Nick Rowe´s wish for 2016

That we have a basic, or minimalist, understanding of recessions:

Recessions are not about output and employment and saving and investment and borrowing and lending and interest rates and time and uncertainty. The only essential things are a decline in monetary exchange caused by an excess demand for the medium of exchange. Everything else is just embroidery.

Is that important? I believe so, since if that were widely understood it is doubtful that most developed economies would still be “rolling in the deep”!

The labor-market´s double burden

First it has to gauge how close the economy is to the first mandate (maximum employment) and is then used to predict the second mandate (the inflation rate).

That strategy derives from the Fed´s (and Yellen´s) firm belief in the Phillips Curve, the theory that there is (in some form) an inverse relation between the unemployment rate and the rate of inflation.

But, naturally, there isn´t. So the Fed is “chasing rainbows” and, apparently, wants to continue to do so.

They could take a leaf from Nick Rowe, and start acting very differently:

The business cycle is a monetary exchange thing.

Which would tell them they are on the wrong track!

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-equilibratingIt’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.

Destination Required_1

Destination Required_2

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

Another chapter on “What´s wrong with economics”

Wolfgang Munchau has an interesting piece on the FT: “Macroeconomists need new tools to challenge consensus”:

Macroeconomists are once again caught up in a discussion about the future of their profession. An example has been the recent debate between Lawrence Summers and Ben Bernanke about the deep causes of the economic slowdown. The former US Treasury secretary has defended the case of a “secular stagnation” while the former chairman of the Federal Reserve sees an excess of savings over investment.

It is an enlightened debate, but it also masks a much deeper problem within macroeconomics. Secular stagnation — a sharp fall in growth rates lasting a very long time — is not something that you can easily square with the current generation of macroeconomic theories and models.

Part of this debate reminds me of a discourse among mathematicians at the end of the 19th century. At the time, mathematicians — and physicists too — thought they had solved most problems, just as economists did until 2008.

The advent of chronic instability is the equivalent challenge for macroeconomics today. The present tools used by mainstream macroeconomists cannot deal with this adequately. New ones are needed. They exist in other disciplines, but to macroeconomists they look as weird today as the abstract stuff looked to mathematicians of the 19th century.

Some comments (with reference to the US):

1 I don´t think there is chronic instability. There was a spate of instability in 2008-09, that configured the crisis. For the past five years what we´ve had is a “great stability” at the “wrong level”.

2 The 1970s was a decade of “Great Instability” (“Great Inflation”) in real growth, unemployment and inflation; but that was followed by more than 20 years of “Great Stability” (“Great Moderation”) in real output, unemployment and inflation.

3 The “Great Disturbance” derived from the fact that policymakers, in particular the ones responsible for monetary policy, came to believe that the source of the “Great Stability” was having kept inflation low and stable (or on target). So when inflation got a direct hit from oil prices they “tightened the monetary screws” and reaped a “Great Instability” followed by an “Inadequate Stability”, also dubbed “Secular Stagnation”!

The necessary tools are certainly there. What´s needed is a revision of the mainstream views on the source of the “Great Stability”!

Nick Rowe has a discussion and suggestion:

Fluctuations in inflation are a noisy signal of monetary disequilibrium, because the firms that do change prices are not always representative of the firms that don’t. And by targeting inflation the central bank makes inflation stickier, and this reduces inflation’s signal/noise ratio. Fluctuations in output are also a noisy signal of monetary disequilibrium. NGDP targeting means targeting the sum of two noisy signals. NGDP targeting is unlikely to be exactly optimal, but may well be better than inflation targeting, which puts all the weight on one noisy signal and ignores the other.

The big puzzle of the recent recession is why the inflation guard dogs failed to bark, to warn central banks of recession. Even in those countries where inflation did fall, it only fell a little. In others it stayed on target, or even rose above target. The NGDP guard dogs barked loud and clear, giving a consistent and correct signal. That is what we need to model. And if we can model that, we may also have a model in which targeting NGDP can do better than targeting inflation.