Brad DeLong

Crowding-in and Rapid Growth in the 1990s: Dean Baker Gets One Wrong, I Think

Dean Baker writes:

Can We Cut the Crap on Robert Rubin and Deficit Reduction?: Ezra Klei… feed[s] this myth when he tells us of the great virtue of deficit reduction in the Clinton years.

Back in the 1990s, we knew why we feared deficits. They raised interest rates and “crowded out” private borrowing. This wasn’t an abstract concern. In 1991, the interest rate on 10-year Treasurys was 7.86 percent. That meant the interest rate for private borrowing was, for the most part, much higher, choking off investment and economic growth. Enter Clintonomics. The theory was simple: Bring down deficits, and you’d bring down interest rates. Bring down interest rates, and you’d make it easier for the private sector to invest and grow. Make it easier for the private sector to invest and grow, and the economy would boom. The theory was correct. By the end of Clinton’s term, the interest rate on 10-year Treasurys had fallen to 5.26 percent — lower than it had been in 30 years. And the economy was, indeed, booming. 'The deficit reduction increased confidence, helped bring interest rates down, and that, in turn, helped generate and sustain the economic recovery, which, in turn, reduced the deficit further,' Treasury Secretary Robert Rubin said in 1998.

Okay, fans of intro economics know that it is the real interest -- the difference between the nominal interest rate and the inflation rate -- that matters for investment, not the nominal interest rate. The inflation rate in the first half of 1991 was over 5.0 percent. This means that the real interest rate -- the rate that all economists understand is relevant for growth -- around 2.5 percent… [in] the last half year of the Clinton administration (and not some cherry picked low-point) the interest rate on 10-year Treasury bonds averaged around 5.7 percent. The inflation rate for the second half of 2000 averaged around 3.5 percent. This gives us a a real interest rate of 2.2 percent (5.7 percent minus 3.5 percent equals 2.2 percent). So we are supposed to believe that the difference between the 2.5 percent real interest rate in the high deficit pre-Clinton years and the 2.2 percent real interest rate at the end of the Clinton years is the difference between the road to hell and the path to prosperity?

The actual inflation rate in 1991 was 5%/year, but the expected inflation rate over the next decade was more like 3%/year. We are not talking about an 0.3 percentage-point decline in real interest rates, but rather about a 2.3 percentage-point decline in real interest rates. Moreover, back in 1992 when we unwound the yield curve and projected interest rates in the future we saw nominal interest rates has highly likely to rise unless the deficit was substantially reduced. The 2000 we were looking forward at had forecast nominal interest rates of not 7.86%/year but 10%/year or so--a real interest rate of 7%/year.

The counterfactual for 2010 is thus different not by 0.3 percentage-points but by 4.8 percentage-points. That is a much bigger deal.

How big a deal? Enough to boost the growth rate of potential output by between 0.5 and 1.0 percentage points per year, in my estimation…

John Cogan, Tobias Cwik, John Taylor, and Volker Wieland's Reputational Bet on Fiscal Policy Is Due, and They Are Bankrupt

Brad DeLong, May 1, 2009, twenty one and a half months ago: "I think the odds are one-in-three that in two years we wish we would have done more [than the Recovery Act], and that the odds are close to zero that in two years we wish we would have done less."

---

Fiscal Stimulus Effects

**J. Bradford DeLong
University of California at Berkeley and NBER
brad.delong@gmail.com
http://delong.typepad.com/
+1 925 708 0467

May 1, 2009

In March I got a note from Ward Hanson asking me to come down here to Stanford and talk about:

the impact of the Stimulus Bill on jobs creation... the contrast between the Romer/Bernstein estimates of the benefits of the stimulus plan versus... Cogan, Taylor et al. that estimate/argue that there will be very little benefit.... I've got agreement from the "Taylor group" to present, as well as Martin Giles of the Economist Magazine to serve as a moderator...

So I said yes. And Tuesday afternoon I sat down to reread Romer and Bernstein (2009), which I had read before, and Cogan, Cwik, Taylor, and Wieland (2009), which I had not, and I ran into a problem. On page 2 Cogan et al. write that their Figure 1 shows how Romer and Bernstein think government spending affects the economy along with:

exactly the same policy change... in another study... by one of us [John Taylor]... the results are vastly different.... [T]he Romer-Bernstein estimates apparently fail a simple robustness test, being far different from existing published results of another model...

This surprised me. I had talked to Christy. I had talked to Jared. I knew that their intention had been to pull standard models off the shelf and use them.

So I dug—and found that Cogan et al.’s claim of “exactly the same policy change” was simply wrong. Romer-Bernstein model an increase in government spending with the Federal Reserve expanding and keeping on expanding the money supply in order to keep the short-term Treasury Bill interest rate the same. Taylor (1993) models an increase in government spending with the Federal Reserve contracting the real money supply to push the short-term Treasury Bill interest rate up over time as unemployment falls and inflation creeps up. There is no “robustness” problem with Romer-Bernstein at all: the results are different because the policy changes are different.

The Full Fiscal Offset Principle (Away from the Zero Lower Bound, That Is): Or, Why One Would Expect the Multiplier to Be Zero Away from the ZLB Weblogging

In trotting around the country giving versions of DeLong and Summers (2012), “Fiscal Policy in a Depressed Economy”, I have found that a point that seemed completely obvious to us is not obvious at all to many.

Here is the point: an optimizing central bank that cares only about inflation and unemployment because it does not find itself at the zero nominal lower bound and does not fear engaging in nonstandard monetary policy will engage in full fiscal offset: it will take care to make sure that if fiscal policy becomes more stimulative then it will make monetary policy less stimulative by the same amount.

Here is the argument:

Christina Romer Is My Choice for the Next Fed Chair

Consider the set of {people appointed to high federal office by President Barack Obama}.

Consider the set of {people who did not grossly underestimate the seriousness of the macroeconomic situation at some time over 2008-2010}.

Consider the single-element union of those two sets.

Christina Romer really ought to be the next Fed Chair. Just saying…

A Very Brief Dialogue on Preparation...

Glaukon: Who did ultimately fill the Federal Reserve governors seat that had been reserved for Alicia Munnell?

Adeimantos: Let me check..,

Platon: Do you always carry with you a list of governors of the Federal Reserve from the beginning of the system in 1914 to the present?

Adeimantos: Doesn't everyone?

The Republican Clown Show Continues: No, These People Should Not Run Our Economy Weblogging

Paul Krugman on the marconomics of Marco Rubio:

More Marcoeconomics: No, that’s not a misspelling of “macroeconomics”. Matt O’Brien beats me to it: Marco Rubio’s SOTU response also included a shout-out to Say’s Law:

Every dollar our government borrows is money that isn’t being invested to create jobs. And the uncertainty created by the debt is one reason why many businesses aren’t hiring.

I know where he gets this stuff: it’s what the Heritage Foundation guys were saying four years ago.

The Long-Run Cost of the Economic Downturn: Gloomy News About Economic Growth

I have been staring at a very gloomy graph--at the Congressional Budget Office's forecasts of "potential output", of what the economy can produce without starting to "overheat" and putting upward pressure on inflation:

Looking at this graph tells me that:

• Real GDP fell relative to potential output by 8% in 2008-2009…
• Real has stayed 8% below its previous growth path ever since…
• The CBO is now forecasting that real GDP will return to potential output as of the end of 2017…
• The CBO is now forecasting that, come the end of 2017, the economy's full-employment productive potential will be 8% below what CBO was forecasting in 2007…

Janet Yellen Points Out That the Federal Reserve Has Had No Help in Stemming the Depression

Jared Bernstein writes:

Janet Yellen Speaks, Makes Critical Points, and Presents a Graph I Shoulda Made: I’ll have more to say about this remarkable speech given yesterday by Fed Vice Chair Janet Yellen (getting ready to go on NOW with Alex Wagner on MSNBC).  Well—remarkable in the sense that it’s brimming with common sense that is far too uncommon these days.

Read this now and study this chart, one I’m kicking myself for not making.

Larry Summers: U.S. Must Do More than Focus on Deficit

I would say not "do more" but "do different": the U.S. has been focusing on the deficit since the end of 2009, and all that has gotten us has been a jobless recovery. Were we to focus on employment and growth, we would be highly likely to make more progress on reducing the future burden of the debt than when we focus on the deficit--that is, indeed, the message of the arithmetic underlying DeLong and Summers (2012).

Arithmetic, by the way, that I do not believe has been challenged by anybody--save for Marty Feldstein when he raised the possibility that maybe a deeper recession now does not retard but speeds the growth of potential output.

Larry's point about housing finance is, I think, key: Fannie Mae and Freddie Mac have made a lot of money over the years because of their government guarantee; in an environment where private-sector risk-tolerance is still abnormally low, they need to pay the government back by taking on more risk and so boosting the economy. In the mid-2000s we had many too many privately-held subprime housing loans held by undercapitalized private banks. But right now what we really need are a lot more subprime housing loans held or guaranteed by the government and the GSEs.

Larry Summers:

Paul Krugman: The Japan Story

The Japan Story:

Dean Baker is annoyed at Robert Samuelson, not for the first time, and with reason. The idea of invoking Japan, of all places, to justify fears that stimulus leads to inflation or asset bubbles is just bizarre….

[W]hat remains true is that Japan has run budget deficits for many years while delivering what appears on the surface to be very disappointing economic performance. What’s the story there?… First, you should never make comments on Japanese growth or lack thereof without taking demography into account…. [T]here were two long periods of depressed output relative to trend, one in the mid-1990s and another, much worse, between 1997 and 2007. And one other thing: Japanese monetary policy was still up against the zero lower bound in 2007, leaving it no room to counter the Great Recession, and hence leaving Japan open to a deep slump when exports plunged.

So how do we think about this problem? Here’s my take. Japan has pretty much spent the past 20 years in a liquidity trap… the amount that people would want to save at full employment exceeds the amount they would be willing to invest, also at full employment…. A debt overhang from the 1980s bubble surely started the process; but surely it’s reasonable to suggest that the demography also contributes…. What you need in this situation is a negative real interest rate — which means that you need some expected inflation, because nominal rates face the zero lower bound. But Japanese policy has never sought to achieve this. Deficit spending has put part, but only part, of the excess desired private saving to work; this has mitigated the slump, but not produced a booming economy….

Japan’s experience is perfectly consistent with an IS-LM type story, with nothing in there to suggest that fiscal stimulus has somehow backfired; stimulus has done exactly what you’d expect given its limited size and the refusal to take the opportunity to break out of the liquidity trap.

What Abenomics seems to be is an attempt, finally, to do what should have been done long ago: combine temporary fiscal stimulus with a real effort to move inflation up.

Oh, and what about the US relevance? We are, for the time being, in the same situation…. [B]ecause we don’t share Japan’s demographic challenge, our liquidity trap is probably temporary… so… fiscal stimulus is much more likely to serve as a bridge to a revived era of normal macroeconomics. That said, I welcome efforts by the Fed to modestly raise inflation expectations, and would like to see more. So, is Japan a cautionary tale? Yes, but not the tale everyone tells. Its performance isn’t that bad given the shortage of Japanese; and it’s a tale of fiscal and monetary policy that have been too cautious, not of stimulus that failed.

The Puzzle of John Taylor: Department of "Huh!?!?!?!?!?!?" Weblogging

Paul Krugman takes his cut:

Calvinist Monetary Economics: Aha. In his latest op-ed, John Taylor comes out as a full-fledged monetary Calvinist. No, not a disciple of John Calvin, the preacher — a disciple of Calvin of Calvin and Hobbes…. Mike Konczal felicitously made that analogy to discuss the people who were calling for a rise in interest rates despite high unemployment and low inflation — a group at the time exemplified by Raghuram Rajan. For those who don’t read the classics, Calvinball is a sport in which you change the rules whenever you feel like it, very much including in the middle of games. Back then the tight-money types were inventing new and peculiar principles of monetary policy on the fly; it was obvious that they were looking for some reason, any reason, to justify a rise in rates, because, well, because.

Now Taylor is doing the same thing. He claims that he can show that the Fed’s low-rate policy is actually contractionary, using “basic microeconomic analysis”. Actually, as Miles Kimball points out, he’s committing a basic microeconomic fallacy — a fallacy you usually identify with Econ 101 freshmen early in the semester…. Taylor argues that low rates engineered by the Fed are just like a price ceiling that reduces the supply of loans, and therefore reduces overall lending. Wow. No, the Fed’s interest rate target isn’t a price control; there is no legal or other restraint on the rates lenders can charge. The Fed is driving down interest rates, or equivalently driving up the price of bonds, by buying bonds; I can’t think of any kind of economic analysis in which that would reduce the quantity of bonds sellers end up issuing, that is, the amount of borrowing (and lending) in the economy. It’s just bizarre, and bears no resemblance to anything a clearly-thinking economist would say.

bcg.perspectives: Brad DeLong on Debt and the Global Economy

bcg.perspectives - Brad DeLong on Debt and the Global Economy

Grand Mal Economic Seizures

Project Syndicate: Across the North Atlantic region, central bankers and governments seem, for the most part, helpless in restoring full employment to their economies. Europe has slipped back into recession without ever really recovering from the financial/sovereign-debt crisis that began in 2008. The United States’ economy is currently growing at 1.5% per year (about a full percentage point less than potential), and growth may slow, owing to fiscal contraction this year.

Industrial market economies have been suffering from periodic financial crises, followed by high unemployment, at least since the Panic of 1825 nearly caused the Bank of England to collapse. Such episodes are bad for everybody – workers who lose their jobs, entrepreneurs and equity holders who lose their profits, governments that lose their tax revenue, and bondholders who suffer the consequences of bankruptcy – and we have had nearly two centuries to figure out how to deal with them. So why have governments and central banks failed?

The “Bloomberg” speech by Ed Balls: 27th August 2010

Tom Watson reminds us of Ed Balls' “Bloomberg” speech:

I am very grateful to Bloomberg for giving me the opportunity to come here this morning to respond to the bullish speech given from this same platform by George Osborne 10 days ago. That speech is the clearest articulation of the Cameron-Clegg Coalition strategy for this parliament. In it, their Chancellor repeated his claim that fiscal retrenchment through immediate and deep public spending cuts to reduce the fiscal deficit would build financial market confidence in the UK economy, keep interest rates low and secure economic recovery by boosting private investment. And the Chancellor once again declared that his was the only possible credible course ahead – dismissing anyone who doubts that fiscal deflation on this scale and at this delicate stage in the economic cycle is necessary or wise.

Hoisted from the Archives: The Safe Asset Shortage and the Current Downturn

In 1829, John Stuart Mill made the key intellectual leap…. Mill saw that excess demand for some particular set of assets in financial markets was mirrored by excess supply of goods and services in product markets, which in turn generated excess supply of workers in labor markets…. If you relieved the excess demand for financial assets, you also cured the… shortfall of aggregate demand….

When the excess demand is for liquid assets used as means of payment – for “money” – the natural response is to have the central bank buy government bonds for cash….

When the excess demand is for longer-term assets – bonds to serve as vehicles for savings that move purchasing power from the present into the future – the natural response is… induce businesses to borrow more and build more capacity, and encourage the government to borrow and spend….

When excess demand is for high-quality assets – places where you can park your wealth and be assured that it will still be there when you come back – the natural response is to have credit-worthy governments guarantee some private assets and buy up others, swapping them out for their own liabilities and thus diminishing the supply of risky assets and increasing the supply of safe assets.

Jeff Frankel: Monetary Alchemy, Fiscal Science

Jeff Frankel:

Monetary Alchemy, Fiscal Science: The austerity-versus-stimulus debate has been thoroughly hashed out…. [T]he long-term consequences of permanently expansionary macroeconomic policy… are unsustainable deficits, debts, and inflation…. [I]n the aftermath of a recession, when unemployment is high and inflation low, the immediate consequences of contractionary macroeconomic policy are continued unemployment, slow growth, and debt/GDP ratios that go up rather than down….

Less thoroughly aired recently is… whether… monetary or fiscal expansion is the more effective instrument…. The answer to the question which form of policy is more effective: under the circumstances that held in the 1930s and that hold again now - which are conditions not just of high unemployment and low inflation, but also near-zero interest rates — stimulus in the specific form of fiscal expansion is much more likely to be effective in the short-term than stimulus in the form of monetary expansion…. The hoary — but still evocative — metaphor is “pushing on a string.” Meanwhile, fiscal expansion is rendered relatively more effective, in that it doesn’t push up those rock-bottom interest rates and thereby crowd out private-sector demand…. It is worth trying all sorts of things:  quantitative easing, forward guidance, nominal targets.  But the effects of each are highly uncertain. 

That monetary policy is less effective than fiscal policy under conditions of high unemployment and zero interest rates should not be a novel position. But many economists have forgotten much of what they knew and politicians may not have even heard the proposition…. A new wave of econometric research estimates fiscal multipliers using methods that allow them to be higher in some circumstances than others. Baum, Poplawski-Riberio and Weber (2012)… Batini, Callegari and Melina (2012)… Auerbach and Gorodnichenko (2012a, 2012b), Baum and Koester (2011), and Fazzari, Morley and Panovska (2012). Most of this research finds high multipliers under conditions of excess capacity and low interest rates. (Few of them have the courage to mention that this is what one would have expected from the elementary textbooks of 50 years ago, perhaps due to fear of sounding old-fashioned.)…

Needless to say, the effects of fiscal policy are subject to substantial uncertainty… the United States would be well-advised to lock in a long-term path toward debt sustainability, even while undertaking a little short-term stimulus…. Nevertheless, if the question is whether it is monetary policy or fiscal policy that can more reliably deliver demand expansion under current conditions, the answer is the latter.  One might even dramatize the contrast by speaking of “monetary alchemy and fiscal science.”

Contra Raghu Rajan: Economic Stimulus Has Not Failed, It Has Not Been Tried (on a Large Enough Scale)

Perhaps the most fundamental truth of monetary economics that the government can always boost (or reduce) the flow of spending, and in a sticky-price world thus drive the flow of production and employment wherever it wants. As Ben Bernanke said, as a last resort to increase production and employment the government can simply throw money out of helicopters--less picturesquely, cut taxes and print cash to fill the resulting deficit, or to get a little more umph buy extra stuff and thus put some extra unemployed people to work in the process of getting the money out into the economy. Expansionary fiscal and expansionary monetary policy together trigger a rise in the circular flow of nominal spending, and unless price expectations are unanchored and prices flexible enough that 100% of that rise shows up as higher inflation, the greater circular flow puts more people to work making more stuff.

Economists fight over what happens when you do one of the two--when you just do a monetary expansion buying government bonds for cash (because people might not spend their extra cash but hoard it as a savings vehicle), or when you just do a fiscal expansion buying stuff or cutting taxes and paying for it not by printing money but by selling bonds (because purchases of government bonds that crowd-out purchases of private bonds simply shift demand away from private investment). Economists fight over what share of the increase in the nominal circular flow will show up as higher prices as opposed to higher output--over what the natural rate of unemployment is, and how it was affected by the crisis.

But back in 2007 I would have said that every macroeconomist who has done any homework at all believes that coordinated monetary and fiscal expansion together increase at least the flow of nominal GDP.

Now comes the very smart Raghu Rajan to say, apparently, not so:

Evidence on the Success of the Federal Reserve's Adoption of the Evans Rule

Matthew Yglesias writes:

January inflation expectations: The Evans Rule at work.: Here's the latest Cleveland Federal Reserve bank estimates of market inflation expectations…. [S]hort-term inflation expectations are way up. Market participants who are deciding right now what to do with money are pushed at the margin to avoid super-safe low-yield assets and to either make riskier (or less liquid) investments or to "invest" in the acquisition of durable goods. But over longer horizons, there's no shift whatsoever. People don't believe the Fed has lost control of the economy.

The higher short-term targets are consistent with longer-term expectations remaining "anchored" basically where the Fed wants them. Unconventional stimulus seems to work in shaping expectations, and doesn't have a downside in terms of longer-term destabilization.

Christina Romer Tries to Understand the Right Wing of the Federal Reserve

Mark Thoma sends us to:

Christina Romer: 'The Fed Drives Best at Higher Speeds': The central bank has adopted a more aggressive monetary policy that could be very helpful to the recovering economy. But... the Fed’s commitment to its new policies appears shaky. Soon after the December meeting, some members of the policy-making committee spoke out against the action….

[P]essimistic views about ... expansionary actions have played a major role in limiting Fed moves over the last few years. Policy makers worry that such actions will do little good and that they could cause inflation, distortions in financial markets, and losses on the Fed’s portfolio. I can’t say for sure that those views are wrong today… But… in two periods when the Fed made terrible errors… the Great Depression of the early 1930s and the high inflation of the early and late 1970s, monetary policy makers did little because they were convinced that action would be ineffective. Subsequent events proved both decisions wrong....

[H]ypothetical fears shouldn’t stop the Fed’s evolution. History is on the side of doing more, not standing on the sidelines.

Not Being Asleep at the Switch: DeLong Self-Smackdown Watch

Paul Krugman:

What Did I Know, And When Did I Know It?: People have been poring over the just-released 2007 Fed transcripts, and the main surprise seems to be how complacent the institution was. Some members of the open market committee, including Janet Yellen and, let’s give credit where due, Tim Geithner, seem to have had a sense of dread; but the overall consensus was that nothing really bad would happen….

It seems to me that the really big determinant of whether you were intellectually ready for this crisis was how much attention you paid to events in the late 1990s — the crisis in emerging Asia, LTCM here, and the Japanese liquidity trap. I paid a lot of attention back then (as did Nouriel Roubini)…. And the result is that I’ve had a pretty good stretch; the only big thing I got wrong, I think, was in underestimating the stickiness of wages, and hence inflation, and therefore overestimating the risks of actual deflation…

I, by contrast, got it more-or-less completely wrong in that I drew the wrong lessons from the 1990s and before:

Neil Irwin: Federal Reserve Largely Asleep at the Switch in 2007

Neil Irwin:

The real surprise in the Fed’s 2007 transcripts: How much they knew, how little they understood: [T]here were hints of clear-headedness. Timothy Geithner… had a consistent view that fall that the financial system was unraveling and that it was no time for policy gradualism. Eric Rosengren of the Boston Fed, Janet Yellen of the San Francisco Fed, and governor Frederic Mishkin were, by the end of the year, arguing for more interest rate cuts and seemingly pulling his hair out over their colleagues’ sanguine views of the outlook….

But I expected to see much more evidence… of understanding the possibility that the entire financial system had become a house of straws built on mortgage securities that were anything but secure, with all sorts of financial institutions over-levered and overly dependent on assets that were near-impossible to value. And I expected them to understand that once a problem that deep begins correcting itself, it can spiral into all sorts of dangerous directions. Which this one did.

And Nick Rowe Is the Latest Economist to Join the Inarticulate Dorks...

As he himself says: "One more for the 'inarticulate dork' pile. We all keep trying. One day we will all think it and write it clearly."

He's wrong. It is worth reading:

Worthwhile Canadian Initiative: Two extreme fiscal/monetary worlds: I want to imagine two extreme worlds…. In the first world (the "fiscal" world), all financial liabilities of the government are non-monetary liabilities, "bonds", that cannot be used as media of exchange. People use something else for money…. In the second world (the "monetary" world), all financial liabilities of the government are monetary liabilities, "money", that are used as media of exchange…. Government money may or may not pay interest…. Let's start with both worlds in equilibrium, and with balanced budgets. Now let's suppose the government wants to increase spending without increasing taxes. What happens to interest rates on government liabilities?

Michael Derby: Read the Full Fed Transcripts From 2007

http://federalreserve.gov/monetarypolicy/fomchistorical2007.htm

Brad Plumer Reads Page 69 of Alan Blinder’s ‘After the Music Stopped’

Alan Blinder’s ‘After the Music Stopped’:

Grab a new book. Open it to page 69. If the passage is compelling…. Today’s edition brings us to Alan Blinder’s “After the Music Stopped”…. On page 69, however, we see him pondering the origins of the subprime housing meltdown:

Consider the sad case of Alberto and Rosa Ramirez, a pair of Mexican American strawberry pickers in California whose annual income was in the $12,000 to $15,000 range and whose English was marginal at best. Egged on and assisted by an unscrupulous real estate agent looking for a big commission, the Ramirezes obtained a $720,000 mortgage from the notorious (and now bankrupt) New Century Financial Corporation to buy a $720,000 house. Yes, you read that right: They didn’t put a penny down, and the mortgage was forty-eight to sixty times their annual income!

The real estate agent apparently recorded their income as $12,000 per month and their occupations as “field technicians.” Slight errors. The Ramirezes moved into their McMansion with another family, and somehow, including receiving financial help from the real estate agent, managed to hang on for a few years before defaulting and losing their home to foreclosure.

Now, here’s a simple test of banking IQ: Should that mortgage have been granted? You may not be an experienced central banker, but your no answer is correct.

Unfortunately, New Century got the answer wrong in 2005 when it actually made this loan and many others like it. Other banks made similarly disgraceful loans. Yes, you are asking the right question: What were these guys smoking? Apparently, the weed was called greed. Make the loan, pocket the commission, pass it downstream, and let someone else worry about the consequences.

“Apparently, the weed was called greed.” Yep, unexpected!

I'm reviewing the book for Foreign Affairs. It's very good…

ROUGH TRANSCRIPT: Stimulus or Stymied?: The Macroeconomics of Recessions

Panel Moderator: J. BRADFORD DELONG (University of California-Berkeley)

Panelists:

• CARLO COTTARELLI (International Monetary Fund)
• PAUL KRUGMAN (Princeton University)
• VALERIE A. RAMEY (University of California-San Diego)
• HARALD UHLIG (University of Chicago)

DELONG: Between 1985 and 2007--the period of the "Great Moderation"--the Federal Reserve and the rest of the U.S. government on the west edge and the central banks and institutions of the European Union on the east edge of the Atlantic Ocean provided a broadly stable macroeconomic environment within which private-sector businesses, workers and investors could make their economic plans. In the U.S., on an annual basis: the rate of nominal GDP growth dropped below 4% for only 3 of those years and rose above 7% for only 2 of those 22 years; the rate of consumer price inflation rose above 5% for only 3 and fell below 2% percent for only 2 of those 22 years; and the civilian adult employment-to-population ratio remained between 60% and 64% for that entire period. And Western Europe experienced a similar "Great Moderation" with low inflation, relatively smooth growth, and diminishing unemployment.

As Robert Lucas put it in those halcyon days: “the problem of depression prevention has been solved”.

Then in 2008-9 the rate of nominal GDP growth in the U.S. crashed to -3%--a major, major downward surprise to anybody expecting and relying on a continuation of "Great Moderation" rates of nominal spending growth--the rate of consumer price inflation on an annual basis bottomed out at -2%, and the employment-to-population ratio dropped from 63% to between 58% and 59%, since when it has flatlined. In Western Europe the initial recession was smaller, but the subsequent labor market performance was even more disappointing, so that now the net fall relative to trend in Western European production and employment exceeds that in the United States.

The problem of depression prevention—and of depression cure—has not been solved.

DeLong Smackdown Watch: Tim Duy Comes to the Defense of and Explains Kansas City Fed President Esther George

Brad DeLong : There Is Something I Do Not Understand About Kansas City Fed President Esther George's Reasoning Here: The Fed's current Quantitative Easing ∞ program involves its buying risky bonds--thus diminishing the pool of risky assets that the private sector can hold. Esther George objects because… it does not make complete sense to me…. Because there is less in the way of risky assets for the private sector to hold--and because that pushes prices of risky assets up and returns on risky assets down--QE ∞ actually makes private-sector portfolios riskier? Is that the argument? It could be--the world is a surprising place, and lots of things can happen. But my first thought would be that a world in which the Federal Reserve takes risk off of private-sector balance sheets and onto the government's balance sheet is one in which the private sector is holding not more-risky but less-risky portfolios…

Tim Duy performs the smackdown:

Safe Assets and the Coordination of Fiscal and Monetary Policy - Tim Duy's Fed Watch: DeLong is looking at a continuum of assets from safe to risky, where cash anchors the safe end of the continuum.  Right next to cash is the somewhat riskier Treasury… by exchanging cash for Treasury securities, you by definition must be removing risk… and thus the public's portfolio is now less riskier. But… this is obviously not how George views the situation…. George… believes that [Fed policies] are in fact making the public's portfolio more, not less, risky…. I think a way you can explain George's position if you consider Treasuries as less risky than cash…. [T]he Treasury bond may be perceived as a safer because it provides some return…. [F]or any given inflation rate, the Treasury bond will thus be a safer store of value [if held to maturity].  If you viewed the world from this perspective, then the Fed is increasing riskiness of the public's portfolio…. George appears to be saying that the Fed is eliminating (more accurately, removing) the safe assets that the public wants to hold.  Suppose that this is true.  Does this mean that the Fed should reverse policy to increase the proportion of safe assets in the public's hands?  Or does it mean that another agency - perhaps a fiscal authority, hint, hint - should take action to increase the proportion of safe assets in the public's hands?  

Once again, we come back to the issue of coordinating monetary and fiscal policy.  If the public has a strong demand for noncash safe assets, monetary policy has something of a secondary role by providing an accommodative environment by which the fiscal authority can issue those assets. If the proportion of safe to risky assets is not "correct", the the fiscal authority should have a role in correcting that imbalance.  In this world, then, it is not really the actions of the monetary authority that is creating the financial sector imbalances that concern George.  It is the lack of action by the fiscal authority that creates those imbalances.  George should be criticizing the fiscal authorities, not the monetary authority.

In other words, if a recession is the result of the public shifting to safe assets, the Fed is trying to respond by taking away the option of safe assets, leaving only risky assets.  Instead, the Fed should view their role creating an environment (making clear that default is not an option) that allows the fiscal authority to issue more safe assets.

All of this, however, suggests that fiscal policy has a much greater role in stabilizing economy activity than conventional wisdom would hold.  I suspect, however, that thinking along these lines is anathema to Federal Reserve officials who maintain that stabilization policy is the domain of monetary policy only.  But if in fact there needs to be greater cooperation, and instead we continue to rely solely on monetary policy, then we will continue to experience less-than-satisfactory economic outcomes which will eventually endanger the cherished independence of central banks.

In short, I don't think you can have a discussion about the influence of monetary policy on the riskiness of the public's portfolio without including some discussion about the role of the issuer of those safe assets, the fiscal authority.

This is, I think, why I want the Fed's QE ∞ policies to take the form of buying genuine long-term risky securities more risky than Treasurys or MBS. If the point is to remove risk from the private sector balance sheet-if the point is to take Vienna--then remove risk from the private sector balance sheet--take Vienna! If the point is to expand the supply of cash to create expectations that interest rates will stay lower for longer, then it is better to buy assets the unwinding of which must by the nature of things be gradual and prolonged rather than buying assets positions in which can be unwound nearly costlessly in the blink of an eye. If the point of QE ∞ is neither to remove risk from the private sector balance sheet nor to back up guidance that interest rates will stay low for a long time, I do not understand what the point of the policy is.

And, of course, he is 100% right that expansionary fiscal policy by credit-worthy governments (or expansionary financial policy via loan guarantees) is the right policy to deal with a shortage of safe nominal assets leading economic agents to try to cut their spending below their income. This is, of course, the reason that I think a proper assessment of Tim Geithner's tenure at the Treasury would be a very harsh one indeed.

Tim's point that for an economic agent with a five-year horizon a five-year Treasury dominates cash is a good one, and I think it points to a flaw in my visualization of the Cosmic All that I do not know how to repair.

There Is Something I Do Not Understand About Kansas City Fed President Esther George's Reasoning Here

The Fed's current Quantitative Easing ∞ program involves its buying risky bonds--thus diminishing the pool of risky assets that the private sector can hold. Esther George objects because… it does not make complete sense to me:

Michael S. Derby; 2013 Fed Voter George Warns of Risks in Current Policy: As she prepares to take on a direct role in setting monetary policy this year, the leader of the Federal Reserve Bank of Kansas City….

We must not ignore the possibility that the low-interest rate policy may be creating incentives that lead to future financial imbalances… [that would] hamper attainment of the [Federal Open Market Committee's] 2 percent inflation goal in the future…. [M]onetary policy, by contributing to financial imbalances and instability, can just as easily aggravate unemployment as heal it….

She noted that prices for bond, farmland, high yield and leveraged loans “are at historically high levels,” and if there were to a big correction in those prices, it could be “destabilizing and cause employment to swing away from its full-employment level and inflation to decline to uncomfortably low levels.”… The policy maker said the Fed buying of Treasury and agency mortgage bonds “almost certainly” increases the risk of calamity when the time comes to shrink the size of the balance sheet…

Because there is less in the way of risky assets for the private sector to hold--and because that pushes prices of risky assets up and returns on risky assets down--QE ∞ actually makes private-sector portfolios riskier? Is that the argument?

It could be--the world is a surprising place, and lots of things can happen. But my first thought would be that a world in which the Federal Reserve takes risk off of private-sector balance sheets and onto the government's balance sheet is one in which the private sector is holding not more-risky but less-risky portfolios…

Lambert Strether: Blogs: Pure Platinum and Legal Tender: Imminent Death of the Blogs Predicted, Except Not

Lambert Strether:

Imminent Death of the Blogs Predicted, Except Not « naked capitalism: [A] single comment ignited a media and policy explosion* two-and-a-half years later. Does that look like a power curve to you, or what? The chart above is a postage stamp-sized version of the History of the Proof Platinum Coin Concept, 2010-2013 timeline** — each of the tiny black horizontal lines is a link to a piece of content, and the links stack up vertically by date. (There are also larger, post card-sized images of the timeline below, annotated in Skitch.) Now, I should say that the timeline is just a super-duper aggregation or link-fest; there’s very little interpretation or analysis. (For that, see Joe Firestones’s series on How the Proof Platinum Coin Concept was Propagated, especially Chapter 1: “Origin and Early History of Platinum Coin Seigniorage In the Blogosphere”.) Still, we can observe a lot by watching.

Justin Wolfers Asks Whether Any of the Right-Wing Worthies Who Put Their Names to This Tripe 26 Months Ago Have Suffered Any Reputational Consequences...

The answer is "No: reporters somehow never ask them why they got it so wrong in late 2010, and how they have revised their visions of the Cosmic All as a result of getting it wrong. Reporters remain eager to take their quotes down and publish them as the informed views of experts."

And the other real shame--besides the journalistic one of pretending that this embarrassment never happened and continuing to burnish the reputation and media presence of the signers--is that, to my knowledge at least, not a single one of the signatories has gone back and explained (a) why they were so certain that QE was a disaster, (b) why they were wrong, (c ) how they have changed their working model of the economy according to Bayes's Rule, and (d) how their policy recommendations will be different in the future.

The tripe:

An Open Letter to Ben Bernanke | e21 - Economic Policies for the 21st Century:

November 15, 2010

To: Chairman Ben Bernanke
Federal Reserve
Washington, DC

Dear Mr. Chairman:

We believe the Federal Reserve's large-scale asset purchase plan (so-called "quantitative easing") should be reconsidered and discontinued. We do not believe such a plan is necessary or advisable under current circumstances. The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed's objective of promoting employment.

We subscribe to your statement in The Washington Post on November 4 that "the Federal Reserve cannot solve all the economy's problems on its own." In this case, we think improvements in tax, spending and regulatory policies must take precedence in a national growth program, not further monetary stimulus.

We disagree with the view that inflation needs to be pushed higher, and worry that another round of asset purchases, with interest rates still near zero over a year into the recovery, will distort financial markets and greatly complicate future Fed efforts to normalize monetary policy.

The Fed's purchase program has also met broad opposition from other central banks and we share their concerns that quantitative easing by the Fed is neither warranted nor helpful in addressing either U.S. or global economic problems.

Respectfully,

Cliff Asness, AQR Capital

Michael J. Boskin, Hoover Institution, Stanford University; Former Chairman, President’s Council of Economic Advisors

Richard X. Bove, Rochdale Securities

Charles W. Calomiris, Columbia University Graduate School of Business

Jim Chanos, Kynikos Associates

John F. Cogan, Hoover Institution, Stanford University; Former Associate Director, U.S. Office of Management and Budget

Niall Ferguson, Harvard University; Author, The Ascent of Money: A Financial History of the World

Nicole Gelinas, Manhattan Institute & e21, Author, After the Fall: Saving Capitalism from Wall Street—and Washington

James Grant, Grant's Interest Rate Observer

Kevin A. Hassett, American Enterprise Institute; Former Senior Economist, Board of Governors of the Federal Reserve

Roger Hertog, Hertog Foundation

Gregory Hess, Claremont McKenna College

Douglas Holtz-Eakin, Former Director, Congressional Budget Office

Seth Klarman, Baupost Group

William Kristol, Editor, The Weekly Standard

David Malpass, GrowPac, Encima Global; Former Deputy Assistant Treasury Secretary

Ronald I. McKinnon, Stanford University

Joshua Rosner, Graham Fisher & Co., Inc.

Dan Senor, Council on Foreign Relations; Co-Author, Start-Up Nation: The Story of Israel's Economic Miracle

Amity Shlaes, Council on Foreign Relations; Author, The Forgotten Man: A New History of the Great Depression

Paul E. Singer, Elliott Management Corporation

John B. Taylor Hoover Institution, Stanford University; Former Undersecretary of Treasury for International Affairs

Peter J. Wallison, American Enterprise Institute; Former Treasury and White House Counsel

Geoffrey Wood, Cass Business School at City University London

Between Greece and Zimbabwe

Within limits—until it starts printing money fast enough to become Zimbabwe—a country that controls its own currency and can print its own money does not face a tight and binding government budget constraint: the government spends what it wishes, taxes what it wishes, borrows what it wishes, prints money to make up the difference, and the exchange rate and the price level and interest rates then do their things as investors try to figure out on what terms they want to hold domestic as opposed to foreign assets and on what terms they want to hold bonds rather than cash.

By contrast, a country with a fixed exchange rate has its money stock nailed by the requirement that it maintain its exchange rate peg. That then forces spending, taxes, and borrowing into a configuration in which bond vigilantes believe that the debt will be paid off—and if they don’t believe that, then spending must be equal to taxes minus the debt repayment the bond vigilantes demand.

But suppose that you are in an intermediate case, where the Treasury and the central bank do not want to peg the currency (and the internal price level) but do not want to let it (them) do their own thing without limit either? Suppose the Treasury Secretary believes that a strong dollar is in America’s interest. What you then have is a mix of the polar gold-standard and MMT cases. But what are the proportions of the mix?

Mark Thoma: What can Washington do to boost the U.S. economy?

What can Washington do to boost the U.S. economy? - CBS News:

[T]he nation's most pressing economic problem remains the slow recovery, particularly the job market. Unemployment is still far too high and the rate at which we are creating new jobs is far too low…. Monetary and fiscal policymakers could accelerate the return to full employment through tax cuts, increases in government spending -- particularly in areas that tend to create lots of jobs -- and further monetary easing. However, the ability of monetary and fiscal policymakers to combat the slow recovery is constrained by three things: fear that aggressive monetary policy will drive up inflation to an unacceptable level; fear that tax cuts or increases in spending will worsen our long-run debt problem; and political disputes over taxes and the size and role of government….

John Quiggin on the (Failed) State of Macroeconomics

John Quiggin:

Is there a consensus? Clearly there was a consensus as of early 2008…. Everyone agreed that the core business of macroeconomic management should be handled by central banks using interest rate adjustments to meet inflation targets. In the background, central banks were assumed to use a Taylor rule to keep both inflation rates and the growth rate of output near their target levels. There was no role for active fiscal policy such as stimulus to counter recessions, but it was generally assumed that, with stable policy settings, fiscal policy would have some automatic stabilizing effects…. It was generally agreed that this approach to macroeconomic policy, combined with financial deregulation had produced a ‘Great Moderation’ in the volatility of economic activity>This broad consensus was destroyed by the Global Financial Crisis and the Great Recession, but it wasn’t replaced by anything resembling a real debate. Rather, different groups have gone off in different directions. Academic macro went on more or less as before…. Central banks have, in effect, treated the entire period since 2008 as a Schmittian “state of exception”, during which normal rules cease to apply. They have used the crisis to push governments to adopt “reforms” favored by the financial sector, such as cutting welfare benefits and other areas of public expenditure. But their central concern has been to restore the status quo ante, and the exclusive primacy of monetary policy, as soon as possible. From the central bank viewpoint, the restoration of low and stable inflation after the shocks of the 1970s is their crowning achievement and one to be maintained at any cost….

UPDATE: Stimulus or Stymied? The Macroeconomics of Recessions: 10:15 AM-12:PM, January 6, 2013, San Diego, CA, Manchester Grand Hyatt, Elizabeth Ballroom F

Panel Moderator: J. BRADFORD DELONG (University of California-Berkeley)

Panelists:

• CARLO COTTARELLI (International Monetary Fund)
• PAUL KRUGMAN (Princeton University)
• VALERIE A. RAMEY (University of California-San Diego)
• HARALD UHLIG (University of Chicago)

Between 1985 and 2007--the period of the "Great Moderation"--the Federal Reserve and the rest of the U.S. government on the west edge and the central banks and institutions of the European Union on the east edge of the Atlantic Ocean provided a broadly stable macroeconomic environment within which private-sector businesses, workers and investors could make their economic plans. In the U.S., on an annual basis: the rate of nominal GDP growth dropped below 4% for only 3 of those years and rose above 7% for only 2 of those 22 years; the rate of consumer price inflation rose above 5% for only 3 and fell below 2% percent for only 2 of those 22 years; and the civilian adult employment-to-population ratio remained between 60% and 64% for that entire period. And Western Europe experienced a similar "Great Moderation" with low inflation, relatively smooth growth, and diminishing unemployment.

Then in 2008-9 the rate of nominal GDP growth in the U.S. crashed to -3%--a major, major downward surprise to anybody expecting and relying on a continuation of "Great Moderation" rates of nominal spending growth--the rate of consumer price inflation on an annual basis bottomed out at -2%, and the employment-to-population ratio dropped from 63% to between 58% and 59%, since when it has flatlined. In Western Europe the initial recession was smaller, but the subsequent labor market performance was even more disappointing, so that now the net fall relative to trend in Western European productio and employment exceeds that in the United States.

In this context, we are here to explore four questions:

1. Are their policies that the Federal Reserve and the rest of the U.S. government on the west edge and the ECB and the governments of the European Union on the east edge of the Atlantic Ocean could adopt that would quickly move the civilian adult employment-to-population ratio back toward what from 1985-2007 we thought of as "normal"--that could produce in the next couple of years rates of employment growth that are, say, within shouting distance of those the U.S. economy experienced over the Reagan boom of 1982-1989?

2. If so, what are those policies?

3. If so, are those policies desirable ones that the Federal Reserve and the rest of the government should adopt?

4. How is your view on questions (1) through (3) different today than it was six years ago?

---

Alas! I failed in my task as moderator: communication among the panelists was by and large not achieved…

Valerie Ramey brought bad news for multipliers--but left a glimmer of hope in that there is still no evidence or argument that the multiplier at the ZLB would not be much greater than the normal-time monetary-offset multiplier. She talked about the need for comprehensive cost-saving health-care reform, an argument would have applied just as well to 2007 or 2017 as to today.

Carlo Cottarelli presented the IMF’s new, revised view on the multiplier. He did not promise that there were policies that could lead to a rapid recovery to full employment or criticize government.

Paul Krugman ably presented his view, which is my view, that governments should borrow and spend more to boost employment and production and that the limits to fiscal policy for credit-worthy governments are so far beyond the bounds of the politically-feasible that there is no point in talking about them.

Harald Uhlig… I am going to have to listen to Harald’s presentation again. It is clear that Harald Uhlig agrees with Valerie Ramey that there are no policies “that the Federal Reserve and the rest of the U.S. government on the west edge and the ECB and the governments of the European Union on the east edge of the Atlantic Ocean could adopt that would quickly move the civilian adult employment-to-population ratio back toward what from 1985-2007 we thought of as ‘normal’”. But it is not at all clear to me why he believes this…

Matt O'Brien vs. Martin Feldstein on Quantitative Easing

Matthew O'Brien:

There are two things you need to know about the Federal Reserve right now. First, it's had to resort to unconventional measures ever since short-term interest rates, its usual policy lever, fell to zero back in 2008. And second, everything you've been told about these unconventional measures has been wrong. The wrong story… the Fed has cut long-term rates by buying long-term bonds…. Lower borrowing costs should mean more borrowing, and more borrowing should mean more growth…. It's the same story you always hear… it's the one Harvard professor and former Reagan adviser Marty Feldstein tells in the Wall Street Journal. Well, kind of. Feldstein worries this story has some unintended consequences -- namely, higher deficits and higher inflation -- that will give it an unhappy ending….

More on the Current State of Macro...

Howard Schneider:

“[IMF] Forecasters significantly underestimated the increase in unemployment and the decline in domestic demand associated with fiscal consolidation,” [Olivier] Blanchard and co-author Daniel Leigh, a fund economist, wrote…. Blanchard… writes… that he could not actually determine what multipliers economists at the country level were using …. The number was implicit in their forecasting models…. Heading into a crisis that nearly tore the euro zone apart, in other words, neither Blanchard or any one of the fund’s vast army of technicians thought to reexamine whether important assumptions about the region would still hold true in times of crisis. That, it turns out, was a big mistake. Multipliers vary… get larger if interest rates are low, output is falling and the banking system is creaky – conditions that make everyone, from households to investors, less likely to spend, and thus makes the role of government-generated demand that much more important.

Blanchard and Leigh deduced that IMF forecasters have been using a uniform multiplier of 0.5, when in fact the circumstances of the European economy made the multiplier as much as 1.5, meaning that a $1 government spending cut would cost $1.50 in lost output…

The War on the Core CPI...

It is a fact that when distributions have thicker tails than the normal Gaussian distribution, trimmed-mean and other robust estimators do a better job of estimating central tendencies than simple averages. It is a fact that food and energy sector prices, especially, have deviations from the overall inflation rate that have much thicker tails than the Gaussian normal. And it is a fact that over the past fifty years in America whenever the full CPI inflation rate has moved away, either up or down, from the core CPI inflation rate--the inflation rate excluding food and energy prices--the odds are better than 9-1 that the gap will then be closed by the full CPI moving back to the core, and not the core moving to the full CPI:

Thus our jaws drop when we read things like those below:

Hoisted from the Comments: Information in the Autocorrelation of Inflation Weblogging

Nick Rowe said:

Yes, I think you may be missing something…. If the central bank is targeting (future) headline inflation correctly, by responding correctly to current headline and core inflation, then neither headline nor core should forecast future headline inflation. This is an immediate implication of the orthogonality of forecast errors wrt the information set under rational expectations on the part of the central bank…. If (for example) you find that current core predicts future headline, that tells you nothing structural. Instead it tells you that the central bank didn't have rational expectations and was making systematic mistakes by not responding strongly enough to core.

This is just one application of a more general theme I've been hammering away at for the last 12 years. If the Bank of Canada is targeting 2% headline inflation at a 2 year horizon, then headline inflation should be unforecastable from everything in the Bank's information set 2 years (or more) prior. If we find headline inflation is forecastable then we have prime facie evidence of systemic mistakes in the Bank's monetary policy reaction function, and can use that evidence to improve its reaction function, in a sort of "learning by past mistakes" method.

Given that it takes 3 or more years for open-market operations to have their full effect on inflation (one year for interest rate changes to affect employment, and then two years or more for employment to affect rates of price increase and price increase expectations) there is useful information about more than the optimality of monetary policy to be found in the correlation between current core and headline inflation and future inflation at horizons of up to three years.

Michael Derby: Fed’s Historic Error Is in Not Acting Boldly Enough, Romer and Romer Paper Argues

Michael Derby: Fed’s Historic Error Is in Not Acting Boldly Enough, Paper Argues:

Federal Reserve officials have been underestimating their powers and have wounded the economy in the process, a new research paper argues. That observation will certainly surprise many in light of the wide range of unprecedented actions taken by the central bank in recent years. That said, a new paper by University of California, Berkeley, economists Christina and David Romer said policy makers need to embrace the powerful tools at their disposal, believing that when they don’t, the economy pays the price. The paper will be presented Saturday at the American Economic Association annual gathering in San Diego. The research is titled “The Most Dangerous Idea in Federal Reserve History: Monetary Policy Doesn’t Matter.“

"Liquidate Labor, Liquidate Stocks, Liquidate the Farmers, Liquidate Real Estate!… Even a Panic Is Not Altogether a Bad Thing" Weblogging

Robert Murphy says that in the absence of Bernanke's excessive inflationary policies we would now be undergoing deflation at a rate of 10%/year.

But he does not understand "why [predicting] price inflation (and interest rates) are the decisive criteria for whose model and hence policy recommendations are right."

And, in his view, Bernanke's policies remain bad and impious: we would have been better off without the expansion of the Federal Reserve's balance sheet from $700 billion to $3 trillion, and with 10%/year deflation right now.

And Jon Hilsenrath of the Wall Street Journal Gets One Wrong...

Jon Hilsenrath: >Fed's Computer Models Pose Problems:

When the Federal Reserve said in December that it would keep short-term interest rates near zero until the unemployment rate falls to 6.5%, it was backed by… [the] computer-modeling programs the central bank uses…. In December…. Fed officials decided to announce they would keep interest rates near zero until the unemployment rate drops to 6.5%. The models told them such a commitment would help nudge unemployment lower—it was 7.7% in November—and wouldn't risk a big burst of inflation.

But here is the problem: The models are deeply flawed. They failed to foresee the financial crisis in 2008 and have tended to overestimate the strength of the economy for several years. Could they fail the Fed again?… Despite all their complexity and sophistication, they have long been plagued by gaps in how they read and project the economy. One of the biggest is that they have ignored the nuances of the financial system—one of the primary channels through which Fed policy works….

The financial gaps in the models worry Nathan Sheets, a Citigroup C -0.62% economist who was Mr. Bernanke's top international adviser at the Fed from 2007 to 2011. Mr. Sheets points to 1994 as an example of why. Back then, small increases in short-term interest rates by the Fed led to a surge in long-term interest rates. The models didn't foresee the financial chaos that would ensue, including the collapse of investment bank Kidder Peabody & Co., the bankruptcy of Orange County, Calif., and the Mexican peso financial crisis…

I was just last week going through my notes from 1994. Yes, the Federal Reserve's model (and other models) "failed": they all forecast that the 1994 raise in the Federal Funds rate from 3%/year to 6%/year would carry with it an increase in long-term nominal Treasuries from 6%/year to 6.75%/year; instead, long-term Treasuries peaked at 8%/year because of (a) an absence of forward interest rate guidance by the Fed and (b) unexpectedly-large endogenous moves in the duration of MBS.

But the unexpectedly-adverse reaction of the bond market in 1994 did not cause the Mexican peso crisis: an extra 1% rise in U.S. bond interest rates is not big enough to cause the Mexican peso to lose 75% of its value. Neither Orange County nor Kidder Peabody had any business holding a portfolio that would be bankrupted by a 10% fall in the value of the long-term Treasury bond. And it is not the business of the Federal Reserve to make sure that nobody holding an over leveraged portfolio goes bankrupt. The "financial chaos" of 1994 had no effect on the real economy in the United States: there was no recession in 1995, but rather the beginnings of the great dot-com boom.

The point of Hilsenrath's article appears to be that something bad may

happen when Fed officials raise interest rates…. The models make predictions about unemployment and inflation, but Mr. Sheets worries they might not foresee new financial shoes poised to drop. "They've really internalized these models and that's very risky," Mr. Sheets said…. in a lower interest rate, and Ferbus spits out predictions of how much growth and inflation should follow. Punch in some other event—like a sudden contraction in government spending or a jump in tax rates—and it spits out predictions of how the economy should respond…. The fingerprints of Ferbus and its friends are all over the Fed's latest interest-rate decisions…. [G]iven the unknowns about unconventional Fed policies, Mr. Sheets's warning warrants attention.

Mr. Sheets's warning certainly warrants attention if you are a hedge fund or an investment bank thinking of replicating Kidder Peabody's or Orange County's portfolio--but you should have already known not to do that.

But should Mr. Sheets's warnings have led the Federal Reserve to do something different than it has done? In retrospect the Federal Reserve certainly wishes that it had given more guidance at the start of 1994 as to the likely shape of its interest-rate tightening cycle and that it had at the start of 1994 incorporated the endogenous duration of MBS into its models in the way that it had incorporated them by the end of 1994. However, if the employment and output recovery evolves going forward as the recovery of the 1990s evolved in 1994 and thereafter, the Federal Reserve will be not dismayed but ecstatic.

Robert Murphy's Bet That Inflation Was Just Around the Corner Has Gone Absolutely Horribly Wrong

Terrifying to see:

Robert Murphy: October 2011: Update on My Inflation Bets: I know that a while ago I made two inflation bets… [with] David R. Henderson… [the] terms:

At any point between now and January 2013, if there is a year/year increase in seasonally adjusted CPI that is at least 10%, then [Henderson pays Murphy] at that time $500.

If we get to January 2013, and there has not been any 12-month stretch in which the above happened, then [Murphy pays Henderson] $500 at that time….

I made the above bets in December 2009. Things are obviously not progressing on the timetable I had thought…. If it weren’t for the crisis in Europe (which is pushing people to flock into dollars), I would still be fine [as of October 2011[!!!!]] with [the bet with Henderson], but it may turn into a nail biter…

The most terrifying thing of all is that being completely, comprehensively, unmistakably, fundamentally, fatally, totally wrong has not led Robert Murphy to rethink or modify any of his analytical positions or ideological beliefs by even one iota.

I mean, one would expect an announcement on his weblog like: "I have been totally wrong, about everything. I am closing down this weblog for five years to avoid misleading readers while I intellectually retool. You will find me sitting at the feet of Paul Krguman, chanting 'om mani padme hum' until I achieve enlightenment."

Not gonna happen...

Ben Bernanke's Secret Message to Congress: More Stimulus, Please

Matt O'Brien:

Ben Bernanke's Secret Message to Congress: More Stimulus, Please: The Fed is already buying $85 billion of bonds a month on an open-ended basis and has promised not to raise rates before unemployment falls below 6.5 percent or inflation rises above 2.5 percent.

But it still thinks inflation will remain subdued, despite its bond-buying.

In other words, the Fed is telling us it will tolerate a bit more inflation, but it won't create it. That's as good an invitation as Congress is going to get to cut taxes or increase spending, at least until inflation is around 2.5 percent. Now, the Fed might buy fewer bonds than it otherwise would if Congress does more, but we know it won't raise rates--there's little guessing how much fiscal stimulus the Fed will allow. The multiplier is big now.

It's right out of Ben Bernanke's playbook. As Tim Duy, a professor at the University of Oregon, points out, Bernanke's often cited "helicopter drop" speech about how to stop deflation -- the idea was you could drop money from the sky as a last resort -- did not say a central bank could do this on its own. Bernanke said a "determined government" could "always generate higher spending and hence positive inflation," emphasis on the word government.

Bernanke wants Congress to help him, and he's doing everything he can to let them know.

DeLong Smackdown Watch: Paul Krugman vs. Invisible Bond Vigilantes Weblogging Edition

Paul Krugman:

Bond Vigilantes and the Power of Three: The popular story about how an attack by bond vigilantes can cause an interest rate spike and turn America into Greece… is incoherent…. Think of a simplified world in which there are three kinds of assets: short-term securities, long-term government bonds, and foreign assets…. Individual investors can shuffle their portfolios…. [T]here are three prices… short-term interest rates, long-term interest rates, and the exchange rate. At any given time, however, one of these is fixed, leaving it up to the other two to do the adjusting. Which two? That depends on the monetary regime….

The United States has independent monetary policy and a floating exchange rate. The Fed uses its independence to set the short-term interest rate… long-term rates and the exchange rate do the adjusting…. If you think short-term rates are heading up [because the Fed thinks the depression is about to end]… long-term bonds become less attractive; better to park your money and wait for better yields…. In such a case long-term rates rise--but because this rise is driven by greater optimism about the future, it's hard to see how it can have a contractionary effect on the economy.

Incidentally, this seems to me to be a big problem with the story Brad DeLong tells about bond vigilantes in the very early 1990s. He argues that the wide gap between short-term and long-term rates reflected market expectations that deficits would eventually cause higher inflation…. But why would such expectations be a drag on the economy? Yes, nominal rates would be higher than otherwise; but real rates would, if anything, be lower. It's not at all easy to tell a coherent story in which the effect of future expected deficits on today's interest rates is contractionary….

I Think Noah Smith Gets One Wrong: State-of-Macroeconomics Weblogging

If Noah Smith does not want to call what I see as serious and significant deficiencies “failures of technique”, then what does he suggest that I call them?

Noah Smith:

Noahpinion: Macro, what have you done for me lately?: Paul Krugman says the state of macroeconomics is rotten. Steve Williamson disagrees…. On the question of whether macro is divided into warring "schools", I'd say Williamson is 85% right, and Krugman only 15%. Yes, there are some systematic disagreements, but they're not very bitter or rancorous, and everyone uses mostly the same "language". The old "freshwater"/"saltwater" distinction is still there to a limited degree among older faculty, but younger faculty don't seem to see much of a dividing line…. So if collegiality and similarity of technique are measures of a field's health, then macro is doing quite well...

I think that is wrong. It depends, I think, on what you take "technique" to mean:

Hoisted from the Archives: Paul Krugman in 2009 on the Future of Macroeconomics

Where Does Macroeconomics Go From Here?: SEPTEMBER 03, 2009: Paul Krugman has questions:

How Did Economists Get it So Wrong?: Between 1985 and 2007 a false peace settled over the field of macroeconomics. There hadn’t been any real convergence of views between the saltwater and freshwater factions. But these were the years of the Great Moderation — an extended period during which inflation was subdued and recessions were relatively mild. Saltwater economists believed that the Federal Reserve had everything under control. Fresh water economists didn’t think the Fed’s actions were actually beneficial, but they were willing to let matters lie.

But the crisis ended the phony peace. Suddenly the narrow, technocratic policies both sides were willing to accept were no longer sufficient — and the need for a broader policy response brought the old conflicts out into the open, fiercer than ever. Why weren’t those narrow, technocratic policies sufficient? The answer, in a word, is zero.

Can It Really Be the Case That the Obama Administration Is Proposing a Deal That Would Cut Social Security Benefits But Not Raise Social Security Revenues

There are many overlapping ways of looking at the federal budget. One way is to look at revenues and spending in total--the "unified budget". Another way is to look at the health of the various "trust funds"--Social Security, Medicare, etc.--that have dedicated revenue streams coming in and dedicated expenditures going out.

For the Social Security trust fund, over the long-term expected revenues are less than planned payments--which means that either (a) benefits will have to be cut, (b) revenues will have to be raised, or (c ) somebody will have to perform some political heavy lifting in order to beef up the trust fund. Changes to Social Security law should ideally involved moves on all three fronts--some of (a), some of (b), and some of (c ) in order to get the long-term arithmetic of the trust fund into balance.

But now the Obama administration appears to be planning to agree to do just some of (a) without touching (b) or (c ).

Can't anybody in the White House play this game?

Coffee with Stephanie Kelton

As of January 1, 2016, enough time will have passed for us to be able to judge whether the Federal Reserve's policy shift to the Evans rule plus an open-ended $1 trillion a year of balance sheet has been a success or not.

Stephanie Kelton is almost certain it will not be a success. I think it might well work. Mike Woodford is almost certain that it will work. It seems to me that there is an opportunity here for me to lock in a profit of some sort here…

The first stage of this is crafting a bet that Stephanie Kelton would accept for what states of the economy on January 1, 2016 would qualify as success for the Fed, and what states of the economy would qualify as failure. She does expect a better economy in three years--She expects private sector deleveraging to continue at its slow pace And as a result the forces making for balance sheet recession to ebb. Success would, for her, have to count as stronger than expected improvement in the economy given this positive underlying trend.

How should I phrase the bet? And then what bet should I offer Mike Woodford when I run into him by accident in San Diego?

DeLong Smackdown Watch: Paul Krugman Says That I Make the Story too Complex Weblogging

Paul Krugman:

Inaction is the Greatest Risk: Inaction is the Greatest Risk (Wonkish) Brad DeLong is exasperated with people who insist that the Fed's modest moves toward more support for the economy are "risky", but cannot explain why in any intelligible fashion…. It is just bizarre to angst about how the Fed might "distort" markets that are already hugely distorted.

But my first take on the nature of that distortion is a lot simpler than Brad's.

Another Person Who Thinks That the Fed's Policy Is "Risky", But Cannot Intelligibly Explain Why...

Muhammed El-Erian:

How risky is the Fed's major move?: A bold and necessary move? Yes, but the Fed's growing activism has limits and is ultimately inconsistent with the proper efficient functioning of a market economy.

Wow! That is what I suspect many investors said when they heard Wednesday's policy announcement…. Yesterday's Fed announcement will go down in the history books…. The Fed took two major steps on Wednesday, one expected and one less so. First, it added to its expected purchases of market securities, doubling the dollar amount to $1 trillion for 2013…. Second, the Fed shifted to quantitative (unemployment and inflation) targets for forward policy guidance…. This further leap into the policy unknown was motivated by continued disappointment with the economy's sluggish growth, persistently high unemployment and increasing concern about joblessness becoming more structurally embedded into the economy….

The bad news is that the institution, with its imperfect tools for the challenge at hand and with other federal government entities essentially MIA, may be taking on an unsustainable burden…. [T]he outcome of the Fed's unusual activism is neither predictable nor costless… an increasing risk of collateral damage and unintended consequences… ultimately inconsistent with the proper efficient functioning of a market economy. With a market share that will end 2013 between 30% and 45% depending on the securities, the Fed is heavily involved in markets as both a referee and player. As such, it distorts their functioning, the price discovery process and the allocation of capital….

What Are the Risks and Costs of Expanding the Federal Reserve's Balance Sheet?

Does anybody understand what Richard Fisher is talking about here?

Fed’s Fisher Worries About ‘Hotel California’ Monetary Policy: Dallas Fed President Richard Fisher said Friday on CNBC he opposed the Federal Open Market Committee‘s recent decision on employment thresholds and that he was extremely concerned that it would become increasingly difficult to exit the Fed’s accomodative monetary policy.

We are at risk of what I call a ‘Hotel California’ monetary policy, referring to the Eagles’ song, where we can check out any time we want from this program, but we can never leave….

We’ve done enough… businesses are awash in liquidity…. We cannot count on central banks to carry an economy. There has to be the right incentives to take what the central banks do, provide monetary stability, provide just the right amount of liquidity to the economy, incentives to put all that to work, and grow the economy...

Does anybody understand what Richard Fisher means?