A slightly off-center perspective on monetary problems.
It’s never the central bank’s fault. Or at least that’s what I hope to show.
I will argue that there has never been an inflation or deflation that was “blamed” on central bank policy. More specifically, this is my argument:
Undesirable inflations and deflations are never blamed on central banks by the consensus of expert opinion in the country affected, during the period when prices are actually changing. Can you think of any counterexamples?
Suppose you have a crystal ball, and are given one peak at the future, say May 2011. But you are only allowed to look at one variable—and it’s not the Dow, it’s the fed funds rate. Now suppose I tell you the following, it will be one of these two numbers:
a. 0.25%
b. 3.75%
In an earlier post I discussed the amazing number of categories in which Denmark led the world.
1. Most liberal (or idealistic) values
2. Most free market economy
3. Most equal income distribution
4. Happiest
That raises the question of whether there is a “Denmark of America.” Probably not, but there is one state that comes pretty close.
Here I’ll try a couple analogies to better explain earlier posts on causation and NGDP targeting. As you will soon see, my literary skills are at the 5th grade level.
I’d like to welcome any new readers from China, who may have discovered this blog through the Netease version. I generally focus on U.S. monetary policy, but today I will discuss the Chinese yuan. I should also mention that I will have to slow down for a few weeks, in order to revise a manuscript on the Great Depression that I am trying to get published. If you are a new reader, there are plenty of older posts that discuss my view of how the current crisis has been misinterpreted. Those views are quickly sketched out in the very first post, “About the blog.” I will take a fairly long trip to China later this year—which might also lead to posts on topics related to China.
I am getting burned out dealing with endless complaints about the way I think about markets. Thus I thought it might be useful to compare my views to what I hear from those down in the trenches. Those who actually know how auction-style markets work. Bob supplied a typical complaint:
The financial instability caused a huge demand for commodities as investment – just look at the USO holdings of futures contracts last spring. Airlines don’t buy ETFs to get their oil.
I’m increasingly coming to the conclusion that academic economists have pretty close to 0 comprehension of how commodity futures markets actually function (this is really not even directed at you Scott). They don’t even understand the theory of futures pricing, let alone the real world nitty-gritty.
There’s been a lot of buzz in the blogosphere recently about attempts by Brad DeLong and Paul Krugman to develop models of asset bubbles. I can’t blame people for trying; we’d all like to understand why we keep getting these crazy price peaks in tech stocks, oil, housing, etc. But as you may have already noticed if you read my EMH post, I am somewhat skeptical. Today I’d like to look at this question from several different angles, starting with a question:
What’s the point of bubble theories?
Here’s what economists knew before the General Theory:
1. Monetary policy and velocity determine NGDP growth.
2. Velocity is positively related to interest rates (and hence investment booms and deficit spending may raise velocity.)
3. Wages and prices are sticky in the short run.
4. Because of point 3 a monetary shock may produce a liquidity effect for short term rates.
5. Because of point 3, money and velocity shocks can destabilize output in the short run.
A few days ago I posted a discussion of the apparent conflict between a well-publicized Fed study of the Taylor Rule’s policy implications, and the traditional Keynesian view of the SRAS. The study claimed that we needed Fed policy to be expansionary enough to reduce interest rates by 5%. The clear implication (since nominal rates are near zero) was that we needed at least 5% inflation expectations. I claimed this made no sense, as the SRAS is generally assumed to be fairly flat in a deep recession, and that with very high unemployment, NGDP increases in the 5-8% range would almost certainly be expected to consist mostly of real output gains, with only mild inflation.
From Kausfiles:
The administration has rolled back transparency rules that require unions to more extensively report their finances, executive compensation and potential conflicts of interest every year. The Labor Department said “it would not be a good use of resources” to require this.
The Obama administration’s first proposed budget calls for cutting the budget of the Labor Department’s Office of Labor-Management Standards, which investigates unions on behalf of workers, to $41 million, down from $45 million last year.
Even people who are sympathetic to my policy views often have trouble swallowing my thesis that the Fed caused the crash of 2008. In my previous post (which you should read first) I argued that people make unjustified distinctions between “active” and “passive” monetary policy stances. The argument is often that the Fed did not “do anything” that might have caused the crash of 2008. Here I will reprise and extend an argument I used in response to Josh over in Nick’s blog.
A few months back I argued that “if policy A would have prevented event B, then not doing policy A caused event B.” This is what happens when you try to talk about concepts like “causation” without having studied philosophy. I still haven’t studied philosophy, but at least I have thought about the issue a bit more.
I received a question from someone about whether my 5% NGDP rule would be a good policy for a country like Estonia or Latvia. Before answering that question, I’d like to talk a bit about why these small countries matter. I will focus on Estonia, the most interesting case. Why is a tiny Eastern European country with 1.4 million people important? Because it might be the only country in the world with the three characteristics that I have argued favor economic success:
1. Free markets
2. Low tax rates
3. Liberal culture
The following quotation discusses one of the more perplexing aspects of quantum mechanics:
In 1935, several years after quantum mechanics had been developed, Einstein, Podolsky, and Rosen published a paper which showed that under certain circumstances quantum mechanics predicted a breakdown of locality. Specifically they showed that according to the theory I could put a particle in a measuring device at one location and, simply by doing that, instantly influence another particle arbitrarily far away. They refused to believe that this effect, which Einstein later called “spooky action at a distance,”1 could really happen, and thus viewed it as evidence that quantum mechanics was incomplete.
I don’t plan to explain this phenomenon (and please don’t write in with an “explanation,” as you’ll only convince me that you don’t understand it.) But regardless of whether there is action at a distance in particles, I am convinced that the concept does not apply to economics. To be more specific, I don’t believe in “inflationary time bombs” hidden in money supply increases. And I don’t believe in “long and variable lags” from monetary policy shocks.
While researching the Taylor Rule, I came across an old Paul Krugman post that responded to a Nick Rowe essay.
I’m not a huge fan of the Keynesian SRAS. I think many Keynesians overestimate how flat it is at less than full employment. But in recent weeks I have started to miss the SRAS, as the economics profession seems to have driven the IS-LM framework into an intellectual cul de sac. A couple posts back I cited a Financial Times story that mentioned a Fed study suggesting negative 5% real interest rates were needed to provide the desired level of stimulus.
One good thing about not having time to read the news recently is that I have been spared from some very silly and tiresome debates—such as whether the press has liberal bias. I don’t know which view is sillier; liberals who deny the liberal bias of the press, or conservatives who complain about it. Here is a news clip that reminded me of this issue. If most reporters weren’t obvious liberals, why would Obama’s joke even be funny? So am I taking the conservative side in this debate? Not at all. But first let’s back up a bit, and consider what it actually means to be “liberal.”
A recent FT piece discussed the progress of QE thus far, and the Fed’s view of what needs to be done next. Here is a key passage:
The last meeting saw the Fed buy long-term treasuries for the first time in decades. The large initial impact of the move on markets is no longer visible, but officials think the policy was reasonably successful.
Previous staff analysis suggested the $300bn purchase would reduce the yield on 10-year treasuries by 25-35 basis points, and officials think the rate today is about this much lower than it would have been if they had not started buying.
Further purchases are possible, particularly if the Fed again downgrades its economic forecasts. The staff analysis comparing unconventional operations to interest rate cuts suggests more might be needed anyway.
Bill Woolsey is very familiar with index futures targeting, but also knows the details of how futures markets actually work much better than I do. Thus I thought this letter from him would help clarify the nuts and bolts of the plan from the perspective of real world futures markets. I would also like to mention that the commenter “123″ noted that the Fed might have to take a large long or short position if there was a sudden change in money demand during a financial crisis. Bill mentions that perhaps the Fed should be allowed to trade on its own account.
Back in 2006 I read an interesting post by Greg Mankiw, which advocated a monetary regime where the Fed would use market expectations to set the monetary policy instrument at the level expected to hit their inflation target. Given my longstanding interest in futures targeting, I was naturally encouraged to see a highly respected mainstream new Keynesian endorse this type of policy regime. Before looking at his specific plan, however, it will be useful to review his more recent essay on negative interest on money.
