Christina Romer on Monetary Policy

As an economic historian, Christina Romer did some useful and interesting things. A well-regarded piece she wrote is this one which, in the 1980s, challenged conventional views about business cycle volatility. At that time, conventional wisdom was that volatility in aggregate economic activity in the United States was much higher in the pre-World War II period than after. That conventional view was certainly consistent with Old Keynesian ideas about policy intervention. Keynesians wanted us to think that post-World War II macroeconomic policy, enlightened by Keynes, Hicks, Samuelson, Tobin, and others, had served us well. Before Christian Romer's work, existing measurement told us that volatility in real GDP was smaller after World War II, consistent with the efficacy of active stabilization policy.

Romer did a careful job of the historical measurement, and found that much of the difference in pre-WWII and post-WWII volatility found by others could be explained by measurement error. The result was all the more striking for its intellectual honesty, coming from a committed Keynesian who had come out of a strongly Keynesian academic environment (MIT Economics Department in the 1980s).

I was reading the Sunday New York times and ran across this, which made me quite happy (for the state of the world) that Christina Romer was back to doing economic history and no longer trying to guide macroeconomic policy in the Obama administration.

Romer's NYT piece, and what I will discuss here, serves as a useful bookend to what I wrote here on her fiscal policy views, which are very much in line with Krugman's, i.e. the no-amount-of-intervention-is-too-much school.

Romer first wants to tell us that the old "hawks vs. doves" characterization of FOMC decision-makers is no longer relevant. Apparently everyone is now a hawk. Now, that does not seem right. It seems to me that what people mean by "dove" is "Keynesian." On the FOMC, Janet Yellen, Eric Rosengren, Charles Evans, and Bernanke himself are clearly Keynesian. Yellen and Rosengren are more Old Keynesian, and Bernanke and Evans are more New Keynesian. Yellen/Rosengren/Evans/Bernanke were likely the serious force behind the Fed's mortgage-backed securities purchases and the recent QE2 operation. Seems to me there are plenty of doves in sight.

So, if "hawks and doves" does not work so well as a characterization of FOMC members, what is Romer's alternative? Apparently these people are either empiricists (translation: good people) or theorists (translation: bad people). In academic life, it would be fairly easy to take individual published articles and classify them as theory or empirical, i.e. quantitative work. We are not going to find much quantitative work in the Journal of Economic Theory (though there is some), and not much pure theory in the Review of Economics and Statistics. Of course, one cannot do good empirical work without theory to put structure on it, and one does not do good theory for the sake of amusing oneself (we hope) but to ultimately explain how the world works and possibly to permit the design of better economic policy.

Clearly any good macroeconomic policymaker has to be thinking about theory and empirical work. He or she has to have a good grip on macroeconomic measurement (available data and the quality of that data), empirical macroeconomic research, and theory. One cannot hope to contribute to the policy discussion and aid in making decisions without walking both sides of the fence. Now, I think what Romer wants us to think is that people like Charles Plosser, Narayana Kocherlakota, Jeff Lacker, and Jim Bullard, for example, are theorists, i.e. bad guys, who have their heads in the clouds. I know all of those people well, and nothing is further from the truth. Kocherlakota for example has an excellent grip on most of what is useful in modern economics. As an academic, he did quantitative work (he can estimate and calibrate) and high-end theory, and he can articulate cutting edge economic ideas in a straightforward way to lay people and other policymakers. Plosser/Koherlakota/Lacker/Bullard have all proved to be effective leaders and decision-makers who have put to work the ideas they absorbed as economic researchers and teachers.

Well, what are the ideas that Romer has in mind? What do the good people (the empiricists), have to offer? Here we go:

Empiricists, as the name suggests, put most weight on the evidence. Empirical analysis shows that the main determinants of inflation are past inflation and unemployment. Inflation rises when unemployment is below normal and falls when it is above normal.

Now, Romer is writing for a lay audience here, so it might be useful to recall this quote from Richard Feynman, which I included in my last post:

I would like to add something that's not essential to the science, but something I kind of believe, which is that you should not fool the layman when you're talking as a scientist.

I know about research by Andy Atkeson and Lee Ohanian that finds, in contradiction to what Romer states, that once we know past inflation, knowing unemployment does not help us forecast future inflation. As well, Romer is not filling the layman in on the fact that there is a long line of research in macroeconomics that attempts to sort out the Phillips curve relationship that is at the heart of her argument. The upshot of that research is that the empirical Phillips curve relationship is in the data for some time periods and not for others, and that (New Keynesian economics notwithstanding) the sometimes-observed Phillips curve is not a structural relationship. Romer discusses this as if she knows what a "normal" unemployment rate is, which any good economist knows she doesn't.

Finally, what are Romer's policy conclusions?

As a confirmed empiricist, I am frustrated that the two sides have been able to agree only on painfully small additional aid for a very troubled economy.

Romer has come to the conclusion that the planned purchase of $600 billion in long-maturity Treasury securities by the Fed is somehow not enough, and "painfully" not enough, and she is willing to state that in the Sunday New York Times. What would be enough then? Would $800 billion work? Would $2 trillion work? What is the objective exactly? At one time an expansion in the size of the Fed's balance sheet of this magnitude would have been considered ludicrous. How does this work differently? Does confirmed empiricism involve making guesses based on how you feel when you wake up in the morning, or what?

The confirmed empiricist tells us that:

[The Fed] could set a price-level target, which, unlike an inflation target, calls for Fed policy to take past years’ price changes into account. That would lead the Fed to counteract some of the extremely low inflation during the recession with a more expansionary policy and lower real rates for a while.

Unfortunately for Romer's argument, a price-level targeting approach will not necessarily give her the conclusion she seems to want. In the chart, if we take the personal consumption expenditure (PCE) deflator as our price level target measure, and take the base period as first quarter 2005, for example, the 2% annual-growth price level path is still well below the actual PCE deflator for fourth quarter 2010. If you take the base period for the target price level path as the peak in 2008, we are certainly on the low side of the desired path, but a base period any time before spring 2007 would imply that the price level is currently too high.

Finally, Romer states:

And any [of her alternatives] would be better than doing too little just because some Fed policy makers believe in an unproven, theoretical view of how inflation works.

Of course Romer's theoretical view is pretty much that of Samuelson and Solow, from 1960. Apparently the Fed can increase the inflation rate only by reducing the unemployment rate, and moving the economy up the Phillips curve.

Romer says some things about economic history in her piece, but of course she is very selective, and seems to want to ignore the period in US economic history and in macroeconomic thought that runs from about 1968 to 1985. Let's review that. (i) Samuelson/Solow and others think that the Phillips curve is a structural relationship - a stable relationship between unemployment and inflation that represents a policy choice for the Fed. (ii) Friedman (in words) says that this is not so. There is no long-run tradeoff between unemployment and inflation. It is possible to have high inflation and high unemployment. (iii) Macroeconomic events play out in a way consistent with what Friedman stated. We have high inflation and high unemployment. (iv) Lucas writes down a theory that makes rigorous what Friedman said. There are parts of the theory that we don't like so much now, but Lucas's work sets off a methodological revolution that changes how we do macroeconomics. One of the things we still like about Lucas's work is his "critique" paper, which tells us why we need theory to make good policy decisions. The key example from the Lucas Critique paper is the Phillips curve: treating an observed correlation in the data as structural can be bad. (iv) Paul Volcker takes Friedman seriously. Friedman had said that "inflation is everywhere and always a monetary phenomenon." The confirmed empiricists are skeptical. They seem to think that the Phillips curve is very flat, and that there will have to be a very long period of very high unemployment to bring the inflation rate down. Not so. Volcker engineers a severe monetary contraction and the ensuing recession is fairly painful, but not so long. Success! Inflation comes down quickly and has remained low since then.

What's missing from Romer's piece? It's the "inflation is everywhere and always a monetary phenomenon" part. Of course we have learned a lot since Friedman said that, about the practical implementation of monetary policy, and about monetary economics. Targeting the growth rate in some monetary aggregate does not seem to be a good idea. In the very short term, setting a nominal interest rate target for some overnight interest rate seems to work pretty well. When there is a large quantity of reserves in the system, swapping reserves for T-bills has essentially no effects. Monetary expansions that are planned to be reversed, and expected to be reversed, can have no effects. We know little, theoretically or empirically, about the effects of large purchases of long-maturity assets by the Fed under the current circumstances, but we are going to learn something about that soon.

Here's what I see in the recent data. The first chart is reserves, since the beginning of 2008, and the second is currency in circulation. The total of these two is total outside money, which is roughly the total quantity of Fed liabilities financing its asset portfolio. In the first chart we see a rapid runup in last few weeks in reserves. For reasons I discussed in other posts, the actions of the Treasury caused a lag in the effects of the QE2 asset purchases by the Fed on outside money, but those actions have been reversed. In the second chart, currency in circulation has increased substantially in recent weeks. Year-over-year percentage increases in the stock of currency in circulation have exceeded 6% since early this year and are approaching 7%. This is potentially serious. Increases in outside money that show up only as increases in reserves are currently irrelevant for inflation, but when this shows up as currency, it can matter. If the recent increases in the currency stock do not represent increases in the real demand for currency in the world, this has to be inflationary. The Fed is only halfway (and less than halfway in terms of published data) through its QE2 program, and if increases in the currency stock continue at the rate of the last few weeks until the end of program, we should be genuinely concerned, Christina Romer notwithstanding.

Cargo Cults

Someone once accused me of practicing "cargo cult economics." At the time this just sounded goofy to me, but a commenter clued me into the fact that this comes from a commencement address that Richard Feynman made at Caltech in 1974. In general, it's quite entertaining, though maybe of limited use for economists as he was thinking mostly in terms of experimental science. However, there are some very nice parts. For example, here he is discussing honesty in science:

It's a kind of scientific integrity, a principle of scientific thought that corresponds to a kind of utter honesty--a kind of leaning over backwards. For example, if you're doing an experiment, you should report everything that you think might make it invalid--not only what you think is right about it: other causes that could possibly explain your results; and things you thought of that you've eliminated by some other experiment, and how they worked--to make sure the other fellow can tell they have been eliminated.

The following sounds like Ed Prescott, don't you think?

There is also a more subtle problem. When you have put a lot of ideas together to make an elaborate theory, you want to make sure, when explaining what it fits, that those things it fits are not just the things that gave you the idea for the theory; but that the finished theory makes something else come out right, in addition.

More on honesty:

The first principle is that you must not fool yourself--and you are the easiest person to fool. So you have to be very careful about that. After you've not fooled yourself, it's easy not to fool other scientists. You just have to be honest in a conventional way after that.

And here's one for Paul Krugman:

I would like to add something that's not essential to the science, but something I kind of believe, which is that you should not fool the layman when you're talking as a scientist.

Happy reading.

Unions

There is currently serious conflict in several states, including Wisconsin, Ohio, and Indiana over union bargaining rights for state employees. The claim of the Republican administration in each of these states is that union power needs to be curtailed in order to get the state budget under control.

I have some personal experience with labor unions, having actually been a one-time union member (I can't say "card-carrying," as I don't remember having been issued a membership card). When I was 19, I worked for a couple of summers for Winchester Canada, which had a unionized plant in Cobourg, Ontario. Winchester appears to still be in business, and of course they make firearms. An ancient Winchester product was what Chuck Connors used in "The Rifleman." When I was 8 years old my friends and I thought that Chuck Connors was very cool.

Working for Winchester was quite weird on many dimensions, including the fact that I had absolutely no interest in guns - a lack of interest that continues to this day. I am allergic to firarms. I see one and run the other way.

An interesting feature of working life at Winchester Canada was that the union was clearly stifling innovation. What I saw certainly conformed to the picture of unions that comes out of Parente and Prescott's "Barriers to Riches," which cites labor unions and trade barriers, among other things, as factors that lower TFP (total factor productivity) and the standard of living in a country. At the Winchester plant, every activity was governed by a set of workplace rules, written up in the union contract. Management and production workers thought of each other as adversaries. This was not a conducive environment for thinking up new ways of organizing production or designing new products. It seemed clear that you could take away the union, create more flexibility, increase productivity, pay everyone more, and bring about a Pareto improvement.

Sometimes I get into arguments with my family in restaurants about economic questions ("Dad, don't get so excited, people are looking."). I enjoy this, perhaps as much as, or more than, helping my sons solve math problems. When unions come up, I take the hardcore laissez faire route, just to be provocative. My youngest son will then tell me about what the union movement accomplished in terms of workplace safety. Maybe he has a point. We don't want to go too far in seeing externalities under every rock, but this certainly looks like one. Getting firms to invest efficiently in safety may require collective action. Maybe the government would not have taken appropriate action on workplace safety if not for the labor movement. In the Winchester plant, I was certainly pleased with whatever safety features were provided for me. My foreman liked to encourage safe practices by showing us his missing thumb, which had been lost while working on the same belt sander that I was required to operate.

One simple way to look at unions comes from Econ 101, where we just apply standard monopoly power arguments. Labor law gives workers the right to effectively act as a monopoly seller of labor. Result? The union drives up wages and extracts rent from the firm. But that argument goes only so far. As long as the firm faces competition, this has to discipline the union. Extract too much rent and you drive the firm out of business.

So what is going on in Wisconsin, Indiana, and Ohio? In general, union organization is not an easy thing in the United States, relative to what happens in other rich countries. Twenty two states, mainly in the south and in the middle of the country have right-to-work laws. In some states, state employees have much less power to form unions relative to what exists in the private sector. However, in Western Europe, unions tend to be relatively powerful. In Canada, labor law is much more conducive to union formation and power. For example, most (if not all) Canadian provinces do not allow the hiring of permanent replacement workers during a strike, and some will not permit the hiring of temporary replacement workers. Strikes of public service workers in Canada are infamous, from old-time disruption in the post office to more recent strikes involving garbage collectors and transit workers in Toronto. The difference in labor laws in Canada and the US is reflected in unionization rates. The US has a unionization rate of only 7% in the private sector, and 29% in the public sector. In Canada, the comparable statistics are 16% in the private sector and 71% in the public sector.

Now, if we believe Scott Walker, the Governor of Wisconsin, public spending in Canada should be wildly out of control. We know, of course, that government is doing much more redistribution in Canada than is the case generally in the United States. But in Canada actual expenditures of all levels of government on goods and services amounted to 21.2% of GDP in Canada in 2009, and 20.6% of GDP in the US. Not much difference there. Further, in spite of union power in the public sector, the Canadian federal government was able to turn around a deficit which had exceeded 5% of GDP in the mid-1990s. Before the recent recession, the Canadian federal government had been running surpluses for several years. We all know how that compares to recent US fiscal performance.

Is Scott Walker likely to save much money by picking on his public sector unions? That's very doubtful. He's certainly creating plenty of unproductive conflict. Is what he is doing politically smart? That's hard to tell. Picking a fight with unions in Madison, Wisconsin may not be the brightest idea. Anyone who has spent time in Madison (4 years for me) knows that there is a large reserve army of people who would enjoy nothing better than spending a couple of weeks camping out in the State Capitol building to bother a Republican Governor. This might play well in the rest of the state, however, where Madison is sometimes viewed as sin city.

Unemployment

Some people seem to be paying attention to this piece by Justin Weidner and John Williams at the San Francisco Fed. For example, someone at The Economist picked up on it. The FRBSF Economic Letters posts, of which the Weidner/Williams piece is one, are short, accessible summaries of research, but in this case there is not much research to back it up. There's really no news here.

I have written on sectoral reallocation issues in earlier posts, for example here and here. To summarize, there are some important labor market anomalies associated with the recent recession. The unemployment rate has risen much more, and employment has dropped much more than is typically observed in conjunction with a drop in real GDP of this magnitude. Further, in spite of the (somewhat slow) recovery in real GDP, employment is still in the cellar. As a result, there has been a large anomalous increase in productivity coming out of the recession.

My casual observations in previous posts, which should be interpreted as suggestive, and not serious research, tell me that there could be something interesting going on related to the the sectoral reallocation of labor and other factors of production. Another important anomaly is in labor market performance in Canada. The magnitude of the real GDP decline in Canada during the recession was similar to what it was in the US, but the unemployment rate (typically a couple of percentage points higher in Canada) is currently 7.8%. The sectoral reallocation process could help to explain the anomalies. To address this seriously, I think we have to go back to 2000 or earlier, and think about: (i) the secular reallocation of labor from manufacturing to services; (ii) secular labor reallocation across geographical regions; (iii) the effects of incentive problems in the mortgage market after 2000, which increased the share of employment in residential construction until 2006, and set the stage for the subsequent reduction in employment share in that industry; (iv) the role played by financial factors in the geographical and sectoral dispersion in employment.

To successfully disentangle what is going on, we need a model with sufficient disaggregated detail to capture the regional and sectoral allocation of labor, and search and matching among firms and workers. Activities of the economic agents in the model should be such that we can ask these agents the same questions that are asked in the BLS household survey, and have the answers make sense. Basic Mortensen-Pissarides won't do the trick, unless we try to somehow load all this sectoral detail into the matching function, which seems unsatisfactory.

Once such a model is up and running, what do we want to do with it? Here are some questions: What would have happened if the mortgage market had somehow been differently organized and regulated? How would the US economy have looked different, starting in 2000? Could there have been better policy responses to the financial crisis and the recession than what we had? Is the US unemployment insurance system adequate (actually, most research on optimal unemployment insurance already says it is far from perfect)? Does the financial crisis tell us something new about labor market policies? I'm hoping that people who know how to do these things are working on the problem. Please let me know if there is some work out there that I am missing.

What I am sure of is that gazing at some Beveridge curve scatter plots, pondering the "natural" unemployment rate, or trying to decompose unemployment into so-called "cyclical," "structural," "demand-deficient," "involuntary," "voluntary," "green," "yellow," "purple," or "chartreuse" components will not answer these questions.

Ron Paul and the Austrians

Ron Paul, who now heads the House Financial Services Committee's subcommittee on monetary policy, has an important job. The Fed also has an important job, and a lot of power, and we want to know that we can trust them. Paul's job is to aid Congress in overseeing the Fed, in part by finding good expert witnesses to speak and answer questions in hearings, in order to shed light on what the Fed does and whether it is performing well.

Ron Paul is of course no friend of central bankers, and has written about putting the Fed out of business. Why? Paul is a libertarian, and is a follower of the "Austrian School," an essentially libertarian branch of economic thought, whose most prominent members were Ludwig von Mises and Freidrich Hayek. The Austrian School lives on as a fringe movement in the profession.

I don't know a lot about the Austrian School, but I have run across Hayek's ideas from time to time. The ideas are extreme, but not crazy. For example, Hayek's Denationalisation of Money, is a coherent argument for a monetary system with private money issue. Conventional economic wisdom is that, if we allow the private sector to issue money, then there is a market failure. Even Milton Friedman - an advocate of laissez faire in most respects - argued in A Program for Monetary Stability that the issue and control of the stock of money was the province of the government, so clearly Hayek's views were unusual.

However, what Hayek was advocating had in fact been put in practice historically in more than one instance. There was free banking (with currency issue by private banks) in Scotland in the early 19th century. The United States had private currency issue from 1837-1863 by state-chartered banks, and Canada had a system of private money before 1935. While the US free banking era (1837-1863) appears to have been quite chaotic (more so in some states than others) the experience with private money issue in Scotland and Canada appears to have been quite good. Canada, for example, went through the early part of the Great Depression with no bank failures, in spite of the fact that there was no central bank to act as lender of last resort.

There are legitimate questions economists should ask, and have asked, about the fundamental role of the central bank, and whether the issue of "money" should be essentially a government monopoly. Gary Gorton, Warren Weber, and Arthur Rolnick, for example, have studied the free banking era in the United States, and there is work in monetary theory, for example by Ricardo Cavalcanti and Neil Wallace, among others, on the role of private money in efficient monetary arrangements. Thus, some of the questions Hayek was interested in have been studied in rigorous economic frameworks.

Thus, the Austrians were libertarian, but not kooky, so the fact that Ron Paul is interested in Austrian economics does not make him a kook. But Ron Paul is also interested in the gold standard. I'm not sure where the Austrians stood on that, but the gold standard has certainly drawn its share of kooks. The gold standard was part of the natural evolution of monetary systems from exchange with pure commodity money to fiat standards. Commodity money is wasteful, in that it is costly to dig gold out of the ground for use as money, and gold has other uses, from which it has to be diverted if it is used in exchange. Gold is also heavy, and therefore costly to carry around in large quantities. If we are able to solve the counterfeiting problem inherent in exchange using paper currency, then we can save the costs of carrying gold around by backing the paper currency one-for-one with gold, with gold exchanging for currency at a fixed rate. We can go even further in resource savings with fractional backing of the currency by gold. Why not go even further and eliminate the backing altogether, and just trust the government to regulate the quantity of money in circulation? That's where our modern fiat money systems come from.

What case do gold bugs make for a return to the good old days of the gold standard? They argue that the government cannot be trusted. Governments, as they argue, will be tempted to use the printing press to finance government deficits, and the cost will be high inflation. The gold standard, whereby a government agency stands ready to buy and sell gold at a fixed price will, they argue, give us price stability. What's the problem with that? First there has to be a resource cost associated with this. In order to maintain a fixed price of gold in terms of central bank liabilities, the government would have to hold a reserve stock of the stuff. The relative price of gold would be higher than it would be otherwise, causing people to economize on it in alternative uses, and causing more of it to be dug out of the ground. Just as was the case historically, there would be waste, but perhaps this would be small. But the principal defect in the gold standard is that the relative price of gold fluctuates substantially, and would continue to fluctuate substantially under a gold standard. These fluctuations occur because of changes in mining technology, changes in the demand for gold in industrial and other uses, and because of the fact that gold is a store of wealth. It seems clear that the gold standard would give us more variability in prices, not less. Further, as was the case historically, a gold standard does not imply that the government is necessarily committed to anything. The government can always decide to change the price at which it buys or sells gold.

So, what has Ron Paul been up to in his role in leading the subcommittee on monetary policy? Well, not much good apparently. The subcommittee recently invited three economists to come to Washington to talk to them: Thomas DiLorenzo, Richard Vedder, and Josh Bivens. The first two are Austrian School types, and DiLorenzo is clearly a quack. Bivens writes pieces for the Economic Policy Institute on the state of the macroeconomy. This is certainly an undistinguished lot, and not the first names that come to my mind as experts on monetary policy.

To repeat, Ron Paul has an important job. We have been through some unusual experiences on the monetary and financial front. Our central bank has made the choice to engage in some unusual practices. The Fed's decisions need to be reviewed and analyzed, and Congress needs to determine whether the Fed did the right things, whether it did the wrong things but should be forgiven, or whether some additional constraints need to be placed on the Fed's behavior.

Currently, the Fed operates under a dual mandate set out in the Humphrey Hawkins Act, which contains vague language about how the Fed should view its influence over real activity and inflation. In some other countries, central banks don't operate that way, but instead negotiate an explicit inflation-targeting arrangement with the legislative branch. Why don't we do that? In any case, these issues should be discussed and debated in Paul's Committee.

But Ron Paul cannot make any headway on these important issues if his agenda is quack economics. My advice would be to ditch DiLorenzo and company and talk to some of these people (I'm assuming Bernanke is the only Fed person who can speak directly to Congress):

Mike Woodford, Columbia University
John Cochrane, University of Chicago
Mark Gertler, NYU
Gary Gorton, Yale
Arthur Rolnick, formerly Minneapolis Fed
Robert Lucas, University of Chicago

Inviting these people to speak to the subcommittee would at least capture the important ideas on monetary policy that are taken seriously at top research institutions in the profession.

Fed Balance Sheet Update

The latest information on the state of the Fed's balance sheet is available here. The Fed continues to purchase long-term Treasury securities at about the rate set out in the QE2 plan in November, with securities holdings increasing by $28 billion over the previous week. Of particular note is that reserves increased by $64 billion, in part due to the Fed's asset purchases, and in part because balances in the Treasury's reserve accounts fell by $41 billion. The balance in the Treasury's general account fell by $16 billion and, of particular note, the balance in the Treasury's supplementary account fell by $25 billion. It is clear what a reduction in the Treasury's balance in the supplementary account does: it increases reserve balances held by the private sector, and reduces outstanding Treasury debt. However the reason for the existence of the account, and the motivation of the Treasury to change the balance in the account are mysteries. The last time there was a reduction in the balance, beginning in October 2009, the Treasury reduced the balance by $35 billion per week until it was close to zero, then increased it again to a level of $200 billion. Presumably there will be reductions at the rate of $25 billion per week again. Another point of interest is that there was a substantial increase in currency outstanding in the past week, of about $8 billion, or about 0.8%. Year-over-year, the currency stock is now growing at about 6%. Thus, QE2 is now producing much greater growth in outside money than it was.

Bedtime Stories

Stories are helpful in economics. Particularly in class, a simple story can get the essence of an idea across, and then you can go on to develop the full-blown analysis that puts some rigorous structure on the idea. One story I like is this one, which comes from Joseph Ostroy (UCLA). There are two people, George and Martha, who agree that they will eat dinner at one or the other's home each Saturday night. They want to share the burden of the cooking equally, but they have very bad memories, and can never remember who last cooked dinner. However, they have a stone. George and Martha have good enough memories that they each can remember where the stone is stored in their respective homes. On Saturday night, each looks in that spot. If the stone is there, they take it over to the other person's house and eat dinner. If the stone is not there, they cook dinner and wait for the other to show up. The person who brought the stone leaves it behind, and the other stores it.

This is a money parable, of course, and it captures the essence of the most important idea that has taken root in monetary economics in the last 30 years: Money is Memory. People use money in exchange because of information frictions - essentially limited recordkeeping, or limited memory.

Paul Krugman has been writing about stories recently, and he too finds these useful. Here's one of his:

Real business cycle theory says that economic fluctuations are the result of technological shocks, amplified by intertemporal labor substitution. My version: think of a farmer who faces sunny and rainy days. On rainy days his labor won’t be as productive as on sunny days; this effect on his output is amplified by his rational decision to stay in bed on rainy days and work extra hard when the sun shines. I think this gets at the essence of the concept; it also makes you wonder, is this really, really what you think happens in recessions?

His RBC story is quite standard. The one I tell to students is pretty close to it. Again, it captures the essence of the idea. Of course, Krugman uses the story to make fun of the idea, but aside from the issue of whether the RBC model helps us understand recessions, the story is quite helpful. At the minimum it can help a student understand intertemporal substitution, which is at the root of much of dynamic macroeconomics.

I have a Keynesian story. There are two farmers, George and Martha (again). George grows peanuts, Martha grows cranberries. George eats only cranberries, and Martha eats only peanuts. These are weird peanuts and cranberries which sprout from the ground every morning, and have to be picked or they rot. Each evening, George and Martha meet at Martha's house, drink beer, and play cards. They get quite drunk, which is what it takes for them to settle down and negotiate the price at which they will trade in the morning. George's peanuts must be harvested before Martha's cranberries each morning. On a typical day, George gets out of bed, harvests his peanuts, and goes to Martha's house. When George arrives, Martha harvests her cranberries, and they trade peanuts for cranberries at the price they negotiated the night before. However, there are days when George wakes up, and it's not a day when he is so enthusiastic about eating his cranberries. The price of cranberries is too high, so he rolls over in bed and goes back to sleep. Martha makes up, and George has not arrived. Martha knows what has happened. She could call George on the phone and renegotiate the price, but she can't bear to do it, and goes back to bed. The situation is bleak. Both George and Martha express a desire to work, but there is no demand. However, there is a government, which is monitoring the situation. The government agent gets George out of bed, and puts them to work digging holes. In exchange for the hole-digging, George is given some bonds which are claims to tomorrow's peanuts. The government plans to tax George in peanuts on the next day, in order to deliver the payoff to the bondholder. However, George does not see through this. His circumstances are now changed. He goes to Martha's, trades bonds and cranberries for peanuts, and everyone is happy.

Does my Keynesian story or Krugman's RBC story help us understand the recent recession? Krugman's story has the advantage of being simple. RBC is a piece of cake relative to Keynesian economics, if you do each properly. But to argue that the recent recession resulted from a productivity shock is not helpful. Is my Keynesian story helpful? No, I'm afraid it does not cut it either.

Bernanke Speech

Ben Bernanke made a speech yesterday at the National Press Club in Washington D.C., posted here. I'm going to focus on the "Monetary Policy" section. Bernanke discusses QE2, the Fed's planned purchases of $600 billion (net) in long-term Treasury securities, beginning in early November 2010, to continue over an eight-month period. Bernanke states:

All these purchases are settled through the banking system, with the result that depository institutions now hold a very high level of reserve balances with the Federal Reserve.

He is being a little cagey here. From the week of November 3 to the week of February 2, the Fed increased its holdings of securities by about $194 billion, actually somewhat short of the planned increase of about $225 billion over that period. Further, due to offsetting effects on the asset side of the Fed's balance sheet due to the unwinding of the New York Fed's interaction with AIG, and offsetting increases in the balances held in Treasury reserve accounts, reserves of private financial institutions increased over this period by only about $96 billion. Thus, while it is true that reserves are at a very high level historically, the net increase in reserves since the beginning of the QE2 operation is only about half the increase in securities held by the Fed. This is certainly not due to an increase in currency outstanding, as currency increased by a modest $13 billion, or about 5% at an annual rate.

Then, there is an attempt to convince us that QE2 is really just business as usual.

Although large-scale purchases of longer-term securities are a different monetary policy tool than the more familiar approach of targeting the federal funds rate, the two types of policies affect the economy in similar ways.

This seems a stretch. I don't think anyone at the Fed can say with a straight face that we have a good theory for how or if QE2 will work, or that they understand the quantitative effects. Pre-financial crisis, the purchase of $600 billion in Treasury securities, of any maturity, over an 8-month period would have been considered ludicrous.

Bernanke then claims success. What is the evidence?

1. The stock market went up. It's hard to argue this one way or the other, so I guess you have to give Bernanke this one. However, this is a dangerous game. If the stock market goes down, then Bernanke owns it. First Law of Central Banking: Don't claim credit for something you can't control.

2. The difference in yields between nominal long-term Treasuries and TIPS has increased. In the first chart, I have plotted the difference in yields between 10-year nominal Treasuries and 10-year TIPS. As you can see, this difference begins to increase at about the time when QE2 became widely anticipated, and continued to increase after the policy was put in place, roughly to a pre-crisis level. The difference in yields between nominal Treasuries is essentially determined by anticipated inflation. Since a stated goal of QE2 was to increase the anticipated inflation rate, the policy appears to be a success on that dimension.

3. Effects on Treasury yields. Here, things get murky. Bernanke states:

Yields on 5- to 10-year Treasury securities initially declined markedly as markets priced in prospective Fed purchases; these yields subsequently rose, however, as investors became more optimistic about economic growth and as traders scaled back their expectations of future securities purchases.

Suppose we focus just on 10-year Treasuries, for simplicity. The next chart shows the 10-year nominal Treasury yield and the 10-year TIPS yield. The TIPS yield is higher than when the QE2 purchases started, and the nominal bond yield is much higher. Now, we should be primarily interested in the TIPS yield in evaluating Bernanke's policy, since he describes the process by which QE2 could affect real activity as working through real long-term interest rates, which are to some extent captured in the TIPS yields. Of course we can't conclude much from looking at the chart, as there are a lot of things changing over this period in addition to monetary policy. In the quote above, Bernanke tries to make the best of it though. He claims credit when bond yields go down, and argues that other factors swamp the monetary policy effect when yields go up. He can't quantify the effect though, as there is no solid theory to go on. In any event, this is another dimension on which the Fed is not conducting business as usual. In normal times, the Fed commits to a fed funds rate target, and it can come quite close to the target, rain or shine. Currently, the Fed says it wants long bond rates to fall, but this is something it has not delivered. See the First Law of Central Banking, above.

Bernanke finishes with an attempt to provide assurance that the Fed can tighten when the need arises.

In particular, it bears emphasizing that we have the necessary tools to smoothly and effectively exit from the asset purchase program at the appropriate time. In particular, our ability to pay interest on reserve balances held at the Federal Reserve Banks will allow us to put upward pressure on short-term market interest rates and thus to tighten monetary policy when required, even if bank reserves remain high. Moreover, we have developed additional tools that will allow us to drain or immobilize bank reserves as required to facilitate the smooth withdrawal of policy accommodation when conditions warrant. If needed, we could also tighten policy by redeeming or selling securities.

Here, Bernanke does not put enough emphasis on the interest rate on reserves, which is actually the key policy instrument of the Fed under current circumstances. The "additional tools" (reverse repos and term deposit reserve accounts) would actually serve no purpose at all, given the large stock of reserves outstanding. One thing Bernanke does not comment on (as it would raise questions about the Fed's independence from the Treasury) is the current "reserve drain," or "immobilization," of about $300 billion due to balances in the Treasury's reserve accounts with the Fed.