Jim Hamilton: There Is No More Macroeconomic Balance

Jim Hamilton believes that there is no "sweet spot" right now: no set of economic policies that will both avoid significantly higher unemployment and avoid significantly higher inflation. We are thus about to be forced to choose between evils:

Econbrowser: Bernanke's tightrope act: Some analysts are saying that Fed Chair Ben Bernanke is walking a tightrope--if he does not drop interest rates quickly enough, the U.S. will be in recession, but if he goes too far, we'll see a resurgence of inflation. I am increasingly persuaded that's not an accurate description....

We've seen some quite remarkable movements in commodity markets the last two months.... Topping the group is wheat, up 46% over two months; I won't try to translate that one into an annual inflation rate because I don't want to scare you.... If it were just a few commodities moving, I wouldn't be concerned.... But we are clearly looking at an aggregate phenomenon here, and it seems unreasonable to suppose that the phenomenon has nothing to do with choices by the Fed.... Now it is true that if you look at the time profile of futures contracts on these commodities, you don't see an upward slope, a fact in which Bernanke has taken solace.... But even if there is no further increase in the price of wheat, surely it's reasonable to anticipate increases yet to come in the price of bread and Wheaties and pasta.

I think part of the basis for Bernanke's optimism on inflation must be the dourness of his outlook for real economic activity. The basic macroeconomic framework in Bernanke's textbook suggests that, for given inflation expectations, if output falls below the "full-employment" level, inflation should go down, not up.

But what exactly does the theoretical full-employment level of output correspond to in the present situation? There are fundamental problems with credit markets... from a real disruption in the basic process of financial intermediation... it may be that "full-employment GDP" would actually decline this year, and an effort to use a monetary expansion to prevent that would indeed be inflationary.

Of course, a serious problem in the market for credit is another area with which Bernanke the academic is quite familiar. But... fiddling with the level of the fed funds rate is not a particularly efficacious tool for dealing with this problem... the primary way in which monetary expansion could help alleviate the current credit problems was described by Brad DeLong with remarkable clinical coolness:

Yes, the financial system is insolvent, but it has nominal liabilities and either it or its borrowers have some real assets. Print enough money and boost the price level enough, and the insolvency problem goes away without the risks entailed by putting the government in the investment and commercial banking business.

The monetary cure for our ails... has a downside... later [we will] need an artificial recession to bring the inflation back down.... [R]ecent Fed rate cuts are buying us higher output at the moment at the cost of lower output in the future.... But I disagree that the recession Bernanke is trying to avoid would be a "small" one. The Fed chief must be worried that a recession in the present instance would precipitate major financial instability, in which case perhaps the choice between paying now and paying later argues in favor of latter....

[T]he tightrope analogy seems... misleading... it presupposes that there exists a choice for the fed funds rate that would somehow contain both the solvency and the inflation problems. In my opinion, there is no such ideal target rate.... Better for everyone to admit up front... that there is no cheap way out....

Comments

[Charles]

In your clinical coolness, could you please note that there are inexpensive solutions to the mortgage crisis, notably temporarily paying the reset rather than buying the house?

I am getting very tired of reading these multi-trillion dollar estimates for what the mortgage crisis will cost us, estimates that conveniently avoid mentioning that they equate to bailing out the banks, making millions of people homeless, and having the houses they were evicted from turned into meth labs. As someone once said, "We can do better."

[Robert J. Gordon]

Jim Hamilton's comments on the Fed's current dilemma are correct. But this rediscovery of the Fed's impotence in the face of stagflation strikes me as "reinventing the wheel." I wrote the first paper (in BPEA 1975) on policy responses to supply shocks, and Ned Phelps wrote a complementary paper in the JMCB 1978 with a slightly different model. I merged our two models, by dropping the unnecessary complications, in the AER Proceedings in 1984. Whenever there is a sharp price increase in a commodity with a low price elasticity of demand (oil and imports in 1974 and 1979-80; oil, food, and imports today), there will be an increase in the share of nominal spending on those products. The rest of the economy must adjust to reduce nominal spending either by a decline in non-commodity prices (unlikely with sticky wages) or a decline in non-commodity real GDP.

A puzzle at the moment is that the feed-through from commodity price inflation to core inflation has been so slow. This may be a structural change since the 1970s that might make the Fed's job easier. Higher oil prices feed through into core inflation through non-energy products such as airline fares, trucking rates, and plastics prices. My inflation equation shows that it takes about three years for the food-energy price effect (the difference between headline and core inflation) to feed )(partly, not entirely) through into core inflation. The Fed is well on the way to "accommodating" supply shocks, which implies that the Fed will be stuck with core inflation at 3 percent or higher over the next few years.

[bigTom]

Robert:
I think we have three "drivers" which are operating more or less simultaneously. The first is your supply shock -mostly oil, and commodities. The second is the bursting of the housing bubble. The third is the banking solvency crisis. There is of course nonzero (and nonlinear) coupling between these three semi-independent processes, but it is probably a useful intellectual excercise to separate them. Applying theory and presciptions that have been developed to handle each one of these crisis in isolation however may not be up to today's task.

[derek]

Junk Charts calls shenanigans on a Greg Mankiw blog entry claiming lower taxes on the middle class. Short version: they're paying lower taxes because they're making less money than they used to.

http://junkcharts.typepad.com/junk_charts/2008/03/dont-believe-wh.html

[Randy Owens]

JBD: Topping the group is wheat, up 46% over two months; I won't try to translate that one into an annual inflation rate because I don't want to scare you....

But I do!! 869% annually there! (Given the precision of that number, it could really be anything from 849% to 889%, so might as well round it off to 870%, at best.)

Now tremble before me!

[bigTom]

Randy,

I don't think it makes any sense to project 46% per 2months forward for a year. But it does seem likely for wheat to continue to rise. The world has been consuming food staples faster than we have been producing them. Clearly this is unsustainable! The real threat is what this may soon mean for the poorer members of the poorer countries. I have real concern that a major humanitarian disaster may be brewing. For the USA it's not so bad. Some are even throwing out the hope that food (which the US is an exporter of) might become like oil -perhaps offsetting our increasing oil bill. I don't think that is very credible, but some are making the case.

[Randy Owens]

Oh, absolutely, it's not going to go up 870% in 12 months (or even 560% in 10). But that is the annual rate if you extrapolate from those two months. I shudder to think what rate would be extrapolated from the higher of those two months!

It did get me wondering, though, why such a steep increase right now? In general, the first thing that comes to mind is ethanol production increases, the higher price for corn leading farmers to switch cropland from wheat to corn, reducing the supply of wheat, and the higher price for corn increasing the use of wheat as an alternative foodstuff, increasing demand. But usually, I'd expect a sudden jump like that to result from some disaster affecting the crop. Is the harsh winter expected to have a significant effect on the winter wheat crop? That's the only recent relevant disaster that comes to mind off the top of my head.

[baileyman]

It's not stagflation.

It's not inflation.

It's devaluation. No policy in the world can correct for a currency previously too high.

After the adjustment, US inflation should look like other countries's inflations, which may be significant due to demand for basic materials and commodities.

Jobs are something we've shed by policy. Who knows what US potential employment is after a devaluation, after the artificial support of a too-high currency is gone?

[anne]

Why am I so terribly tired of paying any attention to analysts who are unable to understand that we are in the midst of spending trillions of dollars on war and occupation and that such spending might, just might, be limiting what we are otherwise doing economically speaking? What is the point of economic anaalysis that has nothing to say of our squandering triliions of dollars?

[anne]

Dear Brad DeLong,

Why are you paying no attention to the work of Joseph Stiglitz? Why are you assuming $3 trillion in wars and occupations is of no economic consequence? Where other than Mark Thoma are economists courageous enough to look to the work of Joseph Stiglitz even in such fearsome times?

[anne]

Better to severely criticize the work of Joseph Stoglitz, than ignore it. Me, I think the work superb and am terribly saddened by economists who turn from Stiglitz. We are in the midst of a horrible horribly costly war and occupation. Please show that this matters or that I am a fool for thinking so.

[bakho]

Exactly. For some sets of especially idiotic fiscal policies, there is no monetary sweet spot. We saw the Fed damage the economy with too low interest rates during the Bush MIA stimulus years. We saw the Fed wreck the economy of the early 80s with too high interest rates to fight the oil spike. This is the equivalent of using a monetary sledgehammer when the prescription calls for the fiscal screwdrivers. It is time to dust off some of the old fiscal tools and put them back to work after a quarter century of neglect.

After years of under-investment in education, infrastructure and technology, government needs to get back in the groove.

This will not be easy because it requires a repudiation of Reaganomics, the greedheads and special interests that have purchased our politicians. The monetarists need to be told, "We appreciate the need for good monetary policy, but monetary policy, no matter how good cannot compensate for busted fiscal policy."

[walkingdaline]

Had an interesting conversation over dinner with a commodity trader for a big firm that actually buys and sells commodities. He was describing how difficult these speculative inflows are for his business (a major international conglomerate).

Funny to see firms like this being bled by speculative capital flows. Less funny if it starts damaging actual production networks. As he said, "speculators allocate 3% from equity to commodities and the cost of hedging goes above our margins."

[Blissex]

«the primary way in which monetary expansion could help alleviate the current credit problems was described by Brad DeLong with remarkable clinical coolness: "Yes, the financial system is insolvent, but it has nominal liabilities and either it or its borrowers have some real assets. Print enough money and boost the price level enough, and the insolvency problem goes away without the risks entailed by putting the government in the investment and commercial banking business."» What he does not say that Brad's advice ensures that not only there would be no bankruptcies or takeovers, thus protecting the jobs, options and bonuses of the executives and the Republican campaign donor class that have done so much for prosperity in the past few years, but inflating away those insolvencies would actually *increase* the rewards for those executives and the Republican campaign donor class, by creating paper profits that could be readily turned into more options and bonuses. «The rest of the economy must adjust to reduce nominal spending either by a decline in non-commodity prices (unlikely with sticky wages) or a decline in non-commodity real GDP. A puzzle at the moment is that the feed-through from commodity price inflation to core inflation has been so slow. This may be a structural change since the 1970s that might make the Fed's job easier.» Wages are less sticky than they used to be -- while headline wages have not gone down that much, the value of benefits has been shrinking (even if the unit cost has been growing, because the quantity of benefits has collapsed). «The monetary cure for our ails... has a downside... later [we will] need an artificial recession to bring the inflation back down.... [R]ecent Fed rate cuts are buying us higher output at the moment at the cost of lower output in the future.... But I disagree that the recession Bernanke is trying to avoid would be a "small" one. The Fed chief must be worried that a recession in the present instance would precipitate major financial instability,» I always wonder how so many so honest so high minded commentators can never bring themselves to mention that this Administration is engaged in two-three wars that are not going that well and cost a fortune, and that the good times must continue to roll to keep the home front distracted and happy. «in which case perhaps the choice between paying now and paying later argues in favor of latter....» I like how it is expressed here: «The Federal Reserve had to show that when faced with the painful choice between maintaining a tight monetary policy to fight inflation and easing monetary policy to combat recession, it would choose to fight inflation. In other words to establish its credibility, the Federal Reserve had to demonstrate its willingness to spill blood, lots of blood, other people's blood.» [Mussa, "American Economic Policy in the 1980s", University of Chicago Press 1994]. This is a quote lifted from Andrew Glyn's excellent "Capitalism Unleashed" (Oxford University Press 2007).

[PSP]

If one is to assume that the Fed's primary job is to fight inflation (which is conventional wisdom but not its statutory mandate)then it would appear as likely that Bernanke is trying to dely the recession until after the election, as a fear of too big a recession.

Paradoxically, the Fed has strong institutional reasons to avoid the appearance of throwing an election as well as a history of partisan intervention.

[bigTom]

Randy:
The link might shed some light on the staples shortage:
http://www.independent.co.uk/environment/green-living/rising-prices-threaten-millions-with-starvation-despite-bumper-crops-790319.html
The claim is that it is demand in developing countries, as new members of the middleclass start eating more eat, that is driving up demand. IMO biofuels are a small -but growing part of the problem. Note also that modern mechanized farming can be thought of as a process that turn oil into food. As the oil price increases, the price of key agricultural inputs rises.

[anne]

Tom:

"IMO biofuels are a small but growing part of the problem."

Report after report, from country after country, is recording biofuels as a large and growing part of the problem.

[anne]

http://krugman.blogs.nytimes.com/2008/02/22/demon-ethanol/

February 22, 2008

Demon Ethanol
By Paul Krugman

I'm almost never censored at the Times. However, I was told that I couldn't use the lede I originally wrote for my column * following the 2007 State of the Union address, in which Bush made ethanol the centerpiece of his energy strategy: "Before the State of the Union address, there had been hints and hopes that President Bush would offer a serious plan to reduce our dependence on imported oil. Instead, however, he took refuge in alcohol."

Well, anyway — the news on ethanol just keeps getting worse. ** Bad for the economy, bad for consumers, bad for the planet — what's not to love?

* http://select.nytimes.com/2007/01/29/opinion/29krugman.html

** http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aUIPybKj4IGs

[anne]

http://matthewyglesias.theatlantic.com/

Ferburary 22, 2008

Cross of Corn
By Matthew Yglesias

The subject of King Corn's destructive iron grip * on the United States can drive people a bit up the wall. Paul Krugman, for example, relates a rare bit of editorial interference ** from The New York Times:

However, I was told that I couldn't use the lede I originally wrote for my column following the 2007 State of the Union address, in which Bush made ethanol the centerpiece of his energy strategy: "Before the State of the Union address, there had been hints and hopes that President Bush would offer a serious plan to reduce our dependence on imported oil. Instead, however, he took refuge in alcohol."

Similarly, when I was in Chuck Schumer's office we were putting together some anti-ethanol talking points for Schumer to use in a committee hearing or on the senate floor or something and I wanted to include something about how "you shall not crucify mankind upon a cross of corn" but that was deemed (correctly) to be over the top. Still, this is what happens when an uncontroversially correct policy argument, widely agreed to by experts from all ideological points of view, runs headlong into a deadly mix of special interest politics and America's idiosyncratic corn-boosting political institutions.

* http://select.nytimes.com/2007/01/29/opinion/29krugman.html

** http://krugman.blogs.nytimes.com/2008/02/22/demon-ethanol/

[anne]

http://www.earthpolicy.org/Updates/2008/Update69.htm

January 24, 2008

Why Ethanol Production Will Drive World Food Prices Even Higher in 2008
By Lester R. Brown

We are witnessing the beginning of one of the great tragedies of history. The United States, in a misguided effort to reduce its oil insecurity by converting grain into fuel for cars, is generating global food insecurity on a scale never seen before.

The world is facing the most severe food price inflation in history as grain and soybean prices climb to all-time highs. Wheat trading on the Chicago Board of Trade on December 17th breached the $10 per bushel level for the first time ever. In mid-January, corn was trading over $5 per bushel, close to its historic high. And on January 11th, soybeans traded at $13.42 per bushel, the highest price ever recorded. All these prices are double those of a year or two ago.

As a result, prices of food products made directly from these commodities such as bread, pasta, and tortillas, and those made indirectly, such as pork, poultry, beef, milk, and eggs, are everywhere on the rise. In Mexico, corn meal prices are up 60 percent. In Pakistan, flour prices have doubled. China is facing rampant food price inflation, some of the worst in decades.

In industrial countries, the higher processing and marketing share of food costs has softened the blow, but even so, prices of food staples are climbing. By late 2007, the U.S. price of a loaf of whole wheat bread was 12 percent higher than a year earlier, milk was up 29 percent, and eggs were up 36 percent. In Italy, pasta prices were up 20 percent.

World grain prices have increased dramatically on three occasions since World War II, each time as a result of weather-reduced harvests. But now it is a matter of demand simply outpacing supply....

[anne]

Joseph Stiglitz however is going about trying to explain how it was that massive increases in military spending along with tax reductions, how it was that war and occupation driven by borrowing threatened to drain credit neeed for private domestic investment, so that the Federal Reserve increased liquidity to allow for reasonable private investment. The argument Stiglitz makes is that the Fed financed the credit boom in housing and gave no attention to the way in which credit was being used.

We are in the midst of spending $3 trillion because of war and occupation, and the effects of the spending and the way in which the spending has been financed is critically important, but where are economists courageous enough to aress the issue? Why is Stiglitz so alone?

[anne]

Why are the economic implications of $3 trillion in military driven spending impossible for so many superb economists to address? What do we have to do to get Brad DeLong to pay attention to Joseph Stiglitz? I suppose we could claim the Stiglitz is secretly supporting Fidel Castro, but that would be wrong.

[bigTom]

anne:
I am of no doubt, that the food to fuel mania is a part of the problem. It is easy to overestimate the magnitude of the effect however. In the US, corn is grown primarily for livestock feed. A byproduct of the corn ethanol is used as cattle feed, the amount of the lost foodvalue of the corn in making ethanol is much smaller than a hundred percent. When evaluating the societal value of a process/industry, all of the inputs, and outputs must be considered. This does not change the picture enough to make corn ethanol a net positive IMO, but we have to be careful about the precision and validity of the numbers we use in our arguments. Too many sources of numbers are leaving out the parts of the calculation that are inconvenient to their favored conclusion.

[anne]

http://www.reuters.com/article/topNews/idUSN2921527420080302

February 2, 2008

Iraq War Hits US Economy: Nobel Winner
By Reuters

The Iraq war has contributed to the US economic slowdown and is impeding an economic recovery, Nobel-winning economist Joseph Stiglitz says.

[anne]

Tom:

"I am of no doubt, that the food to fuel mania is a part of the problem. It is easy to overestimate the magnitude of the effect however."

I will rely on your explanations; but I am finding United Nations warnings from Afghanistan to South Africa about rising food prices and cautious attributions to fuel crop planting, rising fuel prices, patterns of what seem to be climate change and environment depredation extending increasingly to fresh and salt water resources.

[Emma Anne]

I'm with Anne. Having these discussions without talking about the trillion dollars wasted in Iraq is like dusting the nicknacks while ignoring the sinkhole in the living room floor.

[MouseJunior]

"It did get me wondering, though, why such a steep increase right now? ... That's the only recent relevant disaster that comes to mind off the top of my head."

You forget the current state of the financial markets. There's a lot of money sloshing around looking for a place to grow; bond yields are bad (when the bonds themselves aren't junk), stocks seem set for a fall, RE is tanking so a lot of people are directing it at commodities because "hey, people need to eat, right?"

No, it's not rational. Bubbles rarely are.

[anne]

http://krugman.blogs.nytimes.com/2008/03/02/the-economy-never-really-got-its-groove-back/

March 2, 2008

"The Economy Never Really Got Its Groove Back"
By Paul Krugman

Mark Zandi of economy.com, quoted * in this New York Times piece on the weak job market, has a nice turn of phrase for what I've been trying to say on a number of occasions: even during the best years of the "Bush boom," the job market never got remotely as good as it was in the late 1990s. The official unemployment rate has been a deceptive indicator; the employment-population ratio ** has been a much better guide to how the economy feels.

* http://www.nytimes.com/2008/03/02/business/02jobs.html

** http://krugman.blogs.nytimes.com/2008/01/04/employment-a-tale-of-two-administrations/

[anne]

http://krugman.blogs.nytimes.com/2008/03/02/the-economy-never-really-got-its-groove-back/

March 2, 2008

"The Economy Never Really Got Its Groove Back"
By Paul Krugman

Mark Zandi of economy.com, quoted * in this New York Times piece on the weak job market, has a nice turn of phrase for what I've been trying to say on a number of occasions: even during the best years of the "Bush boom," the job market never got remotely as good as it was in the late 1990s. The official unemployment rate has been a deceptive indicator; the employment-population ratio ** has been a much better guide to how the economy feels.

* http://www.nytimes.com/2008/03/02/business/02jobs.html

** http://krugman.blogs.nytimes.com/2008/01/04/employment-a-tale-of-two-administrations/

[anne]

http://krugman.blogs.nytimes.com/2008/01/04/employment-a-tale-of-two-administrations/

January 4, 2008

Employment: a Tale of Two Administrations
By Paul Krugman

For some perspective on the jobs picture, here's the employment-population ratio — the percentage of adults with jobs — since the beginning of the Clinton administration.

[Picture] *

I think the picture speaks for itself.

OK, maybe it doesn't. What it shows is that the "Bush Boom" was really fairly pitiful compared with the boom under Clinton, both in magnitude and in duration.
Does this mean that Clinton gets all the credit for the good things that happened on his watch? No. But bear in mind that the Bushies have been claiming that the modest upturn from mid-2003 to late 2006 validates everything they've done.

* Picturing Paul Krugman's picture:

The job creation number through the Presidency of Bill Clinton was actually 225,000 a month, with total job creation of 21.6 million. Taking the favored 52 months of the Bush Presidency, from August 2003 to December 2007, 8.3 million jobs have been created or 160,000 jobs created a month. ** That is almost 3.4 million fewer jobs created during the 52 most favored months of the Bush Presidency.

We created 2.7 million jobs a year from 1992 to 2000, but we were only at 1.3 million in 2007. We were about 92,700 a month for the final quarter in 2007.

** http://www.whitehouse.gov/news/releases/2008/01/20080104-2.html

[anne]

I'm with Emma Anne (so nice they named her twice):

"Having these discussions without talking about the trillion dollars wasted in Iraq is like dusting the nicknacks while ignoring the sinkhole in the living room floor."

[zinc]

Why don't they try 50 pct (or higher) margin on futures ? Personally, I favor an automatic, sliding margin requirement that kicks in as the speculative money drives the price of commodities sky high.

Excess liquidity from the Fed is probably the source.

[Mr Punch]

I agree that the war's a waste, but Robert J. Gordon's post is the important one here. (After all, getting out of Vietnam didn't help inflation much that time, did it?) I suspect that the main reasons for the slow feed-through from commodity prices are (1) oil is less critical to the economy than it was, and (b) food prices don't work quite the same way as oil prices, because while we have to eat, we have more choices.

[dennisS]

"...and having the houses they were evicted from turned into meth labs."

Thereby increasing the supply of amphetamines, driving down the cost of stimulants (cheaper Starbucks!), which leads to increases in productivity (plus the side-benefit of stemming the tide of obesity), the dollar rises, property values stabilize, balance is restored. It's all good.

Sorry, very unserious. It just had the feel of a future freakonomics piece and I couldn't resist.

What's that you say? Yes, the extra glass of wine had something to do with my tiny bit of levity. I'm way concerned and needed a laugh.

[derrida derider]

Yep, Professor Gordon hit the mark. The commodities boom represents a one-off reduction in real US incomes - more precisely a transfer of real income to the commodity producing countries. There are only a limited number of ways that loss can be distributed.

The Fed now seeks to use the greenback's reserve currency status to cover the loss by debauching the currency. They hope that unanticipated inflation will make foreign bondholders carry much of the loss.

But this is high risk. Apart from the serious longer term effects (there's a limit to the number of times you can do that before the greenback is no longer the world's reserve currency, plus once inflationary expectations are created you can't get rid of them without lots of pain), it depends on people not understanding what you're doing until it's too late (ie being slow to form those expectations).

And yeah, it's true that without that imperial overstretch the US wouldn't have had to borrow so much. Something is seriously wrong with priorities when the US is spending more on "defence" than the rest of the world put together while at the same time mortgaging its future.

[Randy Owens]

Mouse Junior: "You forget the current state of the financial markets. There's a lot of money sloshing around looking for a place to grow; bond yields are bad (when the bonds themselves aren't junk), stocks seem set for a fall, RE is tanking so a lot of people are directing it at commodities because 'hey, people need to eat, right?'"

Dammit, of course. And that's exactly what the book I'm reading right now is going on about, though it's puzzled me somewhat, on account of the apparent paradox (at least to me) that with the oversupply of capital "sloshing around", there's still such a high rate of return on investment expected.

If this food commodity trend continues, I wonder if we might be on a track to finally see hard proof of a Giffen good in action. Exciting times!

[Charles]

Anne, you are correct. This is classic war-driven inflation. But we are forbidden to think of solutions that might actually change things. Even very bright people inhibit their natural wisdom to conclude very silly things.