Brad DeLong’s basic mistake

A James Alexander post

In a response to Paul Krugman’s continuing puzzlement over the Brexit shock, Brad DeLong tries to claim Krugman is making some sort of basic error. It i is not easy to spot what it is but he does commit one himself. He thinks that the main channels for the working of a devaluation are greater exports and a rebound in (?overseas) investment once the currency has dropped far enough and make UK costs internationally attractive.

As I tried to show in my previous post, the main channel for devaluation is domestic not international. The worsening of the value of the pound stimulates nominal demand in the UK, so long as the central bank does not fight it with monetary tightening – aka “defending the currency”. The domestic currency is less valuable, in terms of the goods and services it will buy and this is a good thing. It will prompt people to spend money more quickly, the hot potato effect” in action.

This faster circulation of money, higher velocity, will increase Aggregate Demand and be a successful fightback against the potential Aggregate Supply shock. The market’s immediate response was a mix of political and economic fears, while technically trying to factor the most likely near term impact of leaving the EU – like lower FDI, reduction in output via moving production to EU ex-UK, and indirectly less UK labor demanded, etc.

The rise in Aggregate Demand may not mean in real terms the UK economy will not lose out from the potential Aggregate Supply shock, but it will prevent the potential AS shock from turning into a damaging recession. It will also allow the government time to negotiate new trade relationships with the EU and others and for the real economy to then respond to the new arrangements – which may turn out better than the worst case assumed by dazed (or is it crazed) Europhile doom-merchants , or better than now as Brexiteer economists have modelled.

The devaluation channel is not “more exports” or “more foreign investment”. This is naive despite a widespread belief of much of the financial commentariat that it is the main channel. I would have supposed that someone as knowingly iconoclastic as Brad DeLong would not have fallen into this sort of trap.

Brad DeLong may be making a second huge error, but it is hard to tell. He has a chart in the post that shows UK Gilt yields collapsing after 2008. He doesn’t refer to it in the text but does claim 2016 is different from 1992, when the UK left the Exchange Rate Mechanism and saw a mild potential AS shock swamped by massive monetary easing as the GBP devalued.

I think he may be claiming that because Gilt yields are already on the floor there can be no more easing. If so, then he is making a very common error that associates low interest rates with monetary easing. Low rates are a sign that monetary policy is or has been tight, high rates that monetary policy is or has been easy.

“Money makes the world go round” …but can also bring it crashing down

So I take issue with what Brad DeLong writes:

The dot-plots tell us that the FOMC now thinks that it is headed for a 3% Treasury Bill rate–at the upper end of this range, but still very far from a 5% rate. And if we do live in a semi-permanent age of secular stagnation, this will not be a temporary inconvenience but, rather, a permanent structural fact.

That means that if the FOMC keeps its current inflation target then it will have only 3% of sea-room when the next big recession comes, whether next year, next decade, or a quarter century from now.

That means that if the FOMC keeps attempting to raise interest rates back to a 5% normal–or even, unless it is lucky, to a 3% normal–it will find itself continually undershooting its inflation target, and continually promising that rates will go up more real soon now as soon as the current idiosyncratic fit of sub-2% inflation passes.

I do not know anybody seriously thinking about all this who thinks that 3% of sea-room is sufficient in a world in which shocks as big as 2007-2010 are a thing. And I do not know anybody seriously thinking about all this who thinks that pressing for a premature “normalization” of interest rates is a good idea.

Because, “a world in which shocks as big as 2007-2010 are a thing” is only true if the Fed so wishes.

As a good friend reminds me: “Because of group-think (within the econ profession as well as the FOMC), no one even is considering the idea that monetary policy has been unduly tight and whatever “regime” we’re in is the product of their confusion about what they’ve done or should be doing.  If nothing else, it would be nice to have someone on the committee who would suggest looking at things from a different perspective.”

What does and does not make sense?

In “Explaining the last 10 years”, Simon Wren-Lewis starts off:

The Great Recession was larger than any previous post WWII recession. But that is not what it will be mainly remembered for. Unlike previous recessions, it appears to have led to, or coincided with, a permanent reduction in the productive potential of the economy relative to previous trends.

According to measures of potential output put out by the CBO, the coincidence is clear, with a marked kink in the level of potential output occurring concomitant with the “Great Recession”. If that´s true, as the chart shows the economy has essentially closed the “gap”.

However, according to a deterministic trend, estimated from 1955 to 1997 and projected forward, the “gap” has been rising given that real output growth, after dropping hard during the “GR” has never “bothered” to grow sufficiently to close the “gap”.

The first case indicates that the apostles of the “Great Stagnation” thesis have a point. The second view says that the economy is, in the words of Brad Delong from almost 2 years ago, in a “Greater Depression”:

First it was the 2007 financial crisis. Then it became the 2008 financial crisis. Next it was the downturn of 2008-2009. Finally, in mid-2009, it was dubbed the “Great Recession.” And, with the business cycle’s shift onto an upward trajectory in late 2009, the world breathed a collective a sigh of relief. We would not, it was believed, have to move on to the next label, which would inevitably contain the dreaded D-word.

But the sense of relief was premature. Contrary to the claims of politicians and their senior aides that the “summer of recovery” had arrived, the United States did not experience a V-shaped pattern of economic revival, as it did after the recessions of the late 1970s and early 1980s. And the US economy remained far below its previous growth trend.

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A year and a half ago, those who expected a return by 2017 to the path of potential output – whatever that would be – estimated that the Great Recession would ultimately cost the North Atlantic economy about 80% of one year’s GDP, or $13 trillion, in lost production. If such a five-year recovery began now – a highly optimistic scenario – it would mean losses of about $20 trillion. If, as seems more likely, the economy performs over the next five years as it has for the last two, then takes another five years to recover, a massive $35 trillion worth of wealth would be lost.

When do we admit that it is time to call what is happening by its true name?

Simon Wren Lewis goes on to indicate that:

If we stick to the more plausible idea that this is all somehow the result of the financial crisis and recession, we can again split explanations into two types: those that focus on the financial crisis and argue that crises of this type (rather than other types of recession) impact on potential output, and those that look at the impact of the recession itself. The distinction is important in understanding the impact of austerity. If the length and depth of the recession has permanently hit potential output, as Fatas and Summers suggest, then the cost of austerity is much greater than we could have imagined.

But I believe that´s the wrong focus. The charts show that the economy was “suffocated” not by austerity, but from a highly inadequate monetary policy, as indicated by the behavior of aggregate spending or NGDP.

And that wrong-headed monetary policy remains in place today!

The mother of all shocks

Brad DeLong writes “The Six Major Adverse Shocks that Have Hit the U.S. Macroeconomy since 2005”:

Talk to people at the Federal Reserve these days about how they feel about the institution’s performance during the seven very lean years from late 2008 to late 2015, and they tend to be relatively proud of how the institution performed. Almost smug.

Why? Well, let me pull out my old workhorse-graph of the four salient components of U.S. aggregate demand since 1999

And repeats the chart 5 times, each time emphasizing a different demand component.

He could have saved time and space and put up the only chart that matters, which also indicates that the Fed cannot be proud or smug about its performance. That´s the NGDP Gap chart, which shows that the Fed began the road to perdition in early 2008 and later failed to “turn the boat around”!

Brad DeLong misses the “put”

In “Why Small Booms Cause Big Busts”, DeLong writes:

As bubbles go, it was not a very big one. From 2002 to 2006, the share of the American economy devoted to residential construction rose by 1.2 percentage points of GDP above its previous trend value, before plunging as the United States entered the greatest economic crisis in nearly a century. According to my rough calculations, the excess investment in the housing sector during this period totaled some $500 billion – by any measure a tiny fraction of the world economy at the time of the crash.

The resulting damage, however, has been enormous. The economies of Europe and North America are roughly 6% smaller than we would have expected them to be had there been no crisis. In other words, a relatively small amount of overinvestment is responsible for some $1.8 trillion in lost production every year. Given that the gap shows no signs of closing, and accounting for expected growth rates and equity returns, I estimate that the total loss to production will eventually reach nearly $3 quadrillion. For each dollar of overinvestment in the housing market, the world economy will have suffered $6,000 in losses. How can this be?

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Today, we recognize that clogged credit channels can cause an economic downturn. There are three commonly proposed responses. The first is expansionary fiscal policies, with governments taking up the slack in the face of weak private investment. The second is a higher inflation target, giving central banks more room to respond to financial shocks. And the third is tight restrictions on debt and leverage, especially in the housing market, in order to prevent a credit-fueled price bubble from forming. To these solutions, Keynes would have added a fourth, one known to us today as the “Greenspan put” – using monetary policy to validate the asset prices reached at the height of the bubble.

Just rewrite the underlined sentence as “keeping nominal spending on a stable level path” (a.k.a. NGDP-LT)!

So, it appears even Keynes knew that to be the best option!

 

Even a Great Stagnation requires planning!

In a recent post, Nick Rowe gives a short reply to DeLong´s long post:

Suppose you lived in a world where, whenever the price level fell/rose by 1%, the central bank responded by decreasing/increasing the base money stock by the same 1%. A world like that would not have a long-run Omega point, from which some present equilibrium can be pinned down by back propagation induction.

That’s the sort of world we live in, under the inflation targeting regime. A drunk doing a random walk does not have a destination, from which we can infer his route by working backwards. His long run variance is infinite.

Stop arguing about whether a market macroeconomy is or is not inherently ultimately self-equilibrating. It’s a stupid question. It depends. It depends on the monetary regime.

Instead, let’s solve the stupid question by adopting a nominal level path target.

It´s even worse. If you don´t plan, i.e. provide a “destination” for it, even a “Great Stagnation” becomes “random”!

The charts illustrate.

The first shows why the “Great Moderation” happened. The “destination” was the trend level path, to which the economy returned after monetary policy mistakes dislodged it. Observe what many called a period of “too low for too long” rates doesn´t look like that at all!

In the second chart, we note that after the Fed pulled the economy down, it has been satisfied in keeping it down, i.e. “depressed”. It could come out and say that that´s the path (“destination”) it wants it to follow. But no, by saying it´s about time to “tighten” policy, it is implying that the path might be even lower. Is it A? Is it B? The truth is no one knows!

It certainly does not appear to be X!

Related: David Glasner, Scott Sumner

Will new tools help to “save” the economy?

The BEA has announced the forthcoming release of new analysis tools:

The Bureau of Economic Analysis plans to launch two new statistics that will serve as tools to help businesses, economists, policymakers and the American public better analyze the performance of the U.S. economy. These tools will be available on July 30 and emerge from an annual BEA process where improvements and revisions to GDP data are implemented. BEA created these two new tools in response to demand from our customers.

Average of Gross Domestic Product (GDP) and Gross Domestic Income (GDI)

Final Sales to Private Domestic Purchasers

This new data tool is just one of the ways that BEA is innovating to better measurethe 21st Century economy and provide business and households better tools for understanding that economy. Providing businesses and individuals with new data tools like these is a priority of the Commerce Department’s “Open for Business Agenda.”

Meanwhile the “more government crowd” is strident.

Simon Wren-Lewis:

When we have a recession caused by demand deficiency such that interest rates hit their Zero Lower Bound (ZLB), the obvious response from a macroeconomic point of view is fiscal stimulus. Instead governments have become obsessed by their debt and deficits, and so we have austerity instead.

Brad DeLong:

Arithmetically, the U.S. economy is depressed because residential construction and government purchases are well below previously-expected trend levels…

And governments are not responding to market signals: financial markets are telling them that they have a once-in-a-lifetime opportunity to advantageously pull spending forward from the future into the present and push taxes back from the present into the future. But, because of the ideology of austerity, they are not taking advantage of this opportunity.

Brad calls a spade a spade: “Economy is depressed”, but it´s not because of his GDP components reasons.

Take Final Sales of Domestic Product (FSDP), to remove some of the volatile components of NGDP. The charts below show how it has performed relative to the “Great Moderation” trend. You also see that the 90/91 and 2001 recessions were “overcome” when FSDP growth managed to get FSDP back on trend. Not so following the “Great Recession”, with the result being a depressed economy.

This predicament is not due to “residual seasonality”, “inappropriate tools for analyses” or “ideology of austerity”. It´s wholly due to the Fed constraining the growth of nominal spending at an inadequate level, one that has persisted for 5 years! It´s beyond belief that “growth stability” for that length of time is just a coincidence!

I´m reminded of the wisdom of James Meade, who in his 1977 Nobel Lecture said:

Earlier I spoke of ‘price stability’ as being one of the components of ‘internal balance’. Yet in the outline which I have just given of a possible distribution of responsibilities no one is directly responsible for price stability. To make price stability itself the objective of demand management would be very dangerous.

If there were an upward pressure on prices because the prices of imports had risen or because indirect taxes had been raised, the maintenance of price stability would require an offsetting absolute reduction in domestic money wage costs; and who knows what levels of depression and unemployment it might be necessary consciously to engineer in order to achieve such a result?

The “price stability” obsession is the reason the economy was “knocked down” in 2008!

His “solution”:

I have told this particular story simply to make the point that the choice between fiscal action and monetary action must often depend upon basic policy issues which should certainly be the responsibility of the government rather than of any independent monetary authority. Perhaps the best compromise is an independent monetary authority charged so to manage the money supply and the market rate of interest as to maintain the growth of total money income on its 5-per-cent-per-annum target path, after taking into account whatever fiscal policies the government may adopt.

Unfortunately, the economy has remained depressed for too long. That has certainly “sapped its strength”. Nevertheless, a higher level of spending is certainly achievable. Maybe, for incomprehensible (to me) reasons, it´s not desired!

DeLong gets desperate and blames the Great Recession on Friedman!

In “The Great Depression and the Great Recession in the North Atlantic”, Brad DeLong writes:

Diagnoses of how we got into this mess and why we are still mired in it–albeit to a substantially less degree than in 2009, and to a much less degree than in 2009 we feared we would be in 2010–vary. Let me give you my take–which is disputable, and indeed often disputed. I follow my next-door office neighbor at Berkeley, Barry Eichengreen, and find that one of the many important factors that has led to our current situation was the intellectual success of a book: Milton Friedman and Anna Jacobsen Schwartz’s A Monetary History of the United States. You can read Barry’s version of the argument in his excellent and brand-new book, Hall of Mirrors [see here for a comment on Eichengreen]

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…And of course, the textbook Friedmanite cure was tried á outrance over 2008-2010 and proved insufficient. The monetary policy that Ben Bernanke pursued was Friedman-Schwartz to the max(!). It cushioned the downturn–the U.S. has done better than western Europe about to the degree that Bernanke was more aggressive in lowering interest rates and buying bonds for cash than his European counterpart Trichet. That is evidence that Friedman and his monetarists were wrong about the Great Depression as well. There are thus few people today who have properly done their homework who would say, as Ben Bernanke said to Milton Friedman and Anna Schwartz in 2002:

You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.

And right now Ben Bernanke, now at the Brookings Institution, has changed his mind. He is now calling for Keynesian cures–expansionary fiscal policy, especially infrastructure spending, as the bet road forward.

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And because the intellectual victory in the 1970s and 1980s was complete, policymakers in 2008-2010 were hesitant and unwilling to apply the Keynesian and Minskyite cures to severe downturns enthusiastically enough and on a large enough scale to adequately deal with the problems that emerged. When the collapse came, the economists advising the North Atlantic’s governments and central banks were not ready.

Why did the collapse come? Start with the huge rise in wealth among the world’s richest 0.1% and 0.01% from the 1970s into the 200s, and the consequent pressure for people, governments, and companies to take on increasingly unsustainable levels of debt. Continue with policymakers lulled into complacency by the widespread acceptance of the “efficient-market hypothesis”–believing that investors in deregulated financial markets were relatively good judges of risk. End with hubris: the confidence in the Federal Reserve and elsewhere that grew because the Penn Central collapse of 1970, the Latin American financial crisis of 1982, the stock market crash of 1987, the S&L crisis of 1991, the Mexican crisis of 1995, the East Asian crisis of 1997, the Russian/LTCM crisis of 1998, and the dot-com crash of 2000 had not caused the Federal Reserve problems that it could not handle well enough to keep the unemployment rate from going up by more than two percentage points.

The reasoning can only be a bad sign of the times!