lewis has written a response to a post by Giles Wilkes in which he addresses the nature of the disagreement between monetarists such as Scott Sumner, David Beckworth and Marcus Nunes, and fiscalists such as Paul Krugman, Simon Wren-Lewis and Jonathan Portes. I want to start in the middle because this is the part I have the biggest disagreement with:

“Suppose we had fiscal austerity well away from the ZLB. Suppose further that for some reason the monetary authority did not take measures to offset the impact this had on aggregate demand, and there was a recession as a result. I suspect a MM would tend to say that this recession was caused by monetary policy, even though monetary policy had not ‘done anything’. (In this they follow in the tradition of that great monetarist, Milton Friedman, who liked to say that monetary policy caused the Great Depression.) The reason they would say that is not because fiscal policy has no effect, but because it is the duty of monetary policy to offset shocks like fiscal austerity. That is why fiscal policy multipliers should always be zero, because monetary policy should make them so.So Mark Sadowski got upset with my statement because in his view ECB policy failed to counteract the impact of Eurozone austerity, and could have done so, which meant the recession in 2012/3 was down to monetary policy, not fiscal policy.

So we come to the heart of the disagreement – the ability of monetary policy to offset fiscal actions at the ZLB.”

Sigh. This is *part* of the heart of the disagreement, but an even bigger problem seems to be what constitutes doing “nothing”, and where we seem to think the “ZLB” is located. Let’s review the history of policy interest rates in the big four advanced currency areas since the Great Recession started:


Note that since at least the middle of 2009 policy rates in the U.S., Japan and the U.K. have indeed been more or less constant, and provided one views this strictly in a Neo-Wicksellian sense, it can be argued that the central banks of these currency areas have done “nothing”.  However, notice the big red pimple that bursts forth in 2011. That is the ECB raising the Main Refinancing Operations Rate (MRO) just prior to the start of the second Euro Area recession and the round of the Euro Area sovereign debt crisis. This is most certainly not doing “nothing”, even in an extreme Neo-Wicksellian sense.

The second thing at the heart of our disagreement is where the ZLB is located. ZLB is an acronym which stands for the “zero lower bound” in policy interest rates. In practical terms the ZLB is interpreted as meaning about 0.25%, 0.1% and 0.5% in the U.S., Japan and the U.K, respectively. In the case of the Euro Area the meaning of ZLB is less clear cut although the MRO is currently 0.15% and my impression is that Mario Draghi is still implying that the Governing Council of the ECB is willing to drop the MRO even lower “if necessary”.

But note that prior to raising of the MRO in 2011, it stood at 1.0% which is nowhere near the practical definition of ZLB in any of the big four advanced currency areas. This was raised to 1.25% in April 2011, and then to 1.5% in July. Only in May 2012 was the MRO brought down to the 0.5% rate that in practical terms constitutes the ZLB in the U.K. Only in November 2013 was the MRO dropped to 0.25% which constitutes the upper bound of what in practical terms constitutes the ZLB in the U.S. And the MRO is still above the 0.1% rate that in practical terms constitutes the ZLB in Japan.

So my question to fiscalists is, at what point did zero stop meaning “0” and start meaning “1.0”, or “1.5”, or whatever?

The other thing I want to address is this issue of apparent “asymmetry”. But first let’s look at Simon Wren-Lewis’ description of what he thinks the responsibilities of monetary and fiscal policy should be.

 “I do not like the label fiscalist for this reason – it implies a belief that fiscal policy is always better than monetary policy as a means of stabilising the economy. (Giles Wilkes is not the first to use this term – see for example Cardiff Garcia, who includes more protagonists.) Now there may be some economists who think this, but I certainly do not, and nor I believe does Paul Krugman or Jonathan Portes. I described in this article what I called the consensus assignment: that monetary policy should look after stabilising aggregate demand and fiscal policy should be all about debt stabilisation, and there I described recent research (e.g.) which I think strongly supports this assignment. However there has always been a key caveat to that assignment – it does not apply at the ZLB.”

This seems to have been written in response to a comment I had written here only Simon Wren-Lewis expresses what should be the responsibility of monetary policy even more like what I personally believe than I did in my comment, in part because I was so eager to express the “consensus assignment” in terms which I thought would not be at all controversial. But I truly believe that “stabilizing aggregate demand” (nominal GDP or NGDP) is precisely what monetary policy should be doing.

And this brings us to the problem of “asymmetry”, which is at the heart of Simon Wren-Lewis’ post.

 “Economists like Paul Krugman, Jonathan Portes and myself (and there are many others) do not argue against using UMP. Indeed PK pioneered the idea of forward commitment for Japan, and I have been as critical as anyone about ECB policy. We do not argue that fiscal policy will be so effective as to make unconventional monetary policy unnecessary, and so write countless posts criticising those promoting UCM. To take a specific example, I happen to think that the recent ECB moves will have less impact on the Eurozone than continuing fiscal austerity, but I do not say the ECB is wasting its time as a result. They should do more.”

This is all true of course, but on the other hand I don’t recall Scott Sumner, David Beckworth or Marcus Nunes spilling a lot of ink on what Simon Wren-Lewis acknowledges is the consensus assignment of fiscal policy, which is debt stabilization. I would hardly argue that monetarists are indifferent to the issue of debt stabilization, but they certainly don’t spend all their time arguing about what monetary policy can do to address it, because they readily acknowledge that this is fiscal policy’s responsibility, not monetary policy’s responsibility.

We are now six years out from the start of the Great Recession, and there is now finally what I think is legitimate discussion about when we should be leaving the ZLB, at least in the U.S. and the U.K. At what point will fiscalists stop wringing their hands over the “liquidity trap” and start to worry about what is the consensus assignment of fiscal policy, which is debt stabilization? What I sense is they aren’t really interested in the consensus assignment of fiscal policy.

And who can blame them? Debt stabilization is dull. It is *really* dull. Why worry about something so dull when you can worry about something which is so much more exciting, which is obviously aggregate demand stabilization.

And this I think is the crux of the real asymmetry. Monetarists are genuinely interested in the consensus assignment of monetary policy, which is aggregate demand stabilization. Fiscalists show no interest at all in the consensus assignment of fiscal policy, which is debt stabilization.

So what I think we have here is a severe case of “assignment envy”.

And what I fear is that seven, eight and nine years out from the Great Recession, and with policy interest rates at 1.0%, 2.0% and 3.0% the fiscalists are still going to be talking about the “liquidity trap” and the need for fiscal stimulus, because they simply find fiscal policy’s consensus assignment a tedious bore. (But who can blame them?)


Simon Wren-Lewis Tries to Explain How It is Possible the U.S. Hummingbird Can Fly despite Not Following His Policy Advice

A guest post by Mark Sadowski

Simon Wren-Lewis responds without mentioning who he’s responding to here:

 “If fiscal policy is important at the zero lower bound, why did the US recovery continue in 2012 and 2013 despite a large fiscal contraction? Or to put the same question in a comparative way, why was the Eurozone’s fiscal contraction in 2012/3 associated with a recession, but not in the case of the US?

GDP growth had been reasonable in both the US and the EZ in 2010 and 2011. While US growth continued into 2012/3, EZ growth collapsed. Yet as the chart above shows, fiscal tightening was only slightly greater in the EZ in 2012, and became considerably tighter in the US in 2013.”

I have several problems with this analysis. First of all he’s using OECD estimates of the cyclically adjusted primary balance (CAPB). Personally I prefer the equivalent IMF estimates. Secondly, fiscal contraction started in the U.S. and the Euro Area in 2011, not 2012, and this is true regardless of whose estimates of the CAPB we use. Furthermore the second Euro Area recession started in 2011, not 2012, despite the fact that annual GDP did not decline until 2012, and the sovereign debt crisis also grew much worse in 2011, not 2012. So I think it is important that we look at 2011 as well as 2012 and 2013, as Wren-Lewis’ post that set off this discussion implicitly did. Third, if we’re going to use a single metric for the effects of policies meant to have an impact on aggregate demand (AD) I think it’s important that we actually look at AD (nominal GDP or NGDP) and not real output (real GDP or RGDP). It’s always possible that aggregate supply (AS) shocks could muddy the waters, and I already notice that one commenter has brought up this very issue at Wren-Lewis’ post.

Here’s NGDP growth in the U.S. and the Euro Area in 2011-13.


And here are the IMF’s estimates of the change in CAPB in the U.S. and the Euro Area in 2011-13.


Right away we notice that US NGDP growth has been much less variable than the Euro Area’s, falling within the comparatively tight 3.4% to 4.6% range. In contrast Euro Area NGDP growth fell off a cliff in 2012, going from about 2.8% to 0.7% in a single year. Also, the IMF’s estimates of the CAPB show that US fiscal policy has been tighter than Euro Area fiscal policy all three years. In contrast to the OECD numbers, there is a slight increase in the Euro Area fiscal contraction, not a significant decrease. The unadjusted primary balance increased by 0.5% of GDP in 2012 and 0.6% in 2013. Since the Euro Area output gap increased by almost the same amount in 2012 as in 2013 according to both IMF and OECD estimates, and the unadjusted primary balance increased by nearly the same amount in each year,  I think it is reasonable to expect the CAPB to have increased by about the same amount in both 2012 and 2013. This is one reason why I find the IMF’s estimates of the CAPB more believable than the OECD’s.

So, in particular, note that the IMF’s estimates of the change in CAPB suggest that fiscal policy was more or less equally contractionary in all three years. This stands in sharp contrast to the NGDP performance which declined severely. Quarterly RGDP data show that the Euro Area was in a recession from 2011Q4 through 2013Q1, and that the Netherlands, Spain and Portugal had fallen into recession in 2011Q2 and that Austria, Cyprus, Italy and Slovenia followed suit in 2011Q3.

Which is the more logical explanation of this highly variable NGDP and RGDP performance? Fiscal policy, which was more or less equally contractionary throughout? Or monetary policy, which was tightened through an increase in the Main Refinancing Operations rate (MRO) from 1.0% to 1.25% in April 2011 and then to 1.5% in July, and then loosened through subsequent decreases in the MRO to 1.0% by the end of 2011 and down to 0.5% by May 2012, as well as through a dramatic expansion in the ECB’s “enhanced credit support programmes” (i.e. LTRO) starting in December 2011, which are the Euro Area analogue of the Fed’s now by and large concluded “credit and liquidity programs” (i.e.  the alphabet soup of CPFF, MMIFF, PDCF, TALF, TSLF TAF etc.)?

Simon Wren Lewis assigns one reason for the Euro Area’s poor performance in 2012 to the Euro Area sovereign debt crisis, which in my opinion is a case of circular reasoning.

“In comparative terms, there are two obvious answers looking at 2012. The first is the EZ crisis. Although this began in 2010, it reached a critical position in 2012, when Greece was almost forced out. It is hardly surprising in these uncertain circumstances that EZ investment fell by nearly 4% in 2012.”

It’s important to recall that the Euro Area sovereign debt crisis had two phases: one from October 2009 to June 2010 and another from April 2011 to July 2012. The first matches Greece’s initial surge in spreads which finally paused after Greek Prime Minister Papandreou, Euro Area leaders, and the IMF agreed to the Euro Area’s first sovereign bailout. The second phase started with Portuguese acting Prime Minister Socrates’ bailout request, was marked by peaks in the spreads for all of the GIIPS, and concluded shortly after Spanish Prime Minister Rajoy requested a bailout. The beginning of the second debt crisis more or less coincided with the ECB’s decision to raise the MRO rate in April and July of 2011. Here is a graph of 10-year bond spreads of the GIIPS nations relative to Germany.


You can see that during the nine months from June 2010 to March 2011 that the bond spreads of barely changed in Italy and Spain, and increased moderately from already elevated levels in Ireland, Greece and Portugal. But in the next four months through July, which encompassed the two MRO increases, Italian and Spanish bond spreads increased by over 100 basis points and Greek and Portuguese bond spreads increased significantly more than they had in the previous nine months.

It was pretty obvious to nearly everyone at the time that what had precipitated the second Euro Area sovereign debt crisis was the decision by the ECB to raise the MRO. As Paul Krugman said in November of 2011:

“Ryan Avent joins the chorus of those suggesting that the European Central Bank’s decision last spring to start raising rates — a decision that seemed crazy then, and looks even crazier now — was the point at which everything started to fall apart.”

Simon Wren-Lewis’ other reason for why the Euro Area performed so much worse than the U.S. in 2012 is monetary policy.

“The second is monetary policy. The ECB raised rates from 1% to 1.5% in 2011, and compared to the US there was no Quantitative Easing. Combining the two, monetary conditions tightened considerably in the periphery as a result of the crisis. There was no comparable crisis in the US, which allowed investment to increase by 5.5%.”

But of course there was no comparable crisis in the U.S., because the Fed did not choose to tighten monetary policy in the middle of a financial crisis!

However, Simon Wren-Lewis seems genuinely puzzled by the differing performances of the U.S. and Euro Area economies in 2013.

“Explaining 2013 seems more difficult. Monetary policy had eased in the EZ (although of course not by as much as it should have, and OMT had brought the crisis to an end. In the US there was considerable fiscal tightening. So why did the US continue to grow and EZ GDP continue to fall?

For the EZ one proximate cause was a sharp decline in the contribution of net exports. Net exports added 1.5% to GDP in 2012, but only 0.5% in 2013. If this contribution had been more even at 1% in each year, GDP would have fallen by over 1% in 2012, and stayed roughly flat in 2013. Fiscal policy continued to tighten, which also would have reduced growth.”

In fact, according to Eurostat, Euro Area net exports rose from 1.3% of GDP in 2010 to 1.4% in 2011 to 2.6% in 2012 to 3.4% in 2013. Thus net exports “added” 1.2% to GDP in 2012 and 0.8% in 2013 which is not significantly different. Moreover such huge back-to-back increases in net exports are symptomatic of an economy that is starved of adequate domestic demand, as was evidently true of the Euro Area in 2012-13. In contrast, it’s not surprising that since the recession ended, net exports have actually fallen as a percent of GDP in the three large advanced currency areas that are all at or near the ZLB and that have done QE (i.e. the U.S., Japan and the U.K.).

Simon Wren-Lewis then points to a falling U.S. household savings rate, which in my opinion is another example of circular reasoning.

“In the US something else happened: the savings ratio, which had been elevated at 5.5% or above since 2009, fell to 4.5%. This could have been a result of fiscal tightening, but it seems more probable that it represented the end of a prolonged balance sheet correction. (The US savings ratio averaged 4.5% between 1996 and 2007 and the OECD’s forecasters expect it to fall further this year and next.)”

I think a better measure is the private sector financial balance, which by my calculations has indeed decreased every year since the recession ended, and in contrast increased in the Euro Area in 2012 and 2013. But once again, we usually see the private sector financial balance fall in economies that are doing relatively well, and rise in economies that are in recession.

It’s probably more coherent to actually look at the private sector balance sheets for clues. And what you will find there is that, as Wren-Lewis alludes to, U.S. nominal private sector debt has been rising since 2011Q3. But even though it is rising, the ratio of private sector debt to NGDP, the leverage ratio, continues to fall because NGDP is increasing at an even faster rate. In contrast, Euro Area nominal private sector debt rose straight through 2013Q1, and the leverage ratio at that time was almost as high as it was in 2009Q2 when the first recession ended. As long as NGDP growth is laggard, the Euro Area leverage ratio likely will remain high.

In the final analysis, the question is why is one economy doing well and the other not? And for that you have to look at policy differences. The U.S. has pursued a relatively expansionary monetary policy, whereas with respect to monetary policy the Euro Area has persistently done too little too late.

Simon Wren-Lewis concludes by looking at the U.S. output gap and argues that more could be done, and that the more that could be done is obviously fiscal stimulus.

“The OECD estimates that the US output gap in 2013 was -3.5%, which was much the same as their estimate for 2012. So growth of 2% did nothing to close the output gap in 2013. This was despite a large fall in the savings ratio, perhaps bringing to an end the balance sheet correction that began with the Great Recession. So US growth in 2013 should have been very strong, and the obvious explanation for why it was not is very restrictive fiscal policy.”

This of course assumes that if U.S. fiscal policy had not been so restrictive that U.S. monetary policy would still have been just as expansionary. I think this is a highly dangerous and enormously improbable assumption. One of the primary justifications for the initiation of QE3 was in fact the then impending “fiscal cliff”. If there was no likelihood of a fiscal cliff then the FOMC probably would never have approved QE3.

In fact I see this as a persistent problem with Simon Wren-Lewis’ analysis. He keeps suggesting fiscal stimulus as a way to promote a faster economic recovery implicitly thinking that nothing will change in terms of monetary policy as a result. Either he inexplicably thinks that monetary policy is always impotent (we’re always in a “liquidity trap”), or he bizarrely thinks that the monetary authorities would always welcome additional aggregate demand stimulus, when there’s already considerable evidence that the opposite is very much the case.

The key to a faster economic recovery everywhere is better monetary policy.

Three times Friedman

A Guest Post by Benjamin Cole

No less than three times in his career—at least three—iconic monetarist Milton Friedman bluntly blamed economic contractions on too-tight central bank policies.

The Great Depression, the U.S. recession of 1958, and Japan’s Eternal Stagnation after 1992.

In the last two cases, Friedman unabashedly told central bankers to print a lot more money—in fact, in 1998 he told the Bank of Japan to start buying bonds, and if that didn’t work, then to keep buying more bonds. Run the presses until they melt.

Sadly, economics has become politics in drag, at least in the United States. It is simply un-PC for any right-wing or conservative economist today to ever call for monetary expansionism. To be a perpetual inflation scold is the only acceptable posture, usually in tones of fear-mongering underscored by moralizing righteousness.

(The left-wing is clueless too; they keep rhapsodizing about huge federal deficits, of the type that accomplished nothing in Japan or, more recently, in the United States).

Scouring through the Internet, I have searched in vain for right-wing economists who called for aggressive growth policies by the U.S. Federal Reserve after 2008, or before 2008 for that matter.

Conclusion: A whole pillar of thought has vanished from the conservative landscape. Today, right-wingers do not believe—as Milton Friedman did believe—that an expansionist central bank can spur growth in the right circumstances.

This is a lamentable development, all the more so as the left-wing—so enamored of relentless federal borrowing and spending—also eschews monetary expansionism.

The upshot is, there is no one in the mainstream American political spectrum to fight for an aggressive growth-oriented Federal Reserve, and the Federal Open Market Committee has become populated by nattering nabobs of monetary negativism.

The stagnation wrought by tight money is painfully obvious; Japan after 1992, or Europe today, or the United States after 2008 all are paying the price of too-restrictive central bankers.

So extreme has the modern variant of political correctness become, that many now right-wingers call for a central bankers’ “single mandate”—that is, the Fed exists only to preserve price stability, preferably around zero inflation, unless minor deflation is accommodated.

While obsessed with peering in their economic microscopes for inflation, the American right has forsaken its best raison d’étre—robust economic growth.

Remember that? Robust economic growth? Or is that a concept now consigned to the dustbin of history, as too dangerous for price stability?

What Simon Wren-Lewis thinks he knows is not true

A guest post by Mark Sadowski

Simon Wren-Lewis is at it again:

While the reasons for the Great Recession may still be controversial, the major factor behind the second Eurozone recession is not: contractionary fiscal policy, in the core as well as the periphery. So this is something we really do know.

It is only because of the continuous issuance of preposterous statements like this by people who should know better, that the causes of the Great Recession are even controversial. Not only is this something we do not know, it is something that we know is not true.

The second Euro Area recession was clearly monetary in origin. The ECB raised the MRO rate from 1.0% to 1.25% in April 2011 and then to 1.5% in July. The six quarter second recession started the following quarter. The Euro Area was never near the zero lower bound in interest rates and the ECB chose to raise the policy rate in the face of projections that core inflation would remain below target and the output gap would remain high for at least the next two years.

The US makes a useful comparison. The Fed kept the fed funds rate near zero throughout 2010-2013 and elected to do a second round of QE in late 2010 to mid-2011 and to start a third round in late 2012. The ECB has yet to initiate even a single round of QE.

According to the April 2014 IMF Fiscal Monitor the US increased its cyclically adjusted primary balance (CAPB) by 4.7% of potential GDP between 2010 and 2013 (bottom half  Table 1.1 page 11):

The five core Euro Area nations that Simon Wren-Lewis considers (France, Netherlands, Belgium, Austria and Finland) increased their CAPB by a weighted average (according to 2010 nominal GDP) of 2.6% of potential GDP from 2010 to 2013. The GIIPS increased their CAPB by a weighted average of 5.0% of potential GDP from 2010 to 2013.

Between 2010 and 2013 nominal GDP (NGDP) increased by 12.3% in the US, by 6.2% in the core Euro Area nations and decreased by 1.8% in the GIIPS. Between 2010 and 2013 real GDP (RGDP) increased by 6.6% in the US, by 1.4% in the core Euro Area nations and decreased by 4.1% in the GIIPS.

It would have made absolutely no sense for any of the Euro Area nations to be doing fiscal stimulus when the ECB was nowhere near the zero lower bound and in fact raising the policy interest rates. Moreover the US economy has easily outperformed the economies of all of these countries in both nominal and real terms despite being at the zero lower bound in interest rates, and doing roughly the same amount of fiscal austerity as the GIIPS.

The one thing that the Great Recession, in tandem with the Great Depression, has made absolutely clear is that the liquidity trap is a myth promoted by those with a agenda no matter how much empirical evidence there is to the contrary.

Indications that monetary policy failure has caused permanent damage to the economy

The big news today was that finally, after more than six years, the level of employment had regained its previous peak. There were the inevitable comparisons with the 1981-82 recession, which was deep but employment took less than one year to regain its previous peak.

There were also musings about the fact that over the last three cycles (1990/91, 2001 and 2007-09) something has changed (likely structurally) since employment has taken longer and longer to recover.

And lastly, there were manifested worries about the quality of the jobs being gained.

I will concentrate on just one thing: the role of monetary policy, measured by its effectiveness in keeping nominal aggregate demand (NGDP) close to trend, in the “production” of employment over the last three cycles.

The charts illustrate what I want to convey. The first set of charts covers the 1990-91 and 2001 cycles. Employment is measured from the peak to 77 months on, so the period covered is the same from the peak of the present cycle to May/14.


Takeaways: The deeper the fall in NGDP below trend, the bigger the drop in employment. The longer NGDP remains below trend, the longer employment takes to regain its previous peak. Importantly, it appears that the deeper the fall in NGDP, the more timid the employment growth when NGDP goes back to trend. Maybe that follows from the higher and more persistent level of long term unemployment and the loss of skills that accompany it.

It also appears that employment reaches its previous peak when the NGDP gap closes to -1% or less.

The next chart shows how this recession was “off the charts”.


Now, if it is approximately true that employment reaches its previous peak when the gap closes to something close to -1%, this would mean that the true gap is much, much smaller than could be imagined. The dashed line indicates how the “true” gap has evolved. The “nefarious” implication is that millions of job posts have disappeared because the trend level of nominal aggregate spending has been significantly lowered.

And, due to the deep fall in NGDP, the gains in employment even after the “new gap” is closed will continue to be very slow. As NGDP growth is also very low, the risk of inflation going up in any significant way is also extremely low.

It´s as if something like this has taken place:


Bottom Line: Monetary policy has managed to “throw the baby out with the bathwater”.

Update: “Jobs Report Will Intensify Fed Debate on Rate-Hike Timing” or “More babies will be thrown out”

Friday’s U.S. employment report painted an encouraging picture of the labor market and should reassure Federal Reserve officials that the economy is improving as they have been predicting. It will intensify their debate about when to start raising short-term interest rates, strengthening the hand of those officials who want to move sooner, but the question is far from resolved.

Update (June 12): From the WSJ:

Aftershocks from the deepest recession in generations continue to inflict lasting damage to the world economy’s potential, curbing employment prospects for millions, a new paper finds.

Laurence Ball, a John Hopkins University professor and former Federal Reservevisiting scholar, suggests some of the scars from the Great Recession may be more permanent, or at least less easily reversed, than previously thought.

Update (June 21) Phillipe Weil asks:

Has the Great Recession harmed the long-term growth prospects of the Eurozone economy?

The CEPR Business Cycle Dating Committee recently concluded that there is not yet enough evidence to call a business cycle trough in the Eurozone. Instead, the committee has announced a ‘prolonged pause’ in the recession. This Vox Talk discusses the possible directions that this situation could lead to and questions whether the Great Recession has harmed the Eurozone’s long-term growth prospects to the extent that meagre growth could become the ‘new normal’.

That´s a “no brainer”!

The sort of reasoning that got us into trouble and helps keep us there

On my break, one of the things I´m doing is read. But when I came across this I couldn´t resist a “quickie”.

This is Steven Cecchetti´s take when the May 2003 CPI was released. Remember this professor went on to become Research Director of the New York Fed and later Chief –Economist of the BIS!

I�m thinking of going out and having a bunch of new red and white WIN buttons made and handing them out to the people attending next Tuesday’s FOMC meeting.� Many of you will recall that WIN stands for �Whip Inflation Now,� the anti-inflation program launched by President Ford and his CEA Chair Alan Greenspan in the fall of 1974.� Inflation had risen sharply, from 3 percent in mid-1972 to over 10 percent by the time Richard Nixon resigned in August 1974, and the new President, together with his new chief economic adviser, wanted to do something about it. Wanting to do something about inflation and actually doing something about it are, of course, two entirely different things, and it took the more authoritative FOMC more than 25 years whip inflation.�

Looking at the detail in the BLS release, I am concerned that the dip in inflation over the past few months was an aberration.� My main concern is that core services � that�s services less energy services � rose a whopping 6.1% (a.r.) for the month. And it was the smaller service components leading the way (since owner-equivalent rent increased an annualized 2.2%.).� Service prices are once again rising at a rate exceeding 3% per year. The 4.2% drop in core goods prices (commodities excluding food and energy commodities) is what held down overall inflation to a mere 3.1%.

I am convinced that Chairman Greenspan and his FOMC colleagues have guided us to price stability. That is, for technical reasons I believe a 1.6% reading on the CPI excluding food and energy trend is nearly indistinguishable from a properly measured inflation reading of zero. But what�s here today can be easily be gone tomorrow.� So I�m going to dust off my WIN button (yes, I have one) and wear it just in case I see an FOMC member.

And this is what inflation (also the NGDP gap, unemployment and oil price) was showing in the 18 months around the time he proffered that ‘pearl of wisdom’:

Cechetti 2002

Cechetti 2002_1