Sunday, February 12, 2012

Three Views of the State of the Economy

This post will use Jim Bullard's speech on Monday February 6, and Paul Krugman's NYT column on the same date as a starting point.

Before discussing Jim Bullard's speech, I should reveal my connection to him. Here in St. Louis, we have an excellent working relationship between the economics department at Wash U and the research department at the St. Louis Fed. The relationship is mutually beneficial. Research is better at both institutions as a result. At the University, we can hire better people because those people know that they can interact with the economists at the Fed, and the Fed can hire better people than otherwise because those people know that they can have contact with Wash U. We have a joint seminar in macroeconomics that alternates between the Wash U campus and the Fed. A large number of people in our department have arrangements to do some work for the St. Louis Fed. This includes me. My work consists of visiting the St. Louis Fed about one day a week as a Research Fellow. I have an office there, and when I am at the Fed I talk to my colleagues there about research and other matters of concern to us (e.g. recruiting), I attend seminars and conferences, and I attend informal policy meetings at which Jim Bullard is present. Academics who visit the Fed do not attend formal policy meetings - e.g. briefings for FOMC meetings. We do not have security clearance for such meetings, are completely out of the loop on what transpires at those meetings, and we know nothing of what goes on at the FOMC meetings in D.C. Jim Bullard and I are friends. We have known each other for a long time through our interactions in the economics profession - at conferences principally. Until last year when my youngest son and Jim's daughter were graduating seniors at Clayton High School (and in some of the same classes), we were also Clayton High School parents, and we would see each other frequently at school events.

Thus, this is something of an inside job, but trust me. I'm going to be objective. Jim has come into his own as a central banker since he took on the job as President of the St. Louis Fed. If you have ever seen him speak in public, you know that his grasp of policy issues is excellent, as are his communication skills. Jim can stand up in front of a sizable audience, speak extemporaneously about current policy issues, and make perfect sense, to high-end economists and lay people alike. His foot always stays out of his mouth, even with press people in the room (who can be fond of taking remarks out of context). He is relaxed, has first-rate people skills, and does a lot to inspire confidence in the institution.

Jim's Speech
This is a well-crafted work. There is plenty of language in there that will help to make the ideas comprehensible to a lay person, and the ideas are important. The basic ideas in Jim's speech are as follows.

The Fed has adopted flexible inflation targeting. What this means is that the target for the annual rate of increase in the raw pce deflator is 2%, but the Fed is willing to shade the target up or down, depending on the "output gap." If real GDP is deemed to be too low, the inflation target should be higher than 2%, and if real GDP is deemed to be too high, the inflation target should be lower. The idea here is often formulated in terms of a "Taylor rule," which specifies how the Fed's policy interest rate should react to inflation and the output gap. The FOMC certainly does not specify an explicit rule, but some macroeconomists have argued that the Fed's historical behavior conforms to it.

There is a problem with flexible inflation targeting and Taylor rules. We cannot measure the output gap directly. To measure the gap we need a model. New Keynesians have a well-defined notion of what the output gap is. In a New Keynesian model with sticky prices and/or wages, there is an inefficiency due to relative price distortions. Efficient output is the level of aggregate GDP that would have been achieved if prices and wages were perfectly flexible, everything else held constant. Thus, the output gap arises in a New Keynesian world because of sticky price and/or wage distortions. Not everyone is convinced that this stickiness matters that much in general, or matters that much now. According to the NBER, the last recession in the United States began in December 2007. So, if stickiness were an important factor in propagating the shock or shocks that caused the recession out to the current date, prices and wages would have to be VERY sticky. So sticky, in fact, as to be inconsistent with what we observe in the Bils/Klenow data or in empirical work on New Keynesian models, as far as I can tell. More than four years have passed since the onset of the recession, for Pete's sake.

But maybe there is some other inefficiency that monetary policy can correct? Note the key subtlety here. The central bank needs to define the output gap not only in terms of inefficiency, but in terms of inefficiency that the central bank actually has some control over. What other sources of inefficiency have people suggested? Perhaps a key problem is some kind of "debt overhang?" Maybe people somehow accumulated an inefficient quantity of debt from, say, 2000 on? If the Fed can engineer a higher rate of inflation, then this deflates the debt and solves the problem. Of course, we then redistribute wealth from creditors to debtors. Maybe that is not such a great idea, as some of those creditors are our financial institutions, and the ultimate creditors are the banks' shareholders and depositors. I know there isn't a lot of sympathy for bankers these days, but after our financial crisis experience, we might actually be concerned about the health of our banks. But there are other ways to redistribute wealth. The obvious solution is fiscal policy, which is far more flexible in redistributing wealth than monetary policy will ever be.

Now, it's hard to think of anything else in terms of central-bank-correctible inefficiencies that might exist in the current circumstances. Some people seem to think that the Fed's purchases of mortgage-backed securities somehow corrected a problem in the mortgage market. But one could argue that this simply postponed the adjustment that needed to be made in housing and mortgage markets, and represented a dangerous precedent in terms of the engineering of credit allocation by the Fed.

But, suppose we look at the time series of real GDP for the US, as shown in the chart (actually the natural log). That picture is quite striking. Real GDP is not bouncing back from this recession as has typically happened in the post-World War II time series. Real GDP in the US grows on trend at about 3% per year. Look in the 4th edition of my intermediate macro book, page 6. That chart shows the natural log of per capita real GDP from 1900. The striking thing about the picture is how closely the time series hugs a growth path of about 2% (i.e. about 1% average population growth and 3% average real GDP growth). Of course the Great Depression is different, but the economy is back on trend after World War II - it's as if the Depression and the War never happened, if you are just looking at the time series.

But look again at the chart above. Real GDP falls below the 3% trend in the last recession, then starts growing again, but it shows no sign of wanting to come back to trend. One possibility is that we're in something like the Great Depression, except on a smaller scale. Indeed, some people have taken to calling what we are experiencing the "Lesser Depression." But that doesn't seem right, just looking at the real GDP time series. Real GDP was actually growing at a rate greater than the long-run growth rate coming out of the trough of the Great Depression. The Great Depression lasts so long mainly because the Great Depression is so deep. Real GDP per capita drops by about 29% from 1929 to 1933, and it has to grow from 1933 for a long time above the trend rate of growth to get back to the trend growth path. Coming out of the most recent recession, real GDP growth has been relatively sluggish, and our last observation (for 4th quarter 2011) was 2.8% growth - about at the trend growth rate of 3%.

So, Jim Bullard explores the following idea. Perhaps the output gap is now essentially zero. Why? There was a negative wealth shock that produced a negative level effect on real GDP. We're not going to go back to the 3% real GDP growth path we were on before the recession; we're now on a lower 3% real GDP growth path. Obviously you can't say this is right or wrong, as you actually have to write down a model that's going to allow you to measure the effect. But I think the idea has merit, though perhaps you need to develop it further. Think of this as a collateral shock rather than a wealth shock - it's not quite the same thing. Under any circumstances part of the price of housing is a bubble, just like money is a bubble, for example. A house is not valued only because of the stream of future benefits it provides. It is also valued because the house serves as collateral for acquiring fungible mortgage debt. Further, that mortgage debt can be repackaged in mortgage-backed securities which also serve as collateral in financial arrangments - shadow banking for example. In fact, through the process of rehypothecation, those mortgage-backed securities can be used at any given time to support multiple credit arrangements. Thus, a given house, through a kind of multiplier effect, can support a large quantity of credit, both at the consumer level, and in sophisticated credit arrangements among large financial institutions. This all feeds back to the price of the house, potentially making the bubble component of housing prices quite large.

There is nothing wrong with such a bubble in housing. Indeed, the bubble just reflects the usefulness of real estate as collateral. The problem is when you have a major lax-regulation-driven incentive problem like the one that developed post-2000. Then, part of the housing bubble is built on false pretenses, and when people ultimately catch on to what is going on, the bubble pops. I.e. 2006. So, the reason why we now have a zero output gap could be that we have lost the false-pretense part of the housing bubble. But this also implies that something else is going on. You see, with the false-pretense housing bubble we were hugging the 3% growth trend, or maybe a little worse. So maybe from 2000 on, average growth without the false-pretense bubble would have been poor relative to historical standards. That's not good news at all.

Second View
A second view, more optimistic, comes from the employment report on Friday of last week. Combine this with Bullard's ideas, and maybe we get something a little better ultimately. Possibly the false-pretense bubble isn't as large as it might appear right now from the chart above.

Krugman View
The third view is from Paul Krugman's Monday NYT column. I'm going to be a little half-hearted about this, as I've come to the conclusion that the guy isn't really worth the time I spend on him (and about time you might say). Whatever that Krugman condition was that I had, I may have actually worked through it. Krugman is a has-been academic economist and a schlock journalist, who now appears to get all his information from low-level blogs, and is out of touch with serious current economic research. Nobody is going to learn anything from him anymore, sad to say. What a waste of a fine mind.

But, you might say, Krugman is so good at forecasting the future. I have never seen Krugman issue a proper forecast - one that has numbers in it. Did I ever tell you that I can forecast? I actually did it for a living once, when I was 24. I could out-forecast Krugman any day. But even if Krugman could forecast, why would we care? A really good forecaster is Laurence Meyer, whose forecasting company is in my home town, Clayton Missouri. Meyer actually has Fed experience, but I wouldn't trust him to do monetary policy if my life depended on it. He knows less about state-of-the-art macroeconomics than Krugman does.

In Krugman's column, let's focus on just a couple of things. First:
What’s the reasoning behind those demands [for tighter monetary policy]? Well, it keeps changing. Sometimes it’s about the alleged risk of inflation: every uptick in consumer prices has been met with calls for tighter money now now now. And the inflation hawks at the Fed and elsewhere seem undeterred either by the way the predicted explosion of inflation keeps not happening, or by the disastrous results last April when the European Central Bank actually did raise rates, helping to set off the current European crisis.
I don't hear any strong hue and cry for tighter monetary policy right now. If the so-called inflation hawks on the FOMC felt strongly that we need tighter policy, they would have dissented at the December 2011 FOMC meeting. But they didn't. Indeed, Kocherlakota, Plosser, and Fisher voted for the action (essentially unchanged policy from the previous meeting), but Evans voted against it, as he wanted more accommodation. Thus, the committee was essentially with Krugman, and on net is dovish, not hawkish. Get your facts straight, Krugman. Of course, we know what happened in January. The Fed made an extremely risky, accommodative move. They were with Krugman again. What does he want?

Second:
And every time we get a bit of good news, the purge-and-liquidate types pop up, saying that it’s time to stop focusing on job creation.

Sure enough, no sooner were the new numbers out than James Bullard, the president of the St. Louis Fed, declared that the new numbers make further Fed action to promote growth unnecessary. And the sad truth is that the good jobs numbers have definitely made it less likely that the Fed will take the expansionary action it should.
Read Jim Bullard's speech. The speech was given last Monday, and the jobs report came out the previous Friday. There is nothing in the speech about the jobs report. Clearly Jim Bullard's speech is about a broader issue and not about one month's information. I think Krugman never read the speech, and he guessed that it was a response to the employment report. Sloppy work, but he's willing to bad-mouth a Federal Reserve Bank President based on guesswork, in the pages of the New York Times.

Here's what I'll do henceforth. Krugman commentary will be restricted to the following:

1. Krugman actually says something useful.
2. Krugman attempts to discredit someone I care about in a dishonest way.
3. Krugman says something nasty about me. Then I fight back.

Let's go do some economics.

Bottom line here, on the "three views" issue. I think Bullard's argument has merit. If so, the FOMC decision at the January meeting - i.e. forward guidance of a near-zero policy rate out to the end of 2014 - could be a policy mistake of monumental proportions. More on that later.

72 comments:

  1. "Here's what I'll do henceforth. Krugman commentary will be restricted to the following"

    Amen!

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  2. "Obviously you can't say this is right or wrong, as you actually have to write down a model that's going to allow you to measure the effect. But I think the idea has merit, though perhaps you need to develop it further."

    Does he have a well flushed out model or is just being speculative and airing some ideas in public? If its the latter, its very silly thing for a Fed official to be doing and deserves to be panned. I personally don't find it convincing in the least. If you lose wealth, your immediate impulse is to work even harder to recover the lost wealth. No?

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    1. No. I told you how I thought it worked.

      "If its the latter, its very silly thing for a Fed official to be doing and deserves to be panned."

      No. It's of immediate importance for policy. He's going with what he knows, and in his judgment it's better that he says what he thinks is true than hold it back. He went through the decision theory problem and went for it, I think.

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    2. Lots more later, but, first, you owe me an apology.

      Since well before "the speech" I have writing here that it was all about the level of private debt and the bust in housing prices and that the only logical response was inflation.

      You and your fellow "macros" called me every name in the book and you just admitted I was right about the conditions.

      One employment report means nothing. Japan has had good reports sometimes, also.

      As we look at this let's keep two things in mind:

      1) You write, "There is nothing wrong with such a bubble in housing."

      Wrong, for to permit such a bubble was a violation of the Fed's chart which is to maintain price stability, which meant that the Fed had a duty to prevent a rise in housing prices.

      As you point out, by letting housing prices rise, in effect, the Fed distorted markets by giving false signals.

      In fact, the economy was sick, really sick from 2000 on, most likely due to (this is the paradox) Clinton being successful in bringing down federal borrowing which reduced "safe assets," i.e., the money supply. IOW our problems are in the underlying economy and they are really really big, which Krugman and DeLong understand and which drives their stridency and urgency.

      2) You write, "major lax-regulation-driven incentive problem like the one that developed post-2000. Then, part of the housing bubble is built on false pretenses."

      This is true; it was just fraud by borrowers and investment bankers. You fail to mention that Greenspan and the Fed had the regulatory duty and authority to prevent this and that, instead,they aided,abetted, counseled, and encouraged such.

      3) As you say your purpose in writing is to "educate," why aren't you telling people the truth. If Bullard is correct, this country is f----ked. We are a walking zombie.

      Do you warn you students going to Wash U on debt that they should drop out or that they will envy people who paid for passage with seven years of indentured servitude.

      Last, why don't you at least credit Krugman with his factual premise or assumption. The shock wasn't a war. We have our factories, plant, and equipment. All we have to do is the task that has confronted mankind since we built the Pyramids: find a way to finance putting everyone to work?

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    3. But there are other ways to redistribute wealth. The obvious solution is fiscal policy, which is far more flexible in redistributing wealth than monetary policy will ever be.

      Then why in the speech did Bullard say now is not the time for fiscal policy?

      More than just a little incentive cause bias, no doubt!!!!!!

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    4. So maybe from 2000 on, average growth without the false-pretense bubble would have been poor relative to historical standards. That's not good news at all

      Wonder what was the cause of this "bad news."

      Oh, surprise, surprise, it was trade, free trade, NAFTA, China, etc. which you and every macro said would be great.

      Why won't you say it.

      Perot was right. It was a giant sucking sound, coming from all the macro offices. We all know who was standing and who were on their knee pads.

      Drugger, for us, has the date, "When China devalued"

      And to all you A--H-- who say, "I'm pissed." You're right

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    5. Punishing savers.

      A day or two ago I asked, why didn't Williamson hammer Cantor for taking Bernanke to task for, "mercy me," punishing savers.

      Turns out that Bullard's big concern is that we are punishing savers. Read his speech.


      It that were dearer oh, trust me, I am a Democrat Steve is, we need to be concerned about punishing savers?

      Sorry Steve, but, first, it is a lie, a really really big lie. Savers are being punished because of the demand for safe assets.

      And, second, Steve, this is why I say you have no vision. Young people are our future. If a few can buy houses at 0% thank the Gods.

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    6. I see the crackpot has emerged from his den to yap again. John D., please please please go learn some economics before you speak. You make me weep for humanity.

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    7. John D has forgotten more economics than you will ever know.

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    8. Demonstrably false.

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  3. I don't understand the "money is a bubble" idea...

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    1. Noah,

      One of your more perceptive readers has also figured out this is all political. Peter writes,

      Seems to me Bullard is fishing for reasons to raise rates. Elsewhere he argues that low rates hurts savers. It's politics not economics. (Similarly politics was why Missouri gets two Federal Reserve banks: Kansas City and St. Louis.)

      Doesn't the Fed, the Congressional Budget Office and Blue Chip private forecasters all use GDP trend growth rates that go back decades?

      The bubble reflected credit and capital that was misallocated to housing. What if in a different timeline it had been allocated to more productive, sustainable uses, i.e. Greenspan had done his job as a regulator?

      So with the bubble the trendline was a little too high and then with the panic, post-panic recession, and Fed Fail the trendline is too shallow. It's probably in the middle and in line with the trend going back decades.

      Bullard argues that the trendline is much shallower than it actually is, just as Republican Senators recently gave Bernanke a hard time over supposedly focusing on unemployment and inflation equally.

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    2. Noah,

      This is true in any pure monetary model. Fiat money is intrinsically worthless, so its fundamental value is zero. But, for example, in an OG model, or a Lagos-Wright model (and it's not model-specific of course), money has value, i.e. the price in terms of goods is srictly positive. Thus, there is a bubble - the market price is greater than the fundamental. In fact the fundamental is zero, so fiat money is a pure bubble. Now translate that to other assets, which do in fact have explicit payoffs associated with them - stocks, government debt, for example. Write down the model and calculate the fundamental - appropriately discounted discounted sum of future payoffs. Take the difference between the market price and the fundamental, and that's the bubble. You could also call it a liquidity premium - the bubble is due to the fact that the asset is somehow useful in exchange (like money) or useful as collateral. This is a very key idea - you can find it in plenty of models.

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    3. Oh.

      This seems obviously wrong to me. Fiat money is not intrinsically worthless, since the government forces people to accept it as a medium of exchange. This means that fiat money is an option, because it can be redeemed for real assets at any time. That option will have nonzero fundamental value, just like any stock option has nonzero fundamental value.

      Sure, there are differences; the option value of money is enforced not by pre-existing contract but by a pre-existing government promise to use force on anyone who refuses to accept money in exchange for real assets...but since a contract is simply another kind of government promise to use force on people who refuse to make a transaction, it's conceptually very similar (to see this, note that a stock option would have zero FV if the option contract could not be enforced).

      So I claim that fiat money is not intrinsically worthless.

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    4. Noah: Assume I am big and strong and can beat people up.

      If I said: "Here are 100 bits of paper. At the end of this year I will insist on collecting 95 bits of paper, and will beat people up if they don't have one for me to collect. What am I bid for these 100 bits of paper?"

      (Assume competitive markets, so nobody can corner the market in bits of paper.)

      The bits of paper are not scarce. They have an equilibrium price of zero. People pick up 95, and leave 5 lying in the ground.

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    5. How is government "forcing" people? Is there some law against bartering or asking to be paid in gold? Honest question.

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    6. Nick: A bubble is defined as something that derives its value from its resale value as opposed to whatever you can get if you just hold on to it forever. Algebraically, price = dividends + future price (discounted). If you iterate this forward and the future price (discoutned) does not go away, you have a bubble. If you get money and commit ex-ante to hold on it forever it is worthless to you. That's the sense in which it is a bubble.

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    7. CA asked about Barter to be paid in gold

      a real time exchange yes, such is permitted under the legal tender laws, but under the legal tender laws, a future promise to exchange gold is not enforceable. Instead, you get money damages payable in, you guessed it, dollars

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    8. Noah wonders, "I don't understand the "money is a bubble" idea.."

      Noah, it is sophistry.

      Nothing has "value" in the way Williamson is talking. Knowledge has no value, for the courts might not enforce your patent. Cars have no value for you might not have gas. Chooses in action have no value because the Courts may close. Factories have no value because there may not be coal or iron ore.

      It is the first half of the "we can't see the bubble game." Since the future dividends are in fact unknowable, so that you can actually run a real model, you cannot actually discern if you are in a bubble defined in the way that Williamson defines a bubble.

      Of course we could define bubble based on behavior of those in and about a market, but that leaves macro out of the game, a subject Williamson and I covered a few days ago.

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    9. Noah,

      "Fiat money is not intrinsically worthless, since the government forces people to accept it as a medium of exchange."

      No no. I was giving you an example in terms of a model. I said, consider abstract fiat money - here's how we often model it. Here's the bubble. US Federal Reserve notes are not quite like the fiat money in the model, though the abstraction might go a long way to explaining how money works. What happens in reality? We have to worry about counterfeiting, theft, and the fact that how the central bank behaves (issuing money today, retiring it tomorrow, for example) may matter for how money is valued. But, in fact there are no payoffs associated with Federal Reserve notes. I can't redeem it at the Fed for anything other than more Federal Reserve notes, or at best a financial institution can deposit the notes in its reserve account. That looks a lot like the fiat money in the model. Fundamentally, the Fed notes are going to have a bubbly property, just like the fiat money in the model.

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    10. Hmm, Nick, I'm not sure I understand your example.

      Steve, as I pointed out in email, wouldn't this mean that bonds, preferred stock, or any other asset that pays the holder money (but cannot be exchanged for any pre-specified set of real assets) has a fundamental value of zero?

      I mean, it certainly seems that if fiat money has zero fundamental value, a magic wand that creates fiat money also has zero fundamental value. And a corporate bond is just such a magic wand.

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    11. The following observations blews my mind!
      1- Person A says:
      "This seems obviously wrong to me. Fiat money is not intrinsically worthless"
      (This statement shows that the person A has never read a single paper by Wallace or Kiyotaki or Wright or Williamson -- among many others).
      2- Person A actually gets into argument with monetary theorists over what money is or is not!

      my mind is blown! :|

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    12. Noah, go back to definitions. Bonds need not be a bubble, because if you buy and hold you still get a stream of cash. If you buy and hold cash you get nothing.

      Doesn't mean there can't be a bubble component to bond pricing. Or that the coupon payments are not made with a bubbly asset (money).

      Nothing deep or misterious there, just definitions.

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    13. In this kind of model, bonds have a fundamental value of zero in real terms but not in money terms. Since we usually think about bonds in money terms, we can usually ignore the question of the real fundamental value.

      Is it true that "the government forces people to accept [money] as a medium of exchange"? Not really. The government forces people to accept money as tender for debts. There is no law against barter transactions. It's true that the fundamental value of money is actually greater than zero because there are outstanding debts, so money has fundamental value to debtors, who can use it discharge their obligations. But I don't think this fundamental value is large enough to explain most of the value people place on money. It seems reasonable to me to model money as an asset with zero fundamental value.

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    14. Fiat money is a "stay out of jail" and "keep your house" card at tax time.

      A "stay out of jail" card has more than zero value.

      But that is in our world.

      All bets are off in the make-believe worlds created by the macroeconomic modelers.

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  4. Explain why this isn't what Bullard is saying:

    It's actually a bigger argument than that. Jim Bullard and his ilk are arguing that capitalism is a failed economic system that can no longer produce enough economic growth to increase, or even maintain, living standards.

    The big selling point for capitalism during the Cold War was that it could produce enough so even people of modest means could have a nice kitchen with all the appliances, a nice car, a nice house, an education for their children, medical care, a retirement and so on, but communism couldn't. The record of the last 30 years suggests that capitalism has lost this ability, and the declining ROI most investors experienced during this period reflect that.

    Arguing that the US cannot recover its lost productivity, cannot create well paying jobs to match population growth, cannot raise living living standards, is a flat out admission of failure.

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  5. "Krugman is a has-been academic economist and a schlock journalist, who now appears to get all his information from low-level blogs"

    Is this about Andolfatto?

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    1. Good one. David and I are also of course very good friends. We go way back. I was on his dissertation committee.

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    2. Steve, defending allies is not a bad policy at all. I must admit I have learnt a lot from your macro notes and Krugman's blog.

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    3. I always defend allies when they are right. I won't defend anyone when I think they are misleading you.

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    4. So the statement "Krugman is a has-been academic economist and a schlock journalist, who now appears to get all his information from low-level blogs" is objective? Professional? Scientific? Why stoop to that level? Can't you just stick to the economics, then?

      And what of your ability to out-forecast PK, even if factual? Was that a statement from an adult? Or something akin to what one hears on the school playground? I mean, is there any real point to that statement other than to serve your own ego? For god's sake, your a prof at an esteemed institution!

      I wish I could hear your counterpoint (which is interesting) over the shrilling (which is not interesting)

      Academics, so often full of wind, ego, and a fury signifying nothing. Sheesh.

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    5. I don't think I've ever seen Krugman level anything against Lucas, Cochrane or Williamson as puerile as this. We have one "schlock" claim from One U of C guy against Romer, now another one against Krugman. How does that compare to the more typical "doesn't understand" attacks that Krugman applied? Looks like a major escalation to me.

      Of course, it matters how this argument pans out -- or does 20 million or so unemployed pale in significance to bruised egos of some well-paid professionals?

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    6. We all care about the unemployed, and about everyone else as well. The key question in this instance is: "What can monetary policy do about it, in a way that makes us collectively better off?" There is no easy answer to that question, in spite of what Paul Krugman may tell you. It's possible that some version of "doing nothing" is the appropriate thing to do, and it does not make one an evil person to suggest that we should all consider that possibility seriously.

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    7. It's very easy. X-M = (S-I)+ (T-G). What makes it complicated is politics and social agendas. Nobody's asking for long-term government spending, so why the ruse that there's some permanent loss in capital? Sure we can just wait, but you and I will be 10 years older, a 100 million suffering in the meantime, for no reason than to suffer the economic morality of those who think they know better. Is that care? Than you can have it! You'll care a lot more about the unemployed when you become one of them, living under a bridge, eating out of dempster dumpsters (one of an myriad of possible life styles for the poverty stricken). Try it, it's enlightening. But you have to be tough, it's not for soft-skinned moneyed types who imagine they're being tough, cruel to be kind.

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  7. "But maybe there is some other inefficiency that monetary policy can correct?... What other sources of inefficiency have people suggested?"

    Okay, since you asked here is a quick (incomplete) list:

    (1) How about that guy at WUSTL who has argued that there is a shortage of safe assets? One reason some of the safe private assets have disappeared is because the Fed has failed to keep nominal income on its expected pre-crisis path. Additionally, the Fed's subsequent failure to restore nominal income to some reasonable pre-crisis path (i.e. after accounting for the housing boom)has prevented sufficient new safe assets from being created. The Fed could change that with a NGDP level target and make this guy from WUSTL happier. More on this point here.

    (2) Household portfolios are heavily weighted toward liquid assets and this adversely affects aggregate nominal spending. The Fed could change that through better expectations management

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    1. Hi David,

      On (1), I don't think the safe assets idea is a different idea, but part of the same package. It's all tied up with collateral and financial exchange, right? Long Treasuries serve as collateral and a kind of medium of exchange in financial markets, just as asset-backed securities do. It's been my contention that QE does not help the problem. I don't think NGDP targeting helps in any way either.

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    2. I am with you on safe assets acting as a medium of exchange in financial markets. And yes, treasuries can substitute for private safe assets in this role (See here).

      My question for you is this: wouldn't some (not all) of the safe private assets still be here if the Fed had managed to prevent the collapse in NGDP in late 2008, early 2009?

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  8. @Beckworth: "to some reasonable pre-crisis path"

    Why is it "reasonable"? What is the theory that says NGDP should grow at x% per year?

    And please don't appeal to "expectations". On that basis, the Fed should have keep the NASDAQ / house prices appreciating 20% a year forever.

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    2. Anonymous,
      I did not say NGDP should grow at some constant x% a year. Rather it should grow at a pace that preserves monetary equilibrium given the underlying determinants of growth. During the Great Moderation that turned out to be between 4.5-5% growth. It can and change.

      Regarding expectations, they are important here. Many household and firms signed long-term nominal contracts based on long-run expectations of future nominal income formed during the Great Moderation. I agree that NGDP grew too fast during the housing boom, but even after accounting for that error nominal incomes are on a permanently lower path than any reasonable forecaster would have made. As time goes on, though, this should become less of a problem.

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  9. Steve: Another way to think of it is that the housing boom was driven by a "good" bubble, with no false pretense. However, bubbles are coordination games, they only work if everyone else believes in them. Perhaps the role of monetary policy is to make this coordination game easier by tilting the competition between bubbly assets such as housing and gov't bonds towards the former?

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    1. I like that idea. It's an alternative. The work we have to do is to sort these things out, in theory, and empirically. Note that Jim's speech is just an idea as well. He's not saying this is truth, he just wants to open up the policy debate in a productive way.

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    2. what limits causation to one factor?

      could the real shock have been our closing 40,000 to 50,000 factories and eliminating 5 to 6 million jobs due to mostly Chinese imports, which was masked by an expansion of private debt and housing consumption and (let's assume) relative ease in moving factory workers into new home construction?

      IOW, those who argue that no physical destruction of plant and equipment took place, as if in a war or natural disaster would, could be wrong.

      Physical destruction of plant and equipment did take place on a massive scale, when we closed (and even disassembled factories for reassembly elsewhere).

      Since 2001, the country has lost 42,400 factories, including 36 percent of factories that employ more than 1,000 workers (which declined from 1,479 to 947), and 38 percent of factories that employ between 500 and 999 employees (from 3,198 to 1,972), according to one study.

      Now the "standard theory" has been that this was destruction of low paying work that freed the workers for higher paying work.

      But, at least implicitly, isn't Bullard arguing that the "standard theory" is wrong and there is no higher paying work. (If there was, even if private collateral wouldn't support mobilization, the gov't is creditworthy enough to provide the financing).

      In sum, the implicit argument that you and Bullard are making, seems to me, is that capitalism is broken. Isn't that what you are arguing. We have lost our capacity to grow; that capitalism is incapable of putting our idle people to work at decent, high paying work.

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    3. If the Fed can engineer a higher rate of inflation, then this deflates the debt and solves the problem.

      It seems to me this sentence out to read, "If the Fed can engineer a higher rate of inflation, then this inflates the value of the collateral and solves the problem."

      Are there the two alternatives being offered, for simplicity:

      Krugman view: we haven't lot output capacity; we have same capacity (people, plant, equip, as before); no physical destruction of assets

      Bullard view: we have lost capacity because we have lost "efficiencies," arising out of financing, because "collateral" is gone.

      or is the devil really in this sentence:

      So maybe from 2000 on, average growth without the false-pretense bubble would have been poor relative to historical standards.

      In your view, what caused average growth from 2000 on to be poor relative to history?

      (Drugger and Stiglitz and Keen are the only people I know who have offered a something else view)

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    4. Pretending not to be John D, Crackpot King, doesn't mean we don't know who you are.

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    5. "Drugger and Stiglitz and Keen"

      One of these things is SO not like the others.

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    6. "bubbles are coordination games, they only work if everyone else believes in them. Perhaps the role of monetary policy is to make this coordination game easier"

      These are straight out of HAYEK themes ...

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  10. Absolutely. I just thought you might want to consider adding this to your list of ways in which the Fed's policy could (emphasis on could) help bring the economy back to its former trend-path.

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  11. "preserves monetary equilibrium"

    What does that mean, no excess demand/supply for money, i.e. stable rate of growth of an index of consumer prices?

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  12. None of your post - or any of the comments - address the section of Jim's paper on this alleged drop in potential output (starting at the bottom of page 3 and continuing to the top of page 5 of Jim's paper). This is the argument that Noah Smith, Paul Krugman, Brad DeLong, and Tim Duy have questioned. In other words, this is the substance of the debate. Alas, your post just ignored what this debate is truly about. Sad!

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  13. Yes, Krumgan is pretty sloppy. He forms the big picture in his mind and then is really sloppy about details. Attributing this speech for Bullard's position on interest rates is a good example as you point out. But, I still find PK valuable. For the most part the big picture he points to is accurate. Its hard to imagine that Bullard is doing anything other than trolling here. If he is speculating, it should be with you and others in the Fed, come out with a good model and then distill it to the public. This just makes the guy look eminently silly. And you are being way too charitable in your post.

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  14. For the interested, Bullard has more details

    http://economistsview.typepad.com/economistsview/2012/02/james-bullard-responds-to-tim-duy.html

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  15. "The bits of paper are not scarce. They have an equilibrium price of zero. People pick up 95, and leave 5 lying in the ground."

    Try dropping said pieces of *your* paper on the floor - anywhere - and report back the result.

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  16. Between Paul Krugman and you as forecasters, I would go with Paul anytime, Steve. You have been crying wolf on inflation for too long. Just being sincere.

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  17. "But, in fact there are no payoffs associated with Federal Reserve notes. I can't redeem it at the Fed for anything other than more Federal Reserve notes, or at best a financial institution can deposit the notes in its reserve account. "

    This is mind-blowingly stupid, Steve. Cash or reserves have intrinsic value because they are the legal tender to pay the claims the government imposes on us (so called taxes).

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    1. If all your transaction involved barter, would you still have to pay taxes? My guess is that you would not be subject to a sales or income tax.

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    2. AnonymousTransactionFebruary 15, 2012 at 2:10 PM

      How much of the intrinsic value of cash is because it lets me pay my taxes? All the point Steve is making is that it isn't 100%.

      Why is this so hard?

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  18. "If all your transaction involved barter, would you still have to pay taxes? My guess is that you would not be subject to a sales or income tax."

    Hilarious... I guess that is what Steve was thinking when he said cash has no intrinsic value.

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    1. I do not claim to be a mind reader, but paper money is a textbook definition of fiat money. It is accepted in good faith. If you heard that from tomorrow no one will accept payment in dollars (OK, except the U.S. government), how much of your cash would you keep?

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  19. You apparently have a fan (and hate) club, making you in many ways similar to that other polarizing Canadian, Justin Bieber:

    http://www.econjobrumors.com/topic/steve-williamson-fanclub

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  20. This is a 100% HAYEK story:

    "Think of this as a collateral shock rather than a wealth shock - it's not quite the same thing. Under any circumstances part of the price of housing is a bubble, just like money is a bubble, for example. A house is not valued only because of the stream of future benefits it provides. It is also valued because the house serves as collateral for acquiring fungible mortgage debt. Further, that mortgage debt can be repackaged in mortgage-backed securities which also serve as collateral in financial arrangments - shadow banking for example. In fact, through the process of rehypothecation, those mortgage-backed securities can be used at any given time to support multiple credit arrangements. Thus, a given house, through a kind of multiplier effect, can support a large quantity of credit, both at the consumer level, and in sophisticated credit arrangements among large financial institutions. This all feeds back to the price of the house, potentially making the bubble component of housing prices quite large."

    BIS chief economist William White told a version of this story directly in person to Greenspan at Jackson Hole in 2003 -- foretelling what actually took place.

    Credit Suisse economists have also told this story.

    You can even find a version of this story in Michael Lewis's _The Big Short_.

    Have you got the DSGE math construct built yet?

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    1. The story you tell Stephen was told well on Bloomberg on the Economy by a pair of Credit Suisse economists James Sweeney and Carl Lantz in 2009:

      http://hayekcenter.org/?p=2954

      The story you tell was essentially also told directly to Alan Greenspan by BIS chief economist William White in 2003 at Jackson Hole -- laying out what was going to happen BEFORE it happened. Go to the BIS web site for a number of articles by the BIS research economists on exactly this theme between 2002 and 2010.

      You can even find this story in crude form in Michael Lewis's _The Big Short_.

      It's a HAYEK story as William White and the Credit Suisse economists point out explicitly.

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    2. If someone wants to make an issue of the fact that Williamson's argument comes straight out of Friedrich Hayek's macroeconomics, compare Sweeney, Lantz et al (citing Hayek) to Stephen Williamson above, and then show how there is a dimes worth of difference between them.

      As far as what he has written indicates, Williamson is just as thoroughly ignorant of the history of economic thought as is nearly every macroeconomist under the age of 55 or so. So how should he know what the intellectual pedigree is of what he is doing .. he should anticipate he has not such idea.

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  21. The Crackpot SpotterFebruary 16, 2012 at 12:40 PM

    Welcome back Greg, the other crackpots have missed you.

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    1. You are another witless sock puppets with zero substance on the table.

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  22. You are not a prominent economist. Krugman is so much smarter than you- you have no influence. I know he gets under your skin: It’s funny in this case, because Quiggin is in fact a prominent economist, Williamson not so much.

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    1. The Crackpot SpotterFebruary 17, 2012 at 6:28 AM

      Looks like Jim needs a dictionary -- try looking up the word "prominent", and you'll see it doesn't apply to Quiggin.

      Douchebag.

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    2. Jim,

      1. "You are not a prominent economist." By what measure.
      2. "Krugman is so much smarter than you." How smart is Krugman? How smart am I? How smart are you?
      3. How do you compare me to Quiggin? Do you know me? Do you know him? What do you know exactly?

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  23. As much as I like to argue with Steve, I abhor your comments, Jim... I'd rather see stupid on the other side of the fence.

    "O" Anonimo

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    1. Jim is just confused. Don't give him a hard time. Read this:

      http://newmonetarism.blogspot.com/2012/02/warrenfest-best-day-of-my-life.html

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