“Die Hard”

It´s not about Bruce Willis´ John McLane character but about the ZLB.

Eichengreen

The International Monetary Fund, having just downgraded its forecast for global growth, warned the assembled G20 attendees that yet another downgrade was pending. Despite this, all that emerged from the meeting was an anodyne statement about pursuing structural reforms and avoiding beggar-thy-neighbour policies.

Once again, monetary policy was left – to use the now-familiar phrase – as the only game in town. Central banks have kept interest rates low for the better part of eight years. They have experimented with quantitative easing. In their latest contortion, they have moved real interest rates into negative territory.

The motivation is sound: someone needs to do something to keep the world economy afloat, and central banks are the only agents capable of acting. The problem is that monetary policy is approaching exhaustion. It is not clear that interest rates can be depressed much further.

The solution is straightforward. It is to fix the problem of deficient demand not by attempting to further loosen monetary conditions, but by boosting public spending.

Brad DeLong:

At the zero lower bound on safe nominal short-term interest rates, an expansionary fiscal policy impetus of d percent of current GDP will:

1. raise current output by (μ)d,
2. raise future output by (φμ)d, and
3. raise the debt to GDP ratio by a proportional amount ΔD = (1 – μτ – μφ)d,

where μ is the Keynesian multiplier, τ is the tax rate, and φ is the hysteresis coefficient.

It will then require a commitment of (r-g)ΔD percent of future output the service the additional debt, where r is the real interest rate on government debt and g is the growth rate of the economy. The debt service can be raised through explicit and fiscal deadweight loss-inducing taxation, through inflation–a tax on outside money balances accompanied by disruption of the unit of account–or through financial repression–a tax on the banking system but also imposes financial distortions.

That is the simple arithmetic of expansionary fiscal policy in a liquidity trap.

The question of whether and how much expansionary fiscal policy a government facing a liquidity trap should engage and then becomes a technocratic one of calculating uncertain benefits and uncertain costs.

Larry Summers:

Today’s risks of embedded low inflation tilting towards deflation and of secular stagnation in output growth are at least as serious as the inflation problem of the 1970s. They too will require shifts in policy paradigms if they are to be resolved.

In all likelihood the important elements will be a combination of fiscal expansion drawing on the opportunity created by super low rates and, in extremis, further experimentation with unconventional monetary policies.

Krugman (3 years ago):

I’ve often argued on this blog and in the column that now is a particularly bad time to cut spending, because unlike in normal times, the adverse effects on demand can’t be offset by cutting interest rates. One way to highlight the point is to compare where we are now with a historical episode: the fairly large cuts in federal purchases of goods and services that took place in the early 1990s, as the US military shrank with the end of the Cold War. Here’s federal consumption and investment spending as a share of potential GDP (blue, left scale) versus the Fed funds rate (red, right scale):

The Fed could and did cut rates, helping to cushion the impact of spending cuts. It can’t do anything like this now, because the Fed funds rate has already been cut more or less to zero in an attempt to fight the effects of financial crisis.

Austerity right now is a really, really bad idea.

They all “forget” that monetary policy is the “Bruce McLane” in this story. Larry Summers evokes monetary policy experimentation “in extremis”! But that´s the present situation, when everyone else has “given up” on it!

The charts below indicate, contra Krugman (and all ZLB advocates), that it was monetary policy as defined by NGDP growth, not interest rates, that allowed RGDP growth to come back robustly from the 1990/91 recession, even while government expenditures was being crushed.

At present, tight monetary policy (despite extremely low interest rates), even if accompanied by relatively (to the 1990s) high government expenditures, is what keeps real growth compressed!

Brown X Brownback

In a recent tirade against Jeb Bush, Krugman shows this chart

and says:

On substance, the supply-siders have covered themselves in, well, whatever is the opposite of glory since 2008 — predicting runaway inflation and soaring interest rates, disaster from tax hikes both nationally and in Jerry Brown’s California, triumph in Brownback’s Kansas, and on and on.

But starting the comparison in January 2011 is blatant cherry-picking to make high-tax California look good.

What happens if we, more naturally, do the comparison from the cycle peak in December 2007? Things look very different, especially if you take into account that since 2007 California´s resident population has grown a little over 7% while Kansas has seen resident population grow only just above 4%!

There´s no “disaster” and no “triumph”, just mediocre performance everywhere!

Krugman´s answer to DeLong: We´re in a “Postmodern Economy”!

Krugman responds to DeLong´s “Backward Induction Unraveling”:

One more thing: Brad says that we came into the crisis expecting business cycles and possible liquidity-trap phases to be short. What do you mean we, white man? Again, we had the example of Japan — and even aside from Rheinhart-Rogoff, it was obvious that Postmodern business cycles were different, with prolonged jobless recoveries.

In the end, while the post-2008 slump has gone on much longer than even I expected (thanks in part to terrible fiscal policy), and the downward stickiness of wages and prices has been more marked than I imagined, overall the model those of us who paid attention to Japan deployed has done pretty well — and it’s kind of shocking how few of those who got everything wrong are willing to learn from their failure and our success.

He should have read my answer to him 4 years ago – THERE´S NOTHING “POSTMODERN” ABOUT THIS RECESSION, IT´S A FED ENGINEERED DEPRESSION” –  where I conclude:

By calling this a “postmodern” recession, Krugman is likely saying that the only way-out is through fiscal policy. But that has been tried (according to Krugman the dosage was not big enough) and the collateral effects have been pretty damning.

What all this discussion does is to allow the Fed to stay on the sidelines. After all, it had not much to do with anything that´s been happening. It´s “Postmodern”!

(Note: Postmodernism is a philosophical movement… it holds realities to be plural and relative, and dependent on who the interested parties are and what their interests consist of.)

Let´s put up some images. The first set shows that the both the intensity of the drop in employment and the speed of increase are associated with what happens to aggregate nominal spending (NGDP), something the Fed closely controls, irrespective of where the interest rate happens to be.

Note that things are much more subdued after the Volcker adjustment phase (1981-85). What follows is the “Great Moderation”, when NGDP grows at around 5.5% along a stable level trend.

For example, after the 2001 recession, which was quite shallow in terms of RGDP growth (never becaming negative), NGDP growth lingers for some time below the 5.5% rate of growth. Therefore, employment behavior looks like the base of a wide (shallow) bowl (“jobless recovery”)

The present cycle is another animal altogether. The Fed never had its heart in pulling nominal spending up to a reasonable level, keeping its growth stable at “slow speed”. Employment takes a deep dive and comes back at a speed consistent with the low spending growth.

The next set shows the behavior of inflation over the same periods. The pattern is easy to see. The Volcker adjustment is successful in bringing inflation down. Later, Greenspan places it on (or close to) the 2% “target”, mostly by keeping spending growth close to the trend level path. Then, Bernanke comes along and apparently decides that´s “way too high”. To keep inflation “lower than low” the Fed pulls the hand brake to slowdown nominal spending growth.

The last set illustrates nominal and real growth over the episodes. When you look at the bottom right image, you get the hang of why thinks are so glum.

The “novelty” of the situation depicted in the bottom right image of all the charts is what explains why people’s expectations of the length of the what Krugman calls the “liquidity-trap” phase were “miles off”, and why DeLong says “backward induction unraveled”.

Unfortunately, very few fingers point at the Fed!

Opening the ‘government floodgates’

Brad Delong has given the opening that Krugman needed to come out and explicitly say what he has only been implying for a long time: “We need bigger government”!

Brad DeLong has posted a draft statement on fiscal policy for the IMF conference on “rethinking macroeconomics” — and I’m shocked, in a good way. As regular readers may have noticed, Brad and I share many views, so I expected something along lines I have also been thinking. Instead, however, Brad has come up with what I believe are seriously new ideas — enough so that I want to do two posts, following different lines of thought he suggests.

What Brad argues are two propositions that run very much counter to the prevailing wisdom, especially among Very Serious People. First, he argues that we should not only expect but want government to be substantially bigger in the future than it was in the past. Second, he suggests that public debt levels have historically been too low, not too high. In this post I consider only the first point.

Nowadays, however, governments are involved in a lot more — education, retirement, health care. You can make the case that there are some aspects of education that are a public good, but that’s not really why we rely on the government to provide most education, and not at all why the government is so involved in retirement and health. Instead, experience shows that these are all areas where the government does a (much) better job than the private sector. And Brad argues that the changing structure of the economy will mean that we want more of these goods, hence bigger government.

He also suggests — or at least that’s how I read him — the common thread among these activities that makes the government a better provider than the market; namely, they all involve individuals making very-long-term decisions. Your decision to stay in school or go out and work will shape your lifetime career; your ability to afford medical treatment or food and rent at age 75 has a lot to do with decisions you made when that stage of life was decades ahead, and impossible to imagine.

What I believe governments could do much better, and cheaply, while avoiding becoming gargantuan and stifling, is to design better incentives for people to behave in a more ‘virtuous’ manner regarding the long-run.

Some time ago I presented evidence that “too much government may be bad for the economy´s health“:

I find this quote from a little book called “Common Sense Economics” by James Gwartney, Richard Stroup and Dwight Lee (page 79) very pertinent:

Government is a little bit like food. Food is essential, but when consumed excessively, it leads to obesity, energy loss, and other health-related problems. Similarly, when constrained within proper boundaries, government is a powerful force for prosperity. But when it expands excessively and undertakes activities for which it is ill-suited, it undermines economic progress.

Ben´s blogging has generated more heat than light so far

So far the former and wannabe Fed Chairmen crossed swords over the irrelevant and misguided concepts of GSG & SS. (I´ve given those things some thought here and here).

With big dogs growling at each other, Krugman simply could not help butting in (really to show he had been there before). And for very obvious reasons he ends up giving each a “bone”:

There’s been a really interesting back and forth between Ben Bernanke and Larry Summers over secular stagnation. I agree with most of what both have to say. But there’s a substantive difference in views, in which Bernanke correctly, I’d argue, criticizes Summers for insufficient attention to international capital flows – but then argues that once you do allow for international capital movement it obviates many of the secular stagnation concerns, which I believe is wrong.

As it happens, the role of capital flows in the logic of liquidity traps is an issue I tackled right at the beginning, back in 1998; and I’ve been trying to work out how it plays into the discussion of secular stagnation, which is basically the claim that countries can face very persistent, quasi-permanent liquidity traps. So I think I may have something useful to add here.

Start with Bernanke’s critique of Summers. The most persuasive evidence that the US may face secular stagnation comes from the lackluster recovery of 2001-2007. We experienced the mother of all housing bubbles, fueled by a huge, unsustainable rise in household debt – yet all we got was a fairly unimpressive expansion by historical standards, and little if any inflationary overheating. This would seem to point to fundamental weakness in private demand. But one reason for the sluggish growth in demand for U.S.-produced goods and services was a huge trade deficit, the counterpart of huge reserve accumulation in China and other emerging markets. So Bernanke argues that what Summers sees as evidence of secular stagnation actually reflects the global savings glut.

The 2001-2007 recovery is not evidence, let alone persuasive, of secular stagnation. Krugman is on the right track when he says this “would seem to point to fundamental weakness in private demand.” But at the last minute he veers off in the wrong direction by making the fundamental mistake of “reasoning from a (GDP) component change” (a close cousin of “reasoning from a price change”).

A huge trade deficit somewhere is always the counterpart of a huge reserve accumulation elsewhere. The important reasoning is to discover why this came about when it did and if it might be related to other stuff (such as the US housing boom). For an explanation, read here (below the fold).

If “movements in GDP components” had not distracted Krugman he would probably have found out that the post 2001 recession recovery was slow up to mid-2003, being due to the tightness of monetary policy, despite fast falling interest rates.

When the Fed made monetary policy more expansionary in mid-2003 by adopting forward guidance (FG), despite interest rates remaining put, the recovery took off, with nominal spending rising back to trend. Interestingly, many see this strong growth in nominal spending as reflecting a “loose/easy” monetary policy. Grave mistake. Faster NGDP growth was necessary to take nominal spending to trend. Monetary policy was “just right”!

At that point, unemployment begins to fall and core inflation rise towards the “target” level.

Bernanke had the bad luck to take over almost concomitantly with the peak in house prices. Initially house prices fell only a little, increasing the speed of fall after financial troubles erupted in some important mortgage finance companies.

Unfortunately, the Fed was exceedingly focused on headline inflation, fearful of the oil price rise. Interest rates remained elevated, only being reduced after August 2007, when three funds from Bank Paribas folded. However, the pace of interest rate reduction was deemed too slow by the market. In the December 11 2007 FOMC Meeting, for example, the markets were negatively surprised by the paltry 25 basis points reduction in the FF rate. On that day the S&P fell 2.5% and the 10 year TB yield dropped 17 basis points.

Rate reductions stopped in April 2008 (only resuming in October, after Lehman!). In the June 2008 FOMC, it came out that the next move in rates was likely up!

With all this monetary tightening, nominal spending decelerated and then fell at an increasing rate. One casualty was Lehman! The rest is history!

Give me a break and let´s stop talking “Gluts” and “Stagnations”. Bernanke would do much better if he starts shinning some light and blog about how monetary policy could really have been much better! Will he be daring?

The charts illustrate the story

 

Matt O´Brien thinks it´s the opposite in “Larry Summers and Ben Bernanke are having the most important blog fight ever“

Krugman is frequently inconsistent

Krugman misses a step in “Democratic Booms”

But does this say anything about the presidents in question? Both the Reagan expansion and the Clinton expansion had much more to do with Federal Reserve policy than anything coming from the White House, and Obama’s macroeconomic policy has been hamstrung by GOP opposition almost from the beginning. There are presidents, and sometimes there are job booms when they are president, but the booms aren’t their doing.

If the Reagan and Clinton expansions had much more to do with Volcker and Greenspan, why not conclude that the dismal Obama economy has much more to do with Bernanke and Yellen than with “Obama´s macroeconomic policy being hamstrung by the GOP opposition”?

Update: Krugman´s “inconsistency” derives from the fact that he believes in a ‘liquidity trap’ which makes monetary policy impotent. So it would be up to Obama and fiscal policy. But that´s “hamstrung by GOP opposition”

Krugman remains “confused” -2

Maybe because of his infatuation with the ZLB, which supposedly characterizes the quintessential “postmodern” recession:

But I do think it’s important to realize that this dispute doesn’t invalidate a related point, namely, that the kind of recovery you can expect from a recession depends on the sources of that recession. Way back — before Lehman fell! — I argued that there was a distinction between modern and postmodern recessions. Pre-Great Moderation, recessions were brought on by the Fed, which raised rates to reduce inflation, then loosened the reins, producing a V-shaped recovery. Post-Great Moderation, with inflation low and stable, booms were allowed to run their course, so that recessions came from private-sector overreach — and the Fed had a much harder time engineering recovery. This was especially true after 2007, when we hit the zero sort-of lower bound.

The recessions of 69-70, 73-5, and 81-82 were responses to inflation and the high rates the Fed imposed to fight it; the economy bounced back when the Fed was done. The recessions of 90-91, 2001, and 2007-9 were completely different.

They were different in that the Fed had acquired credibility as an inflation avoider. The 1990-91 and 2001 recessions were shorter and shallower than those that took place in 1973-75 and 1981-82.
What distinguishes the 2007-09 “Great Recession” from ALL the others is that in 2007-09 the Fed allowed nominal spending to contract at a rate not seen by most living people. And the slow recovery is, symmetrically, due to the Fed keeping nominal spending growth on a leash (maybe all this happened because with Bernanke the Fed became an inflation “paranoid”).

So you don´t need to appeal to “austerity”, the (horrible) conduct of monetary policy explains both the “deep dive” and the “slow-motion resurfacing”.

PS. PK is repeating an old argument of his. And so am I!

Krugman remains “confused”

Previously, Steve Williamson said Krugman was “confused”. To sort of “settle the issue, in “Demand Policies in Two Big Recessions” Krugman writes:

With job growth finally running at the pace we’d expect to see after a deep slump, we’re not hearing as much about how Obama’s anti-capitalist policies are the reason we’re not having a V-shaped recovery, the way we did under the Blessed Reagan. But it’s true that recovery was a long time coming. Why?

Well, the answer has long been obvious: constrained monetary policy thanks to the zero sort-of lower bound, constrained fiscal policy because of the combination of debt fears and Republican obstruction.

He shows two pictures as corroboration for his arguments:

And concludes:

[A]t a time when monetary policy was limited in its effectiveness, fiscal policy was perverse. In practice, Reaganomics was far more Keynesian while Boehnernomics — which is what it ended up being, in practice — was anti-Keynesian.

That’s the story of the delayed recovery.

In his post Krugman concentrates on Government Purchases. That´s an incomplete measure of government contribution to demand. Better to look at the fiscal balance (in this case deficit of the Federal Government relative to GDP).

The chart shows that the pattern was similar, with the deficit increasing more during the Obama cycle.

In cyclically adjusted terms (CA), the  outcome is different, with the deficit taking a deeper and quicker “dive” under “Obama”.

But what really provides the explanation for the contrasting recoveries is the behavior of monetary policy, not as (wrongly) inferred from levels and changes in the FF rate, but as reflected in the behavior of nominal spending (NGDP).

 

 

The “confusion” stems from thinking monetary policy is interest rate policy…

And pointing to rising rates as monetary tightening (and falling rates as monetary easing).

Krugman writes:

What’s worrisome is that it’s not clear whether Fed officials see it that way. They need to heed the lessons of history — and the relevant history here is the 1990s, not the 1970s. Let’s party like it’s 1995; let the good, or at least better, times keep rolling, and hold off on those rate hikes.

Steve Williamson retorts:

Note that policy is actually tighter in 1995 than average Fed behavior over the 1990s predicts. But what if the Fed followed Krugman’s advice and behaved like it did in the 1990s? Well, the fitted Taylor rule, given an unemployment rate of 5.5% and a pce inflation rate of 0.2%, implies a fed funds rate of 2.8%. So if the Fed had been behaving like it did in the 1990s, it would have lifted off the zero lower bound long ago. Apparently Krugman is confused.

Monetary policy in 1995 was not “tight”. Just as monetary policy today is not “loose”. You get the appropriate answer by looking not at the change/level of the FF rate but by looking at NGDP relative to trend.

Adrift, but with an attitude!

Simon Wren-Lewis characterizes the “adrift”:

The third interpretation about why central banks are doing nothing is there is nothing they can do. Quantitative Easing seems to have come to a permanent halt either because it has stopped having a useful effect, or because policy makers fear it is having undesirable consequences. Under this interpretation the inflation target loses credibility not because the private sector no longer believes policy makers’ stated objectives, but because they no longer believe they have the means to achieve them. 

This possibility is the one that should really be worrying central banks right now. It is a scenario that is quite consistent with what is currently happening, and it puts at risk central bank credibility in a most fundamental way. Quite simply, central bank credibility is destroyed because people believe they have lost the ability (rather than the will) to do their job, and there is very little central banks can do to get it back because of the ZLB. This is what should be giving central banks nightmares. Strangely, however, they seem to be sleeping just fine.

To “compensate” they put on an “attitude”. To show they´re “active” the Fed has elected employment/unemployment as the “informant” on the “appropriate monetary policy” (or interest rate juggling). Note that, as late as 2009, with unemployment climbing fast towards 10% and inflation – both headline and core – dropping like a stone, they mostly talked about inflation during the FOMC Meetings. Now that they are “adrift”, they scramble to get “support” from the labor market!

Interestingly, 40 years ago Franco Modigliani with Lucas Papademos invented NAIRU (initially NIRU) – Non Accelerating Inflation Rate of Unemployment (Non Inflationary Rate of Unemployment) to argue from the “opposite extreme”. In their case, unemployment was far above NAIRU, therefore monetary policy could be expansionary without igniting an increase in inflation:

On the basis of these and other considerations, we conclude that a conservative interim unemployment target for mid-1977 is 6 percent. Achieving this target will require a growth of output of at least 17 percent over the next two years. Of this total, more than half should be achieved in the first year, to allow the growth rate to abate as the ultimate target is approached. Taking into account the price implications of this growth path, we conclude that in the first year money income should grow at an annual rate above 15 percent. From this it is argued that even if the primary stimulus to recovery comes from fiscal policy, as seems necessary to ensure an early and vigorous revival, the money supply will have to increase for a while at a rate well above 10 percent. There is wide concern that such a sharp acceleration in the money supply would have an unfavorable effect on the rate of inflation. But we allay this concern by showing that the evidence is clearly inconsistent with any influence of money on inflation outside of its indirect effect through its contribution to the determination of aggregate demand and employment.

How did things pan out? The chart below indicates that unemployment, which was above 8% when Modigliani & Papademos wrote, came down slowly, as did inflation. However, when NGDP growth accelerates, unemployment falls faster towards the 6% “target” but inflation begins to rise long before the “target” is reached.

In early 2012, when the Fed introduced the 2% inflation target, unemployment was, as in 1975, above 8%. Given that inflation was sliding below the 2% target the Fed “stipulated” that 6% unemployment would indicate the time was ripe for rates to begin to rise! What´s this fixation on 6% unemployment (understood to be the NAIRU level)?

Nevertheless, with unemployment falling towards “target” but with inflation continuing to drop, the Fed “reestimated” NAIRU at something between 5% and 5.5%. As of today, we are at the top of the “NAIRU band”, but inflation is still moving slowly down! Note, importantly, that differently from the 1970s, NGDP growth has remained stable (shy of 4%), a rate of spending growth that is consistent with higher than target inflation only if trend (potential) real output growth is below 2%. By insisting on keeping the economy at a “depressed” level of activity, low trend growth may in fact become “reality” (or the “new normal”). The Fed will then feel vindicated in raising rates, while the “New Fisherians” will feel vindicated in seeing higher rates hand in hand with higher inflation!

In the 1970s, “targets” for unemployment got us into inflationary troubles. Now, “targets” for unemployment will get us into “stagnation” troubles. My good friend Benjamin Cole clearly prefers the former!

Update: Krugman has something useful to say on the NAIRU “controversy”:

I very much hope that Fed staff remembers the 1990s. Circa 1994 it was widely believed, based on seemingly solid research, that the NAIRU was around 6 percent; but Greenspan and company decided to wait for actual evidence of rising inflation, and the result was a long run of job growth that brought unemployment below 4 percent without any kind of inflationary explosion. Suppose they had targeted the presumed NAIRU instead; they would have sacrificed trillions in foregone output, plus all the good things that come from a tight labor market.

The chart illustrates:

Here,also, NGDP growth is stable (not at the 4% range but at the 5.5% range). Inflation remains low and even falls (productivity shock) and the 6% NAIRU estimate was completely irrelevant!