Fed Fail Part XXVIII

The Employment Situation by Krugman

The New Normal

The Employment Situation by Krugman

Review of End This Depression Now! and 
The Price of Inequality: How Today’s Divided Society Endangers Our Future:

What Krugman & Stiglitz Can Tell Us by Jacob Hacker and Paul Pierson

DeLong: Glasner is the second best monetary economist:

Not, mind you, that I think David is a better monetary economist than Mike Woodford--I do find I learn more from paying careful attention to Mike than to David. But I can't think of anybody else I reliably learn more from paying careful attention to… 

David Glasner:

 John Cochrane Misunderestimates the Fed

In my previous post, I criticized Ben Bernanke’s speech last week at the annual symposium on monetary policy at Jackson Hole, Wyoming. It turns out that the big event at the symposium was not Bernanke’s speech but a 98-page paper by Michael Woodford, of Columbia University. Woodford’s paper was important, because he is widely considered the world’s top monetary theorist, and he endorsed the idea proposed by the intrepid, indefatigable and indispensable Scott Sumner that the Fed stop targeting inflation and instead target a steady growth path of nominal GDP. That endorsement constitutes a rather stunning turn of events in which Sumner’s idea (OK, Scott didn’t invent the idea, but he made a big deal out of it when nobody else was paying any attention) has gone from being a fringe idea to the newly emerging orthodoxy in monetary economics. 

John Cochrane, however, is definitely not with the program, registering his displeasure in a blog post earlier this week. In this post, I am going to challenge two assertions that Cochrane makes. These aren’t the only ones that could be challenged, but it’s getting late.  The first assertion is that inflation can never bring about an increase in output. 

Mike [Woodford]‘s enthusiasm for deliberate inflation is even more puzzling to me.  Mike uses the word “stimulus,” never differentiating between real and nominal stimulus. Surely, we don’t want to cook up some inflation just for its own sake — we want to cook up some inflation because we think it will goose output. But why? Why especially will increasing expected inflation help? Because that is the aim of all the policies under discussion here — promising to keep rates low even once inflation rises, adopting “nominal GDP targets,” helicopter drops, or similar policies such as raising the inflation target. 

I don’t put much faith in Phillips curves to start with  – the idea that deliberate inflation raises output. I put less faith in the idea floating around Jackson hole that a little inflation will set us permanently back on the trend line, not just be a little sugar rush and then back to sclerosis. 

But it’s a rare Phillips curve in which raising expected inflation is a good thing.  It just gives you more inflation, with if anything less output and employment. 

Cochrane is simply asserting that expected inflation cannot increase output and employment. The theoretical basis for that proposition is an argument, generally attributed to Milton Friedman and Edward Phelps, but advanced by others before them, that an increase in inflation cannot generate a permanent increase in employment. The problem with that theoretical argument is that it is a comparative statics result, thus, by assumption, starting from an initial equilibrium with zero inflation and positing an increase in the inflation parameter. The Friedman-Phelps argument shows that a new equilibrium corresponding to the higher rate of inflation has the same level of output and employment as the initial zero-inflation equilibrium, so that derivatives of output and employment with respect to inflation are both zero. That comparative-statics exercise is fine, but it’s irrelevant to the situation we have been in since 2008. We are not starting from equilibrium; we are starting from a disequlibrium in which output and employment are well below their equilibrium levels. The question is whether an increase in inflation, starting from an under-employment disequilibrium, would increase output and employment. The Friedman/Phelps argument tells us exactly nothing about that issue. 

And aside from the irrelevance of the theoretical argument on which Cochrane is relying to the question whether inflation can reduce unemployment when employment is below its equilibrium level – I am here positing that it is possible for employment to be persistently below its equilibrium level – there is also the clear historical evidence that in 1933 a sharp increase in the US price level, precipitated by FDR’s devaluation of the dollar, produced a spectacular increase in output and employment between April and July of 1933 — the fastest four-month expansion of output and employment, combined with a doubling of the Dow-Jones Industrial Average, in US history. The increase in the price level, since it was directly tied to a very public devaluation of the dollar, and an explicit policy objective, announced by FDR, of raising the US price level back to where it had been in 1926, could hardly have been unanticipated. 

The second assertion made by Cochrane that I want to challenge is the following. 

Nothing communicates like a graph. Here’s Mike [Woodford]‘s, which will help me to explain the view:

The graph is nominal GDP and the trend through 2007 extrapolated. (Nominal GDP is price times quantity, so goes up with either inflation or larger real output.) 

Now, let’s be clear what a nominal GDP target is and is and is not. Many people (and a few persistent commenters on this blog!) urge nominal GDP targeting by looking at a graph like this and saying “see, if the Fed had kept nominal GDP on trend, we wouldn’t have had  such a huge recession. Sure, part of it might have been more inflation, but surely part of a steady nominal GDP would have been less recession.” This is NOT what Mike is talking about.

Mike recognizes, as I do, that the Fed can do nothing more to raise nominal GDP today. Rates are at zero. The Fed has did [sic] what it could. The trend line was not achievable. 

Nick Rowe, in his uniquely simple and elegant style, has identified the fallacy at work in Woodford’s and Cochrane’s view of monetary policy which views the short-term interest rate as the exclusive channel by which monetary policy can work. Thus, when you reach the zero lower bound, you (i.e., the central bank) have become impotent. That’s just wrong, as Nick demonstrates. 

Rather than restate Nick’s argument, let me add some historical context. The discovery that the short-term interest rate set by the central bank is the primary tool of monetary policy was not made by Michael Woodford; it goes back to Henry Thornton, at least. It was a commonplace of nineteenth-century monetary orthodoxy. Except that in those days, the bank rate, as the English called it, was viewed as the instrument by which the Bank of England could control the level of its gold reserves, not the overall state of the economy, for which the Bank of England had no legal responsibility. It was Knut Wicksell who, at the end of the nineteenth century, first advocated using the bank rate as a tool for controlling the price level and thus the business cycle. J. M. Keynes and Dennis Robertson also advocated using the bank rate as an instrument for controlling the price level and the business cycle, but the most outspoken and emphatic exponent of using the bank rate as an instrument of macroeconomic control was Ralph Hawtrey. Keynes continued to advocate using the bank rate until the early 1930s, but he then began to advocate fiscal policy and public works spending as the primary weapon against unemployment. Hawtrey never wavered in his advocacy of the bank rate as a control mechanism, but even he acknowledged that could be circumstances under which reducing the bank rate might not be effective in stimulating the economy. Here’s how R. D. C. Black, in a biographical essay on Hawtrey, described Hawtrey’s position: 

It was always a corollary of Hawtrey’s analysis that the economy, although lacking any automatic stabilizer, could nevertheless be effectively stabilized by the proper use of credit policy; it followed that fiscal policy in general and public works in particular constituted an unnecessary and inappropriate control mechanism. Yet Hawtrey was always prepared to admit that there could be circumstances in which no conceivable easing of credit would induce traders to borrow more and that in such a case government expenditure might be the only means of increasing employment. 

This possibility of such a “credit deadlock” was admitted in all Hawtrey’s writings from Good and Bad Trade onwards, but treated as a most unlikely exceptional case. ln Capital and Emþloyment, however, he admitted “that unfortunately since 1930 it has come to plague the world, and has confronted us with problems which have threatened the fabric of civilisation with destruction.” 

So indeed it had, and in the years that followed opinion, both academic and political, became increasingly convinced that the solution lay in the methods of stabilization by fiscal policy which followed from Keynes’s theories rather that in those of stabilization by credit policy which followed from Hawtrey’s. 

However, a few paragraphs later, Black observes that Hawtrey understood that monetary policy could be effective even in a credit deadlock when reducing the bank rate would accomplish nothing. 

Hawtrey was inclined to be sympathetic when Roosevelt adopted the so-called “Warren plan” and raised the domestic price of gold. Despairing of seeing effective international cooperation to raise and stabilize the world price level, Hawtrey now envisaged exchange depreciation as the only way in which a country like the United States could “break the credit deadlock by making some branches of economic activity remunerative.” Not unnaturally there were those, like Per Jacobsson of the Bank for International Settlements, who found it hard to reconcile this apparent enthusiasm for exchange depreciation with Hawtrey’s previous support for international stabilization schemes. To them his repiy was “the difference between what I now advocate and the programme of monetary stability is the difference between measures for treating a disease and measures for maintaining health when re-established. It is no use trying to stabilise a price ievel which leaves industry under-employed and working at a loss and makes half the debtors bankrupt.” Here, as always, Hawtrey was faithful to the logic of his system, which implied that if international central bank co-operation could not be achieved, each individual central bank must be free to pursue its own credit policy, without the constraint of fixed exchange rates.  [See my posts, "Hawtrey on Competitive Devaluations:  Bring It On, and "Hawtrey on the Short, but Sweet, 1933 Recovery."] 

Cochrane asserts that the Fed has no power to raise nominal income. Does he believe that the Fed is unable to depreciate the dollar relative to other currencies? If so, does he believe that the Fed is less able to control the exchange rate of the dollar in relation to, say, the euro than the Swiss National Bank is able to control the value of the Swiss franc in relation to the euro? Just by coincidence, I wrote about the Swiss National Bank exactly one year ago in a post I called “The Swiss Naitonal Bank Teaches Us a Lesson.”  The Swiss National Bank, faced with a huge demand for Swiss francs, was in imminent danger of presiding over a disastrous deflation caused by the rapid appreciation of the Swiss franc against the euro. The Swiss National Bank could not fight deflation by cutting its bank rate, so it announced that it would sell unlimited quantities of Swiss francs at an exchange rate of 1.20 francs per euro, thereby preventing the Swiss franc from appreciating against the euro, and preventing domestic deflation in Switzerland. The action confounded those who claimed that the Swiss National Bank was powerless to prevent the franc from appreciating against the euro. 

If the Fed wants domestic prices to rise, it can debauch the dollar by selling unlimited quantities of dollars in exchange for other currencies at exchange rates below their current levels. This worked for the US under FDR in 1933, and it worked for the Swiss National Bank in 2011. It has worked countless times for other central banks. What I would like to know is why Cochrane thinks that today’s Fed is less capable of debauching the currency today than FDR was in 1933 or the Swiss National Bank was in 2011?

Obama gives up on demand by Yglesias

Dean Baker Reduces Uncertainty

Clinton's Surpluses Were Due to the Stock Bubble by Dean Baker

The huge surpluses of the last Clinton years were the result of a boom that was driven by a stock bubble. The boom was great. Millions of people got jobs who would not have otherwise. We also saw real wage gains up and down the income distribution for the first time since the early 70s.

The greatest minds in the economics profession had assured us that the unemployment rate could not get below 6.0 percent without touching off accelerating inflation. However the boom pushed the unemployment rate down to 4.0 percent as a year-round average in 2000. Guess what? There was no story of accelerating inflation. (Fortunately for economists, continued employment, and even standing in the profession, does not depend on performance.) 

But the key point is that the surplus came from a boom that was not sustainable. Here's the key chart that shows you how we went from the deficit of 2.7 percent of GDP that the Congressional Budget Office had projected in 1996 for 2000 to the surplus of 2.4 percent of GDP that we actually saw in 2000.

This was not a story of tax increases and budget cuts, those had already been on the books by 1996. This was pure and simply a story of the bubble-based boom pushing the economy much further than CBO had expected. (Greenspan deserves a huge amount of credit for allowing the unemployment rate to fall. His Clinton appointed collegues, Lawrence Meyer and Janet Yellen wanted to raise interest rates in 1996 to keep unemployment from falling much below 6.0 percent.)

[(EDITED: Baker mentions 1996 which I somehow missed. The Russian default was in 1998 so I must be confused about this.) Supposedly Greenspan lowered rates because he wanted the Fed to act as the lender of last resort during the Russian default. The hedge fund Long-Term Capital Management failed because of the default. The international scene was a mess even if the U.S. had 6 percent unemployment. N.O.]

Anyhow, when the bubble burst, the surplus was destined to vanish. The Bush tax cuts and even the wars helped to stimulate the economy and maintain employment. There were much better ways to boost the economy, but it is absurd to imagine that the economy somehow would have been better off without this spending.

To repeat a post from last week, the real tragedy of both conventions is that policy is so obsessed with the deficit....

You’re on Your Own vs. We’re In This Together by Jared Bernstein

Clinton Tries To Bring Medicaid Into Focus by Yglesias

Is the Economy on the Mend? by Krugman

Between debt repayment, defaults, and — since recovery began in mid-2009 — rising income, the US has made a lot of progress in deleveraging. Add in the fact that we’ve worked off the excess construction from the Bush years, and there’s a pretty good case that the stage has been set for a much stronger recovery over the next few years. 

Even if that’s true, by the way, inadequate stimulus and debt relief have inflicted huge, gratuitous suffering. But the case that we have been healing all the same is pretty good.

Might be a better jobs report tomorrow. The ADP Employment Report had a good number today.

The Untold Story Of How Clinton's Budget Destroyed The American Economy by Joe Weisenthal

(via Yglesias)

DEPARTMENT OF "HUH?!": WILLIAM WHITE MISINTERPRETS WICKSELL DEPARTMENT by DeLong

Fed Fail Part XXIV (or opportunistic disinflation)

63 to 58 percent of the civilian population.

The Fed hasn't devalued too much so creditors retain the value of their claims. Deleveraging is done on the backs of the poor and working class, not split fairly between creditors and debtors.

Employers get a more pliant workforce with high unemployment and employees afraid to lose their jobs. However there has been downward nominal wage rigidity which probably has helped keep deflation at bay.

But news articles often report that people are taking new jobs at much lower pay levels.

New York Times lead editorial today:

Mr. Bernanke’s Next Task 

It will be another week — at a meeting of the Federal Reserve policy-making committee on Sept. 12 and 13 — before anyone knows for sure what Ben Bernanke thinks the Fed should do, if anything, to stimulate the weak economy. What is known is that, without more help, the economy is likely to remain weak, or grow weaker, through the rest of this year.
In his speech on Friday at the annual meeting on monetary policy in Jackson Hole, Wyo., Mr. Bernanke said that past Fed interventions had been a plus for the economy, raising growth enough to add an estimated two million jobs, but that economic conditions are still “obviously far from satisfactory.” Then he said that more help would be forthcoming “as needed.”  

But, by his own analysis, help is needed now. 

Mr. Bernanke said that national unemployment, at 8.3 percent, is unacceptably high and that much faster growth will be needed to bring that number down. But the economy, instead of accelerating, has slowed, from 4.1 percent in the last quarter of 2011, to 2 percent in the first quarter of 2012 and to 1.7 percent in the second quarter. 

Mr. Bernanke also stressed that persistently high unemployment risks bringing on irreversible economic damage as the long-term unemployed become the permanently unemployable. Even as overall unemployment has declined from a peak of 10 percent in October 2009, the share of jobless workers out of work for more than six months has remained stubbornly high. 

According to Mr. Bernanke, the economy is being held back by a sluggish housing market; counterproductive fiscal policy, as both the federal government and the states cut spending in the face of weak growth; and the euro crisis, which hurts the United States because of trade and financial links to Europe. 

All this is true and reflected in slumping consumer confidence, heightened business uncertainty and a recent slowdown in manufacturing. Unfortunately, meaningful progress on housing and fiscal policy requires Congress to act. Congressional Republicans, however, have long resisted efforts to revive growth on the theory that a weak economy will help them regain the White House. As for the euro crisis, there is nothing much that American policy makers can do. 

That leaves the Fed the only entity with the autonomy and the power to take action. Admittedly, its tools — various ways to reduce borrowing costs and spur lending — are not ideal for the problems that Mr. Bernanke has identified. It would be better, for example, for lawmakers to bolster federal spending in the near term to create jobs than for the Fed to indirectly attempt to boost activity through more lending. It would also be better for Congress to provide more debt relief for underwater homeowners, as the Fed keeps mortgage rates low for new buyers. 

But that is too logical for these times. Mr. Bernanke has laid out the problem, including the economic drag caused by political dysfunction. But he has also risked becoming part of the dysfunctional dynamic, exhorting and waiting for others to act when they are clearly unable or unwilling to do so. 

Here’s hoping that will change at the Fed meeting next week. And here’s hoping that any help is not too little, too late.

So if it were up to Dan Kervick and others critical of the blogosphere's focus on the Fed, the economy would be down 2 million jobs.

A Critique of Fed Policy by Binyamin Appelbaum

Michael Woodford may have written the year’s most important academic paper. Here’s why. by Dylan Matthews

The Good News and the (Very) Bad News about Bernanke’s Speech by David Glasner

[T]he good news from Bernanke’s speech is that he argued that… there is empirical evidence showing that the previous rounds of quantitative easing had a modest stimulative effect. Bernanke maintains that quantitative easing has increased GDP by 3% and private payroll employment by 2 million jobs compared to a scenario with no QE…. Now for the bad news — the very bad news – which is that the arguments he makes for the effectiveness of QE show that Bernanke is totally clueless about how QE could be effective. If Bernanke thinks that QE can only work through the channels he discusses in his speech, then he might as well pack his bags and go back to Princeton…. He is useless, and his tenure has been waste of time.
Consider how Bernanke explains the way that the composition of the Fed’s balance sheet can affect economic activity.

In using the Federal Reserve’s balance sheet as a tool for achieving its mandated objectives of maximum employment and price stability, the FOMC has focused on the acquisition of longer-term securities–specifically, Treasury and agency securities…. Imperfect substitutability of assets implies that changes in the supplies of various assets available to private investors may affect the prices and yields of those assets…. Declining yields and rising asset prices ease overall financial conditions and stimulate economic activity through channels similar to those for conventional monetary policy. 

Bernanke seems to think that changing the amount of MBSs available to the public can alter their prices and change the shape of the yield curve. That is absurd. The long-term assets whose supply the Fed is controlling are but a tiny sliver of the overall stock of assets whose prices adjust to maintain overall capital market equilibrium Affecting the market for a particular group of assets in which it is trading actively cannot force all the other asset markets to adjust accordingly unless the Fed is able to affect either expectations of future real rates or future inflation rates. If the Fed has succeeded in driving down the yields on long term assets, it is because the Fed has driven down expectations of future inflation or has caused expectations of future real rates to fall…. 

Because he completely misunderstands how QE might have provided a stimulus to economic activity, Bernanke completely misreads the evidence on the effects of QE…. [T]he only way in which QE could have provided an economic stimulus was by increasing total spending (nominal GDP) which would have meant rising prices that would have called forth an increase in output. The combination of rising prices and rising output would have caused expected real yields and expected inflation to rise, thereby driving nominal interest rates up, not down. The success of QE would have been measured by the extent to which it would have produced rising, not falling, interest rates…. 

Bernanke views the risk of an unanchoring of inflation expectations as a major cost of undertaking QE. Nevertheless, he exudes self-satisfaction that the expansion of the Fed’s balance sheet over which he has presided “has not materially affected inflation expectations.” OMG! The only possible way by which QE could have provided any stimulus to the economy was precisely what Bernanke was trying to stop from happening. Has there ever been a more blatant admission of self-inflicted failure?

(via DeLong)

Who’s Fighting for Workers? by Jared Bernstein

When Capitalists Cared by Hedrick Smith

From 1948 to 1973, the productivity of all nonfarm workers nearly doubled, as did average hourly compensation. But things changed dramatically starting in the late 1970s. Although productivity increased by 80.1 percent from 1973 to 2011, average wages rose only 4.2 percent and hourly compensation (wages plus benefits) rose only 10 percent over that time, according to government data analyzed by the Economic Policy Institute. 

At the same time, corporate profits were booming. In 2006, the year before the Great Recession began, corporate profits garnered the largest share of national income since 1942, while the share going to wages and salaries sank to the lowest level since 1929. In the recession’s aftermath, corporate profits have bounced back while middle-class incomes have stagnated.

'Anthony Bourdain: No Reservations,’ the Final Season by Mike Hale

Staying Power. review of ‘Mortality,’ by Christopher Hitchens by Christopher Buckley