Friday, September 30, 2011

Plosser Speech

I tend to like Charles Plosser's speeches, and this recent one is no exception. Plosser has an excellent understanding of why central bank commitment to a policy rule is a good thing, and communicates the idea well to a lay audience.

Here is one of the interesting parts:
The ills we currently face are not readily resolved through ever more accommodative monetary policy. If we act as if the Fed has the ability to solve all our economic problems, the credibility of the institution is undermined. The loss of that credibility and confidence could be costly to the economy because it will make it much harder for the Fed to implement effective monetary policy in the future.
We do indeed face ills. A large fraction of the population is significantly worse off than they were in 2007. But there are no monetary policy actions available currently that will make them better off. However, by continuing to engage in unconventional policy actions - QE1, QE2, "forward guidance," and Operation Twist, the Fed is acting as if it knows what it is doing, and can actually reduce unemployment by taking those actions. Further, public statements by some Fed officials, particularly Bernanke, express confidence that these actions actually work. Bernanke, and like-minded people such as Charles Evans, Chicago Fed President, are unfortunately engaged in wishful thinking.

In commenting on his dissent at the August FOMC meeting, Plosser states:
Credibility was also at the center of my opposition to changing the forward policy guidance in August. I was concerned that tying monetary policy to calendar time could be misinterpreted by the public as suggesting that monetary policy is no longer contingent on how the economic outlook evolves. This could also lead to a loss of credibility should economic conditions develop in a way that requires the federal funds rate to be adjusted prior to mid-2013. And in my view, given the outlook, economic conditions will likely warrant that the Fed begin to raise rates before that time.
This is essentially identical to Kocherlakota's justification for his dissent at the same meeting, and it makes sense. While the August FOMC decision may look like it implies more commitment, it actually gives less, as Plosser points out. If inflation happens to be much higher than the Fed forecasts (in fact a serious possibility, given the policy) then there are two possibilities. First, the Fed could choose not to tighten, in which case it loses its credibility for controlling inflation. Second, the Fed could choose to tighten, in which case it violates the promise it made in August. Either way credibility is lost and we are actually worse off than if the FOMC had not made the announcement it did in August.

Finally, Plosser discusses inflation targeting:
An important first step in that direction is for the Federal Reserve to adopt an explicit numerical objective for inflation. The explicit inflation goal would help to anchor inflation expectations, raise policy transparency, and increase the central bank’s accountability for its actions. There is considerable evidence that countries that have adopted such an objective as a cornerstone of their monetary policy decision-making have had more success at achieving price stability without any deterioration in the stability of real activity. In the United States, Congress has given the Fed a mandate to promote the goals of maximum employment, stable prices, and moderate long-term interest rates. Price stability is the most effective way for monetary policy to promote the other two goals. Thus, by helping the Fed achieve and maintain price stability, an explicit inflation objective would help the Fed promote all three of the goals set forth by Congress.
Some people think that the Humphrey Hawkins Act constrains the Fed in such a way that it must speak directly to the second part of the dual mandate, typically in terms of specific goals for the labor market. However, Plosser gives us a way out. Just as many other central banks in the world do, the Fed could announce specific inflation targets (or a price level target, if you like that better). This need not require any authorization from Congress, as the Fed can argue that this actually speaks to the dual mandate. And that is not a lie, as indeed a wide class of economic models tells us just that. In general, the long-run costs of inflation are reflected in real GDP and employment. Further, there are models of short-run nonneutralities of money in which price stability implies that real GDP and employment are maximized. For example, some New Keynesian models work that way.

Owls, Hawks, and Doves

This speech by Fed Governor Sarah Bloom Raskin is mostly a recitation of majority FOMC views, but I thought this was interesting:
Indeed, some commentators assign a label of "hawk" or "dove" to the various FOMC participants in an attempt to characterize how we prioritize the goals of maximum employment and price stability. In my view, such labels are ill conceived and misleading because everyone on the Committee is fully committed to promoting both of these goals. Incidentally, since my kids now love describing everyone as a hawk or a dove or some other kind of bird, I have taken to reminding them of this conviction I have: When my colleagues and I are doing our job correctly, we are neither hawks nor doves but owls--that is, we are trying to be as wise as possible in deploying all the tools we have to fulfill our legal mandate.
I've never thought the labels "hawks" and "doves" were particularly useful. Some people seem to be stuck on the notion that views on the FOMC are simply a matter of choosing a point on the Phillips curve. Hawks and doves in this view are simply individuals with different preferences over inflation and unemployment, with the doves being much more willing to tolerate higher inflation to achieve lower unemployment. Of course since the 1970s we all know that central bankers should not be thinking about Phillips curve tradeoffs, right?

Here is something interesting I learned today. Apparently the average layperson (in this case meaning non-biologist) grossly mischaracterizes the behavior of birds. Sarah Bloom Raskin falls in line with standard mischaracterizations by thinking of the owl as a wise, and presumably "nice", bird. Actually, the owl is as much a predator as the hawk, and typically survives on a diet that includes mice, rats, and hares. The owl's beak is much like a hawk's, allowing it to kill its prey before eating it whole. Further, the owl is very sneaky, having evolved to be extremely quiet so that it can surprise its dinner. Owls are also loners, and not known for getting along in groups.

Further, in terms of vision, the hawk appears to dominate the owl. A hawk can have about 1 million photoreceptors per square mm in the retina as opposed to 200,000 for humans. The owl, however, is noted for being farsighted, perhaps a good quality in central bankers, but basically it can't read the General Theory (or Recursive Methods in Economic Dynamics) up close. As well, the owl is backward-looking, a definite drawback. Though its eyes face forward (making it look human, and therefore "wise"), the eyes don't move in their sockets. The owl compensates for this by turning its whole head. In fact, it can swivel its head 270 degrees, i.e. it can essentially look backward.

According to Louis Lefebvre, a biologist at McGill University, hawks are well up there on the bird IQ scale. No mention of owls unfortunately. They look smart but are apparently dummies.

Here's another interesting tidbit from Dr. Lefebvre. Apparently doves can be nasty.

Wednesday, September 28, 2011

Cole and Ohanian Reply

Here is a clarification of Cole and Ohanian's WSJ piece, sent to me by Hal and Lee.
Paul Krugman claims our economic history is in "incredibly bad faith" by showing that industrial output is positively correlated with the wholesale price index. The main point of our op-ed, as well as our earlier work, is that most of the increase in per-capita output that occurred after 1933 was due to higher productivity – not higher labor input. The figure shows total hours worked per adult for the 1930s. There is little recovery in labor, as hours are about 27 percent down in 1933 relative to 1929, and remain about 21 percent down in 1939. But increasing aggregate demand is supposed to increase output by increasing labor, not by increasing productivity, which is typically considered to be outside the scope of short-run spending/monetary policies.

The facts that labor doesn’t recover very much, and that wages in some sectors of the economy are well above trend, is why we have analyzed the impact of New Deal cartelization policies. And the slow recovery from the Depression has been known for decades, including work by Armen Alchian, Milton Friedman and Anna Schwartz, and Robert Lucas, all of whom point to New Deal policies that depressed competition in labor and product markets.

In terms of the relationship between changes in prices and changes in industrial production, our piece examined the 1932-34 period because that was a period cited by Bernanke for strong growth related to eliminating deflation. And the growth that occurred in industrial production during that period occurred while the CPI was falling (1932-1933). Between 1933-34, the CPI rose, but industrial production didn’t.

In any case, growth during the New Deal was due primarily to productivity – not labor.

Tuesday, September 27, 2011


Sorry to bother you with more of this drivel, but you might as well know. Here is Krugman, spouting off again about how useless we all are.

I looked up a definition of "science," and came up with this:
The intellectual and practical activity encompassing the systematic study of the structure and behavior of the physical and natural world through observation and experiment.
So, as economists we are systematic, we study the structure of the economy and the behavior of individuals in it, and we observe and experiment. Thus, apparently, we are a science. But Krugman does not think so:
I’ve never liked the notion of talking about economic “science” — it’s much too raw and imperfect a discipline to be paired casually with things like chemistry or biology, and in general when someone talks about economics as a science I immediately suspect that I’m hearing someone who doesn’t know that models are only models.
Of course the chemists and biologists also have models, and those models are only models as well. What is it we do, if not science?

Here's what Krugman closes with:
...liberal economists by and large do seem to be genuinely wrestling with what has happened, but conservative economists don’t.
Apparently Krugman has not been to a macro seminar or serious economics conference for a long time. But maybe all the people writing those papers on the financial crisis are all liberals? I didn't ask. Maybe Krugman has in mind a particular definition of "wrestling," i.e. he/she who actually wrestles uses an IS-LM model.

Hal Cole and Lee Ohanian Are Bad Guys

In case you haven't noticed, Hal and Lee have joined the Paul Krugman bad guy club. Writing about Cole and Ohanian's WSJ piece, Krugman says:
This goes beyond holding views I disagree with (as does much of what happens in this debate). This is a deliberate attempt to fool readers, demonstrating that there is no good faith here.
Hal and Lee are two thoughtful and careful economists. I don't agree with everything they have ever said, but to call them liars is appalling.

Monday, September 26, 2011

Lucas and Krugman

I thought that this post by Paul Krugman required a response. It's related to a Lucas interview in the WSJ which, if nothing else, tells you why Krugman's assertions about the "moral failure" of non-Keynesian macroeconomists are absurd.

Krugman's blog post mainly tells us that his deficit in macro-knowledge persists. First, Krugman appears to think that Lucas's only contribution to 20th-century macroeconomics was "Expectations and the Neutrality of Money," in particular the signal-extraction money-surprise story about the non-neutrality of money. Then, Krugman states:
In the 1980s, the Lucas project failed — pure and simple. It became obvious that recessions last too long, and there are too many sources of information, for rational confusion to explain business cycles. Nice try, with a lot of clever modeling, but it just didn’t work.
Money surprises were a tiny part of the "Lucas project." While I think a widely-held view now is that the money-surprise mechanism is unimportant in explaining aggregate fluctuations, the lasting contribution from "Expectations and the Neutrality of Money" is a methodological one. And that methodological contribution is not only the use of rational expectations in a general equilibrium context - very useful in itself - but the use of explicit and consistent economic theory in a macroeconomic context. Further, the "Lucas project" also involved pathbreaking work in asset pricing, monetary economics, economic growth, and dynamic contracts under private information, among other things. Some failure!

Krugman seems to like New Keynesian economics, but:
I find NK economics useful, if only as a way to check my logic, although it’s not really clear if it’s any better than old-fashioned Keynesianism.
Judging from the output, I'm not sure there are any serious checks on Krugman's logic, but we'll give him the benefit of the doubt and assume that he actually grinds through Eggertsson and Krugman whenever he writes a blog post. However, if we take "old-fashioned Keynesianism" to be what is in the General Theory, or in an IS-LM model, then it is hard to argue that Woodford-style New Keynesian economics does not dominate. In its explicit form, New Keynesian economics in fact adheres to the "Lucas project." You can see exactly what is going on - there are optimizing agents, explicit preferences, endowments, and technology, and a well-defined equilibrium concept, in a dynamic context. The General Theory is close to impossible to decipher, and IS-LM is static, with a load of hidden assumptions.

Krugman does not like Prescott economics, and thinks that was a failure too. And he states:
But the math was impressive, and RBC became a self-contained, self-replicating intellectual world.
This is quite a mischaracterization, as RBC was ultimately neither self-contained, nor self-replicating. People built on the basic neoclassical growth model in work in monetary economics, economic growth, optimal taxation, commitment to economic policy, heterogeneous-agent incomplete markets models, etc. Indeed, New Keynesian economics, which is Krugman's logic-checker, evolved directly from RBC models - basic Woodford is RBC + Dixit-Stiglitz + Calvo pricing.

Krugman finishes with this:
But the descendants of the Lucas project know that Keynes was wrong — it’s what their teachers and their teachers’ teachers have been saying all these years. They cannot accept anything resembling a Keynesian explanation without devaluing everything they’ve done with their intellectual lives.
Actually, the descendants of the "Lucas project" are serious economic scientists, who would not say anything so outlandish as "Keynes was wrong." I think modern macroeconomists in general think of Keynesian economics as a small part of macroeconomics - just another friction. Whether Keynesian ideas are useful or not is an open question. There are many holes in Keynesian economics that need to be filled before serious macroeconomists can in fact take Keynesianism seriously. But I don't think anyone finds Keynes threatening. That's just silly.

Cole and Ohanian

Some interesting reading for today is Cole and Ohanian's piece in the WSJ. At the minimum, this is a reminder that there is more to life than aggregate demand. Here's the conclusion:
Policy can also improve today. The bipartisan Joint Select Committee on Deficit Reduction will make a recommendation by Nov. 23 to deal with future deficits. It has an outstanding opportunity to initiate broad-based tax reform that adopts the recommendations of most bipartisan tax reform commissions of the last 20 years: a simpler tax code that improves the incentives to hire and invest, broadens the tax base, lowers the corporate income tax, and also eliminates loopholes to equalize tax treatment of capital income. Sensibly addressing our long-run challenges will do more for the economy than continuing the stop-gap measures that have dominated policy-making for the last three years.
The Joint Select Committee on Deficit Reduction has an opportunity to tackle tax reform in a serious way - to make the tax code much more efficient while also closing the gap between tax revenue and outlays. Likely the Committee will be dysfunctional, but hoping does not hurt.

Thursday, September 22, 2011

Post-FOMC: What Does the Fed Think It Is Up To?

I'll try to dissect the FOMC statement from yesterday.

The primary policy change is:
The Committee intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less.
While some people want to interpret this as different from QE2, which was a swap of $600 billion in reserves for long-maturity Treasury bonds over a period of about 8 months, a swap of short-maturity Treasury bonds for long-maturity Treasury bonds amounts to essentially the same thing under current conditions. The only differences are that the purchase is 2/3 of QE2, and takes place over a longer period of time.

While this asset swap was widely anticipated, the other policy change was not:
To help support conditions in mortgage markets, the Committee will now reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities.
Since mid-2010, Fed policy had been to reinvest these principal payments in long Treasury bonds.

My contention is that both of these interventions are irrelevant, and will have no effect on current or future prices and real activity. First, as I argue here, the asset swaps cannot matter. Second, while the QE1 purchases of mortgage-backed securities (MBS) may have mattered (possibly in some bad ways), under current conditions MBS purchases by the Fed cannot make any difference unless the Fed purchases dominate the market, which they will not.

So what does the FOMC think it is doing? First, it justifies the interventions in terms of its dual mandate:
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee continues to expect some pickup in the pace of recovery over coming quarters but anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets. The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee's dual mandate as the effects of past energy and other commodity price increases dissipate further.
As we know, FOMC statements post-financial crisis now are much more explicit about the dual mandate, in including the "maximum employment" language. Further, note the emphasis on future inflation here. The FOMC is telling us that what matters is the Fed's forecast of future inflation (which is low) not current inflation (which is high). This is quite different from what we saw in Bernanke's justification for QE2:
Today, most measures of underlying inflation are running somewhat below 2 percent, or a bit lower than the rate most Fed policymakers see as being most consistent with healthy economic growth in the long run.
Thus, in November 2010, Bernanke wanted to convince us that QE2 was reasonable by appealing to current inflation observations; now he wants to convince us based on the inflation rate that we have not yet seen. My interpretation of this is that he does not actually care that much about inflation, but is focused on the second part of the mandate (real activity), as Charles Evans (one of the members who voted for the policy) certainly is.

Now, an interesting part of Bernanke's Washington Post piece that justified QE2 was this:
This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.
Maybe Bernanke can explain to us why the Fed's announcement this time coincided with a large drop in stock prices and a narrowing of the spread between nominal Treasury bond yields and TIPS yields (the break-even inflation rate).

I am collecting a set of rules for central bankers. Here are some of them:

1. Don't claim credit for things you cannot control.
2. Don't claim property rights over things you cannot control.
3. Don't engage in interventions when you have no idea what the consequences are.

Bernanke and company have broken all three of those rules.

1. It is dangerous to claim credit for stock price appreciation.
2. The FOMC claims it is intervening to lower the unemployment rate. Under current conditions, it cannot do that.
3. The FOMC does not understand the effects of its policies.

Fisher, Plosser, and Kocherlakota are on the right side of the fence in dissenting on this decision, and I think we should support them.

Tuesday, September 20, 2011

Chuckle of the Day

Krugman describes himself, once again:
A lot of the blame goes to the economists ... many of whom are giving bad advice now, I firmly believe, based more on ego and political affiliation than on analysis.

Monday, September 19, 2011

Pre-FOMC: Trying to look decisive when there are no decisions to make

Some people have been weighing in with some interesting commentary prior to the FOMC meeting on Tuesday/Wednesday. John Taylor thinks that the Fed's dual mandate is a bad idea, and that the Fed should focus only on price stability. Of course, this is standard practice for the ECB, and for central banks with explicit inflation targets, e.g. the Bank of Canada, the Reserve Bank of Australia, the Bank of England, and the Reserve Bank of New Zealand. Taylor cites a paper by Dan Thornton (St. Louis Fed), who looks at the language in Fed policy statements, and finds a recent inclination of the Fed to get much more specific about the second part of the dual mandate. For example, the last FOMC statement says:
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.
This is much stronger than the vague pre-financial crisis language about "sustainable economic growth," for example.

This trend, and public statements like those of Charles Evans, Chicago Fed President, have Paul Volcker worried. The key part of Volcker's NYT op-ed is this:
My point is not that we are on the edge today of serious inflation, which is unlikely if the Fed remains vigilant. Rather, the danger is that if, in desperation, we turn to deliberately seeking inflation to solve real problems — our economic imbalances, sluggish productivity, and excessive leverage — we would soon find that a little inflation doesn’t work. Then the instinct will be to do a little more — a seemingly temporary and “reasonable” 4 percent becomes 5, and then 6 and so on.

What we know, or should know, from the past is that once inflation becomes anticipated and ingrained — as it eventually would — then the stimulating effects are lost. Once an independent central bank does not simply tolerate a low level of inflation as consistent with “stability,” but invokes inflation as a policy, it becomes very difficult to eliminate.
Volcker, as you remember, was the Fed Chairman faced with the task of eliminating the inflation caused by the well-intentioned Fed officials of the 1970s - the Ben Bernankes and Charles Evans of their day. Thus, his opinion should carry some weight, though Paul Krugman of course does not think so.

This WSJ piece suggests that Charles Evans and Charles Plosser (Philadelphia Fed President) have been assigned the task of working out explicit dual mandate targets, as envisioned by Evans. Of course, this leans further in a bad direction. It seems particularly dangerous to be making explicit statements about targets for the unemployment rate, for example. The Fed certainly has no control over the unemployment rate in the long run, and how much influence it can have even over short periods at the best of times is debatable. Further, right now there is absolutely nothing further the Fed can do to move the unemployment rate down.

Essentially, the Fed is faced with a non-decision. Under the current circumstances, with a large positive stock of reserves, all that can matter is a change in the interest rate on reserves (IROR). The Fed will not likely move the IROR to zero, for technical reasons that have to do with money market mutual funds. It will not move the IROR up, as it is not ready to tighten yet. It has already committed to to keeping the IROR at 0.25% for close to two years in the future, and extending that period is not only unlikely, but foolish (as indeed was the commitment made at the last meeting).

What will the Fed do? I think it unlikely that they will actually buy more long-maturity Treasury bonds - i.e. embark on QE3. The most likely outcome will be to lengthen the average maturity of assets in the Fed's portfolio through swaps of short-maturity for long-maturity Treasuries. This of course will accomplish absolutely nothing. However, I think most of the FOMC is convinced that it will.

Wednesday, September 14, 2011

Barro: Investment and Taxation

On the weekend, in the New York Times, Barro proposed a program of fiscal reform to deal with our current ills. Paul Krugman, still struggling to understand how a dynamic economy behaves by using an obsolete static model from 1937, can't seem to figure out what Barro is trying to say, but Tyler Cowen does a pretty good job.

Krugman puzzles:
I would have expected Barro to offer some kind of argument based on real business cycle theory or whatever he believes about macro these days.
Here's what Barro says about the determinants of investment:
What drives investment? Stable expectations of a sound economic environment, including the long-run path of tax rates, regulations and so on.
Barro is of course dressing this up for lay people reading the NYT, but what he says seems consistent with the standard neoclassical growth model. You have to add some details, of course, to the basic model - distorting taxes and regulation. However, the basic idea is that investment decisions are made based on long-run factors. Given time-to-build for new capital, and the long life of the capital after it is put in place, any firm contemplating an investment decision will be looking far into the future. Even if one thinks that sticky prices and wages matter for some of a firm's decisions - employment and utilization - stickiness has to be irrelevant over the investment-decision horizon.

Old-fashioned accelerator theories, to the extent there is any serious theory backing them up, appear to rely on the idea that output is demand-determined. Then, since capital is required to produce output, and investment is the change in the capital stock, investment depends on the change in output, i.e. the change in "demand." But for this to work requires that wages and prices be stuck for very long periods of time, which is not consistent with empirical evidence. This seems to be why New Keynesians do not get into accelerator discussions (except for the financial accelerator, but that's entirely different).

Barro goes on with this:
And employment is akin to investment in that hiring decisions take into account the long-run economic climate.

The lesson is that effective incentives for investment and employment require permanence and transparency. Measures that are transient or uncertain will be ineffective.
The first point is a useful one, and I don't think anyone has been discussing this in the context of the current recession. Employment decisions by a firm are indeed investment decisions, though of course this varies across different types of jobs. In some cases, the firm makes a substantial investment in specific human capital when hiring a worker (shared with the worker in some fashion, as determined by the labor contract), and in other cases the primary human capital input in the job is general human capital that can be used at any firm. Thus, to some extent, employment decisions are governed by the same long-run factors that determine investment. Therefore, if we can understand what is holding investment down, we can understand part of what is holding back employment. Interesting idea.

Here are the components of Barro's tax reform proposal:

1. Bowles-Simpson proposals. Barro says:
reforming Social Security and Medicare by increasing ages of eligibility and shifting to an appropriate formula for indexing benefits to inflation; phasing out “tax expenditures” like the deductions for mortgage interest, state and local taxes and employer-provided health care; and lowering the marginal income-tax rates for individuals.
These all seem fine. Politically, changes in Social Security and Medicare seem difficult to obtain, and elimination of mortgage interest deductibility impossible, except perhaps as part of a larger package - i.e. we take this away from you but give you this in return.

2. A value-added tax. This is common in Western Europe, and Canada has a federal value-added tax. Taxation is not something I work on, so I'm not familiar with the economic arguments in favor of the value-added tax. In the long run, you get the same distortion on the consumption/leisure margin as with the income tax. Maybe the tax base is larger than for the income tax, so you can lower the tax rate and reduce the distortion, but you lose the progressivity you get from the income tax.

3. Eliminate corporate taxation. Optimal dynamic taxation tells us that taxing capital income is a bad idea, though I'm sure there are plenty of qualifications in the taxation literature. In any case, there are at least some sound economic arguments for this one.

4. Other stuff. Barro wants to (i) reverse spending increases that have occurred since 2000; (ii) eliminate estate taxes. For us to evaluate (i), Barro would have to be more specific (Bush's prescription drug plan?), and there seems no particular economic rationale for (ii).

So, Barro has given us a few things to think about. What he wrote is certainly much more useful than this, from Krugman:
So the best thing we could do to spur business investment would be to get a recovery going by whatever means necessary, including fiscal stimulus.
That conclusion is based on an accelerator idea - another obsolete piece of economics.

Friday, September 9, 2011

Evans Speaks

If you think the FOMC is confused, this speech by Charles Evans, Chicago Fed President, might tell you why.

First, Evans wants to take the Fed's dual mandate very seriously - never a good idea. The so-called Humphrey-Hawkins Act of 1978 mandates, in somewhat vague language, that the Fed foster price stability and also pursue policies that promote growth and employment. There is a problem, though. It is essentially universally-accepted among economists that a central bank can control the rate of inflation under most circumstances, though there may be particular circumstances, such as exist currently, under which that is not entirely true. It is also widely-accepted that money is neutral in the long run, and there is much disagreement about the nature and quantitative significance of short-run nonneutralities of money. Thus, any group of economists and non-economists finding themselves sitting in an FOMC meeting will have a hard time interpreting what the dual mandate dictates they should do, and they certainly will not agree on what the Humphrey-Hawkins prescription is.

The Fed has found creative ways of getting around this problem however. First, in speeches by Fed officials and in FOMC statements, lip service is paid to the dual mandate, but the Fed could actually be more-or-less ignoring the real side of the economy. Second, the Fed often uses Phillips curve language, in spite of the fact that the Phillips curve is a problematic object with a sordid history, and output gaps and unemployment rates are of demonstrably little use in forecasting inflation. Why does the Fed do this? Because this is a convenient way to get agreement among FOMC members - if real GDP growth is expected to be high (low) then the Phillips curve tells us that inflation will be high (low), and all the FOMC members vote to tighten (ease), whether they are Keynesians or not. Third, it can be convenient for Fed officials to speak in public about how a low and stable inflation rate actually fosters economic growth. By this logic, in fulfilling one part of the mandate, the Fed can fulfill both, and kill two birds with one stone. The logic is also correct, though we could argue about the quantitative effect of inflation on economic growth.

None of this namby-pamby vague central-bank-speak for Evans, though. He wants to interpret the dual mandate in terms of hard numbers. According to him, the "natural rate" of unemployment is 6%, and price stability means an inflation rate of 2%, so the bliss point for the US economy is a 6% rate of unemployment and a 2% rate of inflation, and the Fed's performance should be measured in terms of a quadratic loss function. Why? Mike Woodford told him it was OK.

What should the Fed do under the current circumstances? Evans anticipates that the inflation rate will fall below 2% and the unemployment rate is of course well above 6%, so the choice is clear for him: there should be more monetary accommodation. Implicit in this argument of course is the Phillips curve - more monetary accommodation implies more inflation and less unemployment. But how much accommodation? For Evans, this is just a matter of what coefficients go into the quadratic loss function. He clearly puts a low weight on the losses from high inflation and a high weight on the losses from high unemployment, so he is willing to bear a much higher inflation rate so as to bring unemployment down.

There are three problems here.

1. Evans is forgetting the lessons of the 1970s. What Evans is proposing is a change in the policy rule - a change in how the state of the economy maps into actions by the Fed. What economists understand today that they did not in 1975, is that commitment by the Fed to a policy rule is critical for its success in fulfilling its mandate. Once the public understands that the Fed intends to exploit a short-run Phillips curve relationship (and the problem is worse if the short-run inflation/unemployment tradeoff in fact does not exist), then all bets are off. High inflation can become well-entrenched and we have to go through an episode like the policy-induced "Volcker recession," followed by a long period where the Fed re-establishes its credibility. This is exactly the logic, I think, behind Kocherlakota's dissent at the last FOMC meeting. In the 1970s, the Fed was dominated by many well-intentioned people much like Charles Evans, and they got us into trouble.

2. What is the economic inefficiency that Evans thinks he is trying to correct? By efficient, I think we mean a state of affairs that is optimal from the point of view of a policymaker - there is nothing that a policymaker can do given that state of affairs to increase aggregate economic welfare. Evans seems convinced that the state we are in is not efficient. In this quote, he comments on "the story" that interprets our bad state of affairs as intractable, from a policymaker's point of view:
I suppose it is natural to believe that some elements of the story are true. But for me, the evidence for this is minimal, and the implications for productive capacity are exceedingly pessimistic. And even if it is true, the market mechanism should cause wages and prices to adjust in order to reemploy unused resources. For example, there should be some lower real wage that would make it profitable for firms to fund the necessary on-the-job training for workers who need some modest acquisition of skills. According to this pessimistic hypothesis, something is preventing the market’s pricing mechanism from achieving such results within a satisfactory time frame.
This seems confused. What he seems to be saying is that theories that attribute a rise in the unemployment rate to frictions associated with sectoral reallocation must rely on price or wage distortions. However, the sectoral reallocation frictions that typically come into play in these discussions involve the time and effort associated with acquiring sector-specific human capital, information frictions, and the costs of moving labor across geographical regions. One would think that wage and price distortions might be key to Evans's argument - he's clearly a hardcore Keynesian, and one would not think he would be appealing to wage and price flexibility to shoot down the alternative case.

So what is our key macroeconomic problem, from Evans's point of view?
...I think the evidence favors the belief that aggregate demand is simply much too low today.
Arrrgghhh. If all economists could take a pledge never to use the words "aggregate demand" again, the world would be a better place. What Evans is saying is that he does not know what is going on. Aggregate demand is Keynesian language. When the language is used, what it means is that there is an inefficiency that the monetary and/or fiscal authority might be able to correct. In Keynesian theory, the inefficiency can come from two sources: (i) sticky wages and prices or (ii) multiple equilibria. The specifics of the inefficiency actually matters for what the optimal policy response is. Which prices are sticky and which are not? Are the prices sticky, are the wages sticky, or both? If the problem is not sticky wages and prices but the fact that we are just in a bad equilibrium, the solution to getting to the good equilibrium might be quite different than solving the price/wage distortion problem.

Further, Evans tells us about Reinhart and Rogoff, the debt overhang, and how this prolongs our economic recovery. How does he know that the "unused resources" he is seeing are not unused because of the financial problems created by the recent crisis? Debt overhang in the economy may create conditions under which those resources will go unused, no matter what the Fed does. Did debt overhang actually go into Evans's 6% "natural rate of unemployment" calculation?

3. How can the Fed actually be more accommodative under current conditions? As I have discussed before, the Fed has only one policy instrument given the large quantity of excess reserves in the financial system: the interest rate on reserves (IROR). Quantitative easing, or changes in the maturity structure of the assets on the Fed's balance sheet will accomplish nothing. Thus, to be more accommodative through current actions is impossible, unless the IROR goes to 0%. Bernanke told us a year ago that this was not on the table, but maybe he has changed his mind. In any case, setting the IROR at 0% will not change anything much. However, the Fed can change its statements about the future path of the IROR, and that can matter.

Evans suggest three types of "forward guidance," that the Fed could contemplate. The first is a policy rule explicitly contingent on the unemployment rate. The second is contingent price-level targeting, and the third is nominal GDP targeting. The first policy is quite ill-advised, partly for reasons discussed above, but in particular because the "natural rate of unemployment," whatever it is (there are many definitions) is a moving object, and it moves in unpredictable ways. The other two proposals actually do not imply anything especially new about how we formulate policy, as you ultimately have to reformulate those things in terms of a rule for the policy interest rate.

Some of what Evans contemplates would open up the possibility of a future with high and sustained inflation. Evans should think carefully about which he prefers - some heat from Krugmaniacs and the unemployed about unused resources, or a lot of heat from everyone about the high rate of inflation.

Thursday, September 8, 2011

Zombie Economics, Redux

For all of you who are dying to know more about John Quiggin's Zombie Economics, here is a review essay I have written. This is somewhat formal and un-bloggy, complete with references, and is not the Journal of Economic Literature review on Quiggin's book that I wrote, which is quite short. I do more in this essay than just critique Zombie Economics. It is in part a defense of contemporary economics, in response to various rabble-rousing, including Paul Krugman's 2009 NYT piece, or this more recent critique. There are also some financial crisis ideas in there.

If you find errors, please let me know, and I'm interested in your comments.