Category Archives: Scott Sumner is Coherent

Narayana Kocherlakota on How the Fed Spoiled the Economy

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Scott Sumner correctly sees Kocherlakota as supporting Sumner’s view of Fed policy during the financial crisis and its aftermath. Kocherlakota says,

I use the public record to document that, as of late 2009, the FOMC felt that it would be appropriate to use its monetary policy tools to foster a relatively slow recovery in both prices and employment. (The recovery that actually unfolded was slower than the FOMC intended in terms of employment, but close to the FOMC’s intentions in terms of inflation.) I argue that the FOMC’s guarded response can be traced back to its pre-2008 policy framework—that is, to the Taylor Rule. Indeed, because of this baseline “normal” policy framework, the FOMC and many outside observers actually saw the Committee as pursuing a highly accommodative policy.

Read the entire speech, or at least read Sumner’s excerpts from it.

Kocherlakota has lobbed a grenade into the macro establishment’s room. If he (and Sumner) are correct, then history will not be kind either to the Bernanke Fed or to the Taylor rule.

Much as I would love to see those icons brought down, for the moment I am going to stick to my view that the Fed did not set the course for the economy.

Scott Sumner’s Theory of Hysteresis

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In The Midas Paradox, he writes,

if depressions do encourage statist policy interventions, then deflationary policies may impose costs that are much larger that [sic] those predicted by natural rate models of the business cycle.

Recently, Blanchard and Summers have argued that demand shocks cause supply shocks in the private sector. That is, if you have a recession, the economy’s potential output falls. Sumner’s view is that demand shocks cause governments to come to power that implement bad supply-side policies. Examples he gives include Roosevelt’s NRA and Argentina’s left-wing government of the early 2000’s. Perhaps the U.S. after 2008 will turn out to be another example.

Of course, I am not as ready as Sumner to go with the AS-AD paradigm.

Scott Sumner on Targets, Instruments, and Indicators

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When I was in graduate school, Benjamin Friedman’s paper on targets, instruments, and indicators of monetary policy (appears to be gated) was assigned in several courses. So I think of it as a classic, but mine may be an idiosyncratic perspective.

A target is a policy goal: Unemployment. Inflation. Nominal GDP.

An instrument is something that the Fed controls. The three old-fashioned textbook examples are the amount of reserves (or reserves plus currency), the required reserve ratio, and the discount rate. More recently, the Fed funds rate is the instrument that economists focused on. Even more recently, there is the size of the Fed’s balance sheet.

An indicator is something that the Fed can watch to see whether the economy is moving toward or away from its target. There are plenty of such indicators: private forecasts of NGDP, high-frequency data, such as retail sales figures, etc.

As I see it, one of Scott Sumner’s objectives, in his blog and in his new book The Midas Paradox which I have just started reading, is to get people to pay less attention to certain indicators of monetary policy. In particular, interest rates and the quantity of money are not reliable indicators, in his view. He wishes that policy makers would forget about such indicators. They should instead turn instruments in order to hit the target.

For example, in recent years, he has said that all you need to know to say that money has been too tight is to look at the growth rate of NGDP. It dropped way below trend, which tells you that monetary policy should have been looser. If you insist on having an indicator, you should use the forecast for NGDP. But even if you respond only to NGDP after it is reported, you should have had a looser policy.

In the 1930s, we did not have a lot of the data that we have today, including NGDP. Sumner regards the Wholesale Price Index as the best target variable available. As I understand it (Scott, if you read this, please correct me), he thinks that the instrument that mattered most at the time was the ratio of gold reserves to currency. When this is high, government is hoarding gold and tightening monetary policy. When this is low, government is dis-hoarding gold and loosening monetary policy.

The private sector also can hoard gold, and this has the same effect as a monetary tightening. If I understand Scott’s thinking correctly, when the private sector does more hoarding, if the central bank wants to hit its nominal target it will have to do some offsetting dis-hoarding.

My own view is that the connection between instruments and targets is very loose. In the current environment, think of the Fed’s instrument as M0, which is currency plus reserves. Think of the money used for transactions as Mt, which is some complex (and variable) weighted average of currency, checking accounts, money market funds, credit lines, frequent-flyer miles, you-name-it. Because these two definitions of money are so different, the Fed can turn its dial a long way without any result, and then when it starts to get results they could end up all over the map.

This is also my instinct for the 1930s, but to be fair I need to read through Sumner’s book before I make up my mind.

I Admit I Do Not Understand a Negative Bond Interest Rate

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The FT reports,

The Swiss 10-year yield fell (meaning prices rose) 0.02 percentage points this morning, touching minus 0.41 per cent, breaking the previous record low of minus 0.39 per cent it hit last week.

Pointer from Tyler Cowen.

Why would I not rather hold Swiss currency than Swiss bonds? Currency would seem to be just as safe, and it does not earn a negative interest rate. Some possibilities:

1. There is a “convenience yield” from holding bonds. If you want to store a lot of wealth, currency is bulky and more easily stolen. So very wealthy individuals and large institutions are willing to hold bonds, even though they yield less than currency.

2. There is a bond bubble. That is, everyone knows that eventually bond prices have to fall (meaning that the interest rate rises), but momentum traders are willing to bet that in the near term bond prices will rise (meaning that rates will fall further). They think that when they buy bonds they will make a short-term profit by selling to the next sucker.

Neither of these stories is persuasive to me, but if I were forced to choose, I would pick (2).

Since writing the above, I came across Scott Sumner’s useful thoughts. He writes,

I recall reading that the SNB was informally discouraging currency use, by telling banks not to pay out large sums of currency to depositors. (Unfortunately I forgot where I read that.) Of course the US government has been trying to criminalize the use of significant sums of currency.

I still think it’s a bond bubble. I personally believe that the odds are that we will see positive interest rates a few years from now, and the people buying medium- and long-term bonds today will get burned.

Scott Sumner on the Great Depression

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His book will be out soon, and no doubt it will break into my earlier list. Meanwhile, he has posted a really useful flowchart summary.

My own views.

All recession are adjustment problems. The Great Depression’s adjustment problems included:

1. Massive reconfiguration of agriculture because of tractors, trucking, and refrigeration. This displaced farm laborers.

2. Massive reconfiguration of manufacturing, as the small electric motor changed many production processes. As Amy Sue Bix points out, as of 1920 there were still men rolling cigars and making light bulbs by blowing glass. Machines could to those jobs better.

3. Sudden changes in asset prices, as a land bubble burst in the late 1920s and a stock market bubble burst in 1929.

4. The rise of fascism/socialism in Europe and a fear of something similar here–regime uncertainty, to use Robert Higgs’ term.

5. Counterproductive New Deal initiatives, such as destroying pigs and organizing industry into cartels (the NRA).

6. Loss of trust in financial intermediaries.

7. Increase in international protectionism.

My Macro Framework

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Scott Sumner and Tyler Cowen have given you theirs. Here is mine.

1. Ditch the concepts of aggregate supply and aggregate demand. Thinking of the economy as if it were a single business, what I call the GDP factory, is misleading. Also, there are two versions of aggregate supply, and no one can keep them straight. Version I treats the GDP factory as operating in a world without prices, or with fixed prices. Version II treats the GDP factory as operating with a sticky nominal wage, so that the profitability of output increases with price.

2. Instead, think of all recessions as adjustment problems. We are in a specialized economy, and at any point in time some people are employed in ways that do not earn a profit. These jobs are unsustainable, and the workers will be let go. Sometimes, the dislocation is temporary, and they can go back to their old jobs. But often the dislocation is permanent.

3. Arriving at sustainable patterns of specialization and trade requires two types of adjustment: static adjustment and dynamic adjustment.

4. Static adjustment means solving for the price vector that clears all markets. What I called Version II is an example of a static adjustment problem–getting “the” real wage to adjust the right level. This problem might exist, but I think it is at most one of many adjustment problems.

5. Dynamic adjustment means entrepreneurial trial-and-error to come up with businesses that employ otherwise-idle workers at a profit. Mathematical models are mostly focused on static adjustment problems, but I think primarily in terms of dynamic adjustment problems.

6. Adjustment is how we get out of a mess. How do we get into messes? To some extent, each unhappy economy is unhappy in its own way. But some elements that one tends to find include Minsky-Kindleberger manias and crashes, sudden changes in credit conditions, sharp movements in important relative prices (oil, home prices), and permanent shifts in the skill structure of work.

7. Kindleberger has a useful concept, which he calls “displacement,” which causes a large shift in wealth. For example, after a war, the winning side can feel wealthier. A bundle of technological innovations or new trading opportunities can have the same effect. The sense of increased wealth that arises from displacement can evolve into a mania. A decade after the end of the first World War, the U.S. experienced a mania. A decade after the end of the Cold War, the U.S. experienced first an Internet mania and then a housing mania.

8. Manias can create unsustainable patterns of specialization and trade and postpone the adjustment to deeper structural change. The mania of the 1920s helped to temporarily disguise the impact of the adjustment to the tractor, the truck, and the electric motor. Many jobs involving manual labor in factories and farms were becoming unsustainable. Ultimately, many of the new jobs were in wholesale and retail trade, but these jobs typically required a high school education. An important part of the adjustment process was that by 1950 a generation of poorly-educated workers had aged out of the labor force. Meanwhile, the U.S. experienced the Great Depression of the 1930s.

9. Similarly, the housing mania of the early 2000s helped to temporarily disguise the impact of the adjustment to the changes brought about by the Internet and globalization. Once again, the composition of the work force appears to be undergoing a shift, as signified by the low rate of labor force participation.

Another AS-AD Anomaly

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Timothy Taylor writes,

[Alan] Krueger argues that the patterns of wage changes and unemployment are roughly what one should expect. He focuses only on short-term employment (that is, employment less than 27 weeks), on the grounds that the long-term unemployed are more likely to be detached from the labor force and thus will exert less pressure on wages. Increases in real wages are measured with the Employment Cost Index data collected by the US Bureau of Labor Statistics, and then subtracting inflation as measured by the Personal Consumption Expenditures price index. In the figure below, the solid line shows the relationship between short-term unemployment and changes in real wages for the period from 1976-2008. (The dashed lines show the statistical confidence intervals on either side of this line.) The points labelled in blue are for the years since 2008. From 2009-2011, the points line up almost exactly on the relationship predicted from earlier data. For 2012-2014, the points are below the predicted relationship, although still comfortably within the range of past experience (as shown by the confidence intervals). For the first quarter of 2015, the point is above the historical prediction.

As an aside, note the particular selection of data series. I am not saying that Krueger is wrong for choosing short-term unemployment, the employment cost index, and the PCE deflator. In fact, I think he shows good taste here. But there are other choices available, and I can think of economists who have defiantly done so, cheered on by other prominent economists.

What I wish to point out is that the relationship as depicted is an anomaly with respect to textbook AS-AD, including both Keynesian economics and Sumnernomics. Timothy Taylor refers to the relationship as a Phillips Curve. However, the Phillips Curve relates nominal wages to unemployment, and the chart shows real wages and unemployment. Although in standard macro nominal wages may rise as the unemployment rate falls, real wages are supposed to move in the opposite direction. In standard macro, aggregate supply is derived from movement along the demand curve for labor. When real wages rise by less than productivity increases, demand for labor rises and output goes up. When real wages rise by more than productivity increases, demand for labor falls and output goes down.

Thus, rather than confirming conventional macroeconomic analysis, Krueger’s chart demonstrates an anomaly. In fact, this is hardly a new anomaly. The procyclical behavior of real wages was something that I had observed when I was in graduate school more than 40 years ago.

Of course, you can modify the Keynesian model to accommodate procyclical real wages. Or, you can find data that you believe demonstrate countercyclical real wages (I think that Sumner would try this latter approach). But that is because Keynesian economics is what I call an interpretive framework. How many anomalies you can tolerate before you discard an interpretive framework is a matter of choice. For me, the AS-AD paradigm has too many anomalies to live with.

Grumpy Monetary Economics

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John Cochrane writes,

I don’t think there really is such a thing as monetary policy any more. Money and government bonds are perfect substitutes. At that point, central bank interest rate setting is the same thing as if the Treasury simply decreed the rate it will pay on government debt. When (if) the Fed raises interest on reserves, and Treasury interest goes up similarly, it will be just as if the Treasury announced it will pay 1% on short term debt.

Read the whole post.

John Taylor, who claims to be the intellectual heir of Milton Friedman, says that the Fed’s big mistake was loose monetary policy prior to the financial crisis and the Fed is too loose now.

Scott Sumner, who claims to be the intellectual heir of Milton Friedman, says that the Fed’s big mistake was too tight monetary policy during the financial crisis and that the Fed is too tight now.

John Cochrane, who claims to be the intellectual heir of Milton Friedman, seems to be saying that these days the Fed is impotent.

I do not claim to be the intellectual heir of Milton Friedman. My views happen to be closest to Cochrane’s.

Mishkin Before vs. Bernanke After

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In Greg Ip’s new book, Foolproof, he writes,

Frederic Mishkin, an expert on banking who had studied the Great Depression, examined what would happen if housing prices fell 20 percent. The Fed, he argued in a lengthy presentation to other central bankers, would lower interest rates quite quickly, the economy would shrink only 0.5 percent, and unemployment would barely rise.

I have not yet read Bernanke’s new book, but I gather that he thinks that without the bailouts the economy was headed toward another Great Depression. So my point is that there is quite a gap between what Mishkin thought would happen if housing prices fell and what Bernanke was afraid was going to happen. Some possibilities.

1. Mishkin actually was right. The economy easily could have withstood the housing price crash. The problem must have been something else. (Scott Sumner would say that it was tight money.)

2. Mishkin was working with a simplistic model of the economy, which did not include the fragility of the financial sector or the feedback from loss of confidence in banks to the rest of the economy. There are two variations on this view

a) the bailouts helped, just as Bernanke says they did.
b) the bailouts made no macroeconomic difference. They simply served to redistribute losses away from the some of the stakeholders in the bailed out firms.

3. Mishkin actually was right. The economy would have recovered quickly with only a small recession. However, Bernanke and other policy makers did the wrong thing and turned what would have been a short-term crisis and the failure of a few firms into a long, drawn-out period of slow growth.

I think that (2a) is the most generally accepted view. My own view is 2b. I could also make a case for (3). Note that in the Great Depression, both Hoover and Roosevelt thought that destructive competition was a major problem. Both tried to discourage businesses from competing, Hoover through exhortation and Roosevelt through the National Industrial Recovery Act. In hindsight, reducing competition was a counterproductive idea. Perhaps in hindsight TARP and the other bailouts will not look so good, either.

By the way, I can offer a lot of praise for Ip’s economic judgment. However, I think I will end up putting Foolproof in the “very good but could have been even better if. . .” category.

Creating Inflation Consciousness

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Scott Sumner writes,

The simplest solution is to commit to buy T-bonds (and, if needed, Treasury-backed MBSs) until TIPS spreads show 4% expected inflation. At that high an inflation rate you don’t need much QE, because the public and banks don’t want to hold much base money.

My reply:

1. Central banks have tried many times to commit to pegging exchange rates, which in principle seems easier to do than pegging an inflation rate. These attempts have often failed, as the central bank finds itself overwhelmed by private speculators. This suggests to me that one should be skeptical of the effectiveness of open-mouth operations.

2. Suppose that the Fed backed up its commitment to 4 percent inflation with a lot of action. My belief is that it would take a great deal of action–an order of magnitude more than what we have seen.

3. By the time inflation reached its 4 percent target, there would be a great deal of “inflation consciousness” among investors and in the general public. We would get into a regime of high and variable inflation. You do not know whether inflation would tend toward 4 percent, 8 percent, or 12 percent.

4. In this regime of high and variable inflation, prices would lose some of their informational value, as people find it harder to sort out relative price changes from general inflation. This would be detrimental to economic activity. Scott and I both remember the 1970s, and from a macroeconomic perspective, they were not pretty.

5. So fairly soon, you would see a reversal of policy, with Scott complaining about the stupidity of the Fed overshooting its inflation target. The Fed would take dramatic action to undo what it did before.

6. After several painful years, we would be back to the regime of low and stable inflation.