Getting in Touch with My Inner Austrian: A Still-Unwritten Paper

Hoisted from Archives:

Fragment of an Unfinished Ms.: Part II of an unfinished paper, "After the Bubble." The paper currently lacks Parts I, III, IV, V, and VI:

II. Aggressively Expansionary Monetary Policy and Macroeconomic Vulnerabilities:

Let us begin with a passage from Mussa (2004), "Global Economic Prospects: Bright for 2004 but with Questions Thereafter" (Washington: Institute for International Economics: April 1), in which Michael Mussa writes about global financial imbalances:

Michael Mussa: ... Policy interest rates are exceptionally low in most industrial countries: zero in Japan and Switzerland, 1 percent in the United States, 2 percent in the euro area, and at or near historic lows in the United Kingdom and Canada.... The very low level of policy interest rates is an imbalance (relative to normal conditions) that reflects exceptionally easy monetary policies to combat economic weakness. This policy imbalance poses an important challenge for the future conduct of monetary policy. Situations of low policy interest rates and low inflation tend to be associated with unusual inertia in the processes of general price inflation, which makes traditional indicators of rising inflationary pressures less reliable as measures of the need to begin to tighten monetary conditions. Also, these situations tend to be associated with high valuations of equities, real estate, and long-term bonds, which can become fertile ground for large, unsustainable increases in asset prices. In this situation, if monetary policy is tightened too much too soon (perhaps because of worries about unsustainable increases in asset prices), the result can be an unnecessary asset market crunch and economic slowdown, and monetary policy may have relatively little room to ease in order to counteract this outcome.

On the other hand, if monetary policy remains too easy for too long (perhaps because subdued general price inflation gives no clear signal of the need for monetary tightening), then large asset price anomalies may develop before corrective action is taken. The monetary authority would then confront the grim choice of trying to keep an unsustainable asset price bubble alive or trying to combat the collapse of such a bubble without a great deal of room for monetary easing.

A further concern related to the general monetary policy imbalance in the industrial countries is its effect on emerging market economies. Interest rate spreads for emerging market borrowers have contracted substantially and flows of new credit have increased. The boom in emerging market credit has not yet reached the frenzy of the first half of 1997, but it is headed in that direction. Another major series of emerging market financial crises (such as 1997-99) does not seem likely in the near term in view of the very low level of industrial country interest rates and the favorable global economic environment for emerging market countries. By 2005 or 2006, however, either upward movements in industrial country interest rates or deterioration of market perceptions of the economic and financial stability of some emerging market countries could trigger another round of crises.

Mussa is warning that the high asset prices produced by very low interest rates pose dangers that may turn out to be substantial. One way to read Mussa's warning is as a polite--a very polite--criticism of Alan Greenspan's self-praise of his own low interest-rate policy contained in Greenspan (2004), "Risk and Uncertainty in Monetary Policy" (Washington: Federal Reserve Board: January 3):

Alan Greenspan: Perhaps the greatest irony of the past decade is that... success against inflation... contributed to the stock price bubble .... Fed policymakers were confronted with forces that none of us had previously encountered. Aside from the then-recent experience of Japan, only remote historical episodes gave us clues to the appropriate stance for policy under such conditions. The sharp rise in stock prices and their subsequent fall were, thus, an especial challenge to the Federal Reserve. It is far from obvious that bubbles, even if identified early, can be preempted at lower cost than a substantial economic contraction and possible financial destabilization--the very outcomes we would be seeking to avoid.... The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble while preserving economic stability is almost surely an illusion.

Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences, we chose, as we noted in our mid-1999 congressional testimony, to focus on policies "to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion."

During 2001, in the aftermath of the bursting of the bubble and the acts of terrorism in September 2001, the federal funds rate was lowered 4-3/4 percentage points. Subsequently, another 75 basis points were pared, bringing the rate by June 2003 to its current 1 percent, the lowest level in 45 years. We were able to be unusually aggressive in the initial stages of the recession of 2001 because both inflation and inflation expectations were low and stable. We thought we needed to be, and could be, forceful in 2002 and 2003 as well because, with demand weak, inflation risks had become two-sided for the first time in forty years.

There appears to be enough evidence, at least tentatively, to conclude that our strategy of addressing the bubble's consequences rather than the bubble itself has been successful. Despite the stock market plunge, terrorist attacks, corporate scandals, and wars in Afghanistan and Iraq, we experienced an exceptionally mild recession--even milder than that of a decade earlier. As I discuss later, much of the ability of the U.S. economy to absorb these sequences of shocks resulted from notably improved structural flexibility. But highly aggressive monetary ease was doubtless also a significant contributor to stability...

Greenspan is confident that raising interest rates and thus raising the unemployment rate during the bubble of the late 1990s would have been the wrong policy, and that aggressively lowering interest rates after the bubble was the right policy. Lowering interest rates cushioned falls in bond prices. Lowering interest rates made use of bond financing for investment more attractive. Lowering interest rates boosted bond and real estate prices, induced households to refinance, and so provided a powerful spur to consumption spending that largely offset the post-bubble fall in investment spending. In Greenspan's view, the aggressive lowering ofinterest rates was exactly the right thing to do in the aftermath of the bubble to shift spending from investment to consumption and so to keep the economy not far from full employment.

Mussa says: not so fast. Very low interest rates, coupled with assurances from high Federal Reserve officials that interest rates will stay very low for substantial periods of time, produce a situation in which the prices of long-duration assets--long-term bonds, growth stocks, and real estate--climb very high. What goes up may come down, and may come down rapidly. And should some class of asset prices come down rapidly and should it turn out that many debtors in the economy go bankrupt because their assets have lost value, serious financial crisis will result. The price of using exceptionally easy money to keep the collapse of the dot-com bubble from turning into a depression has been the creation of a three-fold vulnerability:

1. If the assets the prices of which collapse when interest rates start to rise are emerging-market debt, then the memories of the 1990s and increasing risk will induce large-scale capital flight from the periphery to the core--an echo of the East Asian financial crises of 1997-1998.
2. If the assets the prices of which threaten collapse when interest rates start to rise are domestic bond and real estate holdings that have been pushed to unsustainable levels by positive-feedback "bubble" buying, then the "monetary authority would... confront the grim choice of trying to keep an unsustainable asset price bubble alive or trying to combat the collapse of such a bubble without a great deal of room for monetary easing" to keep real estate and bond prices from falling far and fast.
3. "If monetary policy is tightened too much too soon" (presumably because of fears of positive-feedback "bubble" buying), the result may be a credit crunch and a recession--with no guarantee that a reversal of the monetary policy tightening will undue the effects of the credit crunch. I do not believe that many economists would say that Mussa's fears about the potential macroeconomic vulnerabilities created by the low interest-rate policy the Federal Reserve has pursued since the end of the dot-com bubble are unreasonable. (Few, however, carry their alarm to the degree that Stephen Roach of Morgan Stanley does.) And Mussa expresses them in a coherent language--one in which sustained rises in asset prices induce positive-feedback trading that "bubbles" prices above fundamentals, one in which what goes up comes down rapidly, one in which large sudden falls in asset prices produce chains of bankruptcy and raise risk and default premia enough to threaten to cause deep recessions. The language has echoes of the great Charles P. Kindleberger's (1978) Manias, Panics, and Crashes (New York: Basic Books), and of earlier writings about the consequences of excessive money-printing: "inflation, revulsion, and discredit."

But what Mussa's assessment of risks lacks is a model. And without a model, we have a hard time assessing his argument. Alan Greenspan frightened away the Evil Depression Fairy in 2000-2002 by promising not that he would let the Evil Fairy marry his daughter but by promising high asset prices--unsustainably high asset prices--for a while. Whether this was a good trade or not depends on the relative values of the risks avoided and the risks accepted. And to evaluate this requires a model of some sort.

References:

Alan Greenspan (2004), "Risk and Uncertainty in Monetary Policy" (Washington: Federal Reserve Board: January 3).

Michael Mussa (2004), "Global Economic Prospects: Bright for 2004 but with Questions Thereafter" (Washington: Institute for International Economics: April 1)

Comments

[Neal]

The question of "Who could have predicted...", is answered again.

[a]

"And without a model, we have a hard time assessing his argument. "

I'll confess to think that it is a methodological flaw in economics to suppose that it is important always to have a model (by which I'm taking you mean lots of mathematical formula representing the underlying, "real" situation). I guess formula give the advantage of precision; but then I don't have any problem understanding what Mussa said, so I'm not sure what formulas would clarify.

Do formulas make it easier to test empirically? I guess, but I would think this kind of thing seems to me to be pretty hard to test. (And no matter what, formulas would be destined to fail, because the underlying reality is always more complicated.)

So - serious, honest question here - in what way would a model add to Mussa's description? If modern economics has a hard time assessing Mussa's argument, is that a flaw in the argument, or a flaw in economics?

[Craig Tindale]

The problem with models is that "knees" are hidden behind imperfect data, economics math is not reflecting the math of natural law, in the following excerpt from one of Bernankes papers he infers several linear exponentials in his sugggested monetary measures, where monetary measure must have S curve just like everything else in nature, if we take the exponential knee of the S curve to be in the mid 1990's then the top of s curve about now then we have reached the limits of monetary measures and debt saturation, more monetary viagra less effect, it basically just hieghtens the curve and subsequent inverions of the S to Bell

Good work though the Austrians understood the curves S and B

How is it for instance we can ignore the credit and debt cycle in setting long run price stability scenarios, or for that matter Schumpeter and Minksy concepts of mal investment within those cycles

According to Bernanke credit has no upward bound ?????

Today ivory tower US economists are some of the niave and in some cases stupid in the history economics, "oh why oh why cant we get better economists?"

Brad your intellectual Minsky moment is upon you.:)

Some takes from Berankes paper;-

>If you want to increase demand you just print more money and increase inflation

The general argument that the monetary authorities can increase aggregate demand and prices, even if the nominal interest rate is zero,is as follows: Money, unlike other forms of government debt, pays zero interest and has infinite maturity. The monetary authorities can issue as much money as they like. Hence, if the price level were truly ndependent of money issuance, then the monetary authorities could use the money they create to acquire indefinite quantities of goods and assets. This is manifestly impossible in equilibrium. Therefore money
issuance must ultimately raise the price level, even if nominal interest rates are bounded at zero.

>inflation targeting is smoke and mirrors for the markets consumption (propaganda thats self for filling but does it reduce Fed credibility)

a framework that would have avoided many of the current troubles, I believe, if it had been in place earlier.
BOJ officials have strongly resisted the suggestion of installing an explicit inflation target. Their often-stated concern is that announcing a target that they are not sure they know how to achieve will endanger the Bank¡¦s credibility; and they have expressed skepticism that simple announcements can have any effects on expectations. On the issue of announcement effects, theory and practice suggest that ¡§cheap talk¡¨ can in fact sometimes affect
expectations, particularly when there is no conflict between what a¡§player¡¨ announces and that player¡¦s incentives. The effect of the announcement of a sustained zero-interest-rate policy on the term structure in Japan is itself a perfect example of the potential power
of announcement effects.

>Depreciation of the yen (or in the current case the US dollar) is the theme throughout this paper

as the Japanese economy has fallen back into recession. Since interest rates on yen assets are very low, this appreciation suggests that speculators are anticipating even
greater rates of deflation and yen appreciation in the future. I agree with the recommendations of Meltzer (1999) and McCallum (1999) that the BOJ should attempt to achieve substantial depreciation of the yen, ideally through large open-market sales of yen.

>creating import price inflation

Through its effects on import-price inflation (which has been sharply negative in recent years), on the demand for Japanese goods, and on expectations, a significant yen depreciation would go a long way toward jump-starting the reflationary process in Japan.

>a determined central banker can cause the currency to deprecate

The important question, of course, is whether a determined Bank of Japan would be able to depreciate the yen. I am not aware of any previous historical episode, including the periods of very low interest rates of the 1930s, in which a central bank has been unable to devalue
its currency.

>how do you drive down your own currency and is it really the worst that could happen?

In short, there is a strong presumption that vigorous
intervention by the BOJ, together with appropriate announcements to influence market expectations, could drive down the value of the yen significantly. Further, there seems little reason not to try this strategy. The ¡§worst¡¨ that could happen would be that the BOJ would greatly increase its holdings of reserve assets.

>or if you want to keep the currency strong you can divert money to domestic households (or the home equity atm)

Suppose that the yen depreciation strategy is tried but fails to raise aggregate demand and prices sufficiently, perhaps because at some point Japan¡¦s trading partners do object to further falls in the yen. An alternative strategy, which does not rely at all on trade diversion,
is money-financed transfers to domestic households¡X-the real-life equivalent of that hoary thought experiment, the ¡§helicopter drop¡¨ of newly printed money.

>growth in money equals inflation

I think most economists would agree that a large enough helicopter drop must raise the price level. Suppose it did not, so that the price level remained unchanged. Then the real wealth of the population would grow without bound, as they are flooded with gifts of money from the government¡X-another variant of the arbitrage argument made earlier. Surely at some point the public would attempt to convert
its increased real wealth into goods and services, spending that would increase aggregate demand and prices. Conversion of the public¡¦s money wealth into other assets would also be beneficial, if it raised the prices of other assets.

>taxes go up and spending goes up its neutral

The newly circulated cash bears no interest and thus has no budgetary implications for the government if prices remain unchanged. If instead prices rise, as we anticipate, the government will face higher nominal spending requirements but will also enjoy higher nominal tax receipts
and a reduction in the real value of outstanding nominal government
debt.

>you don¡¦t need to increase taxes you just raise inflation so that the lower taxes provide increased govt revenue because there is more money

To a first approximation then the helicopter drops will not
erode the financial position of the government and thus will not induce a need for extraordinary future taxes.

>So you cut taxes and increase monetary supply

Of course, the BOJ has no unilateral authority to rain money on the population. The policy being proposed¡X-a money-financed tax cut¡X- is a combination of fiscal and monetary policies.

> So the world would need to inflate together

All this means is that some intragovernmental cooperation would be required. Indeed, the case for a tax cut now has already been made, independent of monetary considerations (Posen, 1998); the willingness of the BOJ to purchase
government securities equal to the cost of the tax cut would serve to reduce the net interest cost of the tax cut to the government, possibly increasing the tax cut¡¦s chance of passage.

> It¡¦s the role of the central bank to stabilize prices

In financing a tax cut, the BOJ would be taking a
voluntary action in pursuit of its legally mandated goal, the pursuit of price stability. Cooperation with the fiscal authorities in pursuit of a common goal is not the same as subservience.

>but in the process don't bail out banks (oh the irony)

In thinking about nonstandard open-market operations, it is useful to separate those that have some fiscal component from those that do not. By a fiscal component I mean some implicit subsidy, such as would arise if the BOJ
purchased nonperforming bank loans at face value, for example (this is of course equivalent to a fiscal bailout of the banks, financed by the central bank). This sort of money-financed ¡§gift¡¨ to the private sector would expand aggregate demand for the same reasons that any money-financed transfer does.

> and the Central Bank cant do that kind of thing anyway

Although such operations are perfectly sensible from the standpoint of economic theory, I doubt very much that we will see anything like this in Japan, if only because it is more straightforward for the Diet to vote subsidies or tax cuts directly. Nonstandard open-market operations with a
fiscal component, even if legal, would be correctly viewed as an end run around the authority of the legislature, and so are better left in the realm
of theoretical curiosities.

>so instead you purchase assets eg bonds at market value this way you raise asset prices and in turn stimulate spending (does this sound familiar!!!!!!!!!)

A nonstandard open-market operation without a fiscal component, in contrast, is the purchase of some asset by the central bank (long-term government bonds, for example) at fair market value. The object of such purchases would be to raise asset prices, which in turn would stimulate
spending (for example, by raising collateral values).

>So maybe the fed could start purchasing foreign currencies then they could deprecate it owns currency

I think there is little doubt that such operations, if aggressively pursued, would indeed have the desired effect, for essentially the same reasons that purchases of
foreign-currency assets would cause the yen to depreciate. To claim that nonstandard open-market purchases would have no effect is to claim that the central bank could acquire all of the real and financial assets in the
economy with no effect on prices or yields.

>So the central bank begins acquiring targeted asset which rise in value

Of course, long before that would happen, imperfect substitutability between assets would assert itself,
and the prices of assets being acquired would rise.
As I have indicated, I doubt that extensive nonstandard operations will be needed if the BOJ aggressively pursues reflation by other means. I would hope, though, that the Japanese monetary authorities would not hesitate to
use this approach, if for some reason it became the most convenient.

>and this in turn would be neutral to the central banks balance sheets

It is quite disturbing that BOJ resistance to this idea has focused on largely extraneous issues, such as the possible effects of nonstandard operations on the Bank¡¦s balance sheet.

[G.]

The American Economy was "debased" while our government went from Democracy to Corporatism.

The Bush Administration has cooked the books concerning GDP, employment, inflation and other numbers released monthly by the US Bureau of Labor Statistics. Garbage in… garbage out????

The hedge fund, mortgage and banking liquidity crisis, soon to be a solvency crisis, is just a "catalyst." America and the rest of the world economies are now headed towards a major recession. However, many European countries will exit the recession years before America do to economies based upon higher paying manufacturing jobs providing pensions and other benefits for their citizens. Unfortunately Congress, the Elitist top 1% and US Corporations outsourced America Industry to 3rd world countries. Therefore, American will spend years rebuilding its "former" self. Its industrial based economy that for sixty plus years provided most Americans with a high standard of living, pensions, benefits and plenty of excess cash to spend buying 30% of the worlds manufactured products.

Somebody tell Greenspan and Bernanke the American economy has been "debased". However, this time its America’s Service Industry based economy with its low paying jobs, lack of pensions and/or benefits that turns this recession into a depression... lasting years.

[Pete]

I suppose we could try constructing a model of the trade-off between the targets of general price-output stability and asset price stability using the one instrument of interest rate policy.

However, maybe we could, inspired by Jan Tinbergen, think about adding another instrument. That, I think was Greenspan's main mistake; not low interest rates to avoid recession but, rather, not looking for another instrument to match up with asset price inflation (coulda been something like using margin requirements in the '90s, or being more aggressive in regulating lending standards prior to the real estate bubble).

[Frank the sales forecaster]

Dang I am so confused. I thought what happened was:

GDP growth reported @ 3.7%, 3.9%, 3.2% and 3.4% for the last 4 years was restated, all downward, to 3.1%, 3.6%, 3.1% and 2.9% (in the first week in August.) With 2006 GDP growth of only 2.9% the Fed Funds rate of 5.5% was way too high, and in fact the Fed Funds rate had begun to be excessive early 2006. The high interest rates attracted more capital than could be productively put to work. To get all this capital lent out required lowered credit standards and offering below cost of capital teaser rates. The over-supply of capital lead to no risk premium being present in the return offered investors. Too much capital chasing too few viable investments due to an overly high Fed Funds rate attracting/creating too much capital due to overstated GDP growth.

And, the overly high Fed Funds rate induces a recession.

What did I miss/get wrong?