J. Bradford DeLong's Grasping Reality with All Eight Tentacles

What Are the Central Bankers Thinking?

Ryan Avent calls for Ben Bernanke's head:

The threatened Fed: There is ample reason to feel that the recovery might be weak and jobless. Fed projections basically reflect this. The Federal Open Market Committee generally expects growth for the American economy in the neighbourhood of 2.5% to 3.5% in 2010, with the unemployment rate holding between 9.3% and 9.7%. Expectations for growth in 2011 and 2012 are higher, ranging roughly from 3% to 5%, and the FOMC believes that the unemployment rate might possibly fall as low as 6.8% by the end of 2012. That's five years after the onset of the recession.... Core inflation is forecast to reach no higher than 1.7%, even into 2012.

But the minutes reflect no inclination to do anything more than what has already been put in motion. Indeed, participants remain very concerned about how they'll pull back on their various interventions.... [I]t's hard to know quite what to say. There was some interesting writing last week on the subject of Fed independence and whether or not the central bank could actually generate some inflation, if it wanted to.... [T]he FOMC believes that it probably could... yet it will not, despite its own forecasts indicating that full employment—the maintenance of which is one of the Fed's primary goals—isn't likely to return for at least the next three years.

I noted last week that political control of monetary policy would inevitably lead to accelerating inflation. Central bankers seem to have warped this truth into its mistaken corollary—that price stability means never doing what political actors want, even if what they want is actually what's best. But now the Fed finds itself in a real bind. If it continues ignoring unemployment, then it may face angry legislators determined to rein in the central bank. If it agrees that taking more steps to try and engineer some inflation is a good idea, it may well be perceived to have given in to political pressure.

Another way to put this is to note that there's no avoiding the threat to Fed independence here; there is no safe path to protection of the sanctity of monetary policymaking. Given that, the best thing for the politicians to do may well be to try and put the central bank in a position where it feels confident enough to do the job it's actually supposed to do. And I think that means new blood. Replacing Mr Bernanke with someone publicly committed to focusing on all aspects of the central bank's mission...

Me? I can't see anyone I trust to better analyze central banking issues than Ben Bernanke. I would settle for the Federal Reserve's adoption of a formal 3% per year GDP deflator inflation target. Just saying.

Hoisted from the Archives (2002): Mark-My-Beliefs-to-Market Time: Argentina

Hoisted from the Archives:

Mark-My-Beliefs-to-Market Time: Archive Entry From Brad DeLong's Webjournal: I am reading Michael Mussa's brand-new very short book on the latest Argentinian financial crisis [Michael Mussa (2002), Argentina and the Fund: From Triumph to Tragedy (Washington: Institute for International Economics: 088132339X)]. In The Importance of Being Earnest, Oscar Wilde gets a laugh out of the idea that a chapter on a rupee crisis is too exciting for young ladies--out of the idea that a technical discussion of anything having to do with international finance can be anything but deadly boring. But reading this is different.

First, I'm weird: I'm an economist, which means (these days at least) that I don't even have the sparkle and flash, the willingness to take risks and go out on limbs, that accountants have. Second, the Argentine crisis is an important setback for human happiness--a much more important tragedy even than the closing of a Zambian copper mine. Plus the crisis has important lessons for international economic policy in the future.

Third, Michael Mussa--former chief economist at the IMF for a decade--is a fearless and witty guy: he (reportedly) spoke of his boss at the IMF, Michel Camdessus, as a man who was 'so optimistic he always sees the glass as half full, even when there's no glass at all'; in this book, he writes of the IMF following its standard approach when a government fails to meet the policy targets it has committed to--the standard 'three-monkeys approach: see no evil, hear no evil, speak no evil'; he writes of the proposals of the Meltzer Commission for IMF reform as '...unnecessary, unworkable... fundamentally misguided...'; and he writes of the Fund staff's spring 2001 analysis of the dynamics of Argentina's debt, '...if, if, if... if my grandmother had wheels, she would be a bus...'

Thus I had no trouble staying awake through the book.

Toward its end, Mussa calls for a thorough evaluation of the Fund's role in Argentina, an evaluation to take the broadest possible scope. He writes (p. 71) that:

.>.. it is my view that the Argentine government's basic decision to combine efforts at macroeconomic stabilization with market-oriented reforms was the right policy approach... the spectacular success of the Argentine economy throughout most of the past decade is attributable to this basic policy choice... the spectacular collapse in 2001 is due to the failure to implement this strategy sufficiently vigorously, especially in... fiscal discipline. Others... may be inclined to the view that the policies... are fundamentally wrong and were doomed form the start.... An evaluation of the Fund's role in Argentina should reflect on this broad question...

And so I have begun thinking: What if I wanted to make the argument that the neoliberal policy mix adopted by President Carlos Menem and Finance Minister Domingo Cavallo was a big mistake, that it was all doomed to failure from the beginning and should not have been undertaken, that from the moment he proposed his Convertibility Plan to stop Argentina's hyperinflation the Sunday Horse was pulling the Argentine cart down a track that led nowhere? What would that argument look like?

As I see it, such an argument would have five steps:

First, the neoliberal program pushed by Domingo Cavallo demanded free markets--the end to protectionism, the end to quantitative restrictions of all kinds, the end of limits on freedom of contract, and most importantly the end to controls on the ability of not just goods but money to flow into and out of Argentina, and the end of the government's ability to force Argentines to denominate their wealth in a unit of account--the peso--whose value it controlled.

Second, the neoliberal program pushed by Domingo Cavallo required a hard peg of the value of the peso to the dollar: nothing else would convince Argentines that the days of hyperinflation had passed, and that they no longer had to dissipate resources and waste time insuring themselves against inflation, but could trust the unit of account.

Third, Argentina is a country in which the government constantly promises the people more than it can deliver. It promises rich oligarchs that it will not collect too much in taxes. It promises workers and consumers a generous social insurance state. It promises rapid economic development, large expenditures on infrastructure, jobs for politically well-connected boys, and so forth. An unequal distribution of income and wealth, a lack of social comity between the working and the middle classes, a viciousness in politics going back to General Galtieri, the Dirty War, Juan Peron and his enemies, and even before means that claims on national product and demands that the government enforce those claims are inevitably going to mount up to more than 100% of what is available. The basic political fight over how national product is to be distributed among social classes is unresolved, and any political movement that makes only promises it can keep is doomed to rapid defeat.

Hence, fourth, in Argentina government deficits--large government deficits--are a law of nature, a fact of life. Moreover, everyone knows that large government deficits are a fact of life and a law of nature. Hence interest rates on Argentine debt will be low and reasonable only rarely and for short periods.

Fifth, points one through four mean that the neoliberal reform program in Argentina in the 1990s had exactly the same chance of avoiding disaster as one would expect if one gave a modern gene-splicing biochemistry lab to Doctor Frankenstein. The fundamental unresolved conflicts of Argentine politics mean that debt is going to mount. The fact that everyone knows that Argentine politics generates chronic deficits means that the interest payments due on that debt are likely to explode. Exploding interest payments mean that the dynamics of Argentine debt are unstable, and thus that the hard-currency exchange-rate peg cannot last. And free access to international capital markets, to dollar-denominated bank accounts, and so on, and so forth, means that when the crisis caused by the contradiction between the hard currency peg and the fundamentals of Argentine politics comes, it will be five times as bad: at least with tight controls on foreign exchange and a primitive, underdeveloped banking system, the amount of damage a government default can do to normal economic life is limited.

From this perspective, pushing neoliberal, market-opening reforms on Argentina looks as wise as giving a supply of gasoline to a bunch of pyromaniacs, on the grounds that gasoline is a very useful and powerful fuel.

My intellectual problem right now is that this argument I have just constructed--which was supposed to be a strawman that I, a card-carrying neoliberal, could easily demolish--feels too convincing.

Michael Mussa (2002), Argentina and the Fund: From Triumph to Tragedy (Washington: Institute for International Economics: 088132339X).

Bergsten, p. viii: "[Mussa's] conclusion that the Fund's last pre-crisis loan to Argentina in August 2001 was 'the greatest mistake the Fund made in my ten years there' is thus of considerable importance in the ongoing debate over this crucial and tragic case."

p. 3: "...in other cases... Mexico in 1995; Indonesia, South Korea, and Thailand in the Asian crisis... Brazil... a Fund-supported program was started only after the crisis was already under way. Thus, any failures of the Fund in the pre-crisis period were those of its relatively low-intensity surveillance activities. For Argentina, the failures of the Fund are clearly associated with the core of the Fund's [activities]... when it is providing financial assistance and when the policy and performance of the member are subject to the intense scrutiny of Fund conditionality..."

p.3: "The end result in Argentina has clearly been a disaster... not intended or, until recently, broadly anticipated--by the Argentine authorities, the Fund, or anyone."

p. 4: "...the Fund did make at least two important mistakes... failing to press the Argentine authorities much harder to have a more responsible fiscal policy, especially during the high growth years... extending financial support to Argentina during the summer of 2001, after it had become... clear that... efforts to avoid default and maintain the exchange rate peg had no reasonable chance of success."

pp. 5-6: "...if the Argentines had decided to move to an alternative, more flexible exchange rate and monetary policy regime that maintained reasonable monetary policy discipline, this would also have been acceptable to the Fund. Indeed, at least some in the Fund... would have welcomed serious consideration of such a move..."

p. 6: "As the crisis deepened... and the deficit targets set in the Fund-supported program were missed, the Argentine authorities sought to undertake further austerity measures. The Fund supported these efforts.... However, had the Argentine authorities decided at some time during 2000-2001 ... to pursue an alternative... debt restructuring and a possible change in the exchange rate regime, the Fund would have supported responsible efforts in this direction..."

pp. 9-10: "In sum, if things had broken more in Argentina's favor, this surely would have helped to preserve the success.... Enumerating the many things that contributed to Argentina's tragedy, however, should not obscure the critical, avoidable failure of Argentine economic policy that was the fundamental cause of the disaster--namely, the chronic inability of the Argentine authorities to maintain a responsible fiscal policy..."

pp. 15-16: "In sum, during the period 1993-1998 when the Argentine economy was performing very well [average annual real GDP growth rate of 4.1%] and the Argentina government was receiving substantial nonrecurring revenues from privatization and enjoyed other temporary fiscal benefits [that amounted to 2 percent of a year's GDP], the public-sector debt-to-GDP ratio nevertheless rose by 12 percentage points [from 29 to 41 percent of GDP]. This clearly was not an adequately disciplined or sustainable fiscal policy..."

p. 16: "Because most industrial countries have government debt-to-GDP ratios above 50 percent and some above 100 percent, it might be asked why a debt-to-GDP ratio of just above 40 percent was worrying for Argentina. There are at least five important reasons. First... Argentina has had little success in raising tax revenues (including social security contributions) of more than 20 percent of GDP.... Second... government debt denominated in foreign currency... held externally, Argentina faced the dual challenge of persuading creditors that it was capable both of raising sufficient fiscal revenues to service its debt and of being able to convert these revenues into foreign exchange with an exchange rate that was rigidly pegged to the U.S. dollar.... the ratio of external debt to exports... more than 400 percent.... Third, it is not just the level of the government debt... it is also how the debt has been behaving.... Fourth... Argentina... was potentially vulnerable to external economic shocks.... the collapse of Brazil's crawling-peg exchange rate in early 1999 had important negative spillovers... the debt-to-GDP ratio jumped from 41 percent in 1998 to 50 percent in 2000.... Fifth... Argentina was clearly vulnerable to changes in financial market sentiment... [that might become] self-fulfilling..."

p. 18: "When the actual fiscal deficit began to exceed the program targets during 1995 because of an economy that was weaker than expected, the Fund... showed unusual flexibility (by past Fund standards) in allowing an upward revision of the deficit target. In my view, this was the right approach.... Unfortunately, the Fund's flexibility... was not applied symmetrically. Starting in late 1995, the Argentine economy began three years of very rapid recovery... one would have expected that the Argentine government's fiscal deficit would have come in well below the permitted target... [but] it was just below or even slightly above.... During 1995, when the recession turned out to be steeper... there was plausible reason to grant waivers.... At other times... it is difficult to understand why the Fund did not make active use of its conditionality to press the Argentine government to maintain a more responsible fiscal policy.... And the fiscal targets were significantly less demanding than they appeared to be (even allowing for stronger-than-expected economic growth) because they conveniently ignored... government borrowing that were viewed by the Argentines as off-budget..."

p. 24: "...the fundamental choice of Argentina's monetary policy framework and exchange rate regime was a choice for the duly constituted government of Argentina. The Fund could advise.... However, the basic choice of regime is a decision of the [Fund] member--at least up to the point where the chosen regime has no reasonable chance of success.... Thus, though an independent observer might conclude that the rigidities of the [exchange rate] Convertibility Plan deserve relatively more weight, and the failures of Argentine fiscal policy relatively less weight, in the blame for the tragedy that ultimately befell Argentina, this is not the relevant perspective from which to view the role of the Fund. For the Fund, the relevant question was--given the choice of Argentina to adopt and maintain the Convertibility Plan--what other policies were necessary to make the stabilization and reform effort a success. Given the plan, failure to maintain a sufficiently prudent fiscal policy would likely prove a fatal error. The Fund, having accepted the Convertibility Plan, had the responsibility to press very hard to avoid this fatal error."

pp. 27-30: "For the Fund, the deteriorating situation in Argentina in the autumn of 2000 presented a critical challenge.... A star pupil that the Fund had praised and supported as a model of economic liberalization and reform was in danger of turning into a basket case.... One approach would have been to continue with an essentially standard Fund-supported program... [of] up to 100% of its Fund quota.... The main difficulty... was that... it was clearly inadequate. A second approach would have been to conclude that because of the continuing recession... further official [Fund] support would be available only on the condition that Argentina reach agreement with its private creditors that would substantially reduce its financing requirements in the coming years.... Necessarily, this rescheduling of private credits could not be entirely voluntary.... [A] decision by the Fund in late 2000 to press Argentina into a debt restructuring that would have amounted to a de facto sovereign default would have been a very weighty matter. The Argentine government was dead set against such action.... At the Fund... there was little enthusiasm for such an approach... the Argentine situation was not seen as without realistic hope.... The third approach... actually adopted... [was] levels of support substantially greater than in standard Fund-supported programs... the deficit target would be set so as to carefully balance the need to keep borrowing within responsible limits... against the very real economic and political difficulties of fiscal consolidation in a deepening recession. Official financing would... meet virtually all of Argentina's projected external financing requirements for 2001, assuming the program's fiscal objectives were met..."

pp. 45-8: "By August 2001... prospects for a favorable outcome were pure fantasy.... [I]nterest rate spreads... were... in the range of 1300 to 1600 basis points. This implied nominal interest rates for the Argentine sovereign... of 18 to 22 percent, with real interest rates even higher due to deflation. Economic recovery was impossible in this situation.... The Argentine government's fiscal policy... could not meet its targeted objectives.... The political consensus to raise the huge primary surplus... required to demonstrate sustainable debt dynamics... was, quite understandably, nowhere apparent.... An emergency injection of another $6 billion in cash from the Fund was urgently needed just to stave off immediate default and keep the farce going for another few months.... [A] wide range of analysts... often with differing views on many issues concluded that the game was over for Argentina. Only a fool would conclude otherwise. Why, then, did the Fund... acquiesce in this folly?... Here there was a failure of intellectual courage... and a failure of moral courage.... Argentina was not helped... assistance that was potentially far more valuable in helping to contain the damage once a de facto sovereign default had occurred was instead squandered in a futile effort to avoid the inevitable..."

pp. 60-64: "What should be the elements of the policy program...? Six elements can be delineated.

First, the program should be based on realistically optimistic economic assumptions... real GDP will likely fall 10 to 15 percent in 2002... the value of the peso at the end of 2002... 20 or 25 U.S. cents... domestic inflation... headed over 200 percent [in 2002]...

Second.. the government budget needs... the deficit... within the bounds of what can be financed without... hyperinflation.... Tax revenues are likely to be very low because of the economic collapse and very poor tax compliance... substantial costs to the government from dealing with the mess it has created in the Argentine banking system... the absolutely essential task of reining in the deficits of the provinces and terminating their discretionary authority to borrow...

Third... a reasonable framework for monetary policy... contain the initial inflationary surge from the collapse of the peso and then bring the inflation rate down to more moderate levels during the course of the next two years...

Fourth... [a] unified floating exchange rate... the peso inevitably will depreciate very substantially (from its old parity) in real terms--and even more so in nominal terms...

Fifth, something needs to be done to clean up the horrendous mess in the Argentine banking system.... Four actions of the Argentina government have made the banking system... insolvent.... (1) The government defaulted on its... own dollar-denominated debt... held by Argentine banks. (2) The government reneged on... the Convertibility Plan.... (3) The government mandated that dollar-denominated loans of Argentine banks were payable in pesos. (4) The government mandated that dollar-denominated deposits at Argentina banks be converted into pesos at a [higher] exchange rate...

The first three actions together effectively forced a massive write-down in the dollar value of [bank] assets... a write-down that was unavoidable.... The Argentine government.. lacked the political courage to tell the Argentine people... that the U.S. dollar value of their deposits... was being sharply reduced as a result of government actions. Instead, through the fourth action, the Argentina government sought to purvey the fiction that most of the dollar value of deposits could be preserved... and shift the blame for the losses of depositors from the government to Argentine banks. Now the Argentine public has, with good reason, lost confidence in the banking system and... the government.... Moreover, the owners of Argentine banks... robbed of all their invested capital... have little reason to believe any promises of the Argentine government... no incentive for [anyone]... to put in new capital to refloat the banking system... Sixth... signal their intention to pursue good-faith efforts to deal responsibly with their external sovereign debt.... [F]oreign creditors... need to recognize that... they will not be made whole, but... need to share in the enormous economic losses.... Argentine authorities must ensure that foreign investors are... not forced to accept disproportionately large losses...

p. 67: "The Fund is expected to... act both as a sympathetic social worker and as a tough cop."

"the 'three-monkeys approach' to dealing with government failures to meet policy targets that it has promised the Fund: see no evil, hear no evil, speak no evil..."

p. 71: "... it is my view that the Argentine government's basic decision to combine efforts at macroeconomic stabilization with market-oriented reforms was the right policy approach... the spectacular success of the Argentine economy throughout most of the past decade is attributable to this basic policy choice... the spectacular collapse in 2001 is due to the failure to implement this strategy sufficiently vigorously, especially in... fiscal discipline. Others... may be inclined to the view that the policies... are fundamentally wrong and were doomed form the start.... An evaluation of the Fund's role in Argentina should reflect on this broad question..."

p. 74: proposals of the Meltzer Commission as "...unnecessary, unworkable... fundamentally misguided..."

p. 78: of the Fund staff's spring 2001 analysis of Argentina's debt dynamics, '...if, if, if... If my grandmother had wheels, she would be a bus...'

More Central Bank Independence: The Fed in a Corner?

Tim Duy thinks that the Federal Reserve has backed itself into a corner. He is right that the Fed because it was independent was in a "better position to raise regulatory and supervisory roadblocks during the debt build-up compared to other, more politically susceptible agencies." But at the time the Federal Reserve did not see itself as in a much better position. As one extremely senior member of the FOMC told me in 2005: "We stand up and say: "We don't care that you lenders want to issue this mortgage and you homebuyers want to sign it, we won't let you!' and how long do we last in front of Congress?" And he calls for the Federal Reserve to declare war on all too-big-to-fail financial institutions.

I think Tim is broadly right. This was, in fact, the reason that I was calling for at least partial nationalization and the government's taking of proper equity stakes in the banks last fall. The worst outcome would have been not trying or failing to rescue the banking system. But rescuing the banking system in a way that leaves the public believing that bankers have profited and taxpayers lost--as the public now does--is also a bad place to be.

Tim Duy writes:

Free Exchange muses on central bank independence.

I haven't done a nose count on the FOMC. But it is pretty clear that right now it has too many inflation hawks on it and not enough unemployment hawks. The only saving grace is that other central banks are worse--some much worse.

In the 1970s the American Congress learned that it did not want to exercise oversight over the Federal Reserve--that opining and trying to influence was a political loser, because mistakes would be made and if you had pushed for the policies that produced them you took part of the blame.

Now it looks as though the Congress may be shifting its ground...

Free Exchange:

A big Fed mess: ALAN BLINDER opens a new Washington Post column with what I believe is the conventional wisdom:

The Federal Reserve's performance in this long-running financial and economic crisis deserves separate grades. For the early crisis period, from the summer of 2007 until a few weeks after the Lehman Brothers failure in mid-September 2008, the Fed's response was uneven. I would question several decisions. But the Fed deserves extremely high marks for its work since then. It has hit the bull's-eye regularly under very trying circumstances.

In academia and in the financial markets, the overwhelming attitude is: Hurrah, and thank goodness, for Ben Bernanke, who gets kudos for his boldness, creativity and smarts.  This is what economists seem to believe—that the Fed totally blew it where the housing bubble and oversight of financial markets, pre-crisis, were concerned, but in terms of shepherding the financial system through the crisis, and the economy through recession, Mr Bernanke and company have done a bang up job. But that doesn't really seem to be true. Any world in which the Fed is twiddling its thumbs while prices are flat-to-falling and unemployment is above 10% is not one where Fed policy is "hit[ting] the bull's-eye"....

An independent central bank is crucial. Political control of monetary policy must inevitably lead to accelerating inflation and long-run economic instability. But at the moment, the American economy could use an increase in expected inflation. And a real threat to Fed independence would almost certainly deliver it, either because markets would anticipate increased political influence on monetary policy ever after, or because the Fed would seek to fend off pressure from Congress by easing further, which amounts to the same thing. But we don't actually want there to be a real threat to Fed independence, because that way uncontrolled inflation lies.

How does one try to influence the Fed while simultaneously keeping it independent?... [I]t does no good for prominent, respected economists to continue heaping praise on a Fed that failed in its mission before the crisis and which is failing in its mission now. Because as unpleasant as the prospect of Congressional intervention in monetary policy is, two more years of high unemployment might well lead to far worse.

Three points to serve as background:

First of all, from the day after the collapse of Lehman Brothers, the policies followed by the U.S. Treasury and the U.S. Federal Reserve and the U.S. administrations have been very helpful. They have been good ones. The alternative--standing back and watching the markets deal with the situation--would have gotten us a much higher unemployment rate than we have now. Credit easing by the Fed and support of the banking system by the Fed and the Treasury have significantly helped the economy: have kept things from getting much worse.

Second, the fact that investment bankers did not go bankrupt last December and are profiting immensely this year is a side issue. Each extra percentage point of unemployment lasting for two years costs us $400 billion. A recession twice as deep as the one we have had would have cost us as a country some $2 trillion--and cost the world as a whole four times as much. In that scale and context the bonuses of Goldman Sachs are rounding error. And any attempt to make investment bankers suffer more last fall and winter would have put the entire support operation at risk: as Federal Reserve Vice Chair Don Kohn said, ensuring that a few thousands investment bankers receive their just financial punishment is a non-starter when attempts to do so put the jobs of millions of Americans--and tens of millions outside the United States--at risk.

Third, the Obama administration's fiscal boost program has also significantly helped the economy: aid to impacted states has been a big win, the jury is still out on the effect of the tax cuts in the stimulus, and the flow of government spending on a whole variety of relatively useful causes is in train and is boosting production and employment in the same way that everyone's boost to spending boosts production and employment. And the cost of carrying the extra debt incurred is extraordinarily low: $12 billion a year of extra taxes would be enough to finance the fiscal boost program at current interest rates, and for that cost American taxpayers will get an extra $1 trillion of produced goods and services and employment will be higher by about ten million job-years.

Thus the big valid complaints about policy over the past fourteen months are not that it has run up the national debt and not that it has rewarded the princes of Wall Street, but rather that it has, if anything, been on too small a scale--that we ought to have done more.

Yet these policies appear, somehow, to be political losers in Washington right now: nobody is proposing to do more along the same lines. This is strange: usually when something works the natural impulse is to do it again.

So what is going on?

Paul Krugman reads the tea leaves in what looks like the best piece of economic analysis I have read this month. When we do the things we do well, this is the kind of thing we do:

Interest rates: the phantom menace: From various bat squeaks I’ve put together a view of what I think lies behind the surprising — and damaging — deficit squeamishness of the Obama administration. So here’s what I think they’re thinking.... On the face of it, there’s no reason to be worried about interest rates on US debt. Despite large deficits, the Federal government is able to borrow cheaply.... Underlying these low rates is, in turn, the fact that overall borrowing by the nonfinancial sector hasn’t risen: the surge in government borrowing has in fact, less than offset a plunge in private borrowing.

So what’s the problem? Well, what I hear is that officials don’t trust the demand for long-term government debt, because they see it as driven by a “carry trade”: financial players borrowing cheap money short-term, and using it to buy long-term bonds. They fear that the whole thing could evaporate if long-term rates start to rise, imposing capital losses on the people doing the carry trade... driv[ing] rates way up, even though this possibility doesn’t seem to be priced in by the market.

What’s wrong with this picture?

First of all, what would things look like if the debt situation were perfectly OK? The answer, it seems to me, is that it would look just like what we’re seeing.... [T]he private sector is hurting, it’s spooked, and it’s looking for safety. So it’s piling into “cash”, which really means short-term debt.... Meanwhile, the public sector is sustaining demand with deficit spending.... [S]omeone has to be bridging the gap between the short-term assets the public wants to hold and the long-term debt the government wants to issue; call it a carry trade if you like, but it’s a normal and necessary thing. Now, you could and should be worried if this thing looked like a great bubble — if long-term rates looked unreasonably low given the fundamentals. But do they? Long rates fluctuated between 4.5 and 5 percent in the mid-2000s, when the economy was driven by an unsustainable housing boom. Now we face the prospect of a prolonged period of near-zero short-term rates... which should mean substantially lower long rates.... And if we’re facing a Japanese-type lost decade, which seems all too possible, long rates are in fact still unreasonably high.

Still, what about the possibility of a squeeze, in which rising rates for whatever reason produce a vicious circle of collapsing balance sheets among the carry traders, higher rates, and so on? Well, we’ve seen enough of that sort of thing not to dismiss the possibility. But if it does happen, it’s a financial system problem — not a deficit problem. It would basically be saying not that the government is borrowing too much, but that the people conveying funds from savers, who want short-term assets, to the government, which borrows long, are undercapitalized. And the remedy should be financial, not fiscal. Have the Fed buy more long-term debt; or let the government issue more short-term debt. Whatever you do, don’t undermine recovery by calling off jobs creation.

The point is that it’s crazy to let the rescue of the economy be held hostage to what is, if it’s an issue at all, a technical matter of maturity mismatch. And again, it’s not clear that it even is an issue....

I just don’t think the inner circle gets how much danger we’re in from another vicious circle, one that’s real, not hypothetical. The longer high unemployment drags on, the greater the odds that crazy people will win big in the midterm elections — dooming us to economic policy failure on a truly grand scale.

I am not sure Paul is correct when he says that the possible underlying problem is merely "a technical matter of maturity mismatch." The long Treasury market is thinner than many people think: it is not completely implausible to argue that it is giving us the wrong read on what market expectations really are because long Treasuries right now are held by (a) price-insensitive actors like the PBoC and (b) highly-leveraged risk lovers borrowing at close to zero and collecting coupons as they try to pick up nickles in front of the steamroller. And to the extent that the prices at which businesses can borrow are set by a market that keys off the Treasury market, an unwinding of this "carry trade"--if it really exists--could produce bizarre outcomes.

Bear in mind that this whole story requires that the demand curve slope the wrong way for a while--that if the prices for Treasury bonds fall carry traders lose their shirts and exit the market, and so a small fall in Treasury bond prices turns into a crash until someone else steps in to hold the stock...

This is something to think really hard about....

Who writes:

Out of running room: I THINK Brad DeLong misread this post of mine from yesterday as a shot at him. It wasn't. I agree with him that the constraints which seem to be draping themselves across American policy options are worrisome. I was more focused on those who seized on his earlier post, on how the whole AIG mess has likely soured the American public on big interventions, as a reason to refight old battles about the coddling of banksters. Those responses struck me as off base and unhelpful....

I have been trying, over the past few weeks, to argue that the Fed has been derelict in its duties. As Mr DeLong says in a different post:

Quantitative easing--pouring a whole bunch of cash in the system with the idea of never reversing the money stock expansion could boost spending and employment considerably by creating expectations of inflation and so reducing the spread--but the Federal Reserve is not going there, and regards the idea with horror, shock, and shame...

This seems to be true. At the same time, I think it will probably be easier to sway Fed officials (who are more likely to be impressed by economic arguments) than it will be to convince Congress to pass any kind of fiscal package large enough to have an effect despite the too-tight nature of monetary policy.

I don't like where the American economy is one bit. I think that the Fed is ignoring the political economy effects of its stance, and is therefore settling on an inappropriate policy. I hope that changes.

But I don't think drawing and quartering Lloyd Blankfein or Hank Greenberg will do any of us much good...

I do wonder how much good would be done if the FOMC were simply to stand up and announce that they were raising their long-term GDP-deflator inflation target from 2% to 3%. It might do a lot of good. And it is certainly something the Fed could do without cracking its credibility as committed to low inflation.

But they won't. We would need a very different FOMC than the one we have to consider such a move.

With respect to its: "That's the nature of many of these interventions—we all live to whine another day..."...

For the record, I wrote my piece not to "get a lot of links" but because I was trying to think through what the U.S. government could do over the next two years or so while the economy is flat on its back if it was hit by another big negative shock--as it is every 40 years or so. And I was coming up empty: credit easing does little; quantitative easing would require the resignation of the Fed governors and bank presidents; fiscal policy is out because of worries about the deficit; and banking policy is out because senators won't get out in front because everybody is making money off the TARP except for the government.

So what could we do? We might have to do something, after all, Odds 5%.

It (they?) writes:

Hindsight is occasionally blurry: BRAD DELONG got himself a lot of links yesterday by writing that efforts to save the banking industry last fall, by eroding public trust in government, increased the odds of a replay of the Great Depression from virtually nothing to 5%.... One side of this discussion is whether the government was actually able to handle things differently.... Economics of Contempt says no. I'm sympathetic to Mr Contempt's view, but I also think... the government could have come with something if it had wanted to. And I agree with Felix Salmon.... "[Y]es, given a bit more aggression and foresight, the Fed could have tried to cram down a haircut onto AIG’s counterparties. But at the time, no one was particularly interested in being harsh to the global financial sector; instead, they were trying to rescue it..."

Perhaps Mr DeLong is right, and America now faces a 5% probability of Depression. On the other hand, if you swapped out the folks who were in charge last fall with a group inclined to drive a hard bargain with the banks, you might find yourself in a world in which the Fed and the Treasury fail to convince markets that they'll do whatever they have to do save the financial system, in which a nasty cycle of deleveraging continues to drive important institutions into the ground, and in which the odds of Depression rise to 5%, or higher.

That's the nature of many of these interventions—we all live to whine another day...

Ummm... With respect to Felix, the key issue is not making AIG creditors take a haircut but rather making them share the upside with the government--as Chrysler shared the upside with the government with its loan guarantee program, as Al Gore was able to stand up there at the VP debate in 1996 and say that the U.S. had made money out of its bailout of Mexico.

If Free Exchange wants to ignore the fact that we are now out of macroeconomic running room, they are of course free to do so. But it might be more constructive for Free Exchange to help me think how we can get some of that running room back. We might need it. We might need it real bad.

Mark Thoma is alarmed by our president:

Economist's View: Obama's Wrong-Headed Thinking on the Deficit: Edward Harrison catches this quote from Obama....

Obama warned the United States' climbing national debt could drag the country into a "double-dip recession," though he said he's still considering additional tax incentives for businesses to reverse the rising unemployment rate. "There may be some tax provisions that can encourage businesses to hire sooner rather than sitting on the sidelines. So we're taking a look at those," Obama told Fox News' Major Garrett. "I think it is important, though, to recognize if we keep on adding to the debt, even in the midst of this recovery, that at some point, people could lose confidence in the U.S. economy in a way that could actually lead to a double-dip recession."

I hope his economic advisers set him straight, though I suppose there's a chance that this nonsense is coming from them. We needed a larger stimulus package to begin with, and the economy could still use more help, labor markets in particular. Let's hope that this doesn't turn into a call to actually start balancing the budget before the economy has fully recovered as that would increase the chances of the double dip recession that he is so worried about (something we should have learned from the 1937-38 experience where an attempt to balance the budget prematurely plunged the economy back into recession)...

One way to interpret this--which may or may not be wrong--is that right now we are really and truly fracked beyond previous imagining. Let's go back to the old ca. 1960 standard macroeconomic diagram, with the interest rate on the vertical axis and the economy's level of spending on the horizontal axis. We then have:

• A red curve the IS curve, which tells us what the economy's (real) spending level is--the sum of household spending on consumption, business spending on investment, net exports, all functions of this real interest rate, plus government purchases) as a function of the current value of the (real, long-term, risky) interest rate (and also of lots of other stuff that affects the position of the curve)...

• A blue curve, the LM curve, which tells us what the (short-term safe nominal) interest rate is as a function of the (nominal) spending level that is consistent with households' and businesses' being willing to hold the economy's current money stock...

• A double-headed orange arrow, the spread, the difference between the short-term safe nomina interest rate and the long-term risky real interest rate--the difference between the two being the sum of a term premium, an expected inflation rate, and a risk and default premium...

In this framework, the problem with credit easing--the central bank increasing the money supply now and moving the blue curve to the right without changing expectations of what the money stock will be in the long-term future--is that the curve has flat because cash and short-term Treasury bonds are close substitutes, so you expand the money supply by a lot while doing little to boost spending and employment and land yourself with the problem of unwinding the money stock increase in the future in a way that does not hurt spending and employment when you do so:

(Quantitative easing--pouring a whole bunch of cash in the system with the idea of never reversing the money stock expansion could boost spending and employment considerably by creating expectations of inflation and so reducing the spread--but the Federal Reserve is not going there, and regards the idea with horror, shock, and shame.)

In this framework, banking policy--recapitalizing banks further and issuing government guarantees to shrink the spread--boosts spending and employment even when, as now, cash and short-term Treasuries are close substitutes. The problem with banking policy today is that no member of congress of either party of any political persuasion wants to get out in front supporting it.

In this framework, the problem with fiscal expansion--the government purchasing a bunch more things right now and so shifting the red curve to the right--is that it boosts the supply of government bonds in the future and so may raise the double-headed orange arrow that is the spread, getting you absolutely nowhere:

So what can we do? Looks like we are well and truly fracked.

Well. maybe not. My position on further fiscal expansion is twofold:

• The claim that further government purchases would widen the spread might be true. It might now. Let's try it and see. The debt held by the public on Monday was $7,632,033,766,420.46. The debt held by the public a year and a half ago was $5,218,570,776,014.84. We have managed to boost the debt held by the public by $2,413,462,990,405.62 in eighteen months without materially moving the term premium significantly. (The risk premium has moved--there is a financial crisis on, after all.) So let's try it and find out.

• This is an opportunity. We really need to reduce the deficit after 2030. We really need to have more government purchases now. So raise spending now, and raise taxes and impose spending caps starting in 2013 so that by the end of the 20-year budget window the projected debt is unchanged. Thus we move the red line without increasing the spread: there's now increased supply of bonds in the long term to push up the interest rate on them. And we solve both our current near-depression problem and our post-2030 structural deficit problem.

Brother Joseph Gagnon makes a few points:

The Liquidity Trap Does Not Make Monetary Policy Ineffective: With short-term risk-free interest rates essentially at zero in the major developed economies, conventional monetary policy is in a liquidity trap. As a number of commentators have observed, printing zero-interest-rate money to buy zero-interest-rate assets has no real economic effect because the assets are near-perfect substitutes for money. But does that mean that central banks have lost their power? Jim Hamilton asserts that central bank purchases of other assets, with positive yields, can always create inflation, though he is silent as to whether they can affect output....

In recent months, central banks have purchased large quantities of longer-term assets. These purchases appear to have been effective at pushing down longer-term interest rates, which should stimulate economic activity. For example, the Federal Reserve (Fed) has purchased large quantities of longer-term agency-backed securities and Treasury bonds.... Fed communications about such purchases had substantial effects on a range of long-term interest rates, including on assets that were not included in the purchase program, such as interest rate swaps and corporate bonds.

Since March 19, the Fed has not made any substantive changes to its planned purchases of longer-term assets. Over this period, the 10-year Treasury yield has risen about 75 basis points and the corporate yield has fallen about 200 basis points, reflecting a relaxation of the extreme financial strains and flight-to-quality that characterized the first few months of this year. Conventional fixed mortgage rates, a key target of the Fed's policy easing, have changed little on balance since late March.

Paul Krugman has argued that potential gains and losses when long-term interest rates move make a policy of purchasing such bonds especially risky, and that fiscal stimulus is a safer bet. However, central banks, including the Fed, have always held risky assets, including long-term bonds, foreign exchange reserves, loans to private banks, and even equities. In many cases, such assets comprise the bulk of the central bank's portfolio.

A good definition of expansionary monetary policy is the printing of money to purchase financial assets. Expansionary fiscal policy is the selling of financial assets to purchase goods and services, to cut taxes, or to increase transfers. On these definitions, both monetary and fiscal policy can be effective when short-term interest rates are zero.

I would prefer to divide the policy universe into four categories:

• Monetary policy is the purchase or sale of Treasury bills for cash.
• Fiscal policy is the selling of bonds by the government to cover a deficit.
• Quantitative easing policy is the altering of market expectations of the long-run path of the money stock.
• Banking policy is the altering of the quantity, duration, or riskiness of the assets (other than Treasury bills) held by the private sector.

I think this provides the cleanest and closest to orthogonal basis for discussing macroeconomic policy.

But others may agree. This is a discussion for us Schoolmen and Schoolladies, and us Schoolmen and Schoolladies only...

Audio: Reed Public Policy Lecture (11.07.2009 03-14-36 PM)

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Posted via email from http://braddelong.posterous.com/reed-college-public-policy-lecture-todays-fin at Brad DeLong's Scrapbook

Hoisted from Comments: "a" writes:

Another Bad Employment Report - J. Bradford DeLong's Grasping Reality with All Eight Tentacles: "If we find ourselves in a financial-meltdown world where unemployment or inflation kisses 10%--then I will unhappily concede, and say that Greenspanism was a mistake." - BDL, 16 July 2008

So, it was a mistake, right?

Yes, it was a mistake. I hereby deny, abjure, and repent my previous allegiance to the gospel of "Greenspanism." I reject Greenspan, and all his works, and all his empty promises.

I will strive now to walk in the light.

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Curiously enough, this from my pre-Greenspanist phase actually looks pretty damn smart today...

J. Bradford DeLong (1999), "Should We Fear Deflation?" Brookings Papers on Economic Activity 1999:1 (Spring), pp. 225-252 http://www.jstor.org/stable/2534666

The Bureau of Labor Statistics reports:

The unemployment rate rose from 9.8 to 10.2 percent in October, and nonfarm payroll employment continued to decline (-190,000).... Since the start of the recession in December 2007, the number of unemployed persons has risen by 8.2 million, and the unemployment rate has grown by 5.3 percentage points.

Among the major worker groups, the unemployment rates for adult men (10.7 per- cent) and whites (9.5 percent) rose in October. The jobless rates for adult women (8.1 percent), teenagers (27.6 percent), blacks (15.7 percent), and Hispanics (13.1 percent) were little changed over the month. The unemployment rate for Asians was 7.5 percent, not seasonally adjusted.

The number of long-term unemployed (those jobless for 27 weeks and over) was little changed over the month at 5.6 million. In October, 35.6 percent of unemployed persons were jobless for 27 weeks or more. (See table A-9.)

The civilian labor force participation rate was little changed over the month at 65.1 percent. The employment-population ratio continued to decline in October, falling to 58.5 percent...

If you had told everyone last election day what would happen, economically, in 2009, what policies would they have adopted then to stem this disaster?

And why aren't we implementing those policies now?

Sam Brittan says something smart:

Sam Brittan’s Recipe for Recovery: Commercial banks certainly worsened the recession by greedily seeking higher returns than those provided by market interest rates; and they can put grit in the recovery by refusing to lend. I can only suggest making Paul Krugman, the radical Keynesian economist, Comptroller of the US Currency with over-reaching powers to take over old banks and initiate new ones, with similar appointments in other countries...

Paul Krugman says "ahem!":

I would... quarrel with designating me a “radical Keynesian.”... A perfectly standard New Keynesian model, with intertemporal optimization and all that — the kind of model that is standard in freshwater courses — says that under current conditions fiscal stimulus should be very strong, much stronger than what we’re actually doing. Ryan Lizza’s piece on the Obama economics team makes it clear that Christina Romer — whom nobody would call radical — reached more or less the same conclusions in her economic analysis that I did. The point is that what passes for “sound” economics these days (and maybe most days) isn’t actually sound economics — it’s economic analysis trimmed and softened to fit political realities/prejudices. Questioning that notion of soundness isn’t being radical; it’s just being intellectually honest.

To put it another way, Milton Friedman and Jacob Viner would fit Brittan's definition of "radical Keynesian" these days.

You gotta get demand up. You can do it by deficit spending. You can do it by convincing banks to lend and businesses to borrow. But you gotta do it somehow, by some means.

Glenn Greenwald issues marching orders:

How to avoid the GOP's mistakes during the Bush years?: The Atlantic's Marc Ambinder makes the following observation: "From day one of his administration, the left has held Barack Obama's feet to the fire way more than the right ever did to George W. Bush..." Is there any doubt that this is accurate?  I can't imagine how there could be.  And is there anyone who believes that this is a bad thing?  

It's worth remembering how the GOP and the Right treated Bush and the role they played in his presidency.... The Right's leading commentators saw their role as defending the Bush administration no matter what it did, rather than expressing their honest opinions.... Personalized hagiographies were churned out glorifying the President in borderline-religious tones. Conservative groups devoted themselves to blind defense of the White House.... Conservatives who criticized Bush were deemed the enemy and were excommunicated.... Those who, in general, criticized the President too harshly were deemed unpatriotic, standing with Terrorists, and suffering from personalized and emotional hatred (Bush Derangement Syndrome)....

One need only look at the entrenched rot that is now the conservative movement and the Republican Party to see what happens when that mentality prevails, when internal dissent is treated as blasphemy and well-intentioned critics are deemed suspect and even harmful to The Cause...

We hear and obey.

On my issues:

(1) The Obama administration argued in December and January that it should seek a consensus position on dealing with the financial crisis and recession rather than push for first-best policies--larger short-term deficit spending, more money for banking recapitalization, more stringent regulation of and control of financial services (especially much more aggressive regulation of executive compensation to make every thirty-five year old a risk manager who prospered only in the long run, only if the firm's strategies proved profitable over several cycles, and only if the firms never blew up).

This was a mistake: the 80-20 votes in the Senate and the 390-40 votes in the House for "national unity" economic policies did not materialize, and we are left with insufficient regulation of the financial system to protect the consumer and guard against the next crisis, and with too-small a stabilization policy that threatens now to give us 10% unemployment as far as the eye can see.

(2) The Obama administration started by proposing a cap-and-trade environmental policy with current greenhouse polluters grandfathered in--and with the political dynamic such that, as with the AMT and the R&D tax credit, the grandfathering will be extended year-by-year forever as legislators find one-year-at-a-time extensions to be an extraordinarily good tool for raising campaign contributions from corporate PACs.

This was a mistake. The administration should have started with the right first-best policy: a carbon tax with the revenues dedicated to paying people's FICA contributions. Then, if necessary, it could have let itself be negotiated down to cap-and-trade with some--not 100%--grandfathering.

(3) I simply do not know what the Obama administration's desired health-care reform bill looks like, or what steps the Obama administration is taking to make the congressional reform process reach a good end, or what the economic theory is that suggests that these particular reforms are the right thing to do. I am scared of guaranteed issue and community rating without a real mandate to curb adverse selection and a strong public option as a safety valve. I am very scared of a congress that seems to, with every day, seek to bend the curve of health care costs upward by prohibiting things like comparative effectiveness research. And I am very, very scared of a mandate without an adequate subsidy pool.

I want to see real white papers from the administration explaining why whatever is going to emerge from the congress is a good thing--and why it is the best thing that we could have gotten out of congress this year or next year.

(4) Tim Geithner should have gone to the wall for the requirement that [banks offer "plain vanilla" mortgages and credit cards. The Democratic Party should not be in the business of encouraging banks and other financial service companies into making money by tricking households into bearing risks that they do not understand. And he certainly should not say that he is "supportive of the changes." If he really is, he is in the wrong job. If he is merely grudgingly willing to accept the changes, he should say that instead. The Treasury Secretary's credibility is, after all, his onlly asset.

(5) Nor has the Obama administration yet gone to the wall for long-run fiscal discipline: by now we ought to have standby tax increases or spending cuts written into the law for the out-years a decade or more from now to reassure everyone that the American government does understand and take seriously what the long-run trends--the aging of America and medical-care cost growth--mean for public finances

Don't get me wrong: My complaint is not that the Obama administration has not been liberal enough. My complaint is that the Obama administration, so far, has not been devoted enough to good policy--to the good technocratic policies of what I used to see as the bipartisan center--and has been unwilling to use any leverage at all against a congress that is underbriefed, unfocused, and easily captured by special interests. You can only use such leverage if you have a moment arm--allow daylight to open up between the President's position and the position of the marginal senator, and say that the President's policies are those he and has staff have concluded after sober reflection are best for the nation but that he will take what he can get from congress.

Helps reduce those global imbalances, y'know. Jus' sayin:

UPDATE:China Yuan Ends Up; FX Interventions In Asia Cap Gains: China's yuan ended slightly higher against the dollar Friday, the first day of trading after the National Day holiday, taking its cue from the U.S. unit's broad weakness on global markets in the past week. However, dollar purchases by Asian central banks as they sought to limit strength in their own currencies curbed the yuan's gains....

During China's holiday, the dollar fell sharply against other currencies due to an expected interest rate hike by Australia's central bank, rising gold prices and better-than-expected economic data globally.... The dollar recovered some of its recent losses against other currencies in Asia on Friday after Federal Reserve Chairman Ben Bernanke reiterated the U.S. will need to raise interest rates once the recovery takes hold.... "China's central bank continued to rein in the yuan's rise against the dollar through the central parity rate, so traders didn't sell the dollar aggressively during the session," said a Shanghai-based trader at a foreign bank. The People's Bank of China set the dollar-yuan central parity rate at 6.8270 Friday, down from 6.8290 on Sept. 30. "The dollar's decline against the yuan was also capped by Asian central banks' foreign-exchange intervention to prop up the U.S. unit," said another Shanghai-based trader at a European bank....

Offshore, one-year dollar-yuan nondeliverable forwards were at 6.6791/6.6831, down from 6.6970/6.7020 on Sept. 30.

Rose Yu contributed to this article

In a world in which George Akerlof is not allowed to say "boo" about monetary policy because he is First Spouse of the Federal Reserve Bank of San Francisco, this is remarkable...

Free Exchange writes:

What are these Fed presidents up to?: CALCULATED RISK notes that Federal Reserve governors aren't exactly singing the same tune in public comments on the likely path of monetary policy. Nemo points out that the public disagreements have become remarkably common and overt—and, he says, pointed:

As a general rule, the guys (and gal) on the FRB do not even blow their noses in public without permission. They do not simply stand up and “speak their minds”. Had it started and ended with Warsh going off the reservation two weeks ago, then it might be an anomaly. But that was followed by Richard “speed and intensity” Fisher (speech), Charles “Great Inflation” Plosser (speech), Jeffrey “show stopper” Lacker, and Thomas “sooner rather than later” Hoenig (speech). On the flip side, we heard from William “extended period” Dudley (speech - try searching it for “not well founded”) and Daniel “overstated” Tarullo (speech).

Whew!

This appears to be a deliberate attempt to introduce uncertainty into the market about the future course of monetary policy. Why might they want to do that?

John Jansen has an explanation:

RBS Securities (the firm formerly known as Greenwich Capital) mentioned an interesting article by well respected research firm Wrightson in which Wrightson posits that some of the recent hawkish comments by Federal Reserve officials are a shot across the bow of leveraged speculators. Wrightson makes the salient point that if the trajectory of rates is unclear then leveraged positions are not such safe bets. That is I think a key and under appreciated point with the new world of Federal Reserve transparency regarding policy.

The last Federal Reserve tightening cycle was completely transparent and consisted of 17 consecutive 25 basis point rate hikes which took the funds rate target to 5.25 percent from 1 percent. But Mr Greenspan diminished the effect of the tightening and never thoroughly damped down speculative excess as he made it manifestly clear that he would not raise rates in anything other than discrete 25 basis point intervals. In so doing he allowed the junk which led to the current financial debacle to flourish.

There is an interesting similarity in this to an argument Larry Summers made several years ago, which was highlighted in the recent Ryan Lizza profile:

In 2007, Summers started looking at the looming economic crisis. Back in 2003, he had attended a Federal Reserve conference in Jackson Hole, Wyoming, in which economists were celebrating the fact that central bankers seemed to have mastered the use of monetary policy to tame inflation without causing the economy to slip into a recession, as had happened in the past. Summers warned that perhaps the victory over inflation meant only that the next recession would be caused by some new phenomenon...

In the fall of 2007, his Financial Times columns took on a more urgent tone, starting with a piece on November 25th, titled “Wake Up to the Dangers of a Deepening Crisis.” There had been at least six major financial crises that affected the United States over the past twenty years: the 1987 stock-market crash, the 1990 savings-and-loan crisis, the Mexican-peso crisis, the East Asian economic crisis, the failure of Long Term Capital Management, and the tech-bubble crash. Summers had a theory that tied them together: whereas for many decades most recessions were caused by the Federal Reserve’s attempts to curb inflation, the Fed’s recent mastery of keeping inflation in check had given rise to the financial crisis. Summers explained that, just as the success in curing infectious disease will allow some people to live longer only to die of cancer, the success in battling inflation will prolong an economic expansion only to lead to overconfidence and a financial crisis...

Perhaps the Fed is beginning to think that having control over the business cycle is more important than producing long expansions and frequent bubbles.

I really think Robert's head exploded somewhere in here:

Cochrane Vs Krugman ~ Angry Bear: According to Fox, [Cochrane] wrote:

The centerpiece of our crash was not the relatively free stock or real estate markets, it was the highly regulated commercial banks...

Now he can't believe that.... No one could be that ignorant... fail to have noticed that commercial banks are more tightly regulated than investment banks (especially recently after capital requirements for investment banks were massively relaxed). Writing "commercial banks" when everyone knows that "investment banks" would be closer to the truth is not plausible ignorance.

Cochrane may be completely ignorant about the macro literature except for that recently written somewhere near a great lake, but he must know that investment banks suffered more dramatically than commercial banks. I'm not sure he has noticed that there are no longer any investment banks -- that is all banks in the US are now parts of partly FED-regulated firms, but I am sure that he knows that Bear Sterns, Lehman, and Merrill Lynch are not commercial banks.

One more thing about [Justin] Fox, he concedes that Krugman's arguments are not based on formal models, he fails to note that the arguments made by the Fresh water economists aren't based on any models at all.

I'd be the first to agree with Cochrane that Krugman's vigorous pro-stimulus arguments are based more on hunches and guesswork and politics and history than on any kind of rigorous economic model. I've been even less impressed, though, with anti-stimulus arguments that claim to be based on rigorous models but are utterly devoid of historical perspective, curiosity and common sense.

They have models in which the labor market clears, they are not quite crazy enough to argue that there is no unemployment right now. They make arguments which don't make sense... certainly are less based on any formal model than Krugman's arguments. Fox clearly knows this. That's why he puts in the disclaimer "claim to be based". However, he is a journalist so he can't note that the arguments are definitely not based on formal models. This is he-says-she-says journalism. I'm sure Fox has read Krugman and DeLong on the lack of a model behind the arguments.

It is easy to see if there is a model or there isn't (hint there are models on Krugman's blog -- Fox can check if Fama or Cochrane have presented a model which supports their conclusions. He can ask them to send him their model. He should be able to tell if there is a model of if there isn't and if the model leads to the conclusion.

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Let me say that I am with Robert in the exploding-head brigade. Two years ago, if you had asked me, I would say that practically all economists shared a consensus theory of nominal spending and income. It is Milton Friedman's theory. It goes like this:

• Demand for money is proportional to the benefits of holding money--which are in turn proportional to nominal income.

• Demand for money is also a declining function of the costs of holding money: the short-term nominal interest rate on Treasury securities.

• You can flip the money demand function around and get a prediction of what spending will be as an increasing function of the money stock and of the interest rate, and of other things.

• Expansionary open-market operation monetary policies that raise the money stock also lower interest rates, and have strong effects on nominal spending and income when interest rates are normal, but have weak effects on spending when interest rates are very low and bank reserves and short-term Treasury securities are close substitutes.

• Banking and fiscal policies can affect interest rates and thus change the level of spending holding the money stock constant, but there is lots of uncertainty and disagreement about how well these policies work.

Yet now I find that Luigi Zingales does not know what I thought was this consensus theory. David K. Levine does not know this consensus theory. John Cochrane does not know this consensus theory. Edward Prescott does not know this consensus theory. Eugene Fama does not know this consensus theory but somehow thinks the equilibrium condition that is the savings-investment identity is also a behavioral relationship. Michele Boldrin does not know this consensus theory. Peter Diamond assures me that Robert Lucas does know this consensus theory of nominal income but you could have fooled me from what he has been writing over the past year.

Reed College:

Reed College | Public Policy Lecture Series: Brad DeLong: “Financial Crisis and the Macroeconomy, 1825-Present”

Saturday, November 7, 2 p.m., Vollum lecture hall: J. Bradford DeLong, who served during the Clinton administration as deputy assistant secretary of economic policy for the U.S. Department of the Treasury, is professor of economics at UC Berkeley, chair of UC Berkeley’s political economy major, and a research associate of the National Bureau of Economic Research.. He has written on the evolution and functioning of the U.S. and other nations’ stock markets, the dynamics of long-run economic growth, the making of economic policy, the changing nature of the American business cycle, and the history of economic thought. Before joining the Treasury Department, DeLong was Danziger Associate Professor in the economics department at Harvard University. He has also been a John M. Olin Fellow at the National Bureau of Economic Research, an assistant professor of economics at Boston University, and a lecturer in the department of economics at MIT.

Presented in partnership with the economics department and Reed's Parent & Family Weekend. Sponsored by the Walter Krause Fund for Lectures in Economics.

...for their work on the credit channel and large downturns, if I were running things. It has been the most valuable thing done in the past half-century in helping us to think through policy issues today.

No matter who gets it, they are the ones that deserve it.

Just saying.

Joe Stiglitz thinks that the investment bank culture took over the commercial banks. I think that merging investment and commercial banks gave investment banks more stability in their liabilities that allowed them to ride out the storm more easily.

Alan Blinder agrees with me, which makes me happy.

Ryan Lizza:

Larry Summers and the White House economic team: Many critics have argued that Clinton’s 1999 repeal of the 1933 Glass-Steagall Act, which had separated commercial and investment banks, contributed to the meltdown last year. “It was a clear signal to the big banks to get much bigger and to become kind of financial supermarkets,” Robert Reich, Clinton’s first Labor Secretary, said. “It’s not the biggest factor, but it’s certainly a step along the way.” In an article on the causes of the current crisis, Joseph Stiglitz wrote, “When repeal of Glass-Steagall brought investment and commercial banks together, the investment-bank culture came out on top.”

But others note that the pure investment banks, like Lehman Brothers, have been the greatest source of instability, while the banks with combined commercial and investment arms have fared the best. “Banks did terrible things, investment banks did terrible things, a big insurance company named A.I.G. did terrible things, but basically none of that was enabled by the repeal of Glass-Steagall,” said Alan Blinder, an economist at Princeton, who had his share of confrontations with Summers when he was a member of the C.E.A., in the first two years of the Clinton Administration. Brad DeLong added, “To say that the breaking down of the Glass-Steagall wall between investment banks and commercial banks was the source of the current crisis is just wrong”...

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Ryan Lizza on derivatives regulation:

However, the main criticism of a dozen economists, all of whom know Summers personally, is that during the late Clinton years, in two important cases, he seemed to forget his own warnings about financial markets. The first was a debate over opening up Asian markets to financial liberalization. Summers believed that several Asian countries, especially South Korea, were unfairly refusing to allow American financial-services firms to operate there. “The Asian countries kept pushing to regulate hedge funds, and these guys were dead set against it,” the friend of Rubin and Summers said. “They did have more belief in the ability of the financial markets and financial institutions to police themselves than now seems to be warranted, and that I think is a major issue.”

The second case cited against Summers is his hesitancy about regulating derivatives. In this instance, he was to the right of Rubin. Derivatives are contracts intended to perform the financially useful function of spreading risk. But in recent years they served mainly to concentrate it. In Rubin’s memoir, “In an Uncertain World: Tough Choices from Wall Street to Washington,” he describes the debate that he and Summers had over the issue. “Larry thought I was overly concerned with the risks of derivatives,” Rubin writes. “His argument was characteristic of many students of markets, who argue that derivatives serve an important purpose in allocating risk by letting each person take as much of whatever kind of risk he wants. Larry’s position held together under normal circumstances but seemed to me not to take into account what might happen under extraordinary circumstances.” Summers told me, “If we had known that derivatives markets would mushroom the way they did and that regulators would remain spectators, we would have acted. With hindsight, all of us with involvement in financial policy wish we had done more to forestall problems”...

Paul Krugman is three doors down the hall right now, but I am going to talk to him through the magic of the internet rather than mosying down:

Does unconventional monetary policy solve the zero bound problem?: Some comments on my post on the true cost of fiscal stimulus argue that the zero lower bound aka liquidity trap isn’t really binding, because the Fed is using other measures to expand the economy. A few commenters imply that I haven’t been paying attention.

Well, yes I’m aware that BB is doing a bunch of unconventional stuff. But the available — albeit thin — evidence is that it takes a huge expansion of the Fed’s balance sheet to accomplish as much as would be achieved by a quite modest cut in the Fed funds rate. And the Fed isn’t willing to expand its balance sheet to the $10 trillion or so it would take to be as expansionary as it “should” be given, say, a Taylor rule.

Which means that the zero bound is still binding, which means that right now we’re very much still in liquidity trap territory.

I would put it someehat differently. There's fiscal policy--using the government to expand output holding the risky long-term real interest rate that governs business investment and household borrowing decisions constant. There's monetary policy---using open-market operations to boost or retard the economy holding the short-term safe nominal interest rate constant. And then there is capital markets policy: operating on the wedge between the risky long-term real interest rate and the short-term safe nominal interest rate.

If you set up those three boxes, then a huge number of things fall under the rubric of "capital markets policy"--banking recapitalization. loan guarantees, nationalizations, bank rescues, asset purchases, and the sending of signals that alter the expected rate of future inflation.

You can call Federal Reserve policies aimed at the sending of signals that alter the expected rate of future inflation "monetary policy" if you want, but then you lose analytical clarity--because the way such policies work (if they work) is not the "normal" way that "normal" monetary policy works. Normal monetary policy works by shifting the private sector's asset holdings toward assets that people spend more readily and rapidly, thus boosting spending. Quantitative easing at the zero bound does not do that: it simply exchanges one zero-yield government asset for another. What is does do is to change bond prices, rather by raising the safe short-term nominal interest rate and thus giving people an incentive to spend the money they already have more quickly.

Something old. On March 30, 2009 Tom Keene of Bloomberg's "On the Economy" interviewed Robert Lucas and Edward Prescott.

There is one really interesting juxtaposition from Lucas's part of the interview:

LUCAS: Our economy’s got a remarkable ability to return to its long term growth trend. And for most of the depressions we’ve had or recessions, the return has been quick. Two or three, four years...

[...]

LUCAS: [T]here is no question that fear is what this liquidity crisis is. I mean the reason I got into money [with my portfolio] is that I got afraid to leave my pension fund in other securities. So I’m sitting there with a portfolio full of zero-yield stuff just because I’m afraid to do anything else. I think there are millions of people like me.

KEENE: What will be the signal for Robert Lucas to go back into the markets...?

LUCAS: I don’t know. Robert Rubin made a joke about that in the first session today. Nobody knows...

Let's parse this. First, Robert Lucas says that it is highly likely--certainly his median forecast--that the U.S. economy will be back to normal in three or four years, with a normal level of unemployment, a normal share of profits in national income, and a normal level of dividends and capital gains. This presumably means that stock prices will also be back to normal--a normal multiple of a ten-year moving average of lagged earnings, for example. That means a year-2013 S&P of 2000 or so, compared to its current value of 1044 or its 2009 low of 667. Investing in the S&P 500 for a four-year horizon now is risky, certainly, but the expected return is high. And holding your money in cash is not all that safe either: most of the scenarios I can envision in which the S&P 500 is at a real value in 2013 corresponding to today's 667 are scenarios in which inflation has eaten away most of the value of cash.

So what is Robert Lucas doing holding his entire portfolio in cash? Has risk suddenly increased to an extraordinary extent to force the equity share of his portfolio down from 70% to 0% while his expected four-year return on equities over Treasuries has gone from 2.5% or so to 20%? Has his personal tolerance for risk suddenly collapsed to such an extent because he has become a complete coward? Or does he no longer believe his forecast that the U.S. economy is highly likely to be back to normal in four years? Or is he simply not a von Neumann-Morgenstern agent, and moreover lacks any desire to behave as if he were one?

No von Neumann-Morgenstern agent faced with such returns would hold his entire TIAA-CREF portfolio in cash. Not a one.

Now let me back up a little to Lucas's attack on Robert Shiller and George Akerlof, and their book Animal Spirits:

LUCAS: I just don’t get it. I mean look at the Black_Scholes formula. People come up with a formula for pricing options, just out of purely mathematical reasoning, and then it turns out it fits certain data amazingly well. And it’s been incredibly useful to people. Now it’s not useful for everything, but for what it does it’s a huge advance in human knowledge. Now what’s the behavioral finance contribution? They reinforce the idea of skepticism. Well, skepticism, it’s easy to be a skeptic. What’s harder is to tell somebody how to do something they didn’t know how to do yesterday. That’s what Black and Scholes did...

Lucas seems to miss the entire big point. Black-Scholes tells you how to do things only if the trades of the non-von Neumann-Morgenstern agents in the economy--that's you, Bob--cancel each other out. If they don't cancel each other out--if there are, as you say, "millions of people like me," then a whole bunch of banks running off of Black-Scholes and similar models without taking account of your existence are going to create a hell of a lot of systemic risk, and then 10% unemployment.

Something old. On March 30, 2009 Tom Keene of Bloomberg's "On the Economy" interviewed Robert Lucas and Edward Prescott.

Ed Prescott's part of the interview is much, much stranger than Robert Lucas.

In the part I want to highlight, Prescott starts out with an apparent belief that after 1984 the Federal Reserve stopped trying to stabilize the economy:

PRESCOTT: I don’t see the mechanism for money [to affect the economy].... [O]nce the Fed stopped trying to stabilize the economy, the economy got a lot more stable...

Where this comes from I cannot imagine. It certainly doesn't describe anything the Federal Reserve has done over the past quarter century.

And it gets more bizarre.

Prescott says that the financial crisis did not affect the economy:

PRESCOTT: I think the financial crisis has been greatly overstated as a problem... [it] has had virtually no consequences for the real economy...

What did affect the economy was big bad government scaring people for no reason:

PRESCOTT: [P]eople got scared.... The press scared people. People running for office scared people. Bernanke scared people; Paulson scared people.... [P]eople began not to know what was going to happen. Then they stopped investing--by investing, I mean getting a new car or fixing up your house. And that led to the economy--it was depressed a bit that fourth quarter of last year...

Depressed "a bit"? Yes, a bit--and only a bit:

PRESCOTT: The growth rate from 4th quarter 2007 to 4th quarter of 2008, that includes that bad quarter, was 1%.... And if that fourth quarter was a normal quarter, it would have been almost up to trend...

If only the Federal Reserve and the Treasury had let the economy alone maybe the fourth quarter would have been a normal quarter, Prescott says:

[With] benign neglect the economy would have come roaring back quite quickly...

And if the economy does not come roaring back with a very strong recovery now, Prescott knows what to blame: big government scaring people again.

He simply does not live in the consensus reality with the rest of us.

Ah, well: at least the reality he lives in is a happier place then this one.

A central bank staffer writes:

I enjoyed your macro lecture on recent macro thought. I suppose on this typology I have evolved from a Greenspanist with Producerist sympathies to a Producerist with vestigial Greenspanist sympathies. But there's a possibility you pass over. If effective regulation won't be forthcoming--whether due to regulatory capture or because financial innovation has outpaced the political system's willingness to extend regulators' reach--the central bank might have to tighten into the bubble. I call that Second-Best Punchbowlism...

This seems to me to be exactly right.

It is, I think, dead-on as an estimate of what is likely to happen. Central banks would prefer an effective system of regulation, but due to capture of legislatures by the baning sector they are unlikely to get it. Thus they are going to be driven to be always wondering whether they should be putting extra downward pressure on asset prices--with implications for employment and possibly growth.

The fact that "Punchbowlism" can be implemented by central banks by themselves makes it the default option.

On the fallout from Lehman:

Do not learn wrong lessons from Lehman’s fall: “If the price of oil stabilises, I believe we can weather the financial crisis at limited cost in terms of real activity.” Thus did Olivier Blanchard, newly appointed head of the International Monetary Fund’s research department, describe the prospects ahead on September 2 2008. He was swiftly proved wrong.... Few economists then realised how fragile the global financial system had become. The failure of Lehman Brothers just under two weeks later and the ensuing crisis at AIG, the insurance giant, turned complacency into terror. The financial system plunged into an abyss, dragging the economy behind it.

What lessons are we to learn from this shock, a year later?... When finance ministers and central bank governors of the Group of Seven leading developed countries met in Washington last October, they decided to “take decisive action and use all available tools to support systemically important financial institutions and prevent their failure”. Desperate times; desperate measures. Since large financial institutions are most likely to fail during a crisis, this amounted to an open-ended government guarantee. What makes the decision quite unbearable is that it was, in my view, also correct. The risk of a cascading failure of the good, the bad and the ugly among financial institutions was apparent. Given what had happened after Lehman’s failure, only fools would have run this experiment. We were not that foolish. Thus, the lesson learnt from Lehman’s failure was the precise opposite of what many had hoped on the day it was announced: it is that every systemically significant institution must be rescued in a crisis. That lesson is reinforced by Wednesday’s agreement that the rescue, buttressed by unprecedented monetary and fiscal stimulus, has worked: the panic is over and the world economy is on the mend....

If these are indeed the sorts of lessons we draw, we are making huge mistakes. First, we cannot let stand the doctrine that systemically significant institutions are too big or interconnected to be allowed to fail in a crisis. No normal profit-seeking business can operate without a credible threat of bankruptcy.... The second big potential mistake is to return to the old doctrine that it is better to clean up after a crisis than to take any pre-emptive action.... The third big mistake is more immediate: it is to assume that we are already well on the way to a healthy recovery....

Letting Lehman go was not our biggest mistake. That was letting the economy and financial system become so vulnerable. Equally, the past year has restored neither the financial system nor the economy to health. We have avoided the worst. That is good. It is not enough.

---

On China's recovery:

Wheel of fortune turns as China outdoes west: China has emerged as the most significant winner from the global financial and economic crisis. At the end of 2008, many questioned whether China would achieve its growth target of 8 per cent in 2009. Who now dares to do so? Cushioned by its more than $2,100bn (€1,440bn, £1,260bn) of foreign currency reserves, huge trade and current account surpluses and a robust fiscal position, Beijing has been able to deploy all its levers over the financial system and the economy. Meanwhile, as one senior Chinese participant at the World Economic Forum’s annual meeting of “the new champions”, in Dalian, noted, “the teachers have made big mistakes”. Indeed, any visitor to Asia will recognise the west’s reputation for financial and economic competence is in tatters, while that of China has soared. The wheel of fortune is turning....

[H]owever successful China is in promoting domestic demand, it will not be the locomotive for the world economy. True, China’s merchandise trade surplus has indeed been narrowing: it was $35bn in the second quarter, 40 per cent lower than a year earlier. China’s current account surplus is also shrinking: it may be down to 6 per cent of gross domestic product this year, from 11 per cent in 2007. Yet, since it still only generates some 7 per cent of world output, China is too small to act as the world’s locomotive. Even halving its external surplus would add only 0.4 per cent to aggregate demand in the rest of the world...

---

On financial regulation::

Turner is asking the right questions on finance: Lord Turner is right to argue that... the fundamental issue is not structure, but philosophy. The UK authorities adopted the same view as the US: market forces guaranteed both efficiency and stability. They were wrong. Now that the view has changed, the upheaval caused by transforming the regulatory structure is unnecessary....

Now turn to whether the financial sector is “too large”.... [T]he sector enjoys subsidies from the state, via access to the lender-of-last-resort function of the central bank and explicit and implicit guarantees against insolvency. These need to be offset....

[H]igher capital requirements are far from a panacea. One danger is that banks may take on even more risk, to sustain high returns on equity. Another is that banks would again find a way around higher capital requirements....

That leads naturally to the “Tobin tax”. Obviously, it would have to operate in all significant financial centres. So the chance of its happening is zero....

Finally, how far are changes in the structure and levels of pay the answer? I agree with Lord Turner that “the honest truth is that bad remuneration policies, though relevant, were far less important in the unravelling of the crisis than hopelessly inadequate capital requirements against risky trading strategies”....

[T]he more one analyses both the debate and what is happening, the more difficult it is to believe that a safer and more responsible industry is emerging. I love Lord Turner’s willingness to raise difficult questions. But I am not persuaded that he, or anybody else, offers convincing answers.

I confess I do not understand in what way "bad remuneration policies... were far less important in the unravelling of the crisis than hopelessly inadequate capital requirements against risky trading strategies." I had thought that bad remuneration strategies produced the outsized risky trading strategies.

The Huffington Post simply shouldn't be publishing things like this. The Huffington Post should do better. It owes its readers. And we know that it can do better.

The kindest interpretation I can give what Washington University in St. Louis economist David K. Levine has written is that he is fundamentally confused between levels and derivatives.

David K. Levine:

David K. Levine: An Open Letter to Paul Krugman: Crises have been ubiquitous throughout history. While we can't forecast them we do know how to learn from them.... But the stimulus plan? How can you be arguing for more? Since we are recovering before most of the stimulus money has entered the economy - isn't that evidence it isn't needed? How can you write as if you are proven right in supporting it?

Oh boy. Let's see how far I can get with this...

Start with:

This chart shows what has happened to the civilian adult employment-to-population ratio. That ratio peaked at 63.4%[1] at the end of 2006. It was 59.2% as of mid-August and is probably 59.0% now--and if not now, soon.

A well-functioning labor market--one not deep in market failure--matches workers looking for jobs with jobs looking for workers. A well-working labor market will keep both the number of unemployed and the number of vacancies together in balance, and at relatively low values.

That is not what is happening now.

The number of vacancies--jobs for which employers are actively searching for workers but have not found any to hire yet--is very small. The number of unemployed--of people who want to hold jobs and are qualified to hold jobs--is very high. The result is that some 4% of the 18-65 population that in a normal time would have jobs is now jobless. This is a massive market failure: supply is not matched to demand. And the welfare costs of this elevated degree of market failure are very high: the excess people without jobs are not happy people taking great vacations. They are, rather, stressed out: give them their old jobs back for 3/4 of their old pay without consequences for their likely incomes in future years and they would be ecstatic.

David Levine says that the government should not do anything about this market failure. Right now "we are recovering," he writes. And he believes that because we are recovering activist governmental policies to deal with this collapse in the employment-to-population ratio are unwarranted.

Note, however, three things that "we are recovering" does not mean:

• It does not mean that macroeconomic market failures are small, or are rapidly being reduced to "normal" levels.
• It does not even mean that the magnitude of the macroeconomic market failures is falling--for every competent foreaster expects that the employment-to-population ratio will continue to decline, perhaps for a substantial time, even though it is highly likely that the NBER's final business cycle chronology will declare that we are now in a "recovery" phase of the business cycle..
• It does not mean that monetary and fiscal policy tools to compensate for, repair, or correct those macroeconomic failures have lost any of their juice or are no longer appropriate--they remain appropriate and necessary as long as the macroeconomic market failures remain elevated.

What "we are recovering" means is that:

• the magnitude of macroeconomic market failures--which are well-measured by the gap between the employment-to-population level and its normal level--are now no longer growing rapidly but instead only growing slowly. Things are still getting worse. But at least they are not getting worse rapidly.

As long as the gap between the current employment-to-population ratio and its normal level remains large, policies to compensate for, repair, or correct macroeconomic market failures are entirely appropriate.

For Levine to think that such policies should be abandoned just because macroeconomic market failures are no longer growing rapidly reflects a deep incomprehension of the discipline of economics. Things that Irving Fisher, Knut Wicksell, and in a later generation Milton Friedman knew very well indeed are things that David Levine simply does not understand.

Now there are deeper and more subtle questions for economists to to analyze right now. For example, in this situation:

1. How stimulative should monetary policy be when the employment-to-population ratio is as far below normal levels as it is now?
2. Can conventional monetary policy do the job--or do as much of the job as can be usefully done?
3. Under what circumstances should conventional monetary policy be supplemented?
4. And what policies should supplement it--quantitative easing, public purchase of risky assets, bank recapitalization, informal government guarantees, formal government guarantees, fiscal expansion, scattered nationalizations, full nationalization of the financial sector, or the acquisition of all financial and industrial assets by the government and the rational arrangement of economic affairs according to a common plan?

These are knotty and complicated questions about which competent economists can (and do!) argue, and about which competent economists can (and do!) disagree on matters of theory, on the weight of the empirical evidence, and of policy.

But you cannot have a fruitful discussion about any of those issues with David K. Levine. Someone so clueless that he thinks that the end of a period in which macroeconomic market failures are growing rapidly entails that the policies to compensate for, repair, and correct those market failures should be stopped right now is simply not in our galaxy.

---

[1] A level it attained without, mind you, a single sign that any worker was in any sense "fooled" into taking a job because of an erroneous misperception that his or her real wage was higher than it was in fact. See Krugman http://tinyurl.com/dl20090919a.

Krishna Guha:

FT.com | Money Supply | More stress on the Fed’s exit tools: The Treasury’s decision to run down its supplemental funding programme for the Fed puts yet more pressure on untested tools the Fed is relying on to sterilise excess reserves when the time comes to raise interest rates. I happen to think these tools will work. Still, the Fed can hardly be thrilled about this.

It reminds me that the Fed faces an interesting choice as to whether it should trial some of these techniques - such as the use of reverse repos against its MBS portfolio - long before it actually has to rely on them. I think trial runs make sense, but the Fed would have to manage the signalling side of that very carefully.

John Quiggin Says:

John Quiggin » The macro wars: I’m visiting Berkely at present and just had a chat with Brad DeLong. These are some of the thoughts I had about the great macroeconomics wars as a result.

One important element that can’t be ignored is the effect political partisanship, which is much more bitter in the US now than in most other places. It’s not so much Republicans vs Democrats as Republicans vs anti-Republicans. Krugman has been a leading figure in rejecting the idea that the Republican party represents a serious viewpoint that should be accorded respect, even in disagreement. Not surprisingly, the members of the intellectual class still associated with the Republican Party (relatively few, these days, but still dominant in Chicago) intensely dislike Krugman’s writing for the NYT.

But more important, I think, is the hole in the intellectual landscape opened up by the crisis. As regards macroeconomics, the pre-crisis near-consensus described by Krugman included a lot of “freshwater” macroeconomists whose intellectual roots go back to the New Classical/Real Business Cycle literature of the late 1970. This literature initially suggested that there was no possible role for monetary or fiscal policy unless people had mistaken expectations and drew the implication that a sufficiently credible and determined government could eliminate inflation without any serious cost in terms of output and employment, a theory tested to destruction by the Thatcher government.

Given the empirical difficulties encountered by strong forms of these views, most of the freshwater economists were prepared to make some concessions. As regards monetary policy, they were willing to accept some use of interest rates to target inflation, while arguing against “fine tuning” designed to stabilise the economy – during the Great Moderation it was easy enough to conclude that macro instability was a problem of the past, a claim made explicitly by Robert Lucas.

Similarly, it was easy enough to accept the implication that, in certain extreme circumstances like those of the Great Depression, the standard tools of monetary policy might prove ineffective necessitating direct use of fiscal policy to expand the money supply. In the absence of any perceived risk of a Depression, it was easy enough to make this concession while arguing against any use of active fiscal policy.

In the wake of the crisis, this position was untenable. If you supported fiscal policy at all, it was clear that a massive stimulus was needed. In fact, the arguments of Barro and others that Keynesians had overestimated the multiplier effects of fiscal stimulus implied that the required stimulus was even larger than Keynesian estimates would suggest.

Moreover, there is, as Brad DeLong and others have pointed out, no coherent position under which fiscal policy is totally ineffective while monetary policy is at least partly effective. And the only plausible conditions under which policy is totally ineffective is if the macroeconomy is always in (or close to) equilibrium. So, it’s essentially impossible to believe in recessions and unconditionally oppose fiscal policy.[1]

So we see Cochrane forced all the way back to Say’s Law, the claim that it is logically impossible for (planned) supply to exceed (planned) demand, since willingness to supply, say, labour implies willingness to demand goods. Cochrane accuses Krugman of wanting to scrap the macroeconomics of the last forty years[2] but then makes it clear enough that he wants to dump Keynes and everything that has been written since.

Arguments about Say’s Law are unlikely to be resolved by logical disputation. The only way to address them is to look at the historical record of the economy over the last couple of centuries. If you see stability, interrupted only by the occasional ill effects of government policies, you’ll accept Say’s Law. If you see regular crises, except for a few exceptional periods when macroeconomic stabilization policies have appeared to work, you’ll reject it.

---

fn1. Except for those who can always find some government program or another to blame, even for a case as clear cut as the 1890s Depression in Australia.

fn2. This charge is broadly correct, but I think the correct answer is the one anticipated by Cochrane. Economics did indeed take a wrong turn in the 1970s, responding to the breakdown of (one version of) Keynesianism. We need to find a new and better response, and much of the work of the past 40 years will have to be be discarded or reinterpreted as a result.

Paul Krugman writes:

Freshwater Rage: I’m still on the road, with only sporadic internet access. So I’ve missed out on much of the outpouring of rage over my magazine article. I gather, though, that the usual suspects are utterly outraged at my suggestion that freshwater macro has spent several decades heading down the wrong path. They’re smart! They work hard, using hard math! How dare I say such a thing? And all of this, of course, without a hint of irony.... When freshwater macro came in, there was an active purge of competing views: students were not exposed, at all, to any alternatives. People like Prescott boasted that Keynes was never mentioned in their graduate programs. And what has become clear in the recent debate — for example, in the assertion that Ricardian equivalence rules out any effect from government spending changes, which is just wrong — is that the freshwater side not only turned Keynes into an unperson, but systematically ignored the work being done in the New Keynesian vein. Nobody who had read, say, Obstfeld and Rogoff would have been as clueless about the logic of temporary fiscal expansion as these guys have been...

I would put it slightly differently. I do object to the fact that Chicago macro has not read Obstfeld and Rogoff. But what I object to much more is that they have not read anything at all.

For example, consider:

Most of all, Krugman likes fiscal stimulus. In this quest, he accuses us and the rest of the economics profession of “mistaking beauty for truth.”[1] He’s not that clear on what the “beauty” is that we all fell in love with, and why one should shun it. And for good reason. The first siren of beauty is simple logical consistency. Paul’s Keynesian economics requires that people make plans to consume more, invest more, and pay more taxes with the same income...

It is not just Keynesian economics that concludes that there are times when people in aggregate make plans to spend more than their incomes.

It is Milton Friedman's monetarist economics too.

It is Knut Wicksell's Swedish school.

It is Irving Fisher's quantity theory of money.

Indeed, it is David Hume writing the first article in economic theory ever--"On the Balance of Trade." In it, he supposes "all the money of Great Britain were multiplied fivefold in a night." The immediate consequence is that planned expenditure rises high above income as people try to shed their excess money balances. Planned expenditure continues to run ahead of income until the flow of nominal spending has risen fivefold.

Yet we are told that that chain of events violates "simple logical consistency."

There is nothing illogical or inconsistent about the economy being in a state in which aggregate planned expenditure is greater or less than income. Today's Chicago school would know this, had it not forgotten all of monetary economics from David Hume on.

But if you have never understood David Hume, and if you try to think about the issues on the fly, you are bound to make large, embarrassing, and elementary mistakes. Even this is not necessarily a bad thing. As Nick Rowe says: "we need to encourage finance people to do macro, and macro people to do finance, and part of the price of doing that is we will make mistakes."

But it becomes a bad thing when you think you have something to say about policy--for then you say pointless and destructive things.

---

[1] I actually don't mind that people spend their time developing real business cycle models or investigating the consequences of the efficient market hypothesis. I do, however, wish that they wouldn't write things like:

It is true and very well documented that asset prices move more than reasonable expectations of future cashflows. This might be because people are prey to bursts of irrational optimism and pessimism. It might also be because people’s willingness to take on risk varies over time, and is sharply lower in bad economic times. As Gene Fama pointed out in 1972, these are observationally equivalent explanations at the superficial level of staring at prices and writing magazine articles and opeds...

because such things are simply not true.

They are not observationally equivalent.

When major rises in stock prices--like that of 1995-2000--are due to increases in market risk tolerance or decreases in risk, then at their end investors and commentators tend to think that future returns are likely to be low by historical benchmarks, but that stocks are nevertheless worth holding because (a) their risks are small or (b) we have lowered the covariance between stock returns and our consumption. When major rises in stock prices are due to a wave of optimism, then at their end we find that investors and commentators are thinking that future returns are likely to be high by historical standards--Dow 36000 anyone?--but that risks are not especially low.

And to that I object, because they would be better finance economists if they did not write things that weren't true.

pdf version

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Open publication - Free publishing - More monetarists

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Barry Eichengreen:

The Last Temptation of Risk: We thought that monetary policy had tamed the business cycle. We thought that because changes in central-bank policies had delivered low and stable inflation, the volatility of the pre-1985 years had been consigned to the dustbin of history.... We thought that financial institutions and markets had come to be self-regulating—that investors could be left largely if not wholly to their own devices. Above all we thought that we had learned how to prevent the kind of financial calamity that struck the world in 1929.

We now know that much of what we thought was true was not.... The question is how we could have been so misguided.... [T]he problem lay not so much with the poverty of the underlying theory as with selective reading of it—a selective reading shaped by the social milieu. That social milieu encouraged financial decision makers to cherry-pick the theories that supported excessive risk taking. It discouraged whistle-blowing, not just by risk-management officers in large financial institutions, but also by the economists.... [S]cholarship that warned of potential disaster was ignored. And the result was global economic calamity on a scale not seen for four generations.

SO WHERE were the intellectual agenda setters when the crisis was building?... For economists in business schools the answer is straightforward. Business schools see themselves as suppliers of inputs to business.... J. P. Morgan makes clear the kind of financial engineers it requires, and business schools deem to provide. In the wake of the 1987 stock-market crash, Morgan’s chairman, Dennis Weatherstone, started calling for a daily “4:15 Report” summarizing how much his firm would lose if tomorrow turned out to be a bad day.... Value at Risk, as that number and the process for calculating it came to be known, quickly gained a place in the business-school curriculum.... Getting the machine to spit out a headline number for Value at Risk was straightforward. But deciding what to put into the model was another matter.... Value at Risk, like dynamite, can be a powerful tool when in the right hands. Placed in the wrong hands—well, you know. These simple models should have been regarded as no more than starting points for serious thinking. Instead, those responsible for making key decisions, institutional investors and their regulators alike, took them literally....

For some years those who relied on these artificial constructs were not caught out. Episodes of high volatility, like the 1987 stock-market crash, still loomed large in the data set to which the model was fit. They served to highlight the potential for big shocks and cautioned against aggressive investment strategies.... WITH TIME, however, memories of the 1987 crash faded. In the data used by the financial engineers, the crash became only one observation among many generated in the course of the Great Moderation.... Meanwhile, deregulation was on the march.... [W]here the accelerating pace of change should have prompted more caution, the routinization of risk management encouraged precisely the opposite....

[W]here were the business-school professors while these events were unfolding? Answer: they were writing textbooks about Value at Risk.... Business schools are rated by business publications and compete for students on the basis of their record of placing graduates.... But what of doctoral programs in economics (like the one in which I teach)?... [T]heir faculties do not object to the occasional high-paying consulting gig.... Generous speaker’s fees were thus available to those prepared to drink the Kool-Aid... there was nonetheless a subconscious tendency to embrace the arguments of one’s more “successful” colleagues in a discipline where money, in this case earned through speaking engagements and consultancies, is the common denominator of success.

Those who predicted the housing slump eventually became famous, of course. Princeton University Press now takes out space ads in general-interest publications prominently displaying the sober visage of Yale University economics professor Robert Shiller, the maven of the housing crash.... But such fame comes only after the fact. The more housing prices rose and the longer predictions of their decline looked to be wrong, the lonelier the intellectual nonconformists became....

WHY BELABOR these points? Because it was not that economic theory had nothing to say about the kinds of structural weaknesses and conflicts of interest that paved the way to our current catastrophe... agency theory... compensation practices in the financial sector as encouraging short-termism and excessive risk taking and heightening conflicts of interest.... A Nobel Prize for work on this topic was awarded to Leonid Hurwicz, Eric Maskin and Roger Myerson in 2007... information economics.... George Akerlof, Michael Spence and Joseph Stiglitz were awarded the Nobel Prize for their work on it in 2001. Here again the potential problems of an inadequately regulated financial system would have been quite clear had anyone bothered to look.... [B]ehavioral finance... this small step in the direction of realism can transform one’s view of financial markets... herd behavior, where everyone follows the crowd, giving rise to bubbles, panics and crashes. Economists have succeeded in building elegant mathematical models of decision making under these conditions and in showing how such behavior can give rise to extreme instability. It should not be a surprise that people like the aforementioned George Akerlof and Robert Shiller are among the leaders in this field.

Moreover, what is true of investors can also be true of regulators, for whom information is similarly costly to acquire and who will similarly be tempted to follow convention—even when that convention allows excessive risk taking by the regulated.... And what is true of investors and regulators, introspection suggests, can also be true of academics....

What got us into this mess, in other words, were not the limits of scholarly imagination. It was not the failure or inability of economists to model conflicts of interest, incentives to take excessive risk and information problems that can give rise to bubbles, panics and crises.... Rather, the problem was a partial and blinkered reading of that literature....

WITH THE pressure of social conformity being so powerful, are we economists doomed to repeat past mistakes?... Maybe so. But... there is at least one reason for hope.... [T]he IT revolution has altered the lay of the intellectual land.... [I]t is now empirically oriented graduate students who are the hot property when top doctoral programs seek to hire new faculty. Not surprisingly, the best students have responded....

In contrast, the twenty-first century will be the age of inductive economics, when empiricists hold sway and advice is grounded in concrete observation of markets and their inhabitants. Work in economics, including the abstract model building in which theorists engage, will be guided more powerfully by this real-world observation. It is about time.

Should this reassure us that we can avoid another crisis? Alas, there is no such certainty. The only way of being certain that one will not fall down the stairs is to not get out of bed. But at least economists, having observed the history of accidents, will no longer recommend removing the handrail.

Paul Krugman's summary:

How Did Economists Get It So Wrong?: [R]ereading Friedman’s 1970 summary of his ideas, “A Theoretical Framework for Monetary Analysis,” what’s striking is how Keynesian it seems. And Friedman certainly never bought into the idea that mass unemployment represents a voluntary reduction in work effort or the idea that recessions are actually good for the economy. Yet the current generation of freshwater economists has been making both arguments. Thus Chicago’s Casey Mulligan suggests that unemployment is so high because many workers are choosing not to take jobs: “Employees face financial incentives that encourage them not to work . . . decreased employment is explained more by reductions in the supply of labor (the willingness of people to work) and less by the demand for labor (the number of workers that employers need to hire).” Mulligan has suggested, in particular, that workers are choosing to remain unemployed because that improves their odds of receiving mortgage relief. And Cochrane declares that high unemployment is actually good: “We should have a recession. People who spend their lives pounding nails in Nevada need something else to do.”

Personally, I think this is crazy. Why should it take mass unemployment across the whole nation to get carpenters to move out of Nevada? Can anyone seriously claim that we’ve lost 6.7 million jobs because fewer Americans want to work? But it was inevitable that freshwater economists would find themselves trapped in this cul-de-sac: if you start from the assumption that people are perfectly rational and markets are perfectly efficient, you have to conclude that unemployment is voluntary and recessions are desirable.

Yet if the crisis has pushed freshwater economists into absurdity, it has also created a lot of soul-searching among saltwater economists. Their framework, unlike that of the Chicago School, both allows for the possibility of involuntary unemployment and considers it a bad thing. But the New Keynesian models that have come to dominate teaching and research assume that people are perfectly rational and financial markets are perfectly efficient. To get anything like the current slump into their models, New Keynesians are forced to introduce some kind of fudge factor that for reasons unspecified temporarily depresses private spending. (I’ve done exactly that in some of my own work.) And if the analysis of where we are now rests on this fudge factor, how much confidence can we have in the models’ predictions about where we are going?

The state of macro, in short, is not good. So where does the profession go from here?...

Recent events have pretty decisively refuted the idea that recessions are an optimal response to fluctuations in the rate of technological progress; a more or less Keynesian view is the only plausible game in town. Yet standard New Keynesian models left no room for a crisis like the one we’re having, because those models generally accepted the efficient-market view of the financial sector.

There were some exceptions. One line of work, pioneered by none other than Ben Bernanke working with Mark Gertler of New York University, emphasized the way the lack of sufficient collateral can hinder the ability of businesses to raise funds and pursue investment opportunities. A related line of work, largely established by my Princeton colleague Nobuhiro Kiyotaki and John Moore of the London School of Economics, argued that prices of assets such as real estate can suffer self-reinforcing plunges that in turn depress the economy as a whole. But until now the impact of dysfunctional finance hasn’t been at the core even of Keynesian economics. Clearly, that has to change.

So here’s what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit — and this will be very hard for the people who giggled and whispered over Keynes — that Keynesian economics remains the best framework we have.... Third, they’ll have to do their best to incorporate the realities of finance into macroeconomics.

Many economists will find these changes deeply disturbing. It will be a long time, if ever, before the new, more realistic approaches to finance and macroeconomics offer the same kind of clarity, completeness and sheer beauty that characterizes the full neoclassical approach. To some economists that will be a reason to cling to neoclassicism, despite its utter failure to make sense of the greatest economic crisis in three generations. This seems, however, like a good time to recall the words of H. L. Mencken: “There is always an easy solution to every human problem — neat, plausible and wrong.”...

The vision that emerges as the profession rethinks its foundations may not be all that clear; it certainly won’t be neat; but we can hope that it will have the virtue of being at least partly right.

I would add that there has always been another macro separate from the universities--the macro of the economic forecasters and of the central banks, which has, I think, been in a relatively healthy state for quite a while...

Tyler writes:

Marginal Revolution: What did Milton Friedman favor?: Responding to my initial post, David Henderson gets himself into a bit of trouble when he writes:

He's [Tyler] correct that Friedman wanted the Fed to increase the money supply. I don't think I'm pretending when I say that I don't think Friedman advocated bailing out banks during the Depression. As I think Friedman would have, last fall I advocated an increase in the money supply while opposing a bailout. Those two, contra Cowen, are separable.

When it comes to 1929-1931, Friedman favored the Fed a) buying up a lot more bonds, and b) serving as a lender of last resort to failing banks. They are separable but Friedman favored both.

In the Monetary History, Friedman and Schwartz approvingly quote Walter Bagehot about the need to do whatever is required, however bold or desperate, to stop a banking panic.  Part of the passage runs like this:

The way in which the panic of 1825 was stopped by advancing money has been described in so broad and graphic a way that the passage has become classical. “We lent it,” said Mr. Harman [one of the Bank’s more senior directors] on behalf of the Bank of England, “by every possible means and in modes we have never adopted before;...

Here is Charles Goodhart quoting Friedman on why the Fed should have been a lender of last resort to troubled banks.  Or see p.269 of the Monetary History, where Friedman and Schwartz explain how it was too difficult for banks to borrow from the Fed at favorable rates in the early 1930s.  Or read this Friedman interview.

In the comments Bruce Bartlett, channeling Friedman, responded:

There's no way the Fed could have expanded the money supply in the early 1930s without bailing out the banks. How do you think the money supply declined in the first place? It's because banks failed and their deposits disappeared. To keep those deposits from disappearing in an era before deposit insurance would have required keeping bankrupt banks afloat.

Friedman's model was not one of allowing a boost in currency to substitute for the broader monetary aggregates.  An article in The Freeman is clear, if perhaps even a bit exaggerated:

Friedman and Schwartz argued that all this was due to the Fed’s failure to carry out its assigned role as the lender of last resort.

You might try to draw a distinction between "lender of last resort" and "bailout" but Bernanke's emergency lending is usually considered part of the bailout package.  No one is suggesting Friedman would have favored each and every part of the bailouts that we have seen.  The point is that Friedman favored some bailouts in the past and probably would have favored some this time around as well.  You don't have to think he would have voted for the first Paulson proposal.

Oddly, Henderson in his post takes offense because I suggest that libertarians try to run away from the idea that Friedman favored Fed action beyond simple monetary policy.  Henderson then tries to run away from the idea that... Friedman favored Fed action beyond simple monetary policy.

I now recall that a related point was made by Paul Krugman, although I find that piece problematic in some other ways. 

Here are a few sounder history of thought claims:

1. Friedman and Schwartz argued that if the Fed had been more on the ball with monetary policy earlier on, the lender of last resort actions would not have been needed. That is distinct from opposing such actions in the time of necessity, when necessity comes.

2. At times Friedman suggested that the rise of deposit insurance limited the importance of the lender of last resort role.  (How he would have thought about rescuing the shadow banking system is an interesting question.)  A related issue hovers here, namely whether support for deposit insurance constitutes support for bailouts.  It seems to me it does, though my original point does not rely on this judgment.

3. Friedman thought that "simple" monetary policy, combined with "simple" Fed lending would go pretty far in stopping a banking panic, yet this view was not borne out in the very recent crisis.  In any case it's wrong to conclude that Friedman was necessarily opposed to more vigorous action, if such action would turn out to be needed.  If you read Friedman as a whole his focus is not on drawing particular lines to circumscribe Fed action, but rather doing whatever is needed to keep the banking system up and running. 

One problem is that "Friedman" is underspecified. There are many Friedmans, including:

1. The Keynesian Friedman of "A Framework for Monetary Analysis"
2. The incredibly rigid financial regulatory straightjacket Friedman of "A Program for Monetary Stability"
3. The pro-bailout Friedman of "The Great Contraction"
4. The late Friedman who concluded that money stock-targeting had not lived up to expectations.
5. The early Friedman who believed that keeping the nominal money stock on a smooth growth path would eliminate any possibility for large disturbances in velocity.

These guys are not all consistent, not all the time.

Justin Fox:

Paul Krugman tells how economists got it all wrong: the one big issue I have with the piece is that, while economists certainly got lots of things wrong before the crisis (as did almost all of us), many members of the profession have acquitted themselves pretty well since things turned really ugly last year. Krugman goes on and on about the "freshwater" economists (at the Universities of Chicago, Rochester and Minnesota) and their crazy ideas about perfect markets. But what's telling is that the hardcore freshwaterites have had almost no impact on economic policy for the past year—neither in the Bush months or the Obama ones. Sure, Nobelist Ed Prescott, a former freshwater economist who now teaches in Phoenix and thus should probably be described as a no-water economist, made the statement that:

"I don't know why Obama said all economists agree on [the need for a stimulus bill]," Prescott said. "They don't. If you go down to the third-tier schools, yes, but they're not the people advancing the science."

Unless you believe that pretty much anyplace other than Arizona State University is a third-tier school, this is patently untrue, evidence of the extreme isolation of the remaining true believers in rational expectations and real business cycles and other such elegant but profoundly unhelpful macroeconomic theories developed since the 1960s. Even some of the true believers seem far more aware than Prescott that the past year's events have challenged their theories—as the University of Chicago's Robert Lucas told me last fall, "everyone is a Keynesian in a foxhole." Among economists with actual influence on policy over the past year—Philip Swagel in the Paulson Treasury, Larry Summers and Christina Romer and Austan Goolsbee and etc. in the current White House—there's been a great willingness to experiment and accept that markets don't always deliver optimal results. The result: an economic recovery that seems to be gaining strength. So don't totally count the economists out...

Four remarks:

(1) In context Lucas's "everyone is a Keynesian in a foxhole" is not an endorsement of the position and an admission that he holds it, but instead much closer to a denunciation of economists for their intellectual weakness in reaching for Keynesian remedies:

Well I guess everyone is a Keynesian in a foxhole, but I don't think we are there yet. Explicitly temporary tax cuts do nothing: people just bank them. Supply side tax cuts are fine with me, but they take time to work and at some point we need the revenue to run the government. I feel the current situation requires a lender of last resort but not a fine tuner.

As, indeed, was clear when Lucas made his big denunciation of Christy Romer (and by implication Summers, and Orszag, and Elmendorf, and Bernanke, and Swagel, and so on) for what I can only characterize as "corruption":

Why a Second Look Matters: The Moody's model that Christina Romer -- here's what I think happened.  It's her first day on the job and somebody says, you've got to come up with a solution to this -- in defense of this fiscal stimulus, which no one told her what it was going to be, and have it by Monday morning. So she scrambled and came up with these multipliers and now they're kind of -- I don't know.  So I don't think anyone really believes.  These models have never been discussed or debated in a way that that say -- Ellen McGrattan was talking about the way economists use models this morning.  These are kind of schlock economics. Maybe there is some multiplier out there that we could measure well but that's not what that paper does.  I think it's a very naked rationalization for policies that were already, you know, decided on for other reasons...

Note what Lucas does not say: He does not say that Christy Romer has a different reading of the evidence than he has. He does not say that Christy Romer has a different assessment of policy risks than he has. He does not say that Christy Romer has a different tolerance of policy risks than he has. He says that she is providing a "very naked rationalization" for economic policies that Obama decided upon for completely non-technocratic political reasons.

Now this is complete garbage. Christy Romer does have a very different view--she would call her view an evidence-based view--of what fiscal policy does in conditions of extremely low interest rates than Robert Lucas does.

(2) Unfortunately for us these are not fringe figures. To an outsider to academic economics like Justin Fox they may appear to be embarrassing madmen in the attic--and to the extent that that becomes the conventional wisdom then I think the good guys will have won this one. But inside the profession that is not the case.

Robert Lucas is a Nobel Prize winner and the head of the still-dominant school of business-cycle analysis when he claims that Christy Romer (and by implication Ben Bernanke, and Doug Elmendorf, etc.) is providing "very naked rationalization[s]" for politically motivated policies. John Taylor is a former Undersecretary of the Treasury for International Affairs when he claims that forecasters like Mark Zandi and Larry Meyer who find the stimulus to be being somewhat effective are just "repeating what they said in January" because they "haven't looked at the numbers." Edward Prescott is a Nobel Prize winner and head of the second-plae school of business-cycle analysis when he claims that supporters of current economic policies "are not the people advancing the science."

Eugene Fama is the head of the dominant school in finance and perennially on the Nobel Prize short list and he claims that the existence of the savings-investment identity makes it logically impossible for the government to boost the economy via spending--an analytical error that we here at Berkeley teach our freshman not to do for it is, as Paul Krugman calls it, "the most basic fallac[y] in economics--interpreting an accounting identity as a behavioral relationship." John Cochrane is the smartest analyst of aggregate asset prices I know, and yet he too commits fallacies that I had thought were dead since the 1920s when he writes that "every dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both. This is just accounting, and does not need a complex argument about “crowding out.”

Luigi Zingales is one of the smartest young Chicago economists I know of, and yet demonstrates that he has not thought about general equilibrium in even the most cursory sense--has not thought how you analyze a system in which you have to keep straight the three commodities of cash, financial assets, and goods--when he writes that "if a nuclear bomb had destroyed all roads... [would] we [then claim] that to alleviate the economic impact... we should invest in banks[?]... [I]f the problem is the roads, you want to rebuild roads.... And if the problem is the financial sector, you want to fix this and not build roads."

(3) These are not dumb people. But these are people for whom whole blocks of what used to be called "economics"--the monetary history of the nineteenth and the first half of the twentieth centuries, the "lowbrow" theories of 1920-1980 from Fisher, Wicksell, Keynes, and Hicks through Metzler, Tobin, and Friedman--are taboo. They would be demonstrating to their peers that they were not serious highbrow economists if they consulted them, and so when they have to deal as they have in the past two years with Fisher-Wicksell-Hicks issues they approach them with great ignorance and get them wrong.

(4) Were it not for the Republican Party, this would not matter very much. The failure of high brow macro to have anything to say about our current situation--where is the misperception of relative prices that has given us 10% unemployment with both firms and workers being happy with the situation? Where is the technology shock that has pushed aggregate production relative to trend down by 8%--would lead their colleagues in other subdisciplines to draw the natural conclusions, cut back on hiring domestic macroeconomists, and hire more international finance specialists (where the analytical culture is, I think, healthy), microeconomists, historians, and institutionalists instead. The big problem is the interaction of the guys in the attic on the one hand and the Repubican Party on the other.

Had John McCain won the presidential election of 2008, at the start of 2009 he would have in all likelihood proposed a trillion dollar fiscal stimulus bill--3/4 tax cuts and 1/4 aid to states--and he might have picked Tim Geithner for his Treasury Secretary. Democrats would have called for fewer tax cuts, more state aid, and some government infrastructure spending initiatives in the fiscal policy mix, but the need for the government to cushion the recession would have brought them into line. When Obama took office he bid $800 billion for his fiscal stimulus bill--about 1/3 spending, about 1/3 aid to states, about 1/3 tax cuts--thinking that would be a plan that would win broad bipartisan assent. And he was wrong. The Republicans decided to follow the Gingrich strategy: try as hard as they could to make the Democratic president appear a failure by blocking all his initiatives. But you can't block an initiative without a story for why it is bad for the country. And that, all of a sudden, makes the madmen in the attic the favored economic advisors of the Republican Party.

This is, I think, very dangerous. The Republicans will win elections in the future. And when they do will we want Ed Prescott to be running economic policy?

If global investors lose confidence in governments tomorrow, then we have a huge crisis--and they are right to lose confidence. If global investors do not lose confidence, then we are fine--and those crying "the sky is falling" are wrong and will lose money--as long as we don't let fear of a loss of confidence panic us into prematurely cutting the government deficits that are maintaining demand.

The right policy, therefore, is (a) big deficits now, and (b) big automatic tax increases enacted now to take effect in the future if we then fail to grow our way out of the debt.

But are we smart enough to enact such policies? Certainly not with today's Republican Party.

Ken Rogoff:

From Financial Crisis to Debt Crisis?: Everyone from the Queen of England to laid-off Detroit autoworkers wants to know why more experts did not see the financial crisis coming. It is an awkward question. How can policymakers be so certain that financial catastrophe won't soon recur when they seemed to have no idea that such a crisis would happen in the first place? The answer is not very reassuring. Essentially, there is still a risk that the financial crisis is simply hibernating as it slowly morphs into a government debt crisis.

For better or for worse, the reason most investors are now much more confident than they were a few months ago is that governments around the world have cast a vast safety net under much of the financial system. At the same time, they have propped up economies by running massive deficits, while central banks have cut interest rates nearly to zero. But can blanket government largesse be the final answer? Government backstops work because taxpayers have deep pockets, but no pocket is bottomless. And when governments, particularly large ones, get into trouble, there is no backstop. With government debt levels around the world reaching heights usually seen only after wars, it is obvious that the current strategy is not sustainable.

If the trajectory is unsustainable, how long can debt keep piling up? We don't know. Academic economists have developed useful tools to predict which economies are most vulnerable to a financial crisis. But, although we can identify vulnerabilities, getting the timing right is virtually impossible. Our models show that even an economy that is massively overleveraged can, in theory, plod along for years, even many decades, before crashing and burning. It all boils down to confidence and coordination of expectations, which depend, in turn, on the vagaries of human nature. Thus, we can tell which countries are most vulnerable, but specifying exactly where and when crises will erupt is next to impossible....

Unfortunately, we live in a world where the political and regulatory system is often very weak and shortsighted.... For now, the good news is that the crisis will be contained as long as government credit holds up. The bad news is that the rate at which government debt is piling up could easily lead to a second wave of financial crises within a few years.... The question today is not why no one is warning about the next crisis. They are. The question is whether political leaders are listening.

I remember 2004-2006 being years in which sensible economists made good arguments--or arguments that seemed to me to be good at the time--that we should not worry about a recession brought on by the collapse of a housing bubble. As I recall, there were six of them:

• Any subprime housing bubble is much smaller than the dot-com bubble was.
• Americans will keep paying their mortgages even though their houses are a little bit underwater.
• Banks will be forgiving in a mortgage crisis because it is very bad to have an interest in a house that will stay vacant for any considerable period of time.
• Wall Street firms originating mortgage-backed securities this decade are like the venture capital firms of last decade--they follow the originate-and-distribute model, and the unwinding of the dot-com bubble did not create systemic risk
• In fact, we have had six potential financial crises since Alan Greenspan became Chair of the Fed--1987, 1990, 1994, 1997, 1998, 2000--and all six were nipped in the bud because the Federal Reserve has the tools and the will to stabilize the system because it can create unlimited amounts of what are the safe assets in the global economy.
• The potential crisis to worry about is the dollar crisis--because that is a crisis that the Federal Reserve cannot fix, for once the dollar becomes risky its power drains away. We should be worring about that.

Paul Krugman has a very different view:

How Did Economists Get it So Wrong?: In recent, rueful economics discussions, an all-purpose punch line has become “nobody could have predicted...” It’s what you say with regard to disasters that could have been predicted, should have been predicted and actually were predicted by a few economists who were scoffed at for their pains. Take, for example, the precipitous rise and fall of housing prices. Some economists, notably Robert Shiller, did identify the bubble and warn of painful consequences if it were to burst. Yet key policy makers failed to see the obvious. In 2004, Alan Greenspan dismissed talk of a housing bubble: “a national severe price distortion,” he declared, was “most unlikely.” Home-price increases, Ben Bernanke said in 2005, “largely reflect strong economic fundamentals.”

How did they miss the bubble? To be fair, interest rates were unusually low, possibly explaining part of the price rise. It may be that Greenspan and Bernanke also wanted to celebrate the Fed’s success in pulling the economy out of the 2001 recession; conceding that much of that success rested on the creation of a monstrous bubble would have placed a damper on the festivities.

But there was something else going on: a general belief that bubbles just don’t happen. What’s striking, when you reread Greenspan’s assurances, is that they... were based on the a priori assertion that there simply can’t be a bubble in housing. And the finance theorists were even more adamant on this point. In a 2007 interview, Eugene Fama, the father of the efficient-market hypothesis, declared that “the word ‘bubble’ drives me nuts,” and went on to explain why we can trust the housing market: “Housing markets are less liquid, but people are very careful when they buy houses. It’s typically the biggest investment they’re going to make, so they look around very carefully and they compare prices. The bidding process is very detailed.” Indeed, home buyers generally do carefully compare... the price of their potential purchase with the prices of other houses. But this says nothing about whether the overall price of houses is justified. It’s [Larry Summers's] ketchup economics [point], again: because a two-quart bottle of ketchup costs twice as much as a one-quart bottle, finance theorists declare that the price of ketchup must be right....

Now that the undiagnosed bubble has burst, the true riskiness of supposedly safe assets has been revealed and the financial system has demonstrated its fragility. U.S. households have seen $13 trillion in wealth evaporate. More than six million jobs have been lost, and the unemployment rate appears headed for its highest level since 1940. So what guidance does modern economics have to offer in our current predicament? And should we trust it?...

Let me say that I agree with everything Paul Krugman writes about today's Chicago School--a group who would dismiss Milton Friedman as a dangerously interventionist leftist were he with us today, and a group who seem to me to know little about the economy and to have thought less about fundamental issues in monetary economics that I used to teach my graduate students were settled once and for all in the 1920s and 1930s. Their influence on the future of economics ought to be reduced to a smidgeon of its current value--they made big intellectual bets on what the world is like, and they lost, and they should pay.

The big lesson, I think, is that Wall Street is much less sophisticated than we imagined it was: Goldman Sachs simply did not do any of the due diligence it needed to do to understand the AIG-specific risks it was assuming, Citigroup was unable to manage its own derivatives book to understand what "liquidity put" risks it was assuming, and as for Bear Stearns, Lehman Brothers, Merrill Lynch--hoo boy...

Grasping Reality with Both Hands: The Coming Dollar Crisis?: As is often the case, the most interesting things I learned at last August's round of conferences came not in the formal conference sessions but in the informal small-group conversations before, around, in the interstices of, and after the conference.

Take the Federal Reserve Bank of Kansas City's "Greenspan Era" conference. It was held in Jackson Hole, at the Jackson Lake Lodge in Grand Teton National Park, in the shadow of the Grand Tetons, which are perhaps the most impressive mountain range in North America. ("Perhaps" because the Canadian central bankers present pointed out the Canadian Rockies from Lake Louise to Jasper, while Federal Reserve Bank of San Francisco president Janet Yellen sang the praises of the mountains of her own Federal Reserve District: the east face of the Sierra Nevada as seen from the Owens Valley, to be specific.) You spend the mornings in windowless conference rooms, and the afternoons outside--on the Snake River, hiking, climbing, looking for moose, looking for elk, hoping that bear are not looking for you.

But the afternoons--and the formal and informal breaks in the mornings when you flee the windowless conference room for the fresh air of the west lawn of the lodge to stare at Mount Moran and company across the lake--are filled with arguments. Go with Federal Reserve Governor Don Kohn on an afternoon hike up Cascade Canyon, I am told, and expect to gain 3000 feet in two hours while being quizzed intently about technical details of monetary policy. Try to keep from grounding yourself on sand bars in the Snake River, and you will hear ex-senior executive branch officials of both political parties give their assessments of why neither of the Bush II Treasury Secretaries has been able to make effective use of the thousand or so people who work directly for him.

This time the most interesting rounds of break-and-afternoon conversations I heard were sparked by Sebastian Edwards's paper about the U.S. current account deficit. My conversations quickly exposed a deep fault among the conference attendees. Those who analyzed or forecast the U.S. domestic macroeconomy agreed that a steep decline in the value of the dollar sometime in the next five years was overwhelmingly likely, but by and large they did not think that such a decline would pose a big problem for the U.S. economy. (They agreed that it might well pose a very big problem for some of America's trading partners.) By contrast, those who analyzed or forecast the international economy as a whole were typically terrified by the prospect of a steep (30% or more, perhaps much more) decline in the value of the dollar: they thought a severe U.S. recession was a definite possibility, and that the situation would require exceptionally skillful handling to keep from becoming a serious economic problem.

Why this disjunction?

The domestic macroeconomists would typically argue more or less like this:

Yes, the dollar is likely to decline steeply either when foreign central banks stop buying dollar-denominated assets to keep the values of their currencies down or when international speculators lose confidence or both. But so what? The fall in the value of the dollar will boost foreign demand for U.S. exports. Workers will be pulled out of other sectors into the export sector. The effects of the dollar decline are much more likely to be a plus for employment rather than a minus, a boom rather than a recession.

To this, the international economists would respond more-or-less like this:

When foreign central banks stop buying or international speculators lose confidence in the value of the dollar and thus stop buying U.S. long-term bonds, two things happen: the value of the dollar falls, and the rate of interest on dollar-denominated long-term bonds spikes. The spike in long-term interest rates discourages investment spending directly, and also discourages consumption spending because higher interest rates mean lower housing and stock prices and thus lower consumer wealth. The fall in domestic spending happens now. The rise in exports as the falling dollar makes U.S.-made products more attractive to foreigners happens two years from now. In between, a lot of people are unemployed--and as they are unemployed, they cut back further on their spending. Plus there is the risk that the fall in the value of the dollar and the fall in long-term asset prices generated by the interest rate spike will cause enough bankruptcies among financial institutions to cause a flight to quality--which will further raise non-safe interest rates, and further discourage investment and consumption spending

This then puzzled the domestic economists:

Why should interest rates spike? The Federal Reserve controls American interest rates. If it wants to keep the price of the ten-year Treasury bond high, it can simply start buying bonds until the price of ten-year Treasuries is what the Fed wants it to be. There's no reason for employment in construction and other interest rate-sensitive sectors to fall before employment in exports and related sectors rises--at least not unless the Federal Reserve makes a big mistake and allows rising interest rates to shoot the economy in the head.

And at this point the response of the international economists fragmented:

Some said that the falling dollar would create inflation--with imports at 1/6 of GDP, a 40% fall in the dollar would, if fully passed through to import prices, add 6% to the U.S. price level. The Federal Reserve would feel honor-bound to maintain its reputation as an inflation-fighter, and so would allow interest rates to go high enough to produce enough unemployment to push nominal wages down far enough to offset this rise in import prices. Thus the Federal Reserve would welcome the spike in interest rates as appropriate, and take no steps to offset it.

Others said that the adjustment to the fall in the dollar would require that ten million workers shift out of construction, retail, and consumer services occupations and into export and import-competing manufacturing industries. You cannot move ten million American workers from one sector to another in a matter of a year or two without creating lots of structural unemployment.

Still others said that financial stress would be the key: perhaps some major Wall Street firms would discover big unhedged risks in their derivative books; perhaps perhaps others would find that the values of their portfolios were more responsive to changes in long term interest rates than they had thought. In either case, it is financial distress and chaos that really triggers the recession.

And the domestic side had rebuttals to each of these three points:

1. If the Federal Reserve announces now that it is targeting a measure of inflation that is not grossly affected by import prices--that it is targeting nominal wage growth, say--there is no need for the Federal Reserve to defend its credibility by attacking the economy. Just as the Federal Reserve has trained observers that it is more important to worry about 'core inflation' than 'headline inflation', so the Federal Reserve ought to be preparing observers to recognize that inflation produced by rising import prices is a one-time event, not an inflationary spiral that needs to be fought by triggering a deep recession.

2. A large structural shift will cause high unemployment only if the transition is quick and brutal, and only if workers are pushed out of job-losing rather than pulled into job-gaining sectors. Whether it is quick or gradual and whether it is push or pull depends, once again, on the path of interest rates. Only if the Federal Reserve fails to do its job and allows for a massive interest rate spike is there a problem.

3. Financial stress is something that can be managed: if the Federal Reserve keeps the path of interest rates smooth, great financial stress is unlikely.

And the domestic side of the argument pointed to the historical experience of the U.S. from 1986-1990: Between 1985 and 1989 the value of the U.S. dollar declined by 40%. Between 1986 and 1990 the U.S. trade deficit declined from 4.0% of GDP to 0.5% of GDP--without a big recession, or significant macroeconomic distress.

Before dinner one evening I was lectured by a prominent Washington-area international finance economist about all the reasons that the 1986-1990 U.S. experience was likely to be a bad guide to the future:

1. 1986-90 began with a 50% decline in world oil prices, a powerful stimulus to the world economy. This time the process is beginning with a doubling of world oil prices.

2. 1986-90 saw Europe growing rapidly. Europe has a high propensity to buy U.S. exports, and the European boom meant that U.S. exports grew much faster in the late 1980s than anyone had expected. This time it is Asia that is booming, not Europe. And Asia has a relatively low appetite for U.S. exports.

3. The Japanese government was willing to buy very large amounts of dollar-denominated assets in the late 1980s to keep the decline in the value of the dollar "orderly." In so doing, it inflated its domestic credit base and touched off its own property bubble. No foreign government is going to risk this again just because the U.S. would rather that the decline in the dollar was slow and orderly.

4. The problem then was half as big relative to the size of the U.S. economy as is the problem now.

One way I found myself thinking of the argument is that the domestic-side economists look at the goods market and think of a decline in the value of the dollar as a supply shock, and as not that big a supply shock: if half of the adjustment in import prices is taken in reduced margins by producers abroad, and if the shock is spread out over four years, then 40% / 2 x 16% / 4 = 0.8% increase in inflation relative to baseline over three consecutive years. The Federal Reserve could easily allow that to happen without--providing it explained its causes well--running any risk of damaging the credibility of its commitment to effective price stability. No big deal. International finance economists, by contrast, look at the asset markets. A 40% decline in the dollar over four years is a decline at the rate of 10% per year. Once financial markets convince themselves that such a decline is coming and that they need to be compensated for it, that ought to drive a 400 basis point wedge between U.S. and foreign long-bond expected returns. And that is a very big deal.

Martin Feldstein said something very smart just after we had both taken off our shoes at Jackson Hole airport. He said that the domestic-side economists were keying off the past experience of the U.S. after 1985 and of Britain after 1982, and so were saying "no big deal"; while the international finance economists were keying off of the experiences of developing countries that had run large current-account deficits--Mexico 1994, East Asia 1997, Argentina 2001. Each side had its own preferred models that functioned very well at explaining the past historical cases that they focused on. But there was no way right now of settling, empirically, whether a model built to explain the U.S. in 1985 or Korea in 1998 was more applicable to the U.S. in 2006--you had to make a bet, either that continuities in U.S. economic structure were important, or that financial globalization was important, in choosing your model and your terms of analysis.

It was very interesting. And very disturbing. Brilliant economists, thinking hard, unable to reach even the beginnings of analytical agreement about how to model the distribution of possible futures.

Obama lucky to have Bernanke -- Shanghai Daily | 上海日报 -- English Window to China New: WILLIAM McChesney Martin, a Democrat, was twice reappointed chairman of the United States Federal Reserve by Republican President Dwight D. Eisenhower.

Paul Volcker, a Democrat, was reappointed once by the Reagan administration (but not twice: there are persistent rumors that Reagan's treasury secretary, James Baker, thought Volcker too invested in monetary stability and not in producing strong economies to elect Republicans).

Alan Greenspan, a Republican, was reappointed twice by Bill Clinton. And now Barack Obama has announced his intention to renominate Republican appointee Ben Bernanke to the post.

The Fed chairmanship is the only position in the US government for which this is so: it is a mark of its unique status as a non or not-very-partisan technocratic position of immense power and freedom of action - nearly a fourth branch of government, as David Wessel's recent book "In Fed We Trust" puts it.

The reason American presidents are so willing to reappoint Fed chairmen from the opposite party is closely linked to one of the things a president seeks: The confidence of financial markets that the Fed will pursue non-inflationary policies.

If financial markets lose that confidence - if they conclude that the Fed is too much under the president's thumb to wage the good fight against inflation, or if they conclude that the chairman does not wish to control inflation - then the economic news is almost certain to be bad.

Capital flight, interest-rate spikes, declining private investment, and a collapse in the value of the dollar - all of these are likely should financial markets lose confidence in a Fed chairman.

And if they occur, the chances of success for a president seeking re-election - or for a vice president seeking to succeed him - are very low. By reappointing a Fed chairman chosen by someone else, a president can appear to guarantee to financial markets that the Fed is not too much under his thumb.

But US presidents seek more than just a credible commitment to financial markets that the Fed chairman will fear and fight inflation. They seek intelligence, honor, and a keen sense of public interest and public welfare.

Presidents' futures - their ability to win re-election, to accomplish other policy goals, and to leave a respectable legacy - hinge on the economy's strength.

It may or may not be true, especially these days, that what is good for General Motors is good for America and vice versa, but certainly what is good economically for America is good politically for the president.

It is here that Obama has lucked out. Ben Bernanke is a very good choice for Fed chairman because he is intelligent, honest, pragmatic and clear-sighted in his vision of the economy. He has already guided the Fed through two very tumultuous years with only one major mistake - the bankruptcy of Lehman Brothers.

David Wessel

Obama to Reappoint Fed Chairman Ben Bernanke - WSJ.com: President Barack Obama will announce Tuesday that he is nominating Ben Bernanke for a second four-year term as chairman of the Federal Reserve, White House Chief of Staff Rahm Emanuel said...

Two reactions:

1. I think Bernanke is one of the best in the world for this job--I cannot think of anyone clearly better. He has made only one big mistake--buckling under to pressure from all those yelling at him for enabling moral hazard and not finding a way to takeover Lehman Brothers, and he is not going to make the same mistake again...

2. I am surprised that he is being reappointed. I would have thought that the combination of people angry because he has given too much public money to the banks and people angry because he didn't stop the recession would together make him damaged and that Obama would want to bring in a fresh face--never mind that Bernanke had no way to try to lessen the recession save by policy steps that inevitably involve giving money to the banks. It shows, I think, a seriousness about getting the policies right--or as close to right as we can--that I like to see in a president...

Part III:

Fastest way to end the recession: bailing out homeowners? -- latimes.com: Edward Leamer says the government's focus should be on creating buyers. Brad DeLong says the Treasury ought to bite the bullet and buy up every mortgage.

---

How Greenspan wanted the boom to go, and how it turned out. Counterpoint: Brad DeLong

Let me start by outlining how the 2000s were supposed to work -- according to former Federal Reserve Chairman Alan Greenspan.

The late 1990s had seen a large technology-led boom that had employed millions of Americans and provided a forced draft that intensified the fire of economic growth. It was accompanied by "irrational exuberance" in the venture capital and stock markets, as investors began to think not just that technological progress in information technology was rapid but that it would be easy for the companies they invested in to turn that technological progress into profits. The first half was true -- technological progress in America's Silicon Valley is still ensuing at an extraordinary rate: I just got a spam e-mail offering to sell me a four-gigabyte USB flash disk for $9.25. In 1987, I paid $900 for a 10-megabyte hard disk.

But the second half -- that it would be easy to turn this progress into sustained profits -- turned out to be false. It's very hard to pay a lot of dividends to your investors if you are selling four-gigabyte USB flash disks for $9.25.

In the early 2000s, investors began to realize that technological progress was easy relative to making profits in a competitive market, and stock prices for tech companies collapsed. The American high-tech industry began to shed workers as firms closed.

Greenspan decided to deal with this situation by lowering interest rates. The enormous flood of savings from Asia seeking investments in America had started, so low interest rates could be sustained because demand for funds would not outstrip supply. And low interest rates meant that lots of long-run durable investments would be profitable; you could, after all, borrow the money to produce or to buy them at low interest rates. The biggest long-run durable investment as a share of the American economy is housing. So Greenspan thought that he could keep unemployment low by generating a housing boom, so that as employment in tech companies (and related occupations) fell, employment in construction (and related occupations) would rise.

Did Greenspan worry about what would happen if the housing boom also succumbed to irrational exuberance? Yes. Did he worry very much? No. After all, when high-tech stocks and venture capital bubbles had collapsed, the systemwide consequences for the economy were small. Lots of over-enthusiastic investors lost their money -- but they were rich grown-ups, and the Federal Reserve doesn't exist to keep rich people from risking their money in silly ways. Lots of engineers lost their jobs, but they had been well-paid during the boom and would not have had nearly as good jobs (or perhaps any jobs at all) were it not for the bubble. American consumers got a lot of cheap computers and a lot of extra fiber-optic cables over which to make our phone calls. The winners were American consumers and (during the boom) American workers. The losers were relatively rich American investors. Overall, it was a net plus.

Greenspan expected something similar to come out of the housing boom. If it did turn into a bubble, then the winners would be homeowners who bought houses on good terms by borrowing at low interest rates and renters who would find after the boom a plentiful supply of houses on the market and be able to bargain for big houses at cheap rents. The losers would be irrationally exuberant investors who had lent their money when it was cheap to borrow or bought expensive properties when prices were high. Once again -- Greenspan thought -- the boom as a whole, even with the likely magnitude of irrational exuberance and over-speculation, would be a net plus.

But it did not happen that way. The housing bust was big enough that, as you calculate, we are now back to having not a plentiful housing supply but rather one that is in line with historical trends. And we are still under-building, which you say is "laying the foundation for the next housing mania." Yet because the bust triggered a financial crisis that triggered a recession, the construction industry is not seeing the kind of rising home values that trigger a recovery. Because of the recession, people are doubling up. And a great many houses are not where they should be -- four bedrooms with swimming pools east of San Bernardino, as you say, when what America really needs is multifamily units in northern Orange County. And you're right, Ed.

Thus there is a strong case for government intervention in housing finance to try to get the construction sector back to where it ought to be. You point to California's and the federal government's respective tax credits for new home buyers and say that you hope they're enough to turn the market around.

I don't think they will be. I think we should face the fact that home mortgage finance is broken, that the risk tolerance of the private financial system is impaired and that we will not get the flow of finance to potential home buyers through private banks working again any time soon.

So I think -- I have thought for a year and a half now -- that it is time to bite the bullet. The federal government has already nationalized Fannie Mae and Freddie Mac. It should stop treating them like private companies and start treating them like arms of the Treasury. They should set an interest rate spread above the 30-year Treasury rate and then buy up every single mortgage and transform them into standard 30-year fixed-rate mortgages. The government may well lose money on the deal, but a lot of homeowners who cannot pay their current mortgages and are about to be foreclosed on could pay 30-year loans at a few percentage points above the Treasury rate.

A lot of construction companies would be willing to start building the multifamily units in northern Orange County that we need if they knew that potential condo buyers could get financing from the government on such terms.

And the government might, after all, make money on the deal.

Then, after the crisis is over, we can think about how to re-privatize the mortgage finance arm of the financial sector.

He writes:

Flash: The Head of the Bank of England Confesses: “As I look back, it now seems that, with all the thought and work and good intentions, which we provided, we achieved absolutely nothing … nothing that I did, and very little that old Ben did, internationally produced any good effect — or indeed any effect at all except that we collected money from a lot of poor devils and gave it over to the four winds.”

Of course, the "Ben" is Benjamin Strong, President of the Federal Reserve Bank of New York up to 1928, not Ben Bernanke. The speaker is not today's Governor of the Bank of England Mervyn King, but rather the interwar governor Montagu Norman.

You know, every time I think Paul Davidson and his post-Keynesians ought to have more of economists' collective mindshare, he comes up with something truly dorky like this:

If You Are Looking for a Monument to John Hicks, Look Around You!: If Brad Delong had kept up with John Hick's more recent writings he would have read J.R. Hicks "ISLM : An Explanation", JOURNAL OF POST KEYNESIAN ECONOMICS, Winter 1980-81 issue, where Hicks indicates that over time he became completely dissatisfied with ISLM framework he developed in 1937. In this "ISLM:AN EXPLANATION" article Hicks completely recants on the ISLM apparatus and indicates that the ISLM framework has nothing to do with Keynes or reality. Too bad Brad is wedded to the classical efficient market hypothesis and has never been able to understand the ontological uncertainty involved in the concept of a nonergodic stochastic process that was the basis of Keynes's general thoery and which Hicks ultimately claimed that "nonergodic"system was the same as his own analysis.

Paul

Which of the following should I say?:

• That Paul Davidson is the first person, ever, to have claimed that I am "wedded to the classical efficient markets hypothesis." Nobody has ever said that to me before. It is truly a nonergodic event...

• I would have said that IS-LM has a great deal to do with reality: Hicks implicitly predicted back in 1937 that the enormous expansion in the supply of U.S. Treasury bonds we have seen over the past year would have next to no effect on interest rates. Supply-and-demand would say that if you increase the supply of government bonds by a lot, you lower their price--raise interest rates. Big win for Hicks and IS-LM. But Davidson doesn't see that...

• That IS-LM is the first step you take if you start from the Fisherian quantity theory and attempt to incorporate the fact that the velocity of money is determined by the opportunity cost of holding money balances--voila, you then have an LM curve, and you need something to pin down where on the LM curve the economy is, and that "something" is your IS curve. If you are dealing with people rooted in the quantity theory, then IS-LM is the only one-step way you can get them to think about broadly "Keynesian" issues, and is thus useful for that purpose...

• That IS-LM does not have "nothing to do with Keynes." It has a lot to do with Keynes in at least some of his moods and modes--and deals with issues that, in other moods and modes, Keynes thought of as side issues...

• That I first read Hicks's "ISLM: An Explanation" in the late spring of 1980, after going to Olivier Blanchard's office with some questions about Axel Leijonhufvud and being handed a copy. Hicks's criticisms of IS-LM are that it is:

  • Not properly dynamic
  • If the LM curve is taken to be the quantity theory equation with velocity a function of the short-term nominal interest rate on government bonds, then a huge number of issues are thrown into the IS box and then nailed shut in there where they cannot be easily examined.
  • If the IS curve is taken to be the income-expenditure multiplier framework with investment a function of the real interest rate on actual risky government bonds, then a huge number of issues are thrown into the IS box and then nailed shut in there where they cannot be examined.
  • These are all fine and apposite criticisms, and they are very good reasons not to take IS-LM as the end of your analysis. But if you are trying to introduce the issues to people--like modern-day Chicago--who can't even crawl, it is a way for them to widge across the floor and make some progress.

Pro Growth Liberal accuses me of burying the lead:

EconoSpeak: Why Deficits Have Not Increased Interest Rates: Brad DeLong Makes Me Go Huh?: Brad DeLong makes an interesting observation:

it is astonishing. Between last summer and the end of this year the U.S. Treasury will expand its marketable debt liabilities by $2.5 trillion--an amount equal to more than 20% of all equities in America, an amount equal to 8% of all traded dollar-denominated securities. And yet the market has swallowed it all without a burp...

If Brad wanted to mock the standard new classical belief that we are always near full employment so any significant fiscal stimulus would drive up interest rates, this observation would be a nice rebuttal along the lines of the old fashion Keynesian notions that we are both below full employment and are in a liquidity trap...

Well, yes, that is what I do want to mock (and make a couple of other points alongside).

So let me be more explicit: Last fall I had a large number of conversations with bond market observers who said things like: "Interest rates are low now, but look at how much the Treasury is going to borrow over the next eighteen months. When those borrowings hit the market, Treasury bond prices are going to fall bigtime and interest rates rise. At the moment bond prices are high and interest rates are low, but that's only because finance firms' top management aren't letting traders off their leash to short Treasuries. The traders all expect Treasury prices to fall and interest rates to rise. Mark my words: when the Treasury tries to sell all those bonds next year, it won't find buyers at anything near current prices. Where will all the extra savings to buy those bonds come from?..."

As I wrote:

[S]upply-and-demand are supposed to rule--and a sharp increase in Treasury borrowings is supposed to carry a sharp increase in interest rates along with it to crowd out other forms of interest sensitive spending.

Yet:

Hasn't happened. Hasn't happened at all:

It is astonishing. Between last summer and the end of this year the U.S. Treasury will expand its marketable debt liabilities by $2.5 trillion--an amount equal to more than 20% of all equities in America, an amount equal to 8% of all traded dollar-denominated securities. And yet the market has swallowed it all without a burp...

And the interesting thing is that I knew that this was going to be what would happen--or, rather, I strongly believed that this was going to be what would happen--and all because I had read John Hicks (1937).

Let me give you the Hicksian argument about what happens in a financial crisis--a sudden flight to safety that greatly raises interest rate spreads, and as a result diminishes firms' desires to sell bonds to raise capital for expansion and at the same time leads individuals to wish to save more and spend less on consumer goods as they, too, try to hunker down.

In Hicks's model, the immediate consequence is an excess demand for (safe) bonds in the hands of investment banks: bond prices rise, and interest rates falls. As interest rates fall, (a) firms see that they can get capital on more attractive terms adn so seek to issue more bonds, and (b) households see the interest rate they can get on their savings fall, and so lose some of their desire to save. The market heads toward equilibrium. But as the market heads toward equilibrium, something else happens as well: the fall in interest rates and the rise in savings is accompanied by a greater desire on the part of households and businesses to hold more of their wealth safely--in pure cash. And so the speed with which cash turns over in the economy, the velocity of money, falls. And as the velocity of money falls, total spending falls, and workers are fired, and as workers are fired and lose their incomes their saving goes from positive to negative.

Thus the process of return to equilibrium takes two forms:

• interest rates fall, boosting investment and curbing savings.
• spending and thus employment and production fall, further curbing savings.

In normal times, the correct policy response is for the Federal Reserve to inject more money into the economy: through open-market operations it should buy bonds for cash, thus increasing the amount of cash so that even at the lower velocity we still have the same volume of spending, and thus transform the adjustment process from a fall in interest rates, spending, employment, and production to a fall in interest rates alone.

A little thought, however, will lead us to the conclusion that such open-market operations may fail. In them, the Federal Reserve is buying bonds, shrinking the supply of bonds out there--and thus pushing up their price and pushing down interest rates. For each amount that the Federal Reserve expands the money stock, therefore, it puts downward pressure on interest rates and thus on monetary velocity. In the limit where interest rates are so low that people don't really see a difference between cash and short-term government bonds like Treasury bills, open-market operations have no effect because they simply swap one zero-yielding government asset for another.

It is in this situation that a government deficit can be useful. A government deficit means that the government is printing and issuing a lot of bonds at exactly the same moment that private investors are looking for a safe asset to hold. As these bonds hit the market, people who otherwise would have socked their money away in cash--thus diminishing monetary velocity and slowing spending--buy the bonds instead. A large and timely government deficit thus short-circuits the adjustment mechanism, and avoids the collapse in monetary velocity that was the source of all the trouble.

Thus a Hicksian analysis last fall would have said--did say--"don't worry: a large flood of government bond issues won't push up interest rates; it will stem a collapse in monetary velocity instead as people who want to hold their wealth in safe form and would otherwise be holding money find themselves happy holding government bonds instead."

And it has all come true.

Lector, si requiris monumentum Hickium, circumspice!

Paul Krugman's answer:

Averting the Worst: So it seems that we aren’t going to have a second Great Depression after all. What saved us? The answer, basically, is Big Government.... [T]he economic situation remains terrible... we’re... nine million jobs short of where we should be. And the job market still hasn’t turned around....

For all that, however, the latest flurry of economic reports suggests that the economy has backed up... from the... abyss. A few months ago the possibility of falling into the abyss seemed all too real.... [I]n the 1930s the trend lines just kept heading down. This time, the plunge appears to be ending after just one terrible year. So what saved us from a full replay of the Great Depression? The answer, almost surely, lies in the very different role played by government.

Probably the most important aspect of the government’s role in this crisis isn’t what it has done, but what it hasn’t done: unlike the private sector, the federal government hasn’t slashed spending.... All of this has helped support the economy in its time of need, in a way that didn’t happen back in 1930.... In addition to having this “automatic” stabilizing effect, the government has stepped in to rescue the financial sector. You can argue (and I would) that the bailouts of financial firms could and should have been handled better... while acknowledging that without these bailouts things would have been much worse. The point is that this time, unlike in the 1930s, the government didn’t take a hands-off attitude while much of the banking system collapsed. And that’s another reason we’re not living through Great Depression II.

Last and probably least, but by no means trivial, have been the deliberate efforts of the government to pump up the economy... the American Recovery and Reinvestment Act... was too small. Nonetheless, reasonable estimates suggest that around a million more Americans are working now than would have been employed without that plan — a number that will grow.... All in all, then, the government has played a crucial stabilizing role in this economic crisis. Ronald Reagan was wrong: sometimes the private sector is the problem, and government is the solution.

And aren’t you glad that right now the government is being run by people who don’t hate government?...

[W]e appear to have averted the worst: utter catastrophe no longer seems likely.

And Big Government, run by people who understand its virtues, is the reason why.

The loose end in Krugman's article is why there weren't more Great Depressions back in the old days, before big government. The answers, I think, are two:

1. Business cycles are a disease of the post-agricultural economy--of the nonfarm economy. If you look back at the nonfarm unemployment rate before 1930, things look not as bad as the Great Depression but still pretty bad.

2. Most countries had a form of "big government"--a military large in size relative to its nonfarm economy and an activist, interventionist central bank--reaching far back into the past.

3. The U.S. was the only major industrial power without an activist, interventionist central bank before 1913--but the U.S. Treasury did give the baton to run monetary policy to the Morgan-Belmont syndicate in the 1890s and to Morgan in 1907, so we were not always without an activist, interventionist central bank.

4. And the U.S. looks like the worst as far as pre-1930 business cycles are concerned, with 1874 and 1885 matching 1893 in terms of nonfarm unemployment and industrial distress.

For example, this shows the Weir-basis nonfarm unemployment rate back to 1890:

Fun and games in 1921-22, 1914-15m, 1907-08, and 1893-6 as well as 1885 and 1874...

Mark Thoma asks:

Ask the right questions: [T]he important question is why policymakers didn't take the possibility of a major meltdown seriously. Why didn't they deliver forecasts conditional on a crisis occurring? Why didn't they ask this question of the model?... And... why was the main factor that allowed the crisis to spread, the interconnectedness of financial markets, missed? It was because policymakers couldn't and didn't take seriously the possibility that a crisis and meltdown could occur. And even if they had seriously considered the possibility of a meltdown, the models most people were using were not built to be informative on this question. It simply wasn't a question that was taken seriously by the mainstream.

Why did we, for the most part, fail to ask the right questions? Was it lack of imagination, was it the sociology within the profession...? It wasn't the tools, and it wasn't lack of imagination.... [T]he voices were there... Michael Mussa for one.... Nobody listened even though some people....

And here I think that thought leaders such as Robert Lucas and others... have questions they should ask themselves (e.g. Mr Lucas saying: "At research seminars, people don’t take Keynesian theorizing seriously anymore; the audience starts to whisper and giggle to one another"...).... [That] influences whole generations of economists away from asking certain types of questions...

I think that sociology takes us only so far. Looking back, the Federal Reserve and the Treasury had done a relatively good job in keeping money and finance a fluttering veil for a generation. The stock market crash of 1987--no macroeconomic impact on production and employment. The savings-and-loan crisis of 1990 and the associated credit crunch--minimal macroeconomic impact. The 1998 collapse of LTCM--no macroeconomic impact. The 2000 crash of the dot-com bubble--minimal macroeconomic impact.

The Greenspan Fed batted four-for-four in crises, and many of us--especially me--thought that the Bernanke Fed would do at least as well.

Matthew Yglesias muses on this issue:

Matthew Yglesias: Out of the Frying Pan: One of the more interesting questions about the Housing Bubble Era of 2001-2008 actually has to do with what happened in the years before its rise. Why didn’t the LTCM failure, the “Asian” Financial Crisis (which certainly seemed like a big crisis in Russia at the time), the collapse of the NASDAQ bubble, and the revelation of massive accounting fraud all during the 1997-2000 period prompt some kind of more meaningful action. At the time, I can recall that there was a lot of talk in the air of the need for reform.

John Quiggin recalls:

Neither of these things happened. Advocates of the efficient markets hypothesis, in general, simply ignored the dotcom fiasco, and went on as if nothing had happened. The accounting scandals at Enron and other companies produced the Sarbanes-Oxley Act, which sought to reform corporate governance. But the Act was limited and largely ineffectual. Within a year or two, the conventional wisdom of the financial markets was that Sarbanes-Oxley was an over-reaction to isolated cases of fraud, and that a new push for deregulation was needed.

Financial institutions could disregard the failures of the dotcom bubble because of the (seemingly successful) operation of the Greenspan put. Rather than let the financial sector suffer the consequences of the bursting bubble, Greenspan relaxed monetary policy and inflated a whole new bubble, this time in housing.

This is a somewhat strange problem. Whatever you think of Greenspan’s overall legacy—and I think it’s appropriate to take a very dyspeptic view of his fiscal policy interventions in 1999-2001 and of his interest rate policy in 2004—I think it’s a bit hard to regret that he acted swiftly and decisively to keep the world out of a major recession at the turn of the millennium. The millennial recession was not a fun time for the aversely affected, but relatively few people were aversely affected because it was relatively short and shallow. Letting things fall apart would have led to millions of additional unemployed people, state budget crises, cutbacks in critical social services, etc., etc., etc.

But it really does seem that the success of these operations was taken as a reason to avoid any serious systematic reform. And you can feel the same kind of thing happening today. It’s disturbing.

Definitions of the "Money Stock":

FRB: H.6 Release--Money Stock and Debt Measures:

1. M1 consists of (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) traveler's checks of nonbank issuers; (3) demand deposits at commercial banks (excluding those amounts held by depository institutions, the U.S. government, and foreign banks and official institutions) less cash items in the process of collection and Federal Reserve float; and (4) other checkable deposits (OCDs), consisting of negotiable order of withdrawal (NOW) and automatic transfer service (ATS) accounts at depository institutions, credit union share draft accounts, and demand deposits at thrift institutions. Seasonally adjusted M1 is constructed by summing currency, traveler's checks, demand deposits, and OCDs, each seasonally adjusted separately.

2. M2 consists of M1 plus (1) savings deposits (including money market deposit accounts); (2) small-denomination time deposits (time deposits in amounts of less than $100,000), less individual retirement account (IRA) and Keogh balances at depository institutions; and (3) balances in retail money market mutual funds, less IRA and Keogh balances at money market mutual funds. Seasonally adjusted M2 is constructed by summing savings deposits, small-denomination time deposits, and retail money funds, each seasonally adjusted separately, and adding this result to seasonally adjusted M1.

What Is This "We," Kemosabe?

He has smart things to say--like that, contra Lucas's claim, it was not a victory for the Efficient Market Hypothesis that economists (except for Mussa, Krugman, Baker, and their posse) did not worry about the housing bubble and the size of the lower tail of asset price changes:

Lucas roundtable: Some successes, some failures: Let me focus on some areas where I disagree with Mr Lucas.... I think he is too quick to cite the Efficient Markets Hypothesis (EMH) to dismiss criticism that economists should have predicted the collapse. To be sure, Lucas is correct that we should not expect economists to predict the timing of changes in security markets prices. That said, I do still think that economists—myself included—missed the boat in a fundamental way. Too many economists thought that a collapse of the recent magnitude was unthinkable, especially since financial institution CEOs generally had their own money on the line. To put the point into EMH lingo, we miscalculated systematic risk very badly. We underestimated financial fragility and we underestimated the extent to which common expectational errors, across many entrepreneurs and indeed many nations, were possible. Citing EMH does not in my view excuse this error or account for it. 

Second, one can believe in EMH and still think it is possible to identify bubbles in the housing market ex ante. It is difficult to sell houses short and so the bubble can last for some time, even if it has been identified by informed observers. One group of economists, including Ben Bernanke, significantly underestimated the potential for large and systemic risk in the housing market. This was a simple, flat out error. We don’t have to toss out modern macroeconomics, but we do need to ask why it happened.

Third, Mr Bernanke and many others, again including myself, failed to appreciate how much the Lehman failure would cause some credit flows to shut down. It was surprising to see the interbank repo market collapsing so radically, as has been analysed since by Gary Gorton. There is something fundamental about financial intermediation that we did not understand and probably still do not understand. Why should those markets have dried up so thoroughly and so quickly? Why wasn’t a price adjustment sufficient to restore equilibrium? Why is the continued operation of these markets so important for the real economy? 

Fourth, the recent debates over fiscal policy and stimulus have not enhanced my confidence in macroeconomics. Analytic conclusions in this area seem to line up too tightly with the political views of the researchers. If we can’t understand fiscal policy, I suggest something broader is amiss...

I do however, find myself puzzled by Tyler's last paragraph.

Who is this "we" he speaks of?

Tyler Cowen understands fiscal policy very well. If you ask him how it is that expansionary fiscal policy can increase the flow of nominal demand, he can identify all four parts of the elephant blindfolded:

1. In a Quantity Theory of Money System: If a collapse in market risk tolerance leads to a sharp fall in the short-term nominal interest rate on Treasury securities, that will diminish the opportunity cost of holding money balances and so reduce monetary velocity and thus the flow of nominal demand. Expansionary fiscal policy increases the stock of government bonds outstanding, lowers their price by supply and demand, and thus raises the opportunity cost of holding money balances and puts upward pressure on velocity...

2. In a Neo-Wicksellian Flow-of-Funds System: If a collapse in market risk tolerance pushes the natural rate of interest negative--to a place where the market interest rate cannot go--and so creates an deflationary gap where planned investment is less than actual national net saving, government deficits--dissaving--that reduce national net saving eliminate this deflationary gap between investment and saving, and relieve what would otherwise be downward pressure on the flow of nominal spending...

3. In a Keynesian Income-Expenditure System: If a collapse in market risk tolerance leads to a sharp rise in inventories that causes firms to start firing people, boosting government spending without boosting taxes soaks up those excess inventories, and then there is no signal to private companies adjusting quantities rather than prices that they should fire more workers, which would lower incomes, which would lower consumption spending, which sets off the multiplier process...

4. In a Credit-Channel System: If a collapse in banking-sector capitalization leads to an intensification of moral hazard and adverse selection problems in capital markets, private financial intermediaries will no longer be able to strike contracts to intermediate flows between saver sources and users of funds. But the government--as long as the government's debt remains the safe asset in the economy, that is--is not subject to these moral hazard and adverse selection problems, and expansionary fiscal policy is a way for the government to serve as financial intermediary of last resort...

(My standard references for these four ways of thinking about fiscal policy are Hicks (1937), Krugman (2009) (quoting Jan Hatzius: where is a longer version?), Keynes (1936), and Gertler (2009). Note that these are not, in any sense, contradictory or inconsistent--just different ways of touching the elephant.)

I agree with Tyler that there is something very wrong with those who "cannot understand fiscal policy." I just don't understand why he puts himself in the "we" there--I wish his language were less Aesopian.

And when Tyler says that "analytic conclusions in [macroeconomics] seem to line up too tightly with the political views [of researchers]," I think that is wrong too. Republicans like Glenn Hubbard, Greg Mankiw, Mark Zandi, and Ben Bernanke have no problem advocating fiscal expansions as a tool for fighting recessions (tax cut-heavy fiscal expansions, admittedly). Democrats like Alice Rivlin have no problem saying that it is time to stop thinking deficits are an aid to fighting recession and start worrying again about the long-run fiscal sustainability of the American government. Republicans like Kevin Murphy have no problem saying that even though fiscal policy would be somewhat effective its costs would outweigh its benefits. Democrats like me have no trouble saying that banking-sector policy should be carried out not through the U.S. Treasury but through a bipartisan technocratic institution like the RTC or the RFC.

The divide that worries me isn't sensible Democrat-sensible Republican. The divide that worries me is between economists who understand that the nominal money stock is not a sufficient statistic for the flow of nominal demand--especially when interest rates on short-term Treasuries are very low--and those who don't know enough to have figured that out, and who think that the nominal money stock is a sufficient statistic for the flow of nominal demand--even when interest rates on short-term Treasuries are very low.

Markus Brunnermeier writes:

Mind the frictions: BOB LUCAS rightly points out that a branch of macroeconomics proved very useful in weathering the recent crisis. Research by Ben Bernanke and Mark Gertler, Nobu Kiyotaki and John Moore, Rick Mishkin and other macroeconomists provided helpful policy guidance, exactly because their models emphasise the importance of financial frictions for the macroeconomy...

I gotta protest. Not that Markus is wrong when he says that Bernanke-Gertler-Kiyotaki-Moore-Mishkin and their posse have been very useful in their analyses of financial frictions--they have.

But the Chicago school simply does not believe such frictions are important. They believe, as Markus writes immediately afterwards:

However, the bulk of macroeconomic research simply assumes financial frictions away. The financial system and its institutional details were often seen as a distraction from the main drivers of the economic activity. In these models the failure of a large financial institution, like Lehman, would be of no real consequence. But I think we can all agree--if we learnt one thing from the current financial turmoil it is that financial frictions and financial institutions are of essential importance for the macroeconomy...

That's the reason Robert Lucas and company say that they "really don't get" the point of banking policies--they simply haven't read Bernanke-Gertler, Kiyotaki, Moore, and company.

It is, after all, financial frictions and financial institutions that make banking policies and fiscal policies useful tools for fighting the current recession. Financial frictions make it socially beneficial to finance spending via government borrowing when it is not profitable to finance spending via private borrowing because of financial frictions that the government--as long as its debt remains the safe asset in the economy--can work around. Financial frictions make it socially beneficial to recapitalize the banking system rather than simply letting it fail.

Markus goes on to play a little intellectual judo, saying that Lucas's endorsement of the stimulative monetary policies of Ben Bernanke is really an endorsement of Bernanke's credit-channel financial-friction approach to macroeconomics. It is a clever move, and I hope it succeeds.

And Markus goes on to say a lot more clever and wise things:

In my view these frictions are also the root cause for the failure of the efficient market hypothesis (EMH). For example, bubbles can emerge and persist due to limits to arbitrage. Of course, as Bob Lucas points out, when it is commonly known among all investors that a bubble will burst next week, then they will prick it already today. However, in practice each individual investor does not know when other investors will start trading against the bubble. This uncertainty makes each individual investors nervous about whether he can be out of (or short) the market sufficiently long until the bubble finally bursts. Consequently, each investor is reluctant to lean against the wind. Indeed, investors may in fact prefer to ride a bubble for a long time such that price corrections only occur after a long delay, and often abruptly. Empirical research on stock price predictability supports this view. Furthermore, since funding frictions limit arbitrage activity, the fact that you can’t make money does not imply that the “price is right”.

This way of thinking suggests a radically different approach for the future financial architecture. Central banks and financial regulators have to be vigilant and look out for bubbles, and should help investors to synchronise their effort to lean against asset price bubbles. As the current episode has shown, it is not sufficient to clean up after the bubble bursts, but essential to lean against the formation of the bubble in the first place.

This calls on us economists to further develop our tools (including mathematical tools) to integrate the insights financial economists have developed on frictions and the formation of bubbles into the fully fledged dynamic stochastic general equilibrium macro and monetary models that macroeconomists have been working with. Bringing financial economists, macro- and monetary economists together to take on this challenge of building a new workhorse model that incorporates financial frictions would be a great first step in this important (and exciting) endeavor.

What Should We Be Doing to the Federal Reserve?

Free Exchange muses on central bank independence.

I haven't done a nose count on the FOMC. But it is pretty clear that right now it has too many inflation hawks on it and not enough unemployment hawks. The only saving grace is that other central banks are worse--some much worse.

In the 1970s the American Congress learned that it did not want to exercise oversight over the Federal Reserve--that opining and trying to influence was a political loser, because mistakes would be made and if you had pushed for the policies that produced them you took part of the blame.

Now it looks as though the Congress may be shifting its ground...

Free Exchange:

A big Fed mess: ALAN BLINDER opens a new Washington Post column with what I believe is the conventional wisdom:

The Federal Reserve's performance in this long-running financial and economic crisis deserves separate grades. For the early crisis period, from the summer of 2007 until a few weeks after the Lehman Brothers failure in mid-September 2008, the Fed's response was uneven. I would question several decisions. But the Fed deserves extremely high marks for its work since then. It has hit the bull's-eye regularly under very trying circumstances.

In academia and in the financial markets, the overwhelming attitude is: Hurrah, and thank goodness, for Ben Bernanke, who gets kudos for his boldness, creativity and smarts.  This is what economists seem to believe—that the Fed totally blew it where the housing bubble and oversight of financial markets, pre-crisis, were concerned, but in terms of shepherding the financial system through the crisis, and the economy through recession, Mr Bernanke and company have done a bang up job. But that doesn't really seem to be true. Any world in which the Fed is twiddling its thumbs while prices are flat-to-falling and unemployment is above 10% is not one where Fed policy is "hit[ting] the bull's-eye"....

An independent central bank is crucial. Political control of monetary policy must inevitably lead to accelerating inflation and long-run economic instability. But at the moment, the American economy could use an increase in expected inflation. And a real threat to Fed independence would almost certainly deliver it, either because markets would anticipate increased political influence on monetary policy ever after, or because the Fed would seek to fend off pressure from Congress by easing further, which amounts to the same thing. But we don't actually want there to be a real threat to Fed independence, because that way uncontrolled inflation lies.

How does one try to influence the Fed while simultaneously keeping it independent?... [I]t does no good for prominent, respected economists to continue heaping praise on a Fed that failed in its mission before the crisis and which is failing in its mission now. Because as unpleasant as the prospect of Congressional intervention in monetary policy is, two more years of high unemployment might well lead to far worse.

The Puzzles of American Political Economy Today

Three points to serve as background:

First of all, from the day after the collapse of Lehman Brothers, the policies followed by the U.S. Treasury and the U.S. Federal Reserve and the U.S. administrations have been very helpful. They have been good ones. The alternative--standing back and watching the markets deal with the situation--would have gotten us a much higher unemployment rate than we have now. Credit easing by the Fed and support of the banking system by the Fed and the Treasury have significantly helped the economy: have kept things from getting much worse.

Second, the fact that investment bankers did not go bankrupt last December and are profiting immensely this year is a side issue. Each extra percentage point of unemployment lasting for two years costs us $400 billion. A recession twice as deep as the one we have had would have cost us as a country some $2 trillion--and cost the world as a whole four times as much. In that scale and context the bonuses of Goldman Sachs are rounding error. And any attempt to make investment bankers suffer more last fall and winter would have put the entire support operation at risk: as Federal Reserve Vice Chair Don Kohn said, ensuring that a few thousands investment bankers receive their just financial punishment is a non-starter when attempts to do so put the jobs of millions of Americans--and tens of millions outside the United States--at risk.

Third, the Obama administration's fiscal boost program has also significantly helped the economy: aid to impacted states has been a big win, the jury is still out on the effect of the tax cuts in the stimulus, and the flow of government spending on a whole variety of relatively useful causes is in train and is boosting production and employment in the same way that everyone's boost to spending boosts production and employment. And the cost of carrying the extra debt incurred is extraordinarily low: $12 billion a year of extra taxes would be enough to finance the fiscal boost program at current interest rates, and for that cost American taxpayers will get an extra $1 trillion of produced goods and services and employment will be higher by about ten million job-years.

Thus the big valid complaints about policy over the past fourteen months are not that it has run up the national debt and not that it has rewarded the princes of Wall Street, but rather that it has, if anything, been on too small a scale--that we ought to have done more.

Yet these policies appear, somehow, to be political losers in Washington right now: nobody is proposing to do more along the same lines. This is strange: usually when something works the natural impulse is to do it again.

So what is going on?

What the U.S. Long Bond Market Is Telling Us...

Paul Krugman reads the tea leaves in what looks like the best piece of economic analysis I have read this month. When we do the things we do well, this is the kind of thing we do:

Interest rates: the phantom menace: From various bat squeaks I’ve put together a view of what I think lies behind the surprising — and damaging — deficit squeamishness of the Obama administration. So here’s what I think they’re thinking.... On the face of it, there’s no reason to be worried about interest rates on US debt. Despite large deficits, the Federal government is able to borrow cheaply.... Underlying these low rates is, in turn, the fact that overall borrowing by the nonfinancial sector hasn’t risen: the surge in government borrowing has in fact, less than offset a plunge in private borrowing.

So what’s the problem? Well, what I hear is that officials don’t trust the demand for long-term government debt, because they see it as driven by a “carry trade”: financial players borrowing cheap money short-term, and using it to buy long-term bonds. They fear that the whole thing could evaporate if long-term rates start to rise, imposing capital losses on the people doing the carry trade... driv[ing] rates way up, even though this possibility doesn’t seem to be priced in by the market.

What’s wrong with this picture?

First of all, what would things look like if the debt situation were perfectly OK? The answer, it seems to me, is that it would look just like what we’re seeing.... [T]he private sector is hurting, it’s spooked, and it’s looking for safety. So it’s piling into “cash”, which really means short-term debt.... Meanwhile, the public sector is sustaining demand with deficit spending.... [S]omeone has to be bridging the gap between the short-term assets the public wants to hold and the long-term debt the government wants to issue; call it a carry trade if you like, but it’s a normal and necessary thing. Now, you could and should be worried if this thing looked like a great bubble — if long-term rates looked unreasonably low given the fundamentals. But do they? Long rates fluctuated between 4.5 and 5 percent in the mid-2000s, when the economy was driven by an unsustainable housing boom. Now we face the prospect of a prolonged period of near-zero short-term rates... which should mean substantially lower long rates.... And if we’re facing a Japanese-type lost decade, which seems all too possible, long rates are in fact still unreasonably high.

Still, what about the possibility of a squeeze, in which rising rates for whatever reason produce a vicious circle of collapsing balance sheets among the carry traders, higher rates, and so on? Well, we’ve seen enough of that sort of thing not to dismiss the possibility. But if it does happen, it’s a financial system problem — not a deficit problem. It would basically be saying not that the government is borrowing too much, but that the people conveying funds from savers, who want short-term assets, to the government, which borrows long, are undercapitalized. And the remedy should be financial, not fiscal. Have the Fed buy more long-term debt; or let the government issue more short-term debt. Whatever you do, don’t undermine recovery by calling off jobs creation.

The point is that it’s crazy to let the rescue of the economy be held hostage to what is, if it’s an issue at all, a technical matter of maturity mismatch. And again, it’s not clear that it even is an issue....

I just don’t think the inner circle gets how much danger we’re in from another vicious circle, one that’s real, not hypothetical. The longer high unemployment drags on, the greater the odds that crazy people will win big in the midterm elections — dooming us to economic policy failure on a truly grand scale.

I am not sure Paul is correct when he says that the possible underlying problem is merely "a technical matter of maturity mismatch." The long Treasury market is thinner than many people think: it is not completely implausible to argue that it is giving us the wrong read on what market expectations really are because long Treasuries right now are held by (a) price-insensitive actors like the PBoC and (b) highly-leveraged risk lovers borrowing at close to zero and collecting coupons as they try to pick up nickles in front of the steamroller. And to the extent that the prices at which businesses can borrow are set by a market that keys off the Treasury market, an unwinding of this "carry trade"--if it really exists--could produce bizarre outcomes.

Bear in mind that this whole story requires that the demand curve slope the wrong way for a while--that if the prices for Treasury bonds fall carry traders lose their shirts and exit the market, and so a small fall in Treasury bond prices turns into a crash until someone else steps in to hold the stock...

This is something to think really hard about....

In Which I Agree with Free Exchange...

Who writes:

Out of running room: I THINK Brad DeLong misread this post of mine from yesterday as a shot at him. It wasn't. I agree with him that the constraints which seem to be draping themselves across American policy options are worrisome. I was more focused on those who seized on his earlier post, on how the whole AIG mess has likely soured the American public on big interventions, as a reason to refight old battles about the coddling of banksters. Those responses struck me as off base and unhelpful....

I have been trying, over the past few weeks, to argue that the Fed has been derelict in its duties. As Mr DeLong says in a different post:

Quantitative easing--pouring a whole bunch of cash in the system with the idea of never reversing the money stock expansion could boost spending and employment considerably by creating expectations of inflation and so reducing the spread--but the Federal Reserve is not going there, and regards the idea with horror, shock, and shame...

This seems to be true. At the same time, I think it will probably be easier to sway Fed officials (who are more likely to be impressed by economic arguments) than it will be to convince Congress to pass any kind of fiscal package large enough to have an effect despite the too-tight nature of monetary policy.

I don't like where the American economy is one bit. I think that the Fed is ignoring the political economy effects of its stance, and is therefore settling on an inappropriate policy. I hope that changes.

But I don't think drawing and quartering Lloyd Blankfein or Hank Greenberg will do any of us much good...

I do wonder how much good would be done if the FOMC were simply to stand up and announce that they were raising their long-term GDP-deflator inflation target from 2% to 3%. It might do a lot of good. And it is certainly something the Fed could do without cracking its credibility as committed to low inflation.

But they won't. We would need a very different FOMC than the one we have to consider such a move.

Free Exchange Seems Somewhat... Snittish...

With respect to its: "That's the nature of many of these interventions—we all live to whine another day..."...

For the record, I wrote my piece not to "get a lot of links" but because I was trying to think through what the U.S. government could do over the next two years or so while the economy is flat on its back if it was hit by another big negative shock--as it is every 40 years or so. And I was coming up empty: credit easing does little; quantitative easing would require the resignation of the Fed governors and bank presidents; fiscal policy is out because of worries about the deficit; and banking policy is out because senators won't get out in front because everybody is making money off the TARP except for the government.

So what could we do? We might have to do something, after all, Odds 5%.

It (they?) writes:

Hindsight is occasionally blurry: BRAD DELONG got himself a lot of links yesterday by writing that efforts to save the banking industry last fall, by eroding public trust in government, increased the odds of a replay of the Great Depression from virtually nothing to 5%.... One side of this discussion is whether the government was actually able to handle things differently.... Economics of Contempt says no. I'm sympathetic to Mr Contempt's view, but I also think... the government could have come with something if it had wanted to. And I agree with Felix Salmon.... "[Y]es, given a bit more aggression and foresight, the Fed could have tried to cram down a haircut onto AIG’s counterparties. But at the time, no one was particularly interested in being harsh to the global financial sector; instead, they were trying to rescue it..."

Perhaps Mr DeLong is right, and America now faces a 5% probability of Depression. On the other hand, if you swapped out the folks who were in charge last fall with a group inclined to drive a hard bargain with the banks, you might find yourself in a world in which the Fed and the Treasury fail to convince markets that they'll do whatever they have to do save the financial system, in which a nasty cycle of deleveraging continues to drive important institutions into the ground, and in which the odds of Depression rise to 5%, or higher.

That's the nature of many of these interventions—we all live to whine another day...

Ummm... With respect to Felix, the key issue is not making AIG creditors take a haircut but rather making them share the upside with the government--as Chrysler shared the upside with the government with its loan guarantee program, as Al Gore was able to stand up there at the VP debate in 1996 and say that the U.S. had made money out of its bailout of Mexico.

If Free Exchange wants to ignore the fact that we are now out of macroeconomic running room, they are of course free to do so. But it might be more constructive for Free Exchange to help me think how we can get some of that running room back. We might need it. We might need it real bad.

Fiscal Expansion That Is Deficit Neutral in the Long Run

Mark Thoma is alarmed by our president:

Economist's View: Obama's Wrong-Headed Thinking on the Deficit: Edward Harrison catches this quote from Obama....

Obama warned the United States' climbing national debt could drag the country into a "double-dip recession," though he said he's still considering additional tax incentives for businesses to reverse the rising unemployment rate. "There may be some tax provisions that can encourage businesses to hire sooner rather than sitting on the sidelines. So we're taking a look at those," Obama told Fox News' Major Garrett. "I think it is important, though, to recognize if we keep on adding to the debt, even in the midst of this recovery, that at some point, people could lose confidence in the U.S. economy in a way that could actually lead to a double-dip recession."

I hope his economic advisers set him straight, though I suppose there's a chance that this nonsense is coming from them. We needed a larger stimulus package to begin with, and the economy could still use more help, labor markets in particular. Let's hope that this doesn't turn into a call to actually start balancing the budget before the economy has fully recovered as that would increase the chances of the double dip recession that he is so worried about (something we should have learned from the 1937-38 experience where an attempt to balance the budget prematurely plunged the economy back into recession)...

One way to interpret this--which may or may not be wrong--is that right now we are really and truly fracked beyond previous imagining. Let's go back to the old ca. 1960 standard macroeconomic diagram, with the interest rate on the vertical axis and the economy's level of spending on the horizontal axis. We then have:

• A red curve the IS curve, which tells us what the economy's (real) spending level is--the sum of household spending on consumption, business spending on investment, net exports, all functions of this real interest rate, plus government purchases) as a function of the current value of the (real, long-term, risky) interest rate (and also of lots of other stuff that affects the position of the curve)...

• A blue curve, the LM curve, which tells us what the (short-term safe nominal) interest rate is as a function of the (nominal) spending level that is consistent with households' and businesses' being willing to hold the economy's current money stock...

• A double-headed orange arrow, the spread, the difference between the short-term safe nomina interest rate and the long-term risky real interest rate--the difference between the two being the sum of a term premium, an expected inflation rate, and a risk and default premium...

In this framework, the problem with credit easing--the central bank increasing the money supply now and moving the blue curve to the right without changing expectations of what the money stock will be in the long-term future--is that the curve has flat because cash and short-term Treasury bonds are close substitutes, so you expand the money supply by a lot while doing little to boost spending and employment and land yourself with the problem of unwinding the money stock increase in the future in a way that does not hurt spending and employment when you do so:

(Quantitative easing--pouring a whole bunch of cash in the system with the idea of never reversing the money stock expansion could boost spending and employment considerably by creating expectations of inflation and so reducing the spread--but the Federal Reserve is not going there, and regards the idea with horror, shock, and shame.)

In this framework, banking policy--recapitalizing banks further and issuing government guarantees to shrink the spread--boosts spending and employment even when, as now, cash and short-term Treasuries are close substitutes. The problem with banking policy today is that no member of congress of either party of any political persuasion wants to get out in front supporting it.

In this framework, the problem with fiscal expansion--the government purchasing a bunch more things right now and so shifting the red curve to the right--is that it boosts the supply of government bonds in the future and so may raise the double-headed orange arrow that is the spread, getting you absolutely nowhere:

So what can we do? Looks like we are well and truly fracked.

Well. maybe not. My position on further fiscal expansion is twofold:

• The claim that further government purchases would widen the spread might be true. It might now. Let's try it and see. The debt held by the public on Monday was $7,632,033,766,420.46. The debt held by the public a year and a half ago was $5,218,570,776,014.84. We have managed to boost the debt held by the public by $2,413,462,990,405.62 in eighteen months without materially moving the term premium significantly. (The risk premium has moved--there is a financial crisis on, after all.) So let's try it and find out.

• This is an opportunity. We really need to reduce the deficit after 2030. We really need to have more government purchases now. So raise spending now, and raise taxes and impose spending caps starting in 2013 so that by the end of the 20-year budget window the projected debt is unchanged. Thus we move the red line without increasing the spread: there's now increased supply of bonds in the long term to push up the interest rate on them. And we solve both our current near-depression problem and our post-2030 structural deficit problem.

Macroeconomic Scholasticism

Brother Joseph Gagnon makes a few points:

The Liquidity Trap Does Not Make Monetary Policy Ineffective: With short-term risk-free interest rates essentially at zero in the major developed economies, conventional monetary policy is in a liquidity trap. As a number of commentators have observed, printing zero-interest-rate money to buy zero-interest-rate assets has no real economic effect because the assets are near-perfect substitutes for money. But does that mean that central banks have lost their power? Jim Hamilton asserts that central bank purchases of other assets, with positive yields, can always create inflation, though he is silent as to whether they can affect output....

In recent months, central banks have purchased large quantities of longer-term assets. These purchases appear to have been effective at pushing down longer-term interest rates, which should stimulate economic activity. For example, the Federal Reserve (Fed) has purchased large quantities of longer-term agency-backed securities and Treasury bonds.... Fed communications about such purchases had substantial effects on a range of long-term interest rates, including on assets that were not included in the purchase program, such as interest rate swaps and corporate bonds.

Since March 19, the Fed has not made any substantive changes to its planned purchases of longer-term assets. Over this period, the 10-year Treasury yield has risen about 75 basis points and the corporate yield has fallen about 200 basis points, reflecting a relaxation of the extreme financial strains and flight-to-quality that characterized the first few months of this year. Conventional fixed mortgage rates, a key target of the Fed's policy easing, have changed little on balance since late March.

Paul Krugman has argued that potential gains and losses when long-term interest rates move make a policy of purchasing such bonds especially risky, and that fiscal stimulus is a safer bet. However, central banks, including the Fed, have always held risky assets, including long-term bonds, foreign exchange reserves, loans to private banks, and even equities. In many cases, such assets comprise the bulk of the central bank's portfolio.

A good definition of expansionary monetary policy is the printing of money to purchase financial assets. Expansionary fiscal policy is the selling of financial assets to purchase goods and services, to cut taxes, or to increase transfers. On these definitions, both monetary and fiscal policy can be effective when short-term interest rates are zero.

I would prefer to divide the policy universe into four categories:

• Monetary policy is the purchase or sale of Treasury bills for cash.
• Fiscal policy is the selling of bonds by the government to cover a deficit.
• Quantitative easing policy is the altering of market expectations of the long-run path of the money stock.
• Banking policy is the altering of the quantity, duration, or riskiness of the assets (other than Treasury bills) held by the private sector.

I think this provides the cleanest and closest to orthogonal basis for discussing macroeconomic policy.

But others may agree. This is a discussion for us Schoolmen and Schoolladies, and us Schoolmen and Schoolladies only...

Reed College Public Policy Lecture: Today's Financial Crisis in a Historical Mirror (November 7, 2009)

Audio: Reed Public Policy Lecture (11.07.2009 03-14-36 PM)

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Download now or preview on posterous

Reed College Public Policy.doc (3307 KB)

Download pdf: 20091107 reed slides.pdf

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Posted via email from http://braddelong.posterous.com/reed-college-public-policy-lecture-todays-fin at Brad DeLong's Scrapbook

Abjuration and Recantation...

Hoisted from Comments: "a" writes:

Another Bad Employment Report - J. Bradford DeLong's Grasping Reality with All Eight Tentacles: "If we find ourselves in a financial-meltdown world where unemployment or inflation kisses 10%--then I will unhappily concede, and say that Greenspanism was a mistake." - BDL, 16 July 2008

So, it was a mistake, right?

Yes, it was a mistake. I hereby deny, abjure, and repent my previous allegiance to the gospel of "Greenspanism." I reject Greenspan, and all his works, and all his empty promises.

I will strive now to walk in the light.

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Curiously enough, this from my pre-Greenspanist phase actually looks pretty damn smart today...

J. Bradford DeLong (1999), "Should We Fear Deflation?" Brookings Papers on Economic Activity 1999:1 (Spring), pp. 225-252 http://www.jstor.org/stable/2534666

Another Bad Employment Report

The Bureau of Labor Statistics reports:

The unemployment rate rose from 9.8 to 10.2 percent in October, and nonfarm payroll employment continued to decline (-190,000).... Since the start of the recession in December 2007, the number of unemployed persons has risen by 8.2 million, and the unemployment rate has grown by 5.3 percentage points.

Among the major worker groups, the unemployment rates for adult men (10.7 per- cent) and whites (9.5 percent) rose in October. The jobless rates for adult women (8.1 percent), teenagers (27.6 percent), blacks (15.7 percent), and Hispanics (13.1 percent) were little changed over the month. The unemployment rate for Asians was 7.5 percent, not seasonally adjusted.

The number of long-term unemployed (those jobless for 27 weeks and over) was little changed over the month at 5.6 million. In October, 35.6 percent of unemployed persons were jobless for 27 weeks or more. (See table A-9.)

The civilian labor force participation rate was little changed over the month at 65.1 percent. The employment-population ratio continued to decline in October, falling to 58.5 percent...

If you had told everyone last election day what would happen, economically, in 2009, what policies would they have adopted then to stem this disaster?

And why aren't we implementing those policies now?

Recipes for Recovery

Sam Brittan says something smart:

Sam Brittan’s Recipe for Recovery: Commercial banks certainly worsened the recession by greedily seeking higher returns than those provided by market interest rates; and they can put grit in the recovery by refusing to lend. I can only suggest making Paul Krugman, the radical Keynesian economist, Comptroller of the US Currency with over-reaching powers to take over old banks and initiate new ones, with similar appointments in other countries...

Paul Krugman says "ahem!":

I would... quarrel with designating me a “radical Keynesian.”... A perfectly standard New Keynesian model, with intertemporal optimization and all that — the kind of model that is standard in freshwater courses — says that under current conditions fiscal stimulus should be very strong, much stronger than what we’re actually doing. Ryan Lizza’s piece on the Obama economics team makes it clear that Christina Romer — whom nobody would call radical — reached more or less the same conclusions in her economic analysis that I did. The point is that what passes for “sound” economics these days (and maybe most days) isn’t actually sound economics — it’s economic analysis trimmed and softened to fit political realities/prejudices. Questioning that notion of soundness isn’t being radical; it’s just being intellectually honest.

To put it another way, Milton Friedman and Jacob Viner would fit Brittan's definition of "radical Keynesian" these days.

You gotta get demand up. You can do it by deficit spending. You can do it by convincing banks to lend and businesses to borrow. But you gotta do it somehow, by some means.

Nine Months into the Obama Administration: A Look

Glenn Greenwald issues marching orders:

How to avoid the GOP's mistakes during the Bush years?: The Atlantic's Marc Ambinder makes the following observation: "From day one of his administration, the left has held Barack Obama's feet to the fire way more than the right ever did to George W. Bush..." Is there any doubt that this is accurate?  I can't imagine how there could be.  And is there anyone who believes that this is a bad thing?  

It's worth remembering how the GOP and the Right treated Bush and the role they played in his presidency.... The Right's leading commentators saw their role as defending the Bush administration no matter what it did, rather than expressing their honest opinions.... Personalized hagiographies were churned out glorifying the President in borderline-religious tones. Conservative groups devoted themselves to blind defense of the White House.... Conservatives who criticized Bush were deemed the enemy and were excommunicated.... Those who, in general, criticized the President too harshly were deemed unpatriotic, standing with Terrorists, and suffering from personalized and emotional hatred (Bush Derangement Syndrome)....

One need only look at the entrenched rot that is now the conservative movement and the Republican Party to see what happens when that mentality prevails, when internal dissent is treated as blasphemy and well-intentioned critics are deemed suspect and even harmful to The Cause...

We hear and obey.

On my issues:

(1) The Obama administration argued in December and January that it should seek a consensus position on dealing with the financial crisis and recession rather than push for first-best policies--larger short-term deficit spending, more money for banking recapitalization, more stringent regulation of and control of financial services (especially much more aggressive regulation of executive compensation to make every thirty-five year old a risk manager who prospered only in the long run, only if the firm's strategies proved profitable over several cycles, and only if the firms never blew up).

This was a mistake: the 80-20 votes in the Senate and the 390-40 votes in the House for "national unity" economic policies did not materialize, and we are left with insufficient regulation of the financial system to protect the consumer and guard against the next crisis, and with too-small a stabilization policy that threatens now to give us 10% unemployment as far as the eye can see.

(2) The Obama administration started by proposing a cap-and-trade environmental policy with current greenhouse polluters grandfathered in--and with the political dynamic such that, as with the AMT and the R&D tax credit, the grandfathering will be extended year-by-year forever as legislators find one-year-at-a-time extensions to be an extraordinarily good tool for raising campaign contributions from corporate PACs.

This was a mistake. The administration should have started with the right first-best policy: a carbon tax with the revenues dedicated to paying people's FICA contributions. Then, if necessary, it could have let itself be negotiated down to cap-and-trade with some--not 100%--grandfathering.

(3) I simply do not know what the Obama administration's desired health-care reform bill looks like, or what steps the Obama administration is taking to make the congressional reform process reach a good end, or what the economic theory is that suggests that these particular reforms are the right thing to do. I am scared of guaranteed issue and community rating without a real mandate to curb adverse selection and a strong public option as a safety valve. I am very scared of a congress that seems to, with every day, seek to bend the curve of health care costs upward by prohibiting things like comparative effectiveness research. And I am very, very scared of a mandate without an adequate subsidy pool.

I want to see real white papers from the administration explaining why whatever is going to emerge from the congress is a good thing--and why it is the best thing that we could have gotten out of congress this year or next year.

(4) Tim Geithner should have gone to the wall for the requirement that [banks offer "plain vanilla" mortgages and credit cards. The Democratic Party should not be in the business of encouraging banks and other financial service companies into making money by tricking households into bearing risks that they do not understand. And he certainly should not say that he is "supportive of the changes." If he really is, he is in the wrong job. If he is merely grudgingly willing to accept the changes, he should say that instead. The Treasury Secretary's credibility is, after all, his onlly asset.

(5) Nor has the Obama administration yet gone to the wall for long-run fiscal discipline: by now we ought to have standby tax increases or spending cuts written into the law for the out-years a decade or more from now to reassure everyone that the American government does understand and take seriously what the long-run trends--the aging of America and medical-care cost growth--mean for public finances

Don't get me wrong: My complaint is not that the Obama administration has not been liberal enough. My complaint is that the Obama administration, so far, has not been devoted enough to good policy--to the good technocratic policies of what I used to see as the bipartisan center--and has been unwilling to use any leverage at all against a congress that is underbriefed, unfocused, and easily captured by special interests. You can only use such leverage if you have a moment arm--allow daylight to open up between the President's position and the position of the marginal senator, and say that the President's policies are those he and has staff have concluded after sober reflection are best for the nation but that he will take what he can get from congress.

Federal Reserve Assets

A Weaker Dollar Is in America's--and the World's--Long Run Interest

Helps reduce those global imbalances, y'know. Jus' sayin:

UPDATE:China Yuan Ends Up; FX Interventions In Asia Cap Gains: China's yuan ended slightly higher against the dollar Friday, the first day of trading after the National Day holiday, taking its cue from the U.S. unit's broad weakness on global markets in the past week. However, dollar purchases by Asian central banks as they sought to limit strength in their own currencies curbed the yuan's gains....

During China's holiday, the dollar fell sharply against other currencies due to an expected interest rate hike by Australia's central bank, rising gold prices and better-than-expected economic data globally.... The dollar recovered some of its recent losses against other currencies in Asia on Friday after Federal Reserve Chairman Ben Bernanke reiterated the U.S. will need to raise interest rates once the recovery takes hold.... "China's central bank continued to rein in the yuan's rise against the dollar through the central parity rate, so traders didn't sell the dollar aggressively during the session," said a Shanghai-based trader at a foreign bank. The People's Bank of China set the dollar-yuan central parity rate at 6.8270 Friday, down from 6.8290 on Sept. 30. "The dollar's decline against the yuan was also capped by Asian central banks' foreign-exchange intervention to prop up the U.S. unit," said another Shanghai-based trader at a European bank....

Offshore, one-year dollar-yuan nondeliverable forwards were at 6.6791/6.6831, down from 6.6970/6.7020 on Sept. 30.

Rose Yu contributed to this article

The Fed Presidents Are Off the Reservation

In a world in which George Akerlof is not allowed to say "boo" about monetary policy because he is First Spouse of the Federal Reserve Bank of San Francisco, this is remarkable...

Free Exchange writes:

What are these Fed presidents up to?: CALCULATED RISK notes that Federal Reserve governors aren't exactly singing the same tune in public comments on the likely path of monetary policy. Nemo points out that the public disagreements have become remarkably common and overt—and, he says, pointed:

As a general rule, the guys (and gal) on the FRB do not even blow their noses in public without permission. They do not simply stand up and “speak their minds”. Had it started and ended with Warsh going off the reservation two weeks ago, then it might be an anomaly. But that was followed by Richard “speed and intensity” Fisher (speech), Charles “Great Inflation” Plosser (speech), Jeffrey “show stopper” Lacker, and Thomas “sooner rather than later” Hoenig (speech). On the flip side, we heard from William “extended period” Dudley (speech - try searching it for “not well founded”) and Daniel “overstated” Tarullo (speech).

Whew!

This appears to be a deliberate attempt to introduce uncertainty into the market about the future course of monetary policy. Why might they want to do that?

John Jansen has an explanation:

RBS Securities (the firm formerly known as Greenwich Capital) mentioned an interesting article by well respected research firm Wrightson in which Wrightson posits that some of the recent hawkish comments by Federal Reserve officials are a shot across the bow of leveraged speculators. Wrightson makes the salient point that if the trajectory of rates is unclear then leveraged positions are not such safe bets. That is I think a key and under appreciated point with the new world of Federal Reserve transparency regarding policy.

The last Federal Reserve tightening cycle was completely transparent and consisted of 17 consecutive 25 basis point rate hikes which took the funds rate target to 5.25 percent from 1 percent. But Mr Greenspan diminished the effect of the tightening and never thoroughly damped down speculative excess as he made it manifestly clear that he would not raise rates in anything other than discrete 25 basis point intervals. In so doing he allowed the junk which led to the current financial debacle to flourish.

There is an interesting similarity in this to an argument Larry Summers made several years ago, which was highlighted in the recent Ryan Lizza profile:

In 2007, Summers started looking at the looming economic crisis. Back in 2003, he had attended a Federal Reserve conference in Jackson Hole, Wyoming, in which economists were celebrating the fact that central bankers seemed to have mastered the use of monetary policy to tame inflation without causing the economy to slip into a recession, as had happened in the past. Summers warned that perhaps the victory over inflation meant only that the next recession would be caused by some new phenomenon...

In the fall of 2007, his Financial Times columns took on a more urgent tone, starting with a piece on November 25th, titled “Wake Up to the Dangers of a Deepening Crisis.” There had been at least six major financial crises that affected the United States over the past twenty years: the 1987 stock-market crash, the 1990 savings-and-loan crisis, the Mexican-peso crisis, the East Asian economic crisis, the failure of Long Term Capital Management, and the tech-bubble crash. Summers had a theory that tied them together: whereas for many decades most recessions were caused by the Federal Reserve’s attempts to curb inflation, the Fed’s recent mastery of keeping inflation in check had given rise to the financial crisis. Summers explained that, just as the success in curing infectious disease will allow some people to live longer only to die of cancer, the success in battling inflation will prolong an economic expansion only to lead to overconfidence and a financial crisis...

Perhaps the Fed is beginning to think that having control over the business cycle is more important than producing long expansions and frequent bubbles.

Robert Waldmann on Justin Fox Trying to Referee John Cochrane v. Paul Krugman

I really think Robert's head exploded somewhere in here:

Cochrane Vs Krugman ~ Angry Bear: According to Fox, [Cochrane] wrote:

The centerpiece of our crash was not the relatively free stock or real estate markets, it was the highly regulated commercial banks...

Now he can't believe that.... No one could be that ignorant... fail to have noticed that commercial banks are more tightly regulated than investment banks (especially recently after capital requirements for investment banks were massively relaxed). Writing "commercial banks" when everyone knows that "investment banks" would be closer to the truth is not plausible ignorance.

Cochrane may be completely ignorant about the macro literature except for that recently written somewhere near a great lake, but he must know that investment banks suffered more dramatically than commercial banks. I'm not sure he has noticed that there are no longer any investment banks -- that is all banks in the US are now parts of partly FED-regulated firms, but I am sure that he knows that Bear Sterns, Lehman, and Merrill Lynch are not commercial banks.

One more thing about [Justin] Fox, he concedes that Krugman's arguments are not based on formal models, he fails to note that the arguments made by the Fresh water economists aren't based on any models at all.

I'd be the first to agree with Cochrane that Krugman's vigorous pro-stimulus arguments are based more on hunches and guesswork and politics and history than on any kind of rigorous economic model. I've been even less impressed, though, with anti-stimulus arguments that claim to be based on rigorous models but are utterly devoid of historical perspective, curiosity and common sense.

They have models in which the labor market clears, they are not quite crazy enough to argue that there is no unemployment right now. They make arguments which don't make sense... certainly are less based on any formal model than Krugman's arguments. Fox clearly knows this. That's why he puts in the disclaimer "claim to be based". However, he is a journalist so he can't note that the arguments are definitely not based on formal models. This is he-says-she-says journalism. I'm sure Fox has read Krugman and DeLong on the lack of a model behind the arguments.

It is easy to see if there is a model or there isn't (hint there are models on Krugman's blog -- Fox can check if Fama or Cochrane have presented a model which supports their conclusions. He can ask them to send him their model. He should be able to tell if there is a model of if there isn't and if the model leads to the conclusion.

---

Let me say that I am with Robert in the exploding-head brigade. Two years ago, if you had asked me, I would say that practically all economists shared a consensus theory of nominal spending and income. It is Milton Friedman's theory. It goes like this:

• Demand for money is proportional to the benefits of holding money--which are in turn proportional to nominal income.

• Demand for money is also a declining function of the costs of holding money: the short-term nominal interest rate on Treasury securities.

• You can flip the money demand function around and get a prediction of what spending will be as an increasing function of the money stock and of the interest rate, and of other things.

• Expansionary open-market operation monetary policies that raise the money stock also lower interest rates, and have strong effects on nominal spending and income when interest rates are normal, but have weak effects on spending when interest rates are very low and bank reserves and short-term Treasury securities are close substitutes.

• Banking and fiscal policies can affect interest rates and thus change the level of spending holding the money stock constant, but there is lots of uncertainty and disagreement about how well these policies work.

Yet now I find that Luigi Zingales does not know what I thought was this consensus theory. David K. Levine does not know this consensus theory. John Cochrane does not know this consensus theory. Edward Prescott does not know this consensus theory. Eugene Fama does not know this consensus theory but somehow thinks the equilibrium condition that is the savings-investment identity is also a behavioral relationship. Michele Boldrin does not know this consensus theory. Peter Diamond assures me that Robert Lucas does know this consensus theory of nominal income but you could have fooled me from what he has been writing over the past year.

Objects in Your Calendar Are Closer than They Appear...

Reed College:

Reed College | Public Policy Lecture Series: Brad DeLong: “Financial Crisis and the Macroeconomy, 1825-Present”

Saturday, November 7, 2 p.m., Vollum lecture hall: J. Bradford DeLong, who served during the Clinton administration as deputy assistant secretary of economic policy for the U.S. Department of the Treasury, is professor of economics at UC Berkeley, chair of UC Berkeley’s political economy major, and a research associate of the National Bureau of Economic Research.. He has written on the evolution and functioning of the U.S. and other nations’ stock markets, the dynamics of long-run economic growth, the making of economic policy, the changing nature of the American business cycle, and the history of economic thought. Before joining the Treasury Department, DeLong was Danziger Associate Professor in the economics department at Harvard University. He has also been a John M. Olin Fellow at the National Bureau of Economic Research, an assistant professor of economics at Boston University, and a lecturer in the department of economics at MIT.

Presented in partnership with the economics department and Reed's Parent & Family Weekend. Sponsored by the Walter Krause Fund for Lectures in Economics.

I Would Award This Year's Nobel Prize in Economics to Ben Bernanke and Mark Gertler...

...for their work on the credit channel and large downturns, if I were running things. It has been the most valuable thing done in the past half-century in helping us to think through policy issues today.

No matter who gets it, they are the ones that deserve it.

Just saying.

Glass-Steagall and the Crisis

Joe Stiglitz thinks that the investment bank culture took over the commercial banks. I think that merging investment and commercial banks gave investment banks more stability in their liabilities that allowed them to ride out the storm more easily.

Alan Blinder agrees with me, which makes me happy.

Ryan Lizza:

Larry Summers and the White House economic team: Many critics have argued that Clinton’s 1999 repeal of the 1933 Glass-Steagall Act, which had separated commercial and investment banks, contributed to the meltdown last year. “It was a clear signal to the big banks to get much bigger and to become kind of financial supermarkets,” Robert Reich, Clinton’s first Labor Secretary, said. “It’s not the biggest factor, but it’s certainly a step along the way.” In an article on the causes of the current crisis, Joseph Stiglitz wrote, “When repeal of Glass-Steagall brought investment and commercial banks together, the investment-bank culture came out on top.”

But others note that the pure investment banks, like Lehman Brothers, have been the greatest source of instability, while the banks with combined commercial and investment arms have fared the best. “Banks did terrible things, investment banks did terrible things, a big insurance company named A.I.G. did terrible things, but basically none of that was enabled by the repeal of Glass-Steagall,” said Alan Blinder, an economist at Princeton, who had his share of confrontations with Summers when he was a member of the C.E.A., in the first two years of the Clinton Administration. Brad DeLong added, “To say that the breaking down of the Glass-Steagall wall between investment banks and commercial banks was the source of the current crisis is just wrong”...

---

Ryan Lizza on derivatives regulation:

However, the main criticism of a dozen economists, all of whom know Summers personally, is that during the late Clinton years, in two important cases, he seemed to forget his own warnings about financial markets. The first was a debate over opening up Asian markets to financial liberalization. Summers believed that several Asian countries, especially South Korea, were unfairly refusing to allow American financial-services firms to operate there. “The Asian countries kept pushing to regulate hedge funds, and these guys were dead set against it,” the friend of Rubin and Summers said. “They did have more belief in the ability of the financial markets and financial institutions to police themselves than now seems to be warranted, and that I think is a major issue.”

The second case cited against Summers is his hesitancy about regulating derivatives. In this instance, he was to the right of Rubin. Derivatives are contracts intended to perform the financially useful function of spreading risk. But in recent years they served mainly to concentrate it. In Rubin’s memoir, “In an Uncertain World: Tough Choices from Wall Street to Washington,” he describes the debate that he and Summers had over the issue. “Larry thought I was overly concerned with the risks of derivatives,” Rubin writes. “His argument was characteristic of many students of markets, who argue that derivatives serve an important purpose in allocating risk by letting each person take as much of whatever kind of risk he wants. Larry’s position held together under normal circumstances but seemed to me not to take into account what might happen under extraordinary circumstances.” Summers told me, “If we had known that derivatives markets would mushroom the way they did and that regulators would remain spectators, we would have acted. With hindsight, all of us with involvement in financial policy wish we had done more to forestall problems”...

Monetary Policy, Fiscal Policy, Capital Markets Policy

Paul Krugman is three doors down the hall right now, but I am going to talk to him through the magic of the internet rather than mosying down:

Does unconventional monetary policy solve the zero bound problem?: Some comments on my post on the true cost of fiscal stimulus argue that the zero lower bound aka liquidity trap isn’t really binding, because the Fed is using other measures to expand the economy. A few commenters imply that I haven’t been paying attention.

Well, yes I’m aware that BB is doing a bunch of unconventional stuff. But the available — albeit thin — evidence is that it takes a huge expansion of the Fed’s balance sheet to accomplish as much as would be achieved by a quite modest cut in the Fed funds rate. And the Fed isn’t willing to expand its balance sheet to the $10 trillion or so it would take to be as expansionary as it “should” be given, say, a Taylor rule.

Which means that the zero bound is still binding, which means that right now we’re very much still in liquidity trap territory.

I would put it someehat differently. There's fiscal policy--using the government to expand output holding the risky long-term real interest rate that governs business investment and household borrowing decisions constant. There's monetary policy---using open-market operations to boost or retard the economy holding the short-term safe nominal interest rate constant. And then there is capital markets policy: operating on the wedge between the risky long-term real interest rate and the short-term safe nominal interest rate.

If you set up those three boxes, then a huge number of things fall under the rubric of "capital markets policy"--banking recapitalization. loan guarantees, nationalizations, bank rescues, asset purchases, and the sending of signals that alter the expected rate of future inflation.

You can call Federal Reserve policies aimed at the sending of signals that alter the expected rate of future inflation "monetary policy" if you want, but then you lose analytical clarity--because the way such policies work (if they work) is not the "normal" way that "normal" monetary policy works. Normal monetary policy works by shifting the private sector's asset holdings toward assets that people spend more readily and rapidly, thus boosting spending. Quantitative easing at the zero bound does not do that: it simply exchanges one zero-yield government asset for another. What is does do is to change bond prices, rather by raising the safe short-term nominal interest rate and thus giving people an incentive to spend the money they already have more quickly.

Are Chicago Economics Nobel-Prize Winners von Neumann-Morgenstern Agents?

Something old. On March 30, 2009 Tom Keene of Bloomberg's "On the Economy" interviewed Robert Lucas and Edward Prescott.

There is one really interesting juxtaposition from Lucas's part of the interview:

LUCAS: Our economy’s got a remarkable ability to return to its long term growth trend. And for most of the depressions we’ve had or recessions, the return has been quick. Two or three, four years...

[...]

LUCAS: [T]here is no question that fear is what this liquidity crisis is. I mean the reason I got into money [with my portfolio] is that I got afraid to leave my pension fund in other securities. So I’m sitting there with a portfolio full of zero-yield stuff just because I’m afraid to do anything else. I think there are millions of people like me.

KEENE: What will be the signal for Robert Lucas to go back into the markets...?

LUCAS: I don’t know. Robert Rubin made a joke about that in the first session today. Nobody knows...

Let's parse this. First, Robert Lucas says that it is highly likely--certainly his median forecast--that the U.S. economy will be back to normal in three or four years, with a normal level of unemployment, a normal share of profits in national income, and a normal level of dividends and capital gains. This presumably means that stock prices will also be back to normal--a normal multiple of a ten-year moving average of lagged earnings, for example. That means a year-2013 S&P of 2000 or so, compared to its current value of 1044 or its 2009 low of 667. Investing in the S&P 500 for a four-year horizon now is risky, certainly, but the expected return is high. And holding your money in cash is not all that safe either: most of the scenarios I can envision in which the S&P 500 is at a real value in 2013 corresponding to today's 667 are scenarios in which inflation has eaten away most of the value of cash.

So what is Robert Lucas doing holding his entire portfolio in cash? Has risk suddenly increased to an extraordinary extent to force the equity share of his portfolio down from 70% to 0% while his expected four-year return on equities over Treasuries has gone from 2.5% or so to 20%? Has his personal tolerance for risk suddenly collapsed to such an extent because he has become a complete coward? Or does he no longer believe his forecast that the U.S. economy is highly likely to be back to normal in four years? Or is he simply not a von Neumann-Morgenstern agent, and moreover lacks any desire to behave as if he were one?

No von Neumann-Morgenstern agent faced with such returns would hold his entire TIAA-CREF portfolio in cash. Not a one.

Now let me back up a little to Lucas's attack on Robert Shiller and George Akerlof, and their book Animal Spirits:

LUCAS: I just don’t get it. I mean look at the Black_Scholes formula. People come up with a formula for pricing options, just out of purely mathematical reasoning, and then it turns out it fits certain data amazingly well. And it’s been incredibly useful to people. Now it’s not useful for everything, but for what it does it’s a huge advance in human knowledge. Now what’s the behavioral finance contribution? They reinforce the idea of skepticism. Well, skepticism, it’s easy to be a skeptic. What’s harder is to tell somebody how to do something they didn’t know how to do yesterday. That’s what Black and Scholes did...

Lucas seems to miss the entire big point. Black-Scholes tells you how to do things only if the trades of the non-von Neumann-Morgenstern agents in the economy--that's you, Bob--cancel each other out. If they don't cancel each other out--if there are, as you say, "millions of people like me," then a whole bunch of banks running off of Black-Scholes and similar models without taking account of your existence are going to create a hell of a lot of systemic risk, and then 10% unemployment.

Do Chicago Economics Nobel-Prize Winners Live in the Consensus Reality?

Something old. On March 30, 2009 Tom Keene of Bloomberg's "On the Economy" interviewed Robert Lucas and Edward Prescott.

Ed Prescott's part of the interview is much, much stranger than Robert Lucas.

In the part I want to highlight, Prescott starts out with an apparent belief that after 1984 the Federal Reserve stopped trying to stabilize the economy:

PRESCOTT: I don’t see the mechanism for money [to affect the economy].... [O]nce the Fed stopped trying to stabilize the economy, the economy got a lot more stable...

Where this comes from I cannot imagine. It certainly doesn't describe anything the Federal Reserve has done over the past quarter century.

And it gets more bizarre.

Prescott says that the financial crisis did not affect the economy:

PRESCOTT: I think the financial crisis has been greatly overstated as a problem... [it] has had virtually no consequences for the real economy...

What did affect the economy was big bad government scaring people for no reason:

PRESCOTT: [P]eople got scared.... The press scared people. People running for office scared people. Bernanke scared people; Paulson scared people.... [P]eople began not to know what was going to happen. Then they stopped investing--by investing, I mean getting a new car or fixing up your house. And that led to the economy--it was depressed a bit that fourth quarter of last year...

Depressed "a bit"? Yes, a bit--and only a bit:

PRESCOTT: The growth rate from 4th quarter 2007 to 4th quarter of 2008, that includes that bad quarter, was 1%.... And if that fourth quarter was a normal quarter, it would have been almost up to trend...

If only the Federal Reserve and the Treasury had let the economy alone maybe the fourth quarter would have been a normal quarter, Prescott says:

[With] benign neglect the economy would have come roaring back quite quickly...

And if the economy does not come roaring back with a very strong recovery now, Prescott knows what to blame: big government scaring people again.

He simply does not live in the consensus reality with the rest of us.

Ah, well: at least the reality he lives in is a happier place then this one.

Second-Best Punchbowlism

A central bank staffer writes:

I enjoyed your macro lecture on recent macro thought. I suppose on this typology I have evolved from a Greenspanist with Producerist sympathies to a Producerist with vestigial Greenspanist sympathies. But there's a possibility you pass over. If effective regulation won't be forthcoming--whether due to regulatory capture or because financial innovation has outpaced the political system's willingness to extend regulators' reach--the central bank might have to tighten into the bubble. I call that Second-Best Punchbowlism...

This seems to me to be exactly right.

It is, I think, dead-on as an estimate of what is likely to happen. Central banks would prefer an effective system of regulation, but due to capture of legislatures by the baning sector they are unlikely to get it. Thus they are going to be driven to be always wondering whether they should be putting extra downward pressure on asset prices--with implications for employment and possibly growth.

The fact that "Punchbowlism" can be implemented by central banks by themselves makes it the default option.

Three Things Very Much Worth Reading From Martin Wolf

On the fallout from Lehman:

Do not learn wrong lessons from Lehman’s fall: “If the price of oil stabilises, I believe we can weather the financial crisis at limited cost in terms of real activity.” Thus did Olivier Blanchard, newly appointed head of the International Monetary Fund’s research department, describe the prospects ahead on September 2 2008. He was swiftly proved wrong.... Few economists then realised how fragile the global financial system had become. The failure of Lehman Brothers just under two weeks later and the ensuing crisis at AIG, the insurance giant, turned complacency into terror. The financial system plunged into an abyss, dragging the economy behind it.

What lessons are we to learn from this shock, a year later?... When finance ministers and central bank governors of the Group of Seven leading developed countries met in Washington last October, they decided to “take decisive action and use all available tools to support systemically important financial institutions and prevent their failure”. Desperate times; desperate measures. Since large financial institutions are most likely to fail during a crisis, this amounted to an open-ended government guarantee. What makes the decision quite unbearable is that it was, in my view, also correct. The risk of a cascading failure of the good, the bad and the ugly among financial institutions was apparent. Given what had happened after Lehman’s failure, only fools would have run this experiment. We were not that foolish. Thus, the lesson learnt from Lehman’s failure was the precise opposite of what many had hoped on the day it was announced: it is that every systemically significant institution must be rescued in a crisis. That lesson is reinforced by Wednesday’s agreement that the rescue, buttressed by unprecedented monetary and fiscal stimulus, has worked: the panic is over and the world economy is on the mend....

If these are indeed the sorts of lessons we draw, we are making huge mistakes. First, we cannot let stand the doctrine that systemically significant institutions are too big or interconnected to be allowed to fail in a crisis. No normal profit-seeking business can operate without a credible threat of bankruptcy.... The second big potential mistake is to return to the old doctrine that it is better to clean up after a crisis than to take any pre-emptive action.... The third big mistake is more immediate: it is to assume that we are already well on the way to a healthy recovery....

Letting Lehman go was not our biggest mistake. That was letting the economy and financial system become so vulnerable. Equally, the past year has restored neither the financial system nor the economy to health. We have avoided the worst. That is good. It is not enough.

---

On China's recovery:

Wheel of fortune turns as China outdoes west: China has emerged as the most significant winner from the global financial and economic crisis. At the end of 2008, many questioned whether China would achieve its growth target of 8 per cent in 2009. Who now dares to do so? Cushioned by its more than $2,100bn (€1,440bn, £1,260bn) of foreign currency reserves, huge trade and current account surpluses and a robust fiscal position, Beijing has been able to deploy all its levers over the financial system and the economy. Meanwhile, as one senior Chinese participant at the World Economic Forum’s annual meeting of “the new champions”, in Dalian, noted, “the teachers have made big mistakes”. Indeed, any visitor to Asia will recognise the west’s reputation for financial and economic competence is in tatters, while that of China has soared. The wheel of fortune is turning....

[H]owever successful China is in promoting domestic demand, it will not be the locomotive for the world economy. True, China’s merchandise trade surplus has indeed been narrowing: it was $35bn in the second quarter, 40 per cent lower than a year earlier. China’s current account surplus is also shrinking: it may be down to 6 per cent of gross domestic product this year, from 11 per cent in 2007. Yet, since it still only generates some 7 per cent of world output, China is too small to act as the world’s locomotive. Even halving its external surplus would add only 0.4 per cent to aggregate demand in the rest of the world...

---

On financial regulation::

Turner is asking the right questions on finance: Lord Turner is right to argue that... the fundamental issue is not structure, but philosophy. The UK authorities adopted the same view as the US: market forces guaranteed both efficiency and stability. They were wrong. Now that the view has changed, the upheaval caused by transforming the regulatory structure is unnecessary....

Now turn to whether the financial sector is “too large”.... [T]he sector enjoys subsidies from the state, via access to the lender-of-last-resort function of the central bank and explicit and implicit guarantees against insolvency. These need to be offset....

[H]igher capital requirements are far from a panacea. One danger is that banks may take on even more risk, to sustain high returns on equity. Another is that banks would again find a way around higher capital requirements....

That leads naturally to the “Tobin tax”. Obviously, it would have to operate in all significant financial centres. So the chance of its happening is zero....

Finally, how far are changes in the structure and levels of pay the answer? I agree with Lord Turner that “the honest truth is that bad remuneration policies, though relevant, were far less important in the unravelling of the crisis than hopelessly inadequate capital requirements against risky trading strategies”....

[T]he more one analyses both the debate and what is happening, the more difficult it is to believe that a safer and more responsible industry is emerging. I love Lord Turner’s willingness to raise difficult questions. But I am not persuaded that he, or anybody else, offers convincing answers.

I confess I do not understand in what way "bad remuneration policies... were far less important in the unravelling of the crisis than hopelessly inadequate capital requirements against risky trading strategies." I had thought that bad remuneration strategies produced the outsized risky trading strategies.

The Intellectual Bankruptcy of the Chicago School Infests St. Louis -or- The Huffington Post Needs a Better Quality Control Filter Rather Badly...

The Huffington Post simply shouldn't be publishing things like this. The Huffington Post should do better. It owes its readers. And we know that it can do better.

The kindest interpretation I can give what Washington University in St. Louis economist David K. Levine has written is that he is fundamentally confused between levels and derivatives.

David K. Levine:

David K. Levine: An Open Letter to Paul Krugman: Crises have been ubiquitous throughout history. While we can't forecast them we do know how to learn from them.... But the stimulus plan? How can you be arguing for more? Since we are recovering before most of the stimulus money has entered the economy - isn't that evidence it isn't needed? How can you write as if you are proven right in supporting it?

Oh boy. Let's see how far I can get with this...

Start with:

This chart shows what has happened to the civilian adult employment-to-population ratio. That ratio peaked at 63.4%[1] at the end of 2006. It was 59.2% as of mid-August and is probably 59.0% now--and if not now, soon.

A well-functioning labor market--one not deep in market failure--matches workers looking for jobs with jobs looking for workers. A well-working labor market will keep both the number of unemployed and the number of vacancies together in balance, and at relatively low values.

That is not what is happening now.

The number of vacancies--jobs for which employers are actively searching for workers but have not found any to hire yet--is very small. The number of unemployed--of people who want to hold jobs and are qualified to hold jobs--is very high. The result is that some 4% of the 18-65 population that in a normal time would have jobs is now jobless. This is a massive market failure: supply is not matched to demand. And the welfare costs of this elevated degree of market failure are very high: the excess people without jobs are not happy people taking great vacations. They are, rather, stressed out: give them their old jobs back for 3/4 of their old pay without consequences for their likely incomes in future years and they would be ecstatic.

David Levine says that the government should not do anything about this market failure. Right now "we are recovering," he writes. And he believes that because we are recovering activist governmental policies to deal with this collapse in the employment-to-population ratio are unwarranted.

Note, however, three things that "we are recovering" does not mean:

• It does not mean that macroeconomic market failures are small, or are rapidly being reduced to "normal" levels.
• It does not even mean that the magnitude of the macroeconomic market failures is falling--for every competent foreaster expects that the employment-to-population ratio will continue to decline, perhaps for a substantial time, even though it is highly likely that the NBER's final business cycle chronology will declare that we are now in a "recovery" phase of the business cycle..
• It does not mean that monetary and fiscal policy tools to compensate for, repair, or correct those macroeconomic failures have lost any of their juice or are no longer appropriate--they remain appropriate and necessary as long as the macroeconomic market failures remain elevated.

What "we are recovering" means is that:

• the magnitude of macroeconomic market failures--which are well-measured by the gap between the employment-to-population level and its normal level--are now no longer growing rapidly but instead only growing slowly. Things are still getting worse. But at least they are not getting worse rapidly.

As long as the gap between the current employment-to-population ratio and its normal level remains large, policies to compensate for, repair, or correct macroeconomic market failures are entirely appropriate.

For Levine to think that such policies should be abandoned just because macroeconomic market failures are no longer growing rapidly reflects a deep incomprehension of the discipline of economics. Things that Irving Fisher, Knut Wicksell, and in a later generation Milton Friedman knew very well indeed are things that David Levine simply does not understand.

Now there are deeper and more subtle questions for economists to to analyze right now. For example, in this situation:

1. How stimulative should monetary policy be when the employment-to-population ratio is as far below normal levels as it is now?
2. Can conventional monetary policy do the job--or do as much of the job as can be usefully done?
3. Under what circumstances should conventional monetary policy be supplemented?
4. And what policies should supplement it--quantitative easing, public purchase of risky assets, bank recapitalization, informal government guarantees, formal government guarantees, fiscal expansion, scattered nationalizations, full nationalization of the financial sector, or the acquisition of all financial and industrial assets by the government and the rational arrangement of economic affairs according to a common plan?

These are knotty and complicated questions about which competent economists can (and do!) argue, and about which competent economists can (and do!) disagree on matters of theory, on the weight of the empirical evidence, and of policy.

But you cannot have a fruitful discussion about any of those issues with David K. Levine. Someone so clueless that he thinks that the end of a period in which macroeconomic market failures are growing rapidly entails that the policies to compensate for, repair, and correct those market failures should be stopped right now is simply not in our galaxy.

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[1] A level it attained without, mind you, a single sign that any worker was in any sense "fooled" into taking a job because of an erroneous misperception that his or her real wage was higher than it was in fact. See Krugman http://tinyurl.com/dl20090919a.

Something to Watch: The Federal Reserve's New Toys

Krishna Guha:

FT.com | Money Supply | More stress on the Fed’s exit tools: The Treasury’s decision to run down its supplemental funding programme for the Fed puts yet more pressure on untested tools the Fed is relying on to sterilise excess reserves when the time comes to raise interest rates. I happen to think these tools will work. Still, the Fed can hardly be thrilled about this.

It reminds me that the Fed faces an interesting choice as to whether it should trial some of these techniques - such as the use of reverse repos against its MBS portfolio - long before it actually has to rely on them. I think trial runs make sense, but the Fed would have to manage the signalling side of that very carefully.

Coffee Blogging: What John Quiggin Said

John Quiggin Says:

John Quiggin » The macro wars: I’m visiting Berkely at present and just had a chat with Brad DeLong. These are some of the thoughts I had about the great macroeconomics wars as a result.

One important element that can’t be ignored is the effect political partisanship, which is much more bitter in the US now than in most other places. It’s not so much Republicans vs Democrats as Republicans vs anti-Republicans. Krugman has been a leading figure in rejecting the idea that the Republican party represents a serious viewpoint that should be accorded respect, even in disagreement. Not surprisingly, the members of the intellectual class still associated with the Republican Party (relatively few, these days, but still dominant in Chicago) intensely dislike Krugman’s writing for the NYT.

But more important, I think, is the hole in the intellectual landscape opened up by the crisis. As regards macroeconomics, the pre-crisis near-consensus described by Krugman included a lot of “freshwater” macroeconomists whose intellectual roots go back to the New Classical/Real Business Cycle literature of the late 1970. This literature initially suggested that there was no possible role for monetary or fiscal policy unless people had mistaken expectations and drew the implication that a sufficiently credible and determined government could eliminate inflation without any serious cost in terms of output and employment, a theory tested to destruction by the Thatcher government.

Given the empirical difficulties encountered by strong forms of these views, most of the freshwater economists were prepared to make some concessions. As regards monetary policy, they were willing to accept some use of interest rates to target inflation, while arguing against “fine tuning” designed to stabilise the economy – during the Great Moderation it was easy enough to conclude that macro instability was a problem of the past, a claim made explicitly by Robert Lucas.

Similarly, it was easy enough to accept the implication that, in certain extreme circumstances like those of the Great Depression, the standard tools of monetary policy might prove ineffective necessitating direct use of fiscal policy to expand the money supply. In the absence of any perceived risk of a Depression, it was easy enough to make this concession while arguing against any use of active fiscal policy.

In the wake of the crisis, this position was untenable. If you supported fiscal policy at all, it was clear that a massive stimulus was needed. In fact, the arguments of Barro and others that Keynesians had overestimated the multiplier effects of fiscal stimulus implied that the required stimulus was even larger than Keynesian estimates would suggest.

Moreover, there is, as Brad DeLong and others have pointed out, no coherent position under which fiscal policy is totally ineffective while monetary policy is at least partly effective. And the only plausible conditions under which policy is totally ineffective is if the macroeconomy is always in (or close to) equilibrium. So, it’s essentially impossible to believe in recessions and unconditionally oppose fiscal policy.[1]

So we see Cochrane forced all the way back to Say’s Law, the claim that it is logically impossible for (planned) supply to exceed (planned) demand, since willingness to supply, say, labour implies willingness to demand goods. Cochrane accuses Krugman of wanting to scrap the macroeconomics of the last forty years[2] but then makes it clear enough that he wants to dump Keynes and everything that has been written since.

Arguments about Say’s Law are unlikely to be resolved by logical disputation. The only way to address them is to look at the historical record of the economy over the last couple of centuries. If you see stability, interrupted only by the occasional ill effects of government policies, you’ll accept Say’s Law. If you see regular crises, except for a few exceptional periods when macroeconomic stabilization policies have appeared to work, you’ll reject it.

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fn1. Except for those who can always find some government program or another to blame, even for a case as clear cut as the 1890s Depression in Australia.

fn2. This charge is broadly correct, but I think the correct answer is the one anticipated by Cochrane. Economics did indeed take a wrong turn in the 1970s, responding to the breakdown of (one version of) Keynesianism. We need to find a new and better response, and much of the work of the past 40 years will have to be be discarded or reinterpreted as a result.

More Musings on the Intellectual Train Wreck that is Today's Chicago School...

Paul Krugman writes:

Freshwater Rage: I’m still on the road, with only sporadic internet access. So I’ve missed out on much of the outpouring of rage over my magazine article. I gather, though, that the usual suspects are utterly outraged at my suggestion that freshwater macro has spent several decades heading down the wrong path. They’re smart! They work hard, using hard math! How dare I say such a thing? And all of this, of course, without a hint of irony.... When freshwater macro came in, there was an active purge of competing views: students were not exposed, at all, to any alternatives. People like Prescott boasted that Keynes was never mentioned in their graduate programs. And what has become clear in the recent debate — for example, in the assertion that Ricardian equivalence rules out any effect from government spending changes, which is just wrong — is that the freshwater side not only turned Keynes into an unperson, but systematically ignored the work being done in the New Keynesian vein. Nobody who had read, say, Obstfeld and Rogoff would have been as clueless about the logic of temporary fiscal expansion as these guys have been...

I would put it slightly differently. I do object to the fact that Chicago macro has not read Obstfeld and Rogoff. But what I object to much more is that they have not read anything at all.

For example, consider:

Most of all, Krugman likes fiscal stimulus. In this quest, he accuses us and the rest of the economics profession of “mistaking beauty for truth.”[1] He’s not that clear on what the “beauty” is that we all fell in love with, and why one should shun it. And for good reason. The first siren of beauty is simple logical consistency. Paul’s Keynesian economics requires that people make plans to consume more, invest more, and pay more taxes with the same income...

It is not just Keynesian economics that concludes that there are times when people in aggregate make plans to spend more than their incomes.

It is Milton Friedman's monetarist economics too.

It is Knut Wicksell's Swedish school.

It is Irving Fisher's quantity theory of money.

Indeed, it is David Hume writing the first article in economic theory ever--"On the Balance of Trade." In it, he supposes "all the money of Great Britain were multiplied fivefold in a night." The immediate consequence is that planned expenditure rises high above income as people try to shed their excess money balances. Planned expenditure continues to run ahead of income until the flow of nominal spending has risen fivefold.

Yet we are told that that chain of events violates "simple logical consistency."

There is nothing illogical or inconsistent about the economy being in a state in which aggregate planned expenditure is greater or less than income. Today's Chicago school would know this, had it not forgotten all of monetary economics from David Hume on.

But if you have never understood David Hume, and if you try to think about the issues on the fly, you are bound to make large, embarrassing, and elementary mistakes. Even this is not necessarily a bad thing. As Nick Rowe says: "we need to encourage finance people to do macro, and macro people to do finance, and part of the price of doing that is we will make mistakes."

But it becomes a bad thing when you think you have something to say about policy--for then you say pointless and destructive things.

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[1] I actually don't mind that people spend their time developing real business cycle models or investigating the consequences of the efficient market hypothesis. I do, however, wish that they wouldn't write things like:

It is true and very well documented that asset prices move more than reasonable expectations of future cashflows. This might be because people are prey to bursts of irrational optimism and pessimism. It might also be because people’s willingness to take on risk varies over time, and is sharply lower in bad economic times. As Gene Fama pointed out in 1972, these are observationally equivalent explanations at the superficial level of staring at prices and writing magazine articles and opeds...

because such things are simply not true.

They are not observationally equivalent.

When major rises in stock prices--like that of 1995-2000--are due to increases in market risk tolerance or decreases in risk, then at their end investors and commentators tend to think that future returns are likely to be low by historical benchmarks, but that stocks are nevertheless worth holding because (a) their risks are small or (b) we have lowered the covariance between stock returns and our consumption. When major rises in stock prices are due to a wave of optimism, then at their end we find that investors and commentators are thinking that future returns are likely to be high by historical standards--Dow 36000 anyone?--but that risks are not especially low.

And to that I object, because they would be better finance economists if they did not write things that weren't true.

Simple Keynesianism for Monetarists: A Primer

pdf version

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Open publication - Free publishing - More monetarists

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The Future of Macro: Barry Eichengreen's Take

Barry Eichengreen:

The Last Temptation of Risk: We thought that monetary policy had tamed the business cycle. We thought that because changes in central-bank policies had delivered low and stable inflation, the volatility of the pre-1985 years had been consigned to the dustbin of history.... We thought that financial institutions and markets had come to be self-regulating—that investors could be left largely if not wholly to their own devices. Above all we thought that we had learned how to prevent the kind of financial calamity that struck the world in 1929.

We now know that much of what we thought was true was not.... The question is how we could have been so misguided.... [T]he problem lay not so much with the poverty of the underlying theory as with selective reading of it—a selective reading shaped by the social milieu. That social milieu encouraged financial decision makers to cherry-pick the theories that supported excessive risk taking. It discouraged whistle-blowing, not just by risk-management officers in large financial institutions, but also by the economists.... [S]cholarship that warned of potential disaster was ignored. And the result was global economic calamity on a scale not seen for four generations.

SO WHERE were the intellectual agenda setters when the crisis was building?... For economists in business schools the answer is straightforward. Business schools see themselves as suppliers of inputs to business.... J. P. Morgan makes clear the kind of financial engineers it requires, and business schools deem to provide. In the wake of the 1987 stock-market crash, Morgan’s chairman, Dennis Weatherstone, started calling for a daily “4:15 Report” summarizing how much his firm would lose if tomorrow turned out to be a bad day.... Value at Risk, as that number and the process for calculating it came to be known, quickly gained a place in the business-school curriculum.... Getting the machine to spit out a headline number for Value at Risk was straightforward. But deciding what to put into the model was another matter.... Value at Risk, like dynamite, can be a powerful tool when in the right hands. Placed in the wrong hands—well, you know. These simple models should have been regarded as no more than starting points for serious thinking. Instead, those responsible for making key decisions, institutional investors and their regulators alike, took them literally....

For some years those who relied on these artificial constructs were not caught out. Episodes of high volatility, like the 1987 stock-market crash, still loomed large in the data set to which the model was fit. They served to highlight the potential for big shocks and cautioned against aggressive investment strategies.... WITH TIME, however, memories of the 1987 crash faded. In the data used by the financial engineers, the crash became only one observation among many generated in the course of the Great Moderation.... Meanwhile, deregulation was on the march.... [W]here the accelerating pace of change should have prompted more caution, the routinization of risk management encouraged precisely the opposite....

[W]here were the business-school professors while these events were unfolding? Answer: they were writing textbooks about Value at Risk.... Business schools are rated by business publications and compete for students on the basis of their record of placing graduates.... But what of doctoral programs in economics (like the one in which I teach)?... [T]heir faculties do not object to the occasional high-paying consulting gig.... Generous speaker’s fees were thus available to those prepared to drink the Kool-Aid... there was nonetheless a subconscious tendency to embrace the arguments of one’s more “successful” colleagues in a discipline where money, in this case earned through speaking engagements and consultancies, is the common denominator of success.

Those who predicted the housing slump eventually became famous, of course. Princeton University Press now takes out space ads in general-interest publications prominently displaying the sober visage of Yale University economics professor Robert Shiller, the maven of the housing crash.... But such fame comes only after the fact. The more housing prices rose and the longer predictions of their decline looked to be wrong, the lonelier the intellectual nonconformists became....

WHY BELABOR these points? Because it was not that economic theory had nothing to say about the kinds of structural weaknesses and conflicts of interest that paved the way to our current catastrophe... agency theory... compensation practices in the financial sector as encouraging short-termism and excessive risk taking and heightening conflicts of interest.... A Nobel Prize for work on this topic was awarded to Leonid Hurwicz, Eric Maskin and Roger Myerson in 2007... information economics.... George Akerlof, Michael Spence and Joseph Stiglitz were awarded the Nobel Prize for their work on it in 2001. Here again the potential problems of an inadequately regulated financial system would have been quite clear had anyone bothered to look.... [B]ehavioral finance... this small step in the direction of realism can transform one’s view of financial markets... herd behavior, where everyone follows the crowd, giving rise to bubbles, panics and crashes. Economists have succeeded in building elegant mathematical models of decision making under these conditions and in showing how such behavior can give rise to extreme instability. It should not be a surprise that people like the aforementioned George Akerlof and Robert Shiller are among the leaders in this field.

Moreover, what is true of investors can also be true of regulators, for whom information is similarly costly to acquire and who will similarly be tempted to follow convention—even when that convention allows excessive risk taking by the regulated.... And what is true of investors and regulators, introspection suggests, can also be true of academics....

What got us into this mess, in other words, were not the limits of scholarly imagination. It was not the failure or inability of economists to model conflicts of interest, incentives to take excessive risk and information problems that can give rise to bubbles, panics and crises.... Rather, the problem was a partial and blinkered reading of that literature....

WITH THE pressure of social conformity being so powerful, are we economists doomed to repeat past mistakes?... Maybe so. But... there is at least one reason for hope.... [T]he IT revolution has altered the lay of the intellectual land.... [I]t is now empirically oriented graduate students who are the hot property when top doctoral programs seek to hire new faculty. Not surprisingly, the best students have responded....

In contrast, the twenty-first century will be the age of inductive economics, when empiricists hold sway and advice is grounded in concrete observation of markets and their inhabitants. Work in economics, including the abstract model building in which theorists engage, will be guided more powerfully by this real-world observation. It is about time.

Should this reassure us that we can avoid another crisis? Alas, there is no such certainty. The only way of being certain that one will not fall down the stairs is to not get out of bed. But at least economists, having observed the history of accidents, will no longer recommend removing the handrail.

The State of Macro Today

Paul Krugman's summary:

How Did Economists Get It So Wrong?: [R]ereading Friedman’s 1970 summary of his ideas, “A Theoretical Framework for Monetary Analysis,” what’s striking is how Keynesian it seems. And Friedman certainly never bought into the idea that mass unemployment represents a voluntary reduction in work effort or the idea that recessions are actually good for the economy. Yet the current generation of freshwater economists has been making both arguments. Thus Chicago’s Casey Mulligan suggests that unemployment is so high because many workers are choosing not to take jobs: “Employees face financial incentives that encourage them not to work . . . decreased employment is explained more by reductions in the supply of labor (the willingness of people to work) and less by the demand for labor (the number of workers that employers need to hire).” Mulligan has suggested, in particular, that workers are choosing to remain unemployed because that improves their odds of receiving mortgage relief. And Cochrane declares that high unemployment is actually good: “We should have a recession. People who spend their lives pounding nails in Nevada need something else to do.”

Personally, I think this is crazy. Why should it take mass unemployment across the whole nation to get carpenters to move out of Nevada? Can anyone seriously claim that we’ve lost 6.7 million jobs because fewer Americans want to work? But it was inevitable that freshwater economists would find themselves trapped in this cul-de-sac: if you start from the assumption that people are perfectly rational and markets are perfectly efficient, you have to conclude that unemployment is voluntary and recessions are desirable.

Yet if the crisis has pushed freshwater economists into absurdity, it has also created a lot of soul-searching among saltwater economists. Their framework, unlike that of the Chicago School, both allows for the possibility of involuntary unemployment and considers it a bad thing. But the New Keynesian models that have come to dominate teaching and research assume that people are perfectly rational and financial markets are perfectly efficient. To get anything like the current slump into their models, New Keynesians are forced to introduce some kind of fudge factor that for reasons unspecified temporarily depresses private spending. (I’ve done exactly that in some of my own work.) And if the analysis of where we are now rests on this fudge factor, how much confidence can we have in the models’ predictions about where we are going?

The state of macro, in short, is not good. So where does the profession go from here?...

Recent events have pretty decisively refuted the idea that recessions are an optimal response to fluctuations in the rate of technological progress; a more or less Keynesian view is the only plausible game in town. Yet standard New Keynesian models left no room for a crisis like the one we’re having, because those models generally accepted the efficient-market view of the financial sector.

There were some exceptions. One line of work, pioneered by none other than Ben Bernanke working with Mark Gertler of New York University, emphasized the way the lack of sufficient collateral can hinder the ability of businesses to raise funds and pursue investment opportunities. A related line of work, largely established by my Princeton colleague Nobuhiro Kiyotaki and John Moore of the London School of Economics, argued that prices of assets such as real estate can suffer self-reinforcing plunges that in turn depress the economy as a whole. But until now the impact of dysfunctional finance hasn’t been at the core even of Keynesian economics. Clearly, that has to change.

So here’s what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit — and this will be very hard for the people who giggled and whispered over Keynes — that Keynesian economics remains the best framework we have.... Third, they’ll have to do their best to incorporate the realities of finance into macroeconomics.

Many economists will find these changes deeply disturbing. It will be a long time, if ever, before the new, more realistic approaches to finance and macroeconomics offer the same kind of clarity, completeness and sheer beauty that characterizes the full neoclassical approach. To some economists that will be a reason to cling to neoclassicism, despite its utter failure to make sense of the greatest economic crisis in three generations. This seems, however, like a good time to recall the words of H. L. Mencken: “There is always an easy solution to every human problem — neat, plausible and wrong.”...

The vision that emerges as the profession rethinks its foundations may not be all that clear; it certainly won’t be neat; but we can hope that it will have the virtue of being at least partly right.

I would add that there has always been another macro separate from the universities--the macro of the economic forecasters and of the central banks, which has, I think, been in a relatively healthy state for quite a while...

Tyler Cowen's Ultimate Milton Friedman Post

Tyler writes:

Marginal Revolution: What did Milton Friedman favor?: Responding to my initial post, David Henderson gets himself into a bit of trouble when he writes:

He's [Tyler] correct that Friedman wanted the Fed to increase the money supply. I don't think I'm pretending when I say that I don't think Friedman advocated bailing out banks during the Depression. As I think Friedman would have, last fall I advocated an increase in the money supply while opposing a bailout. Those two, contra Cowen, are separable.

When it comes to 1929-1931, Friedman favored the Fed a) buying up a lot more bonds, and b) serving as a lender of last resort to failing banks. They are separable but Friedman favored both.

In the Monetary History, Friedman and Schwartz approvingly quote Walter Bagehot about the need to do whatever is required, however bold or desperate, to stop a banking panic.  Part of the passage runs like this:

The way in which the panic of 1825 was stopped by advancing money has been described in so broad and graphic a way that the passage has become classical. “We lent it,” said Mr. Harman [one of the Bank’s more senior directors] on behalf of the Bank of England, “by every possible means and in modes we have never adopted before;...

Here is Charles Goodhart quoting Friedman on why the Fed should have been a lender of last resort to troubled banks.  Or see p.269 of the Monetary History, where Friedman and Schwartz explain how it was too difficult for banks to borrow from the Fed at favorable rates in the early 1930s.  Or read this Friedman interview.

In the comments Bruce Bartlett, channeling Friedman, responded:

There's no way the Fed could have expanded the money supply in the early 1930s without bailing out the banks. How do you think the money supply declined in the first place? It's because banks failed and their deposits disappeared. To keep those deposits from disappearing in an era before deposit insurance would have required keeping bankrupt banks afloat.

Friedman's model was not one of allowing a boost in currency to substitute for the broader monetary aggregates.  An article in The Freeman is clear, if perhaps even a bit exaggerated:

Friedman and Schwartz argued that all this was due to the Fed’s failure to carry out its assigned role as the lender of last resort.

You might try to draw a distinction between "lender of last resort" and "bailout" but Bernanke's emergency lending is usually considered part of the bailout package.  No one is suggesting Friedman would have favored each and every part of the bailouts that we have seen.  The point is that Friedman favored some bailouts in the past and probably would have favored some this time around as well.  You don't have to think he would have voted for the first Paulson proposal.

Oddly, Henderson in his post takes offense because I suggest that libertarians try to run away from the idea that Friedman favored Fed action beyond simple monetary policy.  Henderson then tries to run away from the idea that... Friedman favored Fed action beyond simple monetary policy.

I now recall that a related point was made by Paul Krugman, although I find that piece problematic in some other ways. 

Here are a few sounder history of thought claims:

1. Friedman and Schwartz argued that if the Fed had been more on the ball with monetary policy earlier on, the lender of last resort actions would not have been needed. That is distinct from opposing such actions in the time of necessity, when necessity comes.

2. At times Friedman suggested that the rise of deposit insurance limited the importance of the lender of last resort role.  (How he would have thought about rescuing the shadow banking system is an interesting question.)  A related issue hovers here, namely whether support for deposit insurance constitutes support for bailouts.  It seems to me it does, though my original point does not rely on this judgment.

3. Friedman thought that "simple" monetary policy, combined with "simple" Fed lending would go pretty far in stopping a banking panic, yet this view was not borne out in the very recent crisis.  In any case it's wrong to conclude that Friedman was necessarily opposed to more vigorous action, if such action would turn out to be needed.  If you read Friedman as a whole his focus is not on drawing particular lines to circumscribe Fed action, but rather doing whatever is needed to keep the banking system up and running. 

One problem is that "Friedman" is underspecified. There are many Friedmans, including:

1. The Keynesian Friedman of "A Framework for Monetary Analysis"
2. The incredibly rigid financial regulatory straightjacket Friedman of "A Program for Monetary Stability"
3. The pro-bailout Friedman of "The Great Contraction"
4. The late Friedman who concluded that money stock-targeting had not lived up to expectations.
5. The early Friedman who believed that keeping the nominal money stock on a smooth growth path would eliminate any possibility for large disturbances in velocity.

These guys are not all consistent, not all the time.

Krugman, Fox, McCain, Prescott, and Company

Justin Fox:

Paul Krugman tells how economists got it all wrong: the one big issue I have with the piece is that, while economists certainly got lots of things wrong before the crisis (as did almost all of us), many members of the profession have acquitted themselves pretty well since things turned really ugly last year. Krugman goes on and on about the "freshwater" economists (at the Universities of Chicago, Rochester and Minnesota) and their crazy ideas about perfect markets. But what's telling is that the hardcore freshwaterites have had almost no impact on economic policy for the past year—neither in the Bush months or the Obama ones. Sure, Nobelist Ed Prescott, a former freshwater economist who now teaches in Phoenix and thus should probably be described as a no-water economist, made the statement that:

"I don't know why Obama said all economists agree on [the need for a stimulus bill]," Prescott said. "They don't. If you go down to the third-tier schools, yes, but they're not the people advancing the science."

Unless you believe that pretty much anyplace other than Arizona State University is a third-tier school, this is patently untrue, evidence of the extreme isolation of the remaining true believers in rational expectations and real business cycles and other such elegant but profoundly unhelpful macroeconomic theories developed since the 1960s. Even some of the true believers seem far more aware than Prescott that the past year's events have challenged their theories—as the University of Chicago's Robert Lucas told me last fall, "everyone is a Keynesian in a foxhole." Among economists with actual influence on policy over the past year—Philip Swagel in the Paulson Treasury, Larry Summers and Christina Romer and Austan Goolsbee and etc. in the current White House—there's been a great willingness to experiment and accept that markets don't always deliver optimal results. The result: an economic recovery that seems to be gaining strength. So don't totally count the economists out...

Four remarks:

(1) In context Lucas's "everyone is a Keynesian in a foxhole" is not an endorsement of the position and an admission that he holds it, but instead much closer to a denunciation of economists for their intellectual weakness in reaching for Keynesian remedies:

Well I guess everyone is a Keynesian in a foxhole, but I don't think we are there yet. Explicitly temporary tax cuts do nothing: people just bank them. Supply side tax cuts are fine with me, but they take time to work and at some point we need the revenue to run the government. I feel the current situation requires a lender of last resort but not a fine tuner.

As, indeed, was clear when Lucas made his big denunciation of Christy Romer (and by implication Summers, and Orszag, and Elmendorf, and Bernanke, and Swagel, and so on) for what I can only characterize as "corruption":

Why a Second Look Matters: The Moody's model that Christina Romer -- here's what I think happened.  It's her first day on the job and somebody says, you've got to come up with a solution to this -- in defense of this fiscal stimulus, which no one told her what it was going to be, and have it by Monday morning. So she scrambled and came up with these multipliers and now they're kind of -- I don't know.  So I don't think anyone really believes.  These models have never been discussed or debated in a way that that say -- Ellen McGrattan was talking about the way economists use models this morning.  These are kind of schlock economics. Maybe there is some multiplier out there that we could measure well but that's not what that paper does.  I think it's a very naked rationalization for policies that were already, you know, decided on for other reasons...

Note what Lucas does not say: He does not say that Christy Romer has a different reading of the evidence than he has. He does not say that Christy Romer has a different assessment of policy risks than he has. He does not say that Christy Romer has a different tolerance of policy risks than he has. He says that she is providing a "very naked rationalization" for economic policies that Obama decided upon for completely non-technocratic political reasons.

Now this is complete garbage. Christy Romer does have a very different view--she would call her view an evidence-based view--of what fiscal policy does in conditions of extremely low interest rates than Robert Lucas does.

(2) Unfortunately for us these are not fringe figures. To an outsider to academic economics like Justin Fox they may appear to be embarrassing madmen in the attic--and to the extent that that becomes the conventional wisdom then I think the good guys will have won this one. But inside the profession that is not the case.

Robert Lucas is a Nobel Prize winner and the head of the still-dominant school of business-cycle analysis when he claims that Christy Romer (and by implication Ben Bernanke, and Doug Elmendorf, etc.) is providing "very naked rationalization[s]" for politically motivated policies. John Taylor is a former Undersecretary of the Treasury for International Affairs when he claims that forecasters like Mark Zandi and Larry Meyer who find the stimulus to be being somewhat effective are just "repeating what they said in January" because they "haven't looked at the numbers." Edward Prescott is a Nobel Prize winner and head of the second-plae school of business-cycle analysis when he claims that supporters of current economic policies "are not the people advancing the science."

Eugene Fama is the head of the dominant school in finance and perennially on the Nobel Prize short list and he claims that the existence of the savings-investment identity makes it logically impossible for the government to boost the economy via spending--an analytical error that we here at Berkeley teach our freshman not to do for it is, as Paul Krugman calls it, "the most basic fallac[y] in economics--interpreting an accounting identity as a behavioral relationship." John Cochrane is the smartest analyst of aggregate asset prices I know, and yet he too commits fallacies that I had thought were dead since the 1920s when he writes that "every dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both. This is just accounting, and does not need a complex argument about “crowding out.”

Luigi Zingales is one of the smartest young Chicago economists I know of, and yet demonstrates that he has not thought about general equilibrium in even the most cursory sense--has not thought how you analyze a system in which you have to keep straight the three commodities of cash, financial assets, and goods--when he writes that "if a nuclear bomb had destroyed all roads... [would] we [then claim] that to alleviate the economic impact... we should invest in banks[?]... [I]f the problem is the roads, you want to rebuild roads.... And if the problem is the financial sector, you want to fix this and not build roads."

(3) These are not dumb people. But these are people for whom whole blocks of what used to be called "economics"--the monetary history of the nineteenth and the first half of the twentieth centuries, the "lowbrow" theories of 1920-1980 from Fisher, Wicksell, Keynes, and Hicks through Metzler, Tobin, and Friedman--are taboo. They would be demonstrating to their peers that they were not serious highbrow economists if they consulted them, and so when they have to deal as they have in the past two years with Fisher-Wicksell-Hicks issues they approach them with great ignorance and get them wrong.

(4) Were it not for the Republican Party, this would not matter very much. The failure of high brow macro to have anything to say about our current situation--where is the misperception of relative prices that has given us 10% unemployment with both firms and workers being happy with the situation? Where is the technology shock that has pushed aggregate production relative to trend down by 8%--would lead their colleagues in other subdisciplines to draw the natural conclusions, cut back on hiring domestic macroeconomists, and hire more international finance specialists (where the analytical culture is, I think, healthy), microeconomists, historians, and institutionalists instead. The big problem is the interaction of the guys in the attic on the one hand and the Repubican Party on the other.

Had John McCain won the presidential election of 2008, at the start of 2009 he would have in all likelihood proposed a trillion dollar fiscal stimulus bill--3/4 tax cuts and 1/4 aid to states--and he might have picked Tim Geithner for his Treasury Secretary. Democrats would have called for fewer tax cuts, more state aid, and some government infrastructure spending initiatives in the fiscal policy mix, but the need for the government to cushion the recession would have brought them into line. When Obama took office he bid $800 billion for his fiscal stimulus bill--about 1/3 spending, about 1/3 aid to states, about 1/3 tax cuts--thinking that would be a plan that would win broad bipartisan assent. And he was wrong. The Republicans decided to follow the Gingrich strategy: try as hard as they could to make the Democratic president appear a failure by blocking all his initiatives. But you can't block an initiative without a story for why it is bad for the country. And that, all of a sudden, makes the madmen in the attic the favored economic advisors of the Republican Party.

This is, I think, very dangerous. The Republicans will win elections in the future. And when they do will we want Ed Prescott to be running economic policy?

Ken Rogoff May Be Right to Fear

If global investors lose confidence in governments tomorrow, then we have a huge crisis--and they are right to lose confidence. If global investors do not lose confidence, then we are fine--and those crying "the sky is falling" are wrong and will lose money--as long as we don't let fear of a loss of confidence panic us into prematurely cutting the government deficits that are maintaining demand.

The right policy, therefore, is (a) big deficits now, and (b) big automatic tax increases enacted now to take effect in the future if we then fail to grow our way out of the debt.

But are we smart enough to enact such policies? Certainly not with today's Republican Party.

Ken Rogoff:

From Financial Crisis to Debt Crisis?: Everyone from the Queen of England to laid-off Detroit autoworkers wants to know why more experts did not see the financial crisis coming. It is an awkward question. How can policymakers be so certain that financial catastrophe won't soon recur when they seemed to have no idea that such a crisis would happen in the first place? The answer is not very reassuring. Essentially, there is still a risk that the financial crisis is simply hibernating as it slowly morphs into a government debt crisis.

For better or for worse, the reason most investors are now much more confident than they were a few months ago is that governments around the world have cast a vast safety net under much of the financial system. At the same time, they have propped up economies by running massive deficits, while central banks have cut interest rates nearly to zero. But can blanket government largesse be the final answer? Government backstops work because taxpayers have deep pockets, but no pocket is bottomless. And when governments, particularly large ones, get into trouble, there is no backstop. With government debt levels around the world reaching heights usually seen only after wars, it is obvious that the current strategy is not sustainable.

If the trajectory is unsustainable, how long can debt keep piling up? We don't know. Academic economists have developed useful tools to predict which economies are most vulnerable to a financial crisis. But, although we can identify vulnerabilities, getting the timing right is virtually impossible. Our models show that even an economy that is massively overleveraged can, in theory, plod along for years, even many decades, before crashing and burning. It all boils down to confidence and coordination of expectations, which depend, in turn, on the vagaries of human nature. Thus, we can tell which countries are most vulnerable, but specifying exactly where and when crises will erupt is next to impossible....

Unfortunately, we live in a world where the political and regulatory system is often very weak and shortsighted.... For now, the good news is that the crisis will be contained as long as government credit holds up. The bad news is that the rate at which government debt is piling up could easily lead to a second wave of financial crises within a few years.... The question today is not why no one is warning about the next crisis. They are. The question is whether political leaders are listening.

Which Economists Got it So Wrong?

I remember 2004-2006 being years in which sensible economists made good arguments--or arguments that seemed to me to be good at the time--that we should not worry about a recession brought on by the collapse of a housing bubble. As I recall, there were six of them:

• Any subprime housing bubble is much smaller than the dot-com bubble was.
• Americans will keep paying their mortgages even though their houses are a little bit underwater.
• Banks will be forgiving in a mortgage crisis because it is very bad to have an interest in a house that will stay vacant for any considerable period of time.
• Wall Street firms originating mortgage-backed securities this decade are like the venture capital firms of last decade--they follow the originate-and-distribute model, and the unwinding of the dot-com bubble did not create systemic risk
• In fact, we have had six potential financial crises since Alan Greenspan became Chair of the Fed--1987, 1990, 1994, 1997, 1998, 2000--and all six were nipped in the bud because the Federal Reserve has the tools and the will to stabilize the system because it can create unlimited amounts of what are the safe assets in the global economy.
• The potential crisis to worry about is the dollar crisis--because that is a crisis that the Federal Reserve cannot fix, for once the dollar becomes risky its power drains away. We should be worring about that.

Paul Krugman has a very different view:

How Did Economists Get it So Wrong?: In recent, rueful economics discussions, an all-purpose punch line has become “nobody could have predicted...” It’s what you say with regard to disasters that could have been predicted, should have been predicted and actually were predicted by a few economists who were scoffed at for their pains. Take, for example, the precipitous rise and fall of housing prices. Some economists, notably Robert Shiller, did identify the bubble and warn of painful consequences if it were to burst. Yet key policy makers failed to see the obvious. In 2004, Alan Greenspan dismissed talk of a housing bubble: “a national severe price distortion,” he declared, was “most unlikely.” Home-price increases, Ben Bernanke said in 2005, “largely reflect strong economic fundamentals.”

How did they miss the bubble? To be fair, interest rates were unusually low, possibly explaining part of the price rise. It may be that Greenspan and Bernanke also wanted to celebrate the Fed’s success in pulling the economy out of the 2001 recession; conceding that much of that success rested on the creation of a monstrous bubble would have placed a damper on the festivities.

But there was something else going on: a general belief that bubbles just don’t happen. What’s striking, when you reread Greenspan’s assurances, is that they... were based on the a priori assertion that there simply can’t be a bubble in housing. And the finance theorists were even more adamant on this point. In a 2007 interview, Eugene Fama, the father of the efficient-market hypothesis, declared that “the word ‘bubble’ drives me nuts,” and went on to explain why we can trust the housing market: “Housing markets are less liquid, but people are very careful when they buy houses. It’s typically the biggest investment they’re going to make, so they look around very carefully and they compare prices. The bidding process is very detailed.” Indeed, home buyers generally do carefully compare... the price of their potential purchase with the prices of other houses. But this says nothing about whether the overall price of houses is justified. It’s [Larry Summers's] ketchup economics [point], again: because a two-quart bottle of ketchup costs twice as much as a one-quart bottle, finance theorists declare that the price of ketchup must be right....

Now that the undiagnosed bubble has burst, the true riskiness of supposedly safe assets has been revealed and the financial system has demonstrated its fragility. U.S. households have seen $13 trillion in wealth evaporate. More than six million jobs have been lost, and the unemployment rate appears headed for its highest level since 1940. So what guidance does modern economics have to offer in our current predicament? And should we trust it?...

Let me say that I agree with everything Paul Krugman writes about today's Chicago School--a group who would dismiss Milton Friedman as a dangerously interventionist leftist were he with us today, and a group who seem to me to know little about the economy and to have thought less about fundamental issues in monetary economics that I used to teach my graduate students were settled once and for all in the 1920s and 1930s. Their influence on the future of economics ought to be reduced to a smidgeon of its current value--they made big intellectual bets on what the world is like, and they lost, and they should pay.

The big lesson, I think, is that Wall Street is much less sophisticated than we imagined it was: Goldman Sachs simply did not do any of the due diligence it needed to do to understand the AIG-specific risks it was assuming, Citigroup was unable to manage its own derivatives book to understand what "liquidity put" risks it was assuming, and as for Bear Stearns, Lehman Brothers, Merrill Lynch--hoo boy...

Hoisted from Archives from September 2005: The Coming Dollar Crisis?

Grasping Reality with Both Hands: The Coming Dollar Crisis?: As is often the case, the most interesting things I learned at last August's round of conferences came not in the formal conference sessions but in the informal small-group conversations before, around, in the interstices of, and after the conference.

Take the Federal Reserve Bank of Kansas City's "Greenspan Era" conference. It was held in Jackson Hole, at the Jackson Lake Lodge in Grand Teton National Park, in the shadow of the Grand Tetons, which are perhaps the most impressive mountain range in North America. ("Perhaps" because the Canadian central bankers present pointed out the Canadian Rockies from Lake Louise to Jasper, while Federal Reserve Bank of San Francisco president Janet Yellen sang the praises of the mountains of her own Federal Reserve District: the east face of the Sierra Nevada as seen from the Owens Valley, to be specific.) You spend the mornings in windowless conference rooms, and the afternoons outside--on the Snake River, hiking, climbing, looking for moose, looking for elk, hoping that bear are not looking for you.

But the afternoons--and the formal and informal breaks in the mornings when you flee the windowless conference room for the fresh air of the west lawn of the lodge to stare at Mount Moran and company across the lake--are filled with arguments. Go with Federal Reserve Governor Don Kohn on an afternoon hike up Cascade Canyon, I am told, and expect to gain 3000 feet in two hours while being quizzed intently about technical details of monetary policy. Try to keep from grounding yourself on sand bars in the Snake River, and you will hear ex-senior executive branch officials of both political parties give their assessments of why neither of the Bush II Treasury Secretaries has been able to make effective use of the thousand or so people who work directly for him.

This time the most interesting rounds of break-and-afternoon conversations I heard were sparked by Sebastian Edwards's paper about the U.S. current account deficit. My conversations quickly exposed a deep fault among the conference attendees. Those who analyzed or forecast the U.S. domestic macroeconomy agreed that a steep decline in the value of the dollar sometime in the next five years was overwhelmingly likely, but by and large they did not think that such a decline would pose a big problem for the U.S. economy. (They agreed that it might well pose a very big problem for some of America's trading partners.) By contrast, those who analyzed or forecast the international economy as a whole were typically terrified by the prospect of a steep (30% or more, perhaps much more) decline in the value of the dollar: they thought a severe U.S. recession was a definite possibility, and that the situation would require exceptionally skillful handling to keep from becoming a serious economic problem.

Why this disjunction?

The domestic macroeconomists would typically argue more or less like this:

Yes, the dollar is likely to decline steeply either when foreign central banks stop buying dollar-denominated assets to keep the values of their currencies down or when international speculators lose confidence or both. But so what? The fall in the value of the dollar will boost foreign demand for U.S. exports. Workers will be pulled out of other sectors into the export sector. The effects of the dollar decline are much more likely to be a plus for employment rather than a minus, a boom rather than a recession.

To this, the international economists would respond more-or-less like this:

When foreign central banks stop buying or international speculators lose confidence in the value of the dollar and thus stop buying U.S. long-term bonds, two things happen: the value of the dollar falls, and the rate of interest on dollar-denominated long-term bonds spikes. The spike in long-term interest rates discourages investment spending directly, and also discourages consumption spending because higher interest rates mean lower housing and stock prices and thus lower consumer wealth. The fall in domestic spending happens now. The rise in exports as the falling dollar makes U.S.-made products more attractive to foreigners happens two years from now. In between, a lot of people are unemployed--and as they are unemployed, they cut back further on their spending. Plus there is the risk that the fall in the value of the dollar and the fall in long-term asset prices generated by the interest rate spike will cause enough bankruptcies among financial institutions to cause a flight to quality--which will further raise non-safe interest rates, and further discourage investment and consumption spending

This then puzzled the domestic economists:

Why should interest rates spike? The Federal Reserve controls American interest rates. If it wants to keep the price of the ten-year Treasury bond high, it can simply start buying bonds until the price of ten-year Treasuries is what the Fed wants it to be. There's no reason for employment in construction and other interest rate-sensitive sectors to fall before employment in exports and related sectors rises--at least not unless the Federal Reserve makes a big mistake and allows rising interest rates to shoot the economy in the head.

And at this point the response of the international economists fragmented:

Some said that the falling dollar would create inflation--with imports at 1/6 of GDP, a 40% fall in the dollar would, if fully passed through to import prices, add 6% to the U.S. price level. The Federal Reserve would feel honor-bound to maintain its reputation as an inflation-fighter, and so would allow interest rates to go high enough to produce enough unemployment to push nominal wages down far enough to offset this rise in import prices. Thus the Federal Reserve would welcome the spike in interest rates as appropriate, and take no steps to offset it.

Others said that the adjustment to the fall in the dollar would require that ten million workers shift out of construction, retail, and consumer services occupations and into export and import-competing manufacturing industries. You cannot move ten million American workers from one sector to another in a matter of a year or two without creating lots of structural unemployment.

Still others said that financial stress would be the key: perhaps some major Wall Street firms would discover big unhedged risks in their derivative books; perhaps perhaps others would find that the values of their portfolios were more responsive to changes in long term interest rates than they had thought. In either case, it is financial distress and chaos that really triggers the recession.

And the domestic side had rebuttals to each of these three points:

1. If the Federal Reserve announces now that it is targeting a measure of inflation that is not grossly affected by import prices--that it is targeting nominal wage growth, say--there is no need for the Federal Reserve to defend its credibility by attacking the economy. Just as the Federal Reserve has trained observers that it is more important to worry about 'core inflation' than 'headline inflation', so the Federal Reserve ought to be preparing observers to recognize that inflation produced by rising import prices is a one-time event, not an inflationary spiral that needs to be fought by triggering a deep recession.

2. A large structural shift will cause high unemployment only if the transition is quick and brutal, and only if workers are pushed out of job-losing rather than pulled into job-gaining sectors. Whether it is quick or gradual and whether it is push or pull depends, once again, on the path of interest rates. Only if the Federal Reserve fails to do its job and allows for a massive interest rate spike is there a problem.

3. Financial stress is something that can be managed: if the Federal Reserve keeps the path of interest rates smooth, great financial stress is unlikely.

And the domestic side of the argument pointed to the historical experience of the U.S. from 1986-1990: Between 1985 and 1989 the value of the U.S. dollar declined by 40%. Between 1986 and 1990 the U.S. trade deficit declined from 4.0% of GDP to 0.5% of GDP--without a big recession, or significant macroeconomic distress.

Before dinner one evening I was lectured by a prominent Washington-area international finance economist about all the reasons that the 1986-1990 U.S. experience was likely to be a bad guide to the future:

1. 1986-90 began with a 50% decline in world oil prices, a powerful stimulus to the world economy. This time the process is beginning with a doubling of world oil prices.

2. 1986-90 saw Europe growing rapidly. Europe has a high propensity to buy U.S. exports, and the European boom meant that U.S. exports grew much faster in the late 1980s than anyone had expected. This time it is Asia that is booming, not Europe. And Asia has a relatively low appetite for U.S. exports.

3. The Japanese government was willing to buy very large amounts of dollar-denominated assets in the late 1980s to keep the decline in the value of the dollar "orderly." In so doing, it inflated its domestic credit base and touched off its own property bubble. No foreign government is going to risk this again just because the U.S. would rather that the decline in the dollar was slow and orderly.

4. The problem then was half as big relative to the size of the U.S. economy as is the problem now.

One way I found myself thinking of the argument is that the domestic-side economists look at the goods market and think of a decline in the value of the dollar as a supply shock, and as not that big a supply shock: if half of the adjustment in import prices is taken in reduced margins by producers abroad, and if the shock is spread out over four years, then 40% / 2 x 16% / 4 = 0.8% increase in inflation relative to baseline over three consecutive years. The Federal Reserve could easily allow that to happen without--providing it explained its causes well--running any risk of damaging the credibility of its commitment to effective price stability. No big deal. International finance economists, by contrast, look at the asset markets. A 40% decline in the dollar over four years is a decline at the rate of 10% per year. Once financial markets convince themselves that such a decline is coming and that they need to be compensated for it, that ought to drive a 400 basis point wedge between U.S. and foreign long-bond expected returns. And that is a very big deal.

Martin Feldstein said something very smart just after we had both taken off our shoes at Jackson Hole airport. He said that the domestic-side economists were keying off the past experience of the U.S. after 1985 and of Britain after 1982, and so were saying "no big deal"; while the international finance economists were keying off of the experiences of developing countries that had run large current-account deficits--Mexico 1994, East Asia 1997, Argentina 2001. Each side had its own preferred models that functioned very well at explaining the past historical cases that they focused on. But there was no way right now of settling, empirically, whether a model built to explain the U.S. in 1985 or Korea in 1998 was more applicable to the U.S. in 2006--you had to make a bet, either that continuities in U.S. economic structure were important, or that financial globalization was important, in choosing your model and your terms of analysis.

It was very interesting. And very disturbing. Brilliant economists, thinking hard, unable to reach even the beginnings of analytical agreement about how to model the distribution of possible futures.

DeLong: Project Syndicate: Obama Has Lucked Out with Bernanke

Obama lucky to have Bernanke -- Shanghai Daily | 上海日报 -- English Window to China New: WILLIAM McChesney Martin, a Democrat, was twice reappointed chairman of the United States Federal Reserve by Republican President Dwight D. Eisenhower.

Paul Volcker, a Democrat, was reappointed once by the Reagan administration (but not twice: there are persistent rumors that Reagan's treasury secretary, James Baker, thought Volcker too invested in monetary stability and not in producing strong economies to elect Republicans).

Alan Greenspan, a Republican, was reappointed twice by Bill Clinton. And now Barack Obama has announced his intention to renominate Republican appointee Ben Bernanke to the post.

The Fed chairmanship is the only position in the US government for which this is so: it is a mark of its unique status as a non or not-very-partisan technocratic position of immense power and freedom of action - nearly a fourth branch of government, as David Wessel's recent book "In Fed We Trust" puts it.

The reason American presidents are so willing to reappoint Fed chairmen from the opposite party is closely linked to one of the things a president seeks: The confidence of financial markets that the Fed will pursue non-inflationary policies.

If financial markets lose that confidence - if they conclude that the Fed is too much under the president's thumb to wage the good fight against inflation, or if they conclude that the chairman does not wish to control inflation - then the economic news is almost certain to be bad.

Capital flight, interest-rate spikes, declining private investment, and a collapse in the value of the dollar - all of these are likely should financial markets lose confidence in a Fed chairman.

And if they occur, the chances of success for a president seeking re-election - or for a vice president seeking to succeed him - are very low. By reappointing a Fed chairman chosen by someone else, a president can appear to guarantee to financial markets that the Fed is not too much under his thumb.

But US presidents seek more than just a credible commitment to financial markets that the Fed chairman will fear and fight inflation. They seek intelligence, honor, and a keen sense of public interest and public welfare.

Presidents' futures - their ability to win re-election, to accomplish other policy goals, and to leave a respectable legacy - hinge on the economy's strength.

It may or may not be true, especially these days, that what is good for General Motors is good for America and vice versa, but certainly what is good economically for America is good politically for the president.

It is here that Obama has lucked out. Ben Bernanke is a very good choice for Fed chairman because he is intelligent, honest, pragmatic and clear-sighted in his vision of the economy. He has already guided the Fed through two very tumultuous years with only one major mistake - the bankruptcy of Lehman Brothers.

Bernanke's Reappointment

David Wessel

Obama to Reappoint Fed Chairman Ben Bernanke - WSJ.com: President Barack Obama will announce Tuesday that he is nominating Ben Bernanke for a second four-year term as chairman of the Federal Reserve, White House Chief of Staff Rahm Emanuel said...

Two reactions:

1. I think Bernanke is one of the best in the world for this job--I cannot think of anyone clearly better. He has made only one big mistake--buckling under to pressure from all those yelling at him for enabling moral hazard and not finding a way to takeover Lehman Brothers, and he is not going to make the same mistake again...

2. I am surprised that he is being reappointed. I would have thought that the combination of people angry because he has given too much public money to the banks and people angry because he didn't stop the recession would together make him damaged and that Obama would want to bring in a fresh face--never mind that Bernanke had no way to try to lessen the recession save by policy steps that inevitably involve giving money to the banks. It shows, I think, a seriousness about getting the policies right--or as close to right as we can--that I like to see in a president...

My Side of an LA Times Debate with Ed Leamer, Part III

Part III:

Fastest way to end the recession: bailing out homeowners? -- latimes.com: Edward Leamer says the government's focus should be on creating buyers. Brad DeLong says the Treasury ought to bite the bullet and buy up every mortgage.

---

How Greenspan wanted the boom to go, and how it turned out. Counterpoint: Brad DeLong

Let me start by outlining how the 2000s were supposed to work -- according to former Federal Reserve Chairman Alan Greenspan.

The late 1990s had seen a large technology-led boom that had employed millions of Americans and provided a forced draft that intensified the fire of economic growth. It was accompanied by "irrational exuberance" in the venture capital and stock markets, as investors began to think not just that technological progress in information technology was rapid but that it would be easy for the companies they invested in to turn that technological progress into profits. The first half was true -- technological progress in America's Silicon Valley is still ensuing at an extraordinary rate: I just got a spam e-mail offering to sell me a four-gigabyte USB flash disk for $9.25. In 1987, I paid $900 for a 10-megabyte hard disk.

But the second half -- that it would be easy to turn this progress into sustained profits -- turned out to be false. It's very hard to pay a lot of dividends to your investors if you are selling four-gigabyte USB flash disks for $9.25.

In the early 2000s, investors began to realize that technological progress was easy relative to making profits in a competitive market, and stock prices for tech companies collapsed. The American high-tech industry began to shed workers as firms closed.

Greenspan decided to deal with this situation by lowering interest rates. The enormous flood of savings from Asia seeking investments in America had started, so low interest rates could be sustained because demand for funds would not outstrip supply. And low interest rates meant that lots of long-run durable investments would be profitable; you could, after all, borrow the money to produce or to buy them at low interest rates. The biggest long-run durable investment as a share of the American economy is housing. So Greenspan thought that he could keep unemployment low by generating a housing boom, so that as employment in tech companies (and related occupations) fell, employment in construction (and related occupations) would rise.

Did Greenspan worry about what would happen if the housing boom also succumbed to irrational exuberance? Yes. Did he worry very much? No. After all, when high-tech stocks and venture capital bubbles had collapsed, the systemwide consequences for the economy were small. Lots of over-enthusiastic investors lost their money -- but they were rich grown-ups, and the Federal Reserve doesn't exist to keep rich people from risking their money in silly ways. Lots of engineers lost their jobs, but they had been well-paid during the boom and would not have had nearly as good jobs (or perhaps any jobs at all) were it not for the bubble. American consumers got a lot of cheap computers and a lot of extra fiber-optic cables over which to make our phone calls. The winners were American consumers and (during the boom) American workers. The losers were relatively rich American investors. Overall, it was a net plus.

Greenspan expected something similar to come out of the housing boom. If it did turn into a bubble, then the winners would be homeowners who bought houses on good terms by borrowing at low interest rates and renters who would find after the boom a plentiful supply of houses on the market and be able to bargain for big houses at cheap rents. The losers would be irrationally exuberant investors who had lent their money when it was cheap to borrow or bought expensive properties when prices were high. Once again -- Greenspan thought -- the boom as a whole, even with the likely magnitude of irrational exuberance and over-speculation, would be a net plus.

But it did not happen that way. The housing bust was big enough that, as you calculate, we are now back to having not a plentiful housing supply but rather one that is in line with historical trends. And we are still under-building, which you say is "laying the foundation for the next housing mania." Yet because the bust triggered a financial crisis that triggered a recession, the construction industry is not seeing the kind of rising home values that trigger a recovery. Because of the recession, people are doubling up. And a great many houses are not where they should be -- four bedrooms with swimming pools east of San Bernardino, as you say, when what America really needs is multifamily units in northern Orange County. And you're right, Ed.

Thus there is a strong case for government intervention in housing finance to try to get the construction sector back to where it ought to be. You point to California's and the federal government's respective tax credits for new home buyers and say that you hope they're enough to turn the market around.

I don't think they will be. I think we should face the fact that home mortgage finance is broken, that the risk tolerance of the private financial system is impaired and that we will not get the flow of finance to potential home buyers through private banks working again any time soon.

So I think -- I have thought for a year and a half now -- that it is time to bite the bullet. The federal government has already nationalized Fannie Mae and Freddie Mac. It should stop treating them like private companies and start treating them like arms of the Treasury. They should set an interest rate spread above the 30-year Treasury rate and then buy up every single mortgage and transform them into standard 30-year fixed-rate mortgages. The government may well lose money on the deal, but a lot of homeowners who cannot pay their current mortgages and are about to be foreclosed on could pay 30-year loans at a few percentage points above the Treasury rate.

A lot of construction companies would be willing to start building the multifamily units in northern Orange County that we need if they knew that potential condo buyers could get financing from the government on such terms.

And the government might, after all, make money on the deal.

Then, after the crisis is over, we can think about how to re-privatize the mortgage finance arm of the financial sector.

Michael Perelman Is Very Clever!

He writes:

Flash: The Head of the Bank of England Confesses: “As I look back, it now seems that, with all the thought and work and good intentions, which we provided, we achieved absolutely nothing … nothing that I did, and very little that old Ben did, internationally produced any good effect — or indeed any effect at all except that we collected money from a lot of poor devils and gave it over to the four winds.”

Of course, the "Ben" is Benjamin Strong, President of the Federal Reserve Bank of New York up to 1928, not Ben Bernanke. The speaker is not today's Governor of the Bank of England Mervyn King, but rather the interwar governor Montagu Norman.

I am Not Now, Nor Have I Ever Been, Wedded to the Classical Efficient Markets Hypothesis

You know, every time I think Paul Davidson and his post-Keynesians ought to have more of economists' collective mindshare, he comes up with something truly dorky like this:

If You Are Looking for a Monument to John Hicks, Look Around You!: If Brad Delong had kept up with John Hick's more recent writings he would have read J.R. Hicks "ISLM : An Explanation", JOURNAL OF POST KEYNESIAN ECONOMICS, Winter 1980-81 issue, where Hicks indicates that over time he became completely dissatisfied with ISLM framework he developed in 1937. In this "ISLM:AN EXPLANATION" article Hicks completely recants on the ISLM apparatus and indicates that the ISLM framework has nothing to do with Keynes or reality. Too bad Brad is wedded to the classical efficient market hypothesis and has never been able to understand the ontological uncertainty involved in the concept of a nonergodic stochastic process that was the basis of Keynes's general thoery and which Hicks ultimately claimed that "nonergodic"system was the same as his own analysis.

Paul

Which of the following should I say?:

• That Paul Davidson is the first person, ever, to have claimed that I am "wedded to the classical efficient markets hypothesis." Nobody has ever said that to me before. It is truly a nonergodic event...

• I would have said that IS-LM has a great deal to do with reality: Hicks implicitly predicted back in 1937 that the enormous expansion in the supply of U.S. Treasury bonds we have seen over the past year would have next to no effect on interest rates. Supply-and-demand would say that if you increase the supply of government bonds by a lot, you lower their price--raise interest rates. Big win for Hicks and IS-LM. But Davidson doesn't see that...

• That IS-LM is the first step you take if you start from the Fisherian quantity theory and attempt to incorporate the fact that the velocity of money is determined by the opportunity cost of holding money balances--voila, you then have an LM curve, and you need something to pin down where on the LM curve the economy is, and that "something" is your IS curve. If you are dealing with people rooted in the quantity theory, then IS-LM is the only one-step way you can get them to think about broadly "Keynesian" issues, and is thus useful for that purpose...

• That IS-LM does not have "nothing to do with Keynes." It has a lot to do with Keynes in at least some of his moods and modes--and deals with issues that, in other moods and modes, Keynes thought of as side issues...

• That I first read Hicks's "ISLM: An Explanation" in the late spring of 1980, after going to Olivier Blanchard's office with some questions about Axel Leijonhufvud and being handed a copy. Hicks's criticisms of IS-LM are that it is:

  • Not properly dynamic
  • If the LM curve is taken to be the quantity theory equation with velocity a function of the short-term nominal interest rate on government bonds, then a huge number of issues are thrown into the IS box and then nailed shut in there where they cannot be easily examined.
  • If the IS curve is taken to be the income-expenditure multiplier framework with investment a function of the real interest rate on actual risky government bonds, then a huge number of issues are thrown into the IS box and then nailed shut in there where they cannot be examined.
  • These are all fine and apposite criticisms, and they are very good reasons not to take IS-LM as the end of your analysis. But if you are trying to introduce the issues to people--like modern-day Chicago--who can't even crawl, it is a way for them to widge across the floor and make some progress.

If You Are Looking for a Monument to John Hicks, Look Around You!

Pro Growth Liberal accuses me of burying the lead:

EconoSpeak: Why Deficits Have Not Increased Interest Rates: Brad DeLong Makes Me Go Huh?: Brad DeLong makes an interesting observation:

it is astonishing. Between last summer and the end of this year the U.S. Treasury will expand its marketable debt liabilities by $2.5 trillion--an amount equal to more than 20% of all equities in America, an amount equal to 8% of all traded dollar-denominated securities. And yet the market has swallowed it all without a burp...

If Brad wanted to mock the standard new classical belief that we are always near full employment so any significant fiscal stimulus would drive up interest rates, this observation would be a nice rebuttal along the lines of the old fashion Keynesian notions that we are both below full employment and are in a liquidity trap...

Well, yes, that is what I do want to mock (and make a couple of other points alongside).

So let me be more explicit: Last fall I had a large number of conversations with bond market observers who said things like: "Interest rates are low now, but look at how much the Treasury is going to borrow over the next eighteen months. When those borrowings hit the market, Treasury bond prices are going to fall bigtime and interest rates rise. At the moment bond prices are high and interest rates are low, but that's only because finance firms' top management aren't letting traders off their leash to short Treasuries. The traders all expect Treasury prices to fall and interest rates to rise. Mark my words: when the Treasury tries to sell all those bonds next year, it won't find buyers at anything near current prices. Where will all the extra savings to buy those bonds come from?..."

As I wrote:

[S]upply-and-demand are supposed to rule--and a sharp increase in Treasury borrowings is supposed to carry a sharp increase in interest rates along with it to crowd out other forms of interest sensitive spending.

Yet:

Hasn't happened. Hasn't happened at all:

It is astonishing. Between last summer and the end of this year the U.S. Treasury will expand its marketable debt liabilities by $2.5 trillion--an amount equal to more than 20% of all equities in America, an amount equal to 8% of all traded dollar-denominated securities. And yet the market has swallowed it all without a burp...

And the interesting thing is that I knew that this was going to be what would happen--or, rather, I strongly believed that this was going to be what would happen--and all because I had read John Hicks (1937).

Let me give you the Hicksian argument about what happens in a financial crisis--a sudden flight to safety that greatly raises interest rate spreads, and as a result diminishes firms' desires to sell bonds to raise capital for expansion and at the same time leads individuals to wish to save more and spend less on consumer goods as they, too, try to hunker down.

In Hicks's model, the immediate consequence is an excess demand for (safe) bonds in the hands of investment banks: bond prices rise, and interest rates falls. As interest rates fall, (a) firms see that they can get capital on more attractive terms adn so seek to issue more bonds, and (b) households see the interest rate they can get on their savings fall, and so lose some of their desire to save. The market heads toward equilibrium. But as the market heads toward equilibrium, something else happens as well: the fall in interest rates and the rise in savings is accompanied by a greater desire on the part of households and businesses to hold more of their wealth safely--in pure cash. And so the speed with which cash turns over in the economy, the velocity of money, falls. And as the velocity of money falls, total spending falls, and workers are fired, and as workers are fired and lose their incomes their saving goes from positive to negative.

Thus the process of return to equilibrium takes two forms:

• interest rates fall, boosting investment and curbing savings.
• spending and thus employment and production fall, further curbing savings.

In normal times, the correct policy response is for the Federal Reserve to inject more money into the economy: through open-market operations it should buy bonds for cash, thus increasing the amount of cash so that even at the lower velocity we still have the same volume of spending, and thus transform the adjustment process from a fall in interest rates, spending, employment, and production to a fall in interest rates alone.

A little thought, however, will lead us to the conclusion that such open-market operations may fail. In them, the Federal Reserve is buying bonds, shrinking the supply of bonds out there--and thus pushing up their price and pushing down interest rates. For each amount that the Federal Reserve expands the money stock, therefore, it puts downward pressure on interest rates and thus on monetary velocity. In the limit where interest rates are so low that people don't really see a difference between cash and short-term government bonds like Treasury bills, open-market operations have no effect because they simply swap one zero-yielding government asset for another.

It is in this situation that a government deficit can be useful. A government deficit means that the government is printing and issuing a lot of bonds at exactly the same moment that private investors are looking for a safe asset to hold. As these bonds hit the market, people who otherwise would have socked their money away in cash--thus diminishing monetary velocity and slowing spending--buy the bonds instead. A large and timely government deficit thus short-circuits the adjustment mechanism, and avoids the collapse in monetary velocity that was the source of all the trouble.

Thus a Hicksian analysis last fall would have said--did say--"don't worry: a large flood of government bond issues won't push up interest rates; it will stem a collapse in monetary velocity instead as people who want to hold their wealth in safe form and would otherwise be holding money find themselves happy holding government bonds instead."

And it has all come true.

Lector, si requiris monumentum Hickium, circumspice!

Why Aren't We Undergoing Another Great Depression?

Paul Krugman's answer:

Averting the Worst: So it seems that we aren’t going to have a second Great Depression after all. What saved us? The answer, basically, is Big Government.... [T]he economic situation remains terrible... we’re... nine million jobs short of where we should be. And the job market still hasn’t turned around....

For all that, however, the latest flurry of economic reports suggests that the economy has backed up... from the... abyss. A few months ago the possibility of falling into the abyss seemed all too real.... [I]n the 1930s the trend lines just kept heading down. This time, the plunge appears to be ending after just one terrible year. So what saved us from a full replay of the Great Depression? The answer, almost surely, lies in the very different role played by government.

Probably the most important aspect of the government’s role in this crisis isn’t what it has done, but what it hasn’t done: unlike the private sector, the federal government hasn’t slashed spending.... All of this has helped support the economy in its time of need, in a way that didn’t happen back in 1930.... In addition to having this “automatic” stabilizing effect, the government has stepped in to rescue the financial sector. You can argue (and I would) that the bailouts of financial firms could and should have been handled better... while acknowledging that without these bailouts things would have been much worse. The point is that this time, unlike in the 1930s, the government didn’t take a hands-off attitude while much of the banking system collapsed. And that’s another reason we’re not living through Great Depression II.

Last and probably least, but by no means trivial, have been the deliberate efforts of the government to pump up the economy... the American Recovery and Reinvestment Act... was too small. Nonetheless, reasonable estimates suggest that around a million more Americans are working now than would have been employed without that plan — a number that will grow.... All in all, then, the government has played a crucial stabilizing role in this economic crisis. Ronald Reagan was wrong: sometimes the private sector is the problem, and government is the solution.

And aren’t you glad that right now the government is being run by people who don’t hate government?...

[W]e appear to have averted the worst: utter catastrophe no longer seems likely.

And Big Government, run by people who understand its virtues, is the reason why.

The loose end in Krugman's article is why there weren't more Great Depressions back in the old days, before big government. The answers, I think, are two:

1. Business cycles are a disease of the post-agricultural economy--of the nonfarm economy. If you look back at the nonfarm unemployment rate before 1930, things look not as bad as the Great Depression but still pretty bad.

2. Most countries had a form of "big government"--a military large in size relative to its nonfarm economy and an activist, interventionist central bank--reaching far back into the past.

3. The U.S. was the only major industrial power without an activist, interventionist central bank before 1913--but the U.S. Treasury did give the baton to run monetary policy to the Morgan-Belmont syndicate in the 1890s and to Morgan in 1907, so we were not always without an activist, interventionist central bank.

4. And the U.S. looks like the worst as far as pre-1930 business cycles are concerned, with 1874 and 1885 matching 1893 in terms of nonfarm unemployment and industrial distress.

For example, this shows the Weir-basis nonfarm unemployment rate back to 1890:

Fun and games in 1921-22, 1914-15m, 1907-08, and 1893-6 as well as 1885 and 1874...

Sociology vs. Complacency in the Failures of Macroeconomics

Mark Thoma asks:

Ask the right questions: [T]he important question is why policymakers didn't take the possibility of a major meltdown seriously. Why didn't they deliver forecasts conditional on a crisis occurring? Why didn't they ask this question of the model?... And... why was the main factor that allowed the crisis to spread, the interconnectedness of financial markets, missed? It was because policymakers couldn't and didn't take seriously the possibility that a crisis and meltdown could occur. And even if they had seriously considered the possibility of a meltdown, the models most people were using were not built to be informative on this question. It simply wasn't a question that was taken seriously by the mainstream.

Why did we, for the most part, fail to ask the right questions? Was it lack of imagination, was it the sociology within the profession...? It wasn't the tools, and it wasn't lack of imagination.... [T]he voices were there... Michael Mussa for one.... Nobody listened even though some people....

And here I think that thought leaders such as Robert Lucas and others... have questions they should ask themselves (e.g. Mr Lucas saying: "At research seminars, people don’t take Keynesian theorizing seriously anymore; the audience starts to whisper and giggle to one another"...).... [That] influences whole generations of economists away from asking certain types of questions...

I think that sociology takes us only so far. Looking back, the Federal Reserve and the Treasury had done a relatively good job in keeping money and finance a fluttering veil for a generation. The stock market crash of 1987--no macroeconomic impact on production and employment. The savings-and-loan crisis of 1990 and the associated credit crunch--minimal macroeconomic impact. The 1998 collapse of LTCM--no macroeconomic impact. The 2000 crash of the dot-com bubble--minimal macroeconomic impact.

The Greenspan Fed batted four-for-four in crises, and many of us--especially me--thought that the Bernanke Fed would do at least as well.

Matthew Yglesias muses on this issue:

Matthew Yglesias: Out of the Frying Pan: One of the more interesting questions about the Housing Bubble Era of 2001-2008 actually has to do with what happened in the years before its rise. Why didn’t the LTCM failure, the “Asian” Financial Crisis (which certainly seemed like a big crisis in Russia at the time), the collapse of the NASDAQ bubble, and the revelation of massive accounting fraud all during the 1997-2000 period prompt some kind of more meaningful action. At the time, I can recall that there was a lot of talk in the air of the need for reform.

John Quiggin recalls:

Neither of these things happened. Advocates of the efficient markets hypothesis, in general, simply ignored the dotcom fiasco, and went on as if nothing had happened. The accounting scandals at Enron and other companies produced the Sarbanes-Oxley Act, which sought to reform corporate governance. But the Act was limited and largely ineffectual. Within a year or two, the conventional wisdom of the financial markets was that Sarbanes-Oxley was an over-reaction to isolated cases of fraud, and that a new push for deregulation was needed.

Financial institutions could disregard the failures of the dotcom bubble because of the (seemingly successful) operation of the Greenspan put. Rather than let the financial sector suffer the consequences of the bursting bubble, Greenspan relaxed monetary policy and inflated a whole new bubble, this time in housing.

This is a somewhat strange problem. Whatever you think of Greenspan’s overall legacy—and I think it’s appropriate to take a very dyspeptic view of his fiscal policy interventions in 1999-2001 and of his interest rate policy in 2004—I think it’s a bit hard to regret that he acted swiftly and decisively to keep the world out of a major recession at the turn of the millennium. The millennial recession was not a fun time for the aversely affected, but relatively few people were aversely affected because it was relatively short and shallow. Letting things fall apart would have led to millions of additional unemployed people, state budget crises, cutbacks in critical social services, etc., etc., etc.

But it really does seem that the success of these operations was taken as a reason to avoid any serious systematic reform. And you can feel the same kind of thing happening today. It’s disturbing.

Note to Self: The Money Stock

Definitions of the "Money Stock":

FRB: H.6 Release--Money Stock and Debt Measures:

1. M1 consists of (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) traveler's checks of nonbank issuers; (3) demand deposits at commercial banks (excluding those amounts held by depository institutions, the U.S. government, and foreign banks and official institutions) less cash items in the process of collection and Federal Reserve float; and (4) other checkable deposits (OCDs), consisting of negotiable order of withdrawal (NOW) and automatic transfer service (ATS) accounts at depository institutions, credit union share draft accounts, and demand deposits at thrift institutions. Seasonally adjusted M1 is constructed by summing currency, traveler's checks, demand deposits, and OCDs, each seasonally adjusted separately.

2. M2 consists of M1 plus (1) savings deposits (including money market deposit accounts); (2) small-denomination time deposits (time deposits in amounts of less than $100,000), less individual retirement account (IRA) and Keogh balances at depository institutions; and (3) balances in retail money market mutual funds, less IRA and Keogh balances at money market mutual funds. Seasonally adjusted M2 is constructed by summing savings deposits, small-denomination time deposits, and retail money funds, each seasonally adjusted separately, and adding this result to seasonally adjusted M1.

Tyler Cowen on the State of Macroeconomics

What Is This "We," Kemosabe?

He has smart things to say--like that, contra Lucas's claim, it was not a victory for the Efficient Market Hypothesis that economists (except for Mussa, Krugman, Baker, and their posse) did not worry about the housing bubble and the size of the lower tail of asset price changes:

Lucas roundtable: Some successes, some failures: Let me focus on some areas where I disagree with Mr Lucas.... I think he is too quick to cite the Efficient Markets Hypothesis (EMH) to dismiss criticism that economists should have predicted the collapse. To be sure, Lucas is correct that we should not expect economists to predict the timing of changes in security markets prices. That said, I do still think that economists—myself included—missed the boat in a fundamental way. Too many economists thought that a collapse of the recent magnitude was unthinkable, especially since financial institution CEOs generally had their own money on the line. To put the point into EMH lingo, we miscalculated systematic risk very badly. We underestimated financial fragility and we underestimated the extent to which common expectational errors, across many entrepreneurs and indeed many nations, were possible. Citing EMH does not in my view excuse this error or account for it. 

Second, one can believe in EMH and still think it is possible to identify bubbles in the housing market ex ante. It is difficult to sell houses short and so the bubble can last for some time, even if it has been identified by informed observers. One group of economists, including Ben Bernanke, significantly underestimated the potential for large and systemic risk in the housing market. This was a simple, flat out error. We don’t have to toss out modern macroeconomics, but we do need to ask why it happened.

Third, Mr Bernanke and many others, again including myself, failed to appreciate how much the Lehman failure would cause some credit flows to shut down. It was surprising to see the interbank repo market collapsing so radically, as has been analysed since by Gary Gorton. There is something fundamental about financial intermediation that we did not understand and probably still do not understand. Why should those markets have dried up so thoroughly and so quickly? Why wasn’t a price adjustment sufficient to restore equilibrium? Why is the continued operation of these markets so important for the real economy? 

Fourth, the recent debates over fiscal policy and stimulus have not enhanced my confidence in macroeconomics. Analytic conclusions in this area seem to line up too tightly with the political views of the researchers. If we can’t understand fiscal policy, I suggest something broader is amiss...

I do however, find myself puzzled by Tyler's last paragraph.

Who is this "we" he speaks of?

Tyler Cowen understands fiscal policy very well. If you ask him how it is that expansionary fiscal policy can increase the flow of nominal demand, he can identify all four parts of the elephant blindfolded:

1. In a Quantity Theory of Money System: If a collapse in market risk tolerance leads to a sharp fall in the short-term nominal interest rate on Treasury securities, that will diminish the opportunity cost of holding money balances and so reduce monetary velocity and thus the flow of nominal demand. Expansionary fiscal policy increases the stock of government bonds outstanding, lowers their price by supply and demand, and thus raises the opportunity cost of holding money balances and puts upward pressure on velocity...

2. In a Neo-Wicksellian Flow-of-Funds System: If a collapse in market risk tolerance pushes the natural rate of interest negative--to a place where the market interest rate cannot go--and so creates an deflationary gap where planned investment is less than actual national net saving, government deficits--dissaving--that reduce national net saving eliminate this deflationary gap between investment and saving, and relieve what would otherwise be downward pressure on the flow of nominal spending...

3. In a Keynesian Income-Expenditure System: If a collapse in market risk tolerance leads to a sharp rise in inventories that causes firms to start firing people, boosting government spending without boosting taxes soaks up those excess inventories, and then there is no signal to private companies adjusting quantities rather than prices that they should fire more workers, which would lower incomes, which would lower consumption spending, which sets off the multiplier process...

4. In a Credit-Channel System: If a collapse in banking-sector capitalization leads to an intensification of moral hazard and adverse selection problems in capital markets, private financial intermediaries will no longer be able to strike contracts to intermediate flows between saver sources and users of funds. But the government--as long as the government's debt remains the safe asset in the economy, that is--is not subject to these moral hazard and adverse selection problems, and expansionary fiscal policy is a way for the government to serve as financial intermediary of last resort...

(My standard references for these four ways of thinking about fiscal policy are Hicks (1937), Krugman (2009) (quoting Jan Hatzius: where is a longer version?), Keynes (1936), and Gertler (2009). Note that these are not, in any sense, contradictory or inconsistent--just different ways of touching the elephant.)

I agree with Tyler that there is something very wrong with those who "cannot understand fiscal policy." I just don't understand why he puts himself in the "we" there--I wish his language were less Aesopian.

And when Tyler says that "analytic conclusions in [macroeconomics] seem to line up too tightly with the political views [of researchers]," I think that is wrong too. Republicans like Glenn Hubbard, Greg Mankiw, Mark Zandi, and Ben Bernanke have no problem advocating fiscal expansions as a tool for fighting recessions (tax cut-heavy fiscal expansions, admittedly). Democrats like Alice Rivlin have no problem saying that it is time to stop thinking deficits are an aid to fighting recession and start worrying again about the long-run fiscal sustainability of the American government. Republicans like Kevin Murphy have no problem saying that even though fiscal policy would be somewhat effective its costs would outweigh its benefits. Democrats like me have no trouble saying that banking-sector policy should be carried out not through the U.S. Treasury but through a bipartisan technocratic institution like the RTC or the RFC.

The divide that worries me isn't sensible Democrat-sensible Republican. The divide that worries me is between economists who understand that the nominal money stock is not a sufficient statistic for the flow of nominal demand--especially when interest rates on short-term Treasuries are very low--and those who don't know enough to have figured that out, and who think that the nominal money stock is a sufficient statistic for the flow of nominal demand--even when interest rates on short-term Treasuries are very low.

Markus Brunnermeier on Which Macroeconomics for the Future?

Markus Brunnermeier writes:

Mind the frictions: BOB LUCAS rightly points out that a branch of macroeconomics proved very useful in weathering the recent crisis. Research by Ben Bernanke and Mark Gertler, Nobu Kiyotaki and John Moore, Rick Mishkin and other macroeconomists provided helpful policy guidance, exactly because their models emphasise the importance of financial frictions for the macroeconomy...

I gotta protest. Not that Markus is wrong when he says that Bernanke-Gertler-Kiyotaki-Moore-Mishkin and their posse have been very useful in their analyses of financial frictions--they have.

But the Chicago school simply does not believe such frictions are important. They believe, as Markus writes immediately afterwards:

However, the bulk of macroeconomic research simply assumes financial frictions away. The financial system and its institutional details were often seen as a distraction from the main drivers of the economic activity. In these models the failure of a large financial institution, like Lehman, would be of no real consequence. But I think we can all agree--if we learnt one thing from the current financial turmoil it is that financial frictions and financial institutions are of essential importance for the macroeconomy...

That's the reason Robert Lucas and company say that they "really don't get" the point of banking policies--they simply haven't read Bernanke-Gertler, Kiyotaki, Moore, and company.

It is, after all, financial frictions and financial institutions that make banking policies and fiscal policies useful tools for fighting the current recession. Financial frictions make it socially beneficial to finance spending via government borrowing when it is not profitable to finance spending via private borrowing because of financial frictions that the government--as long as its debt remains the safe asset in the economy--can work around. Financial frictions make it socially beneficial to recapitalize the banking system rather than simply letting it fail.

Markus goes on to play a little intellectual judo, saying that Lucas's endorsement of the stimulative monetary policies of Ben Bernanke is really an endorsement of Bernanke's credit-channel financial-friction approach to macroeconomics. It is a clever move, and I hope it succeeds.

And Markus goes on to say a lot more clever and wise things:

In my view these frictions are also the root cause for the failure of the efficient market hypothesis (EMH). For example, bubbles can emerge and persist due to limits to arbitrage. Of course, as Bob Lucas points out, when it is commonly known among all investors that a bubble will burst next week, then they will prick it already today. However, in practice each individual investor does not know when other investors will start trading against the bubble. This uncertainty makes each individual investors nervous about whether he can be out of (or short) the market sufficiently long until the bubble finally bursts. Consequently, each investor is reluctant to lean against the wind. Indeed, investors may in fact prefer to ride a bubble for a long time such that price corrections only occur after a long delay, and often abruptly. Empirical research on stock price predictability supports this view. Furthermore, since funding frictions limit arbitrage activity, the fact that you can’t make money does not imply that the “price is right”.

This way of thinking suggests a radically different approach for the future financial architecture. Central banks and financial regulators have to be vigilant and look out for bubbles, and should help investors to synchronise their effort to lean against asset price bubbles. As the current episode has shown, it is not sufficient to clean up after the bubble bursts, but essential to lean against the formation of the bubble in the first place.

This calls on us economists to further develop our tools (including mathematical tools) to integrate the insights financial economists have developed on frictions and the formation of bubbles into the fully fledged dynamic stochastic general equilibrium macro and monetary models that macroeconomists have been working with. Bringing financial economists, macro- and monetary economists together to take on this challenge of building a new workhorse model that incorporates financial frictions would be a great first step in this important (and exciting) endeavor.