Category Archives: Scott Sumner is Coherent

How to Fix Infrastructure

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Scott Sumner writes,

I think a better comparison for New York would be a high income, world-class city like Singapore or Hong Kong or Dubai. Those places are able to build very good infrastructure quickly and at low cost. They might use Bangladeshi migrant workers at $1/hour instead of American “prevailing wage” workers at $50/hour. Indeed even cities like Paris and Berlin build new subway lines at 1/7th the cost of the New York project. A small part of this cost gap may be due to physical differences between the various cities, but by no means all of it…

This demonstrates one of the many internal contradictions of American progressivism. (And by the way, American conservatives have just as many internal contradictions.) You can have your strong public employee unions, “prevailing wages” and restrictive work rules, or you can have nice infrastructure. New Yorkers have (perhaps unknowingly) made their choice. Now they must live with the consequences. Few progressives (with the notable exception of Matt Yglesias) understand these internal contradictions.

The FOMC and its Target

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Van R. Hoisington and Lacy H. Hunt write,

The Federal Open Market Committee (FOMC) has continuously been overly optimistic regarding its expectations for economic growth in the United States since the last recession ended in 2009. If their annual forecasts had been realized over the past four years, then at the end of 2013 the U.S. economy should have been approximately $1 trillion, or 6%, larger.

They go on to say that the Fed has over-estimated the “wealth effect” by which higher asset prices lead to more consumption.

If the wealth effect was as powerful as the FOMC believes, consumer spending should have turned in a stellar performance last year. In 2013 equities and housing posted strong gains. On a yearly average basis, the real S&P 500 stock market index increase was 17.7%, and the real Case Shiller Home Price Index increase was 9.1%. The combined gain of these wealth proxies was 26.8%, the eighth largest in the 84 years of data. The real per capital PCE gain of just 1.2% ranked 58th of 84. The difference between the two was the fifth largest in the 84 cases. Such a huge discrepancy in relative performance in 2013, occurring as it did in the fourth year of an economic expansion, raises serious doubts about the efficacy of the wealth effect

Let me try to put on a Scott Sumner hat and speak for him. If he reads this, he can correct me.

1. If the Fed under-forecasts nominal GDP (NGDP) in one quarter, than it ought to try raise its target for NGDP in subsequent quarters. That is, it should engage in level targeting, not simply stick to a growth-rate target after a forecast miss.

2. The Fed should use market forecasts rather than rely on a model to forecast. Ideally, we would have NGDP futures contracts. But in their absence, other nominal market variables, such as the spread between non-indexed and indexed bonds, can be helpful.

3. Wealth effect, shmealth effect. Who cares what particular component of the Fed model caused it to underpredict NGDP? Given (1) and (2), there is no good excuse for the Fed missing its targets by such a large cumulative amount.

4. The period 2008-2014 is the mirror image of 1969-1979. In the 1970s’, the Fed consistently under-predicted NGDP, with the result that monetary policy was too loose. In the recent episode, the Fed consistently over-predicted NGDP, with the result that monetary policy was too tight.

Remember that when I take off my Scott Sumner hat, I reject macroeconomics altogether in favor of PSST.

Mian-Sufi vs. Scott Sumner and John Taylor

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They write,

What we are witnessing is the limit of what monetary policy alone can do. Sometimes there is a tendency to assume that the Fed can “target” any inflation rate it wishes, or that it can target the overall price level – the so-called nominal GDP targeting. The evidence suggests that the Fed may not be so omnipotent.

Pointer from Mark Thoma. A couple of comments.

1. This seems like an argument against Scott Sumner’s view that monetary policy was too tight in 2008. That is, I take them as saying that there was nothing that the Fed could have done. Scott Sumner would insist that the Fed lacked the will, not the way.

2. Mian and Sufi offer a chart showing that core inflation was below the Fed’s 2 percent target almost the entire period starting in 2000. This seems like an argument against John Taylor’s view that monetary policy was too loose in 2004-2006.

3. I believe that in 2007 the Fed folks thought that inflation was rising, in part because they looked at oil prices, not just core inflation.

4. Mian and Sufi entitle their post “Monetary Policy and Secular Stagnation.” I still want to see an economist reconcile a belief in secular stagnation with a belief in Piketty’s claim that the return on capital is going to exceed the growth rate of the economy on a secular basis. For the record, I believe neither.

Shiller-Bashing

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Scott Sumner writes,

I distinctly recall that Robert Shiller did not recommend that people buy stocks in 2009. That made me wonder when Robert Shiller did say it was a good time to buy stocks.

Barry Ritholtz writes,

By one metric — Yale professor Robert Shiller’s cyclically adjusted price-to-earnings ratio, or CAPE ratio — stocks are especially pricey. This has become the bears’ favorite valuation measure. But beware of cherry-picking any particular metric that rationalizes your position. Indeed, over the past 20 years, the CAPE measure has pegged U.S. equities as “overvalued” 85 percent of the time.

But for me, the most interesting Shiller-bashing is in the book I am reading by Duncan Watts, Everything is Obvious. He reproduces a chart created by David Pennock and Dan Reeves, using option prices to derive the probability distribution of future stock prices. The chart shows clearly that the uncertainty about future stock prices is much higher than the variation of past stock prices. That is exactly the criticism that I made of Shiller’s famous “variance bounds” estimates when he first published his work on that topic, and which he told the journal editor to reject. I still think that I was right. I should note that Watts does not make the Shiller connection in his book. However, I think that Watts gives us plenty of reason to be cautious about making statements like “Shiller called the housing bubble.”

I wish that more economists were aware of Watts.

Working with the Tautology Model

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Scott Sumner writes,

the NGDP approach is a very naive model that treats NGDP sort of like a big pot of money, which is shared out among workers with sticky wages. If some day the pot is smaller, then there’s less money to share, and some workers end up disappointed (unemployed.) It’s completely agnostic about the micro foundations…

Which is fine with me. Again, think of the mineshaft analogy, with real-world observations on the surface and the optimization-equilibrium paradigm buried below. To connect the two, you can try to start inside the mine and tunnel out, or you can start outside and tunnel in. My displeasure with much of macro the past thirty years is that it insists on the inside-out approach.

Consider the tautology model: hours worked = total wages divided by the hourly wage.

If the Fed were to target total wages, what could go wrong? Sumner cites the Lucas critique. In this context that would mean that the sticky nominal wages you observed in the past were due to the Fed not trying to mess with total wages. As soon as the Fed tries to mess with total wages, workers will catch on and start paying closer attention to real wages.

I believe that something else will go wrong. The Fed will not be able to hit its target for total wages! Suppose we write MV = W, where W is total wages and V is the velocity of money expressed in terms of total wages rather than nominal GDP. What I am inclined to believe is that moderate changes in M will lead to approximately equal and opposite changes in V.

Picture this as the Fed having a steering wheel, M, that is only loosely connected with the front axle, W. The Fed can turn the wheel quite hard while the axle barely wiggles. It may take extensive turning of the monetary steering wheel over a long period of time to obtain a response of total wages. In fact, the period over which wages are sticky may turn out to be shorter than the lag between shifts in monetary policy and changes in total nominal wages.

We have a complex, sophisticated monetary system, in which people’s ability to undertake transactions is not proportional to the amount of currency in circulation. We have a large financial system, in which the Fed is only one player. I keep trying to hold down people’s estimation of the power of the Fed.

Scott Sumner on the Fed Transcripts

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He writes,

Note that on the very day of the September 16 meeting, the meeting at which the Fed refused to cut rates due to fear of “high inflation,” the TIPS spreads were showing only 1.23% inflation over the next 5 years, well below target. The Fed should have ignored its own worries about inflation, and instead relied on the wisdom of the crowds. The crowd is not always right, but they are more reliable than the Fed, especially when conditions are changing rapidly. Market participants saw the bottom dropping out of the economy using millions of pieces of highly dispersed information, while the clumsy Fed waited for macro data that comes in with long lags.

The idea of relying on market forecasts is what puts the “market” in market monetarism. An interesting question is how much the Fed would have had to do to cause both actual and expected inflation (or nominal GDP) to change. My inclination is to believe that a lot more M would have merely resulted in a lot less V.

Inferring from an Identity

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Scott Sumner writes,

To my eyes it looks like “real wages” [(nominal average hourly earnings)/(NGDP/pop)] lead unemployment by about a month or two

Shock me, shock me. Let’s see:

NGDP = RGDP * P = N * (RGDP/N) * W*(P/W)

In words, nominal GDP = employment times output/worker times nominal wages times the price markup.

Solve this for the ratio of the nominal wage to nominal GDP:

W/NGDP = (W/P) * (RGDP/N)/N

In words, Sumner’s “real wage” (the nominal wage divided by nominal GDP) equals the inverse of the price markup times the inverse of productivity times 1/employment. If the price markup and productivity remain about unchanged, then by definition the “real wage” is inversely related to employment.

Scott is fond of saying, “Never reason from a price change.” I say, “Never draw a behavioral inference from an identity.”

Macro Experiments are not Controlled

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Alex Tabarrok writes,

I happen to agree with Krugman that one test is not decisive. The economy is very complex and we don’t have controlled macro-experiments so lots of things are going on at the same time.

Read the whole thing, especially if you do not know the austerity-test controversy to which Alex is referring. And if you want more, you can read Mark Thoma or Scott Sumner either at EconLog or at MoneyIllusion.

My comments.

1. Don’t throw all your eggs at Paul Krugman. Save some for Mark Zandi, of Macroeconomic Advisers Moody’s, who also forecast dire consequences from the sequester.

2. You don’t have to believe the fiscal austerity was a non-event. You can believe that the economy was about to expand rapidly, and trimming the budget deficit held it back. Although, as Alex points out, telling this story makes it a little harder to say that we were in a liquidity trap/secular stagnation. Anyway, believing that austerity held back a boom is just the mirror image of believing that the stimulus worked, and the only reason that unemployment ended up higher than what was predicted without the stimulus is that the economy was in a deeper hole than we thought. The “deeper hole” theory is now the conventional wisdom among Stan Fischer’s 72 Ph.D advisees and their descendants. That is the beauty of macro. Even something that is defined ahead of time as a “test” is not a controlled experiment.

3. Even if you believe that fiscal austerity was a non-event, you do not have to believe that it was “monetary offset” that made it so. I would suggest that the process of business creation and business destruction did its thing without regard to fiscal and monetary policy.

4. Try to explain why nominal interest rates went up. If austerity matters, then interest rates should come down. If monetary offset works the way it does in old-fashioned textbook models, then interest rates should come down even more.

5. In Scott Sumner’s floofy world where the Fed directly controls NGDP expectations, you would expect nominal interest rates to go up with monetary offset. But I am still trying to come up with even a thought experiment that would refute market monetarism. If 2013 had been a down year, it would just have shown that the Fed failed to maintain NGDP expectations. This is uncharitable, but I think of market monetarism as a theory that can only be confirmed, never rejected.*

Is there anyone I haven’t offended yet?

*To be less uncharitable, let Scott speak for himself.

In my view the now famous Krugman “test” of market monetarism is an indication of the pathetic state of modern macro. We are still in the Stone Age. Future generations will look back on us and shake their heads. What were they thinking? Why didn’t they simply create a NGDP futures market? They’ll look back on us the way modern chemists look back on alchemists. It’s almost like people don’t want to know the truth, they don’t want answers to these questions, as then the mystical power of macroeconomists with their structural models would be exposed as a sham. Remember when the Christian church produced bibles and sermons in a language that only the priesthood could understand? That’s macroeconomics circa 2013.

Ben Bernanke’s Valedictory

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He says,

The Federal Reserve responded forcefully to the liquidity pressures during the crisis in a manner consistent with the lessons that central banks had learned from financial panics over more than 150 years and summarized in the writings of the 19th century British journalist Walter Bagehot: Lend early and freely to solvent institutions

The Bagehot policy is to lend freely, at a penalty rate. If you lend freely at a penalty rate, you effect financial triage. Banks that are fine don’t borrow. Banks that are insolvent go under anyway. And banks that are temporarily illiquid use your loans to recover. Instead, if all you do is lend freely, then you are simply handing out favors, which turns banking into an exercise in favor-seeking.

He goes on to say,

Weak recoveries from financial crises reflect, in part, the process of deleveraging and balance sheet repair: Households pull back on spending to recoup lost wealth and reduce debt burdens, while financial institutions restrict credit to restore capital ratios and reduce the riskiness of their portfolios. In addition to these financial factors, the weakness of the recovery reflects the overbuilding of housing (and, to some extent, commercial real estate) prior to the crisis, together with tight mortgage credit; indeed, recent activity in these areas is especially tepid in comparison to the rapid gains in construction more typically seen in recoveries.

This is a popular story among Keynesians now. It was not in the textbooks before the crisis.

Scott Sumner will be disappointed to see that Bernanke does not believe in the theory of monetary offset.

Phillips Curve Specifications and the Microfoundations Debate

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Scott Sumner writes,

As you may know I view inflation as an almost worthless concept… In contrast Krugman discusses the original version of the Phillips curve…which used wage inflation instead of price inflation. Whereas price inflation is a useless concept, wage inflation is a highly useful concept.

Fine. But Krugman also draws attention to how the level of the unemployment rate affects the level of the wage inflation rate. This takes us back to the original, pre-1970 Phillips Curve, from Act I in my terminology (Act I was the Forgotten Moderation, from 1960-1969, Act II was the Great Stagflation, from 1970-1985. Act III was the Great Moderation, from 1986-2007, and Act IV is whatever you want to call what we are in now.) The Act I Phillips Curve says flat-out that (wage) inflation will be high when unemployment is low, and vice-versa.

The Phillips Curve was revised in Act II, when the specification became that the rate of wage inflation increases when the unemployment rate is above below the NAIRU and decreases when it is belowabove the NAIRU. In other words, it relates the change in the rate of wage inflation to the unemployment rate. At the time, cognoscenti were saying that Friedman had moved the Phillips Curve one derivative.

Some comments.

1. The Act I Phillips Curve works better over the 27-year period (Acts III and IV) that Krugman covers. Within the sample period, in 9 out of the 10 years when unemployment is near the bottom of its range (less than 5 percent), wage inflation is near the top of its range (3.5 percent or higher). In all three high-unemployment years, wage inflation is less than 2.5 percent.

2. Although the rate-of-change in wage inflation is also correlated with the unemployment rate, the relationship is not as impressive. In the late 1990s, we had the lowest unemployment rate, but wage inflation actually declined (admittedly by only a small amount). More troubling is the fact that the very high rate of unemployment in recent years produced a decline in wage inflation hardly larger than that of the much milder previous recessions.

3. The overall variation in wage inflation over the 27 years is remarkably low. It ranges from 1.5 percent to 4 percent. When there is this little variation to explain, the actual magnitude of the effect of variations in unemployment on inflation is going to be pretty small. See the post by Menzie Chinn. If you do not have any data points that include high inflation, then you cannot use the Phillips Curve to explain high inflation. Chinn argues that the relationship is nonlinear. I would say that we do not know that there exists a nonlinear relationship. What we know is that we observe a relationship that, if linear, has a shallow slope. The most we can say is that if there is a steep slope somewhere, then there is a nonlinear relationship.

4. If you had given a macroeconomist only the information that wage inflation varied between 1.5 percent and 4 percent, that macroeconomist would never have believed that such a time period included the worst unemployment performance since the Great Depression. In terms of wage inflation, the last five years look like a continuation of the Great Moderation.

Some larger points concerning market monetarism, paleo-Keynesianism, and the microfoundations debate:

5. Concerning Scott’s view of things, I have said this before: Arithmetically, nominal GDP growth equals real GDP growth plus growth in unit labor costs plus the change in the price markup. If you keep the price markup constant and hold productivity growth constant, then nominal GDP growth equals real GDP growth plus wage growth. So it is nearly an arithmetic certainty that when nominal GDP grows more slowly than wages, then real GDP declines. But to me, this says nothing about a causal relationship. You could just as easily say that a decline in real GDP causes nominal GDP to grow more slowly than wages. What you have are three endogenous variables.

Scott insists on treating nominal GDP growth as the exogenous variable controlled by the central bank. To me, that is too much of a stretch. I am not even sure that the central bank can control any of the important interest rates in the economy, much less the growth rate of nominal GDP. Yes, if they print gobs and gobs of money, then inflation will be high and variable, and so will nominal GDP growth. But otherwise, I am skeptical.

6. I view paleo-Keynesianism as being hostile to Act III macro. I share this hostility. However, right now, you have saltwater economists saying, “Freshwater economists reduce macroeconomics to a single representative agent with flexible prices solving stochastic calculus problems. Hah-hah. That is really STOOpid.”

The way I look at it, the Act III New Keynesians reduced macroeconomics to a single representative agent with sticky prices solving stochastic calculus problems. They should not be so proud of themselves.

Paul Krugman calls Act III macro a wrong turn. (Pointer from Mark Thoma.) I would not be so kind. I also would not be as kind as he is to the MIT macroeconomists who emerged in that era.

You cannot just blame Lucas and Prescott for turning macro into a useless exercise in mathematical…er…self-abuse. You have to blame Fischer and Blanchard, too. Personally, I blame them even more.

Having said all that, I do not share Krugman’s paleo-Keynesianism. Just because the Lucas critique was overblown does not mean that other critiques are not valid. I have developed other doubts about the Act I model, and these lead me to believe that PSST is at least as plausible a starting point for thinking about macro.