The FOMC Meeting of September 16, 2008

Journalists are busy reading the 2008 FOMC transcripts looking for things to write about. Matt Yglesias is no exception, and he has written a piece arguing that Ben Bernanke and his FOMC made a critical blunder on September 16, 2008, which was not to lower the fed funds rate target.

New documents released last week by the Federal Reserve shed important new light on one of the most consequential and underdiscussed moments of recent American history: the decision to hold interest rates flat on Sept. 16, 2008. At the time, the meeting at which the decision was made was overshadowed by the ongoing presidential campaign and Lehman Brothers’ bankruptcy filing the previous day. Political reporters were focused on the campaign, economic reporters on Lehman, and since the news from the Fed was that nothing was changing, it didn’t make for much of a story. But in retrospect, it looks to have been a major policy blunder—one that was harmful on its own terms and that set a precedent for a series of later disasters.

So, it's like there was a fire at City Hall, and five years later a reporter for the local rag is complaining that the floor wasn't swept while the fire was in progress.

Lehman Brothers filed for bankruptcy on September 15, 2008, and an FOMC meeting took place on September 16. On April 30, the target rate for fed funds had been set at 2%. On September 16, the FOMC agreed to keep the fed funds rate target constant at 2%. Seems like this was pretty dim-witted of the committee, given what was going on in financial markets that very day, right? Wrong. At that point, the fed funds market target rate had become completely irrelevant.

First, here is the fed funds rate for the period 08/01/08 to 10/31/08.

You'll note that after about September 12, the Fed could not even hit its target. The fed funds market is an unsecured overnight market. Given the disruption in financial markets at the time, fed funds lending had become quite risky, with risk depending on the borrower. So, the effective fed funds rate reflected a substantial amount of risk at the time - we're not looking at some risk-free rate. Further the effective fed funds rate does not reflect all of fed funds market activity. In fact, a majority of fed funds trading is not even included in that measure. At the time, there would have been good reason to think that the actual average interest rate on fed funds trades was substantially different from the effective fed funds rate, as measured.

On top of that, an element of Fed activity at the time that was key to the response to the financial crisis was the quantity of loans the Fed was extending to financial institutions. Total borrowing from the Fed looks like this:

The Fed had already been lending in a big way, before the Lehman failure, in part through the Term Auction Facility that had been set up a year previously. Further, that lending increased from $169 billion on September 10, to $268 billion on September 17, and to $543 billion on October 1 (the quantity is measured weekly).

So, though the FOMC didn't change the fed funds rate target in mid-September, the regional Feds were extending credit massively to the financial system through the month of September.

The large quantity of Fed lending was reflected in the quantity of reserve balances outstanding:

In particular, reserve balances went from $9 billion on September 10 to $47 billion on September 17, to $104 billion on September 24, to $167 billion on October 1. To put this in perspective, daylight financial transactions through the Fed can be supported with a small quantity of reserves. That quantity was sometimes about $5 billion before the financial crisis. So, $47 billion in reserves is a big number. Indeed, it may be a large enough quantity to drive the risk-free overnight rate to its lower bound, which at the time was zero - the interest rate on reserves. On October 1, 2008, the Fed began paying interest on reserves at 0.25%, and that became the floor rate at that time (though for technical reasons the fed funds rate currently is below that rate).

Thus, by September 16, 2008, it seems the Fed was effectively already at the zero lower bound. At that time the fed funds target was irrelevant, as there were excess reserves in the system, and the effective fed funds rate was irrelevant, as it reflected risk. Note, for example, that by October 31, when the interest rate on reserves was 0.25% and the fed funds rate target was 1%, the effective fed funds rate was 0.22%.

As I discussed in this post, much of what we would like to know about the financial crisis and the policy response cannot be found in FOMC transcripts. Some of the key Fed interventions had to do with: (i) Who borrowed how much and at what rate from the Fed, and what were the related conversations that went on between Fed officials and the officials of the large financial institutions involved? (ii) What assets were purchased by the Fed from what financial institutions, and at what price, and, again, what were the related discussions that occurred involving the Fed and the officials of those financial institutions? Further, we know that the Treasury was involved, and we would like to know what was discussed vis-a-vis the Fed, the Treasury, and the financial community.

Matt Yglesias's piece is written like a blog, not like a well-researched piece of journalism. He cites the FOMC transcripts, and then provides his own interpretation of what is going on. Apparently, there was no attempt to check this with anyone who might have some expertise. Nevertheless, Yglesias is willing to level the charge that the guy who ran the Fed during the crisis made a "big mistake." Unfortunately, it's Yglesias that is making the big mistake.

The Financial Crisis in Retrospect

The release of FOMC transcripts from 2008 is an important event. These are key documents for anyone interested in understanding the role of policy in the financial crisis. Jim Bullard has written a short piece on the events in the latter half of 2008. Bullard's view seems to be that the Lehman failure was widely anticipated, and perhaps beyond policymakers' control, though of course the resulting systemic events appear to have come as a surprise.

Jeff Lacker gave what I think is an extremely important speech this past Friday on the crisis, the monetary policy response, and the role of economic theory during the crisis and in the aftermath. The speech is both enlightening and thought-provoking. Lacker has a unique perspective on the financial crisis. He has been President of the Richmond Fed for 10 years and, before assuming a management role at the Fed, worked on research problems in banking, financial contracts, and incentives. The Bank of America is in the Richmond Fed district, so Lacker would have had an inside track on what was going on in one of the largest financial institutions in the country, and thus in much of the rest of the financial system.

Some of the interesting points in Lacker's speech are the following:

1. Economists had plenty of tools and models available to apply to the problems of the financial crisis. But they may not have applied them very well. Lacker traces the roots of the crisis to August 2007, when interest rate spreads began to rise in the market for asset-backed commercial paper. This brought on a response from the Fed in the form of a change in discount window policy. Lacker questions whether that was the appropriate policy response, and uses this as an example of poor application of the available economic theory to the problem at hand. What Lacker mentions in his speech relates to a particular FOMC discussion, which can be found in the 2007 FOMC transcripts. In the transcripts, there is a very long discussion of the policy, and Bernanke defends it by citing chapter 6 in a book by Allen and Gale. My interpretation is that the policy decision had been made - the discount rate would be lowered - and Lacker was questioning the policy. Bernanke's response was to find a piece of academic work that supported the policy move, but that piece of work had questionable relevance to the problem at hand.

2. Too-big-to-fail is at the heart of the financial crisis. The U.S. financial system is fragile. Unless the features of financial disruption in 2008-09 were somehow only a symptom of some large underlying shock - a view which at this point seems a very long stretch - this seems clear. But where does that fragility come from? One view is that the fragility is inherent to financial systems. This view is framed in some versions of the Diamond-Dybvig model, in which the maturity mismatch and illiquidity inherent in banking imply that bank panics are possible. An alternative view is that the fragility is induced. It is well-known, for example, that deposit insurance induces risk-taking by banks that can be curbed through regulation - e.g. capital requirements. For small banks in the U.S., regulation is simple, because small banks are simple. Further, the failure of small bank is no big deal. In many cases, the FDIC can step in on a Friday, resolve the failed bank over the weekend, and have it open on Monday under new management.

Big banks and other financial institutions are another matter altogether. These large financial intermediaries are complicated and hard to regulate. Indeed, large financial institutions like Bear Stearns and Lehman Brothers could take on some of the characteristics of banks - e.g. maturity mismatch - while falling outside the regulatory umbrella that covers banks. As well, the failure and resolution of a large financial institution is a potential nightmare. The possibility of systemic disruption (which we saw in the financial crisis with the Lehman failure and the subsequent problems at AIG) from a large financial institution is what leads to the too-big-to-fail moral hazard problem. That is, a too-big-to-fail financial institution understands that it is too-big-to-fail, and therefore takes on too much risk, relative to what is socially optimal. This high level of risk could be reflected, for example, in a high-aggregate-risk asset portfolio, or in a maturity mismatch between assets an liabilities.

The too-big-to-fail problem is not only a long-run problem, but could manifest itself within a crisis period, as it may have in 2007-08. For example, it appears to have been well-known to regulators, and to Lehman Brothers itself, that Lehman was on shaky ground, perhaps a year or more before it failed. When Bear Stearns failed in March 2008, the Fed intervened in key ways, and helped engineer a sale to JP Morgan Chase. This could have created the expectation in other large financial institutions that their incipient failure would be met with the same type of intervention. Thus, it is possible that Lehman Brothers could have taken corrective action, including increasing capital and reducing dependence on short-term funding, to ward off failure, if it had correctly anticipated that a bailout would not occur.

Lacker states:

Lehman Brothers filed for bankruptcy on September 15, 2008. One day later, the insurance company American International Group (AIG) received a large credit extension from the New York Fed. At that point, regulators had resolved six large failing financial firms in five different ways. Some positions in the capital structure were rescued in one firm's resolution but not rescued in another's. Each had been handled on an ad hoc basis, without comment on how similar cases might be handled in the future. Market conditions following Lehman and AIG cried out for a general policy statement providing guidance on future interventions.

So this points to a policy failure. There was no explicit policy on how to deal with large financial insititutions, and those large institutions had to be confused about what would happen in the event of looming trouble. The most uncharitable view of Fed policy would be that, rather than saving the U.S. economy from the Great Depression, in the fall of 2008 Ben Bernanke was only cleaning up his own mess.

One might be tempted to think that too-big-to-fail is just an unsolvable commitment problem that we just have to live with. But, as Lacker points out

The thesis that financial market instability is inherent, rather than induced by poor policies, must also confront the fact that instances of instability are quite unevenly distributed across different countries and different regulatory regimes, as exemplified by the contrasting experiences of the United States and Canada. Over the past 180 years, the United States has experienced 14 major banking crises, compared with just two mild illiquidity episodes in Canada over the same period. If financial fragility were an inherent feature of financial markets, financial panics would be ubiquitous, but that's not what we see.

So, somehow the Canadians managed to solve the too-big-to-fail problem. While I'm quite willing to entertain the possibility that Canadians are superior human beings whose financial acumen is beyond the comprehension of Americans, I think we should entertain the possibility that there are things going on in the Great White North that we can easily replicate.

3. Economic researchers need to think more carefully about their policy advice. There is no hint in Lacker's speech that pre-financial-crisis economic theory was somehow lacking. Obviously we have learned a lot from the financial crisis, and that episode raised questions and moved some researchers in different directions. But the economics that Lacker brings to bear in understanding the events of the financial crisis was well in place long ago. That economic theory included information economics, the theory of incentives and insurance, the theory of financial contacts, and banking theory. While some people want to tell us that the financial crisis demonstrated that economics is a failure, I think we can safely argue that any failure was in the inability of regulators and policymakers to apply what was on the shelf.

But we can do better, of course. Lacker is critical of the tendency for economists to produce "possibility theorems," i.e. models which tell us that such-and-such can happen under such-and-such conditions, without worrying too much about how to apply such knowledge in practice. In my experience, contact between policymakers and researchers can cure that problem easily. And that was exactly what the conference at Arizona State University (organized by Ed Prescott), where Lacker gave his speech, was all about.

4. Central bank crisis intervention is not primarily about the overnight nominal interest rate and Taylor rules. This was not one of Lacker's bullet points, but this idea is implicit in his speech. Lacker talked for an hour on monetary policy in the financial crisis without mentioning the overnight interest rate. During a financial crisis, a decision about whether the fed funds rate target should be 2% or 1.5% is second order relative to who is borrowing at the discount window, how much, and at what rate; what Fed officials are saying to what CEO of which large financial institution; or what assets the Fed is buying and putting on its balance sheet.

RBC and NK in a Nutshell

Paul Krugman is a very bad student. He doesn't pay attention in class, he refuses to read, and he complains constantly that he's not learning anything.

Latest complaint:

Take real business cycle theory – I know it’s a horse I beat a lot, but it’s not dead, and it’s a prime example within economics of what I have in mind. I still want to spend at least some time explaining that theory to my undergrads, so I’ve been looking for a simple, intuitive explanation by an RBC theorist of what’s going on. And I haven’t been able to find one!

Krugman could of course look in any of the standard undergrad macro texts, including my favorite. But I'll boil it down and make it really easy for him, and put RBC and NK (New Keynesian economics) in one picture. Full blown RBC, and basic NK (which is just RBC with stickiness) includes intertemporal choice, but for the basic ideas, static analysis works OK.

The picture shows production possibilities frontiers (PPFs) and the indifference curves of the representative agent. I've taken out government spending, as it's not part of the basic story for either RBC or NK, so production possibilities represents simply a technological tradeoff between consumption and leisure. All output is consumed, so consumption equals output. Initially, this economy is in equilibrium at point A. That's also a Pareto optimum as this economy is frictionless, for now. A negative TFP shock shifts the PPF in, and the equilibrium is at point B. The way I've shown it, leisure rises, hours of work fall, and consumption (equal to outuput) also falls. So it looks like a recession as we know it. One can also show that, for the model to work, the elasticity of labor supply with respect to the wage (minus the slope of the PPF at the equilibrium point) has to be sufficiently large - just disentangle the income and substitution effects, and it's clear that leisure could fall when TFP falls.

So that's RBC. What about NK? This is a cashless economy - as in a Woodford world - but we can imagine that prices are quoted in "dollars." P is the dollar price of goods, W is the dollar price of labor, and W/P is the real wage. Suppose further - much in the spirit of Woodford - that the central bank sets P. So, if the nominal wage is flexible, then a negative TFP shock gives us the same thing - the competitive equilibrium goes from A to B. But suppose the central bank does nothing in response to the TFP shock, and W is fixed. Then, after the TFP shock the equilibrium is at D, not B. At D, the real wage is the same as at A, i.e. the slope of the PPF is the same at D as at A. So in the NK world there is an inefficiency when the economy is hit with a shock, and we can see the welfare loss in the picture - the representative agent is on a lower indifference curve at D than at B.

What to do about the efficiency loss? In the NK world, the central bank could increase P, or the fiscal authority could subsidize hiring and pay for that with a lump sum tax. In either case, the appropriate policy will take us to B. Done.

So, that is a simple apparatus, that an intermediate-level undergrad can handle easily, and principles students can do it too. This can be a launching pad for ideas about what TFP is, what a TFP shock is, and what these basic stories leave out. Is it really very useful to think about TFP shocks driving business cycles if we can't measure aggregate TFP well? That NK story about monetary policy seems pretty crude. Shouldn't we elaborate more on what central banks actually do? Shouldn't we include financial factors in both the RBC and NK stories?

And for the really sophisticated stuff, boiled down into words with no mathematics, read Kartik's book.

Email Conversation with Binyamin Appelbaum

In connection with this post, and this New York Times article by Binyamin Appelbaum, a question came up in the comments section from Noah Smith, as to how Prescott's comments may have been taken out of context. Prescott and I were both, I think, interviewed in the same way for Appelbaum's piece, i.e. by email. Here's how I was quoted in Appelbaum's article:

“Suffice to say that I am very surprised by his current policy views and how he articulates them,” Stephen Williamson, a professor of economics at Washington University in Saint Louis, said in an email. “I don’t think his views have changed. I think this is just a side of Narayana we didn’t know was there.”

It's useful to compare that to my email conversation with Appelbaum. I left out one question, which I thought was too personal, and I did not answer the question. Here's the rest of it:

BA: More than four years later, how would you assess his performance as president of the Minneapolis Fed?

SW: I'm guessing that if you asked the participants at FOMC meetings what they thought, they would be very enthusiastic.

BA: Narayana has argued that stronger forward guidance could help to increase employment, and that the Fed has room to try because inflation remains low. Why do you regard this view as mistaken?

SW: I think that the Fed's experiments with forward guidance have been unsuccessful. They have only succeeded in confusing people. A useful exercise is to count the number of words in the FOMC statement, and compare pre-financial crisis to post-financial crisis. I can parse that and understand what the FOMC is trying to say, but I think the average financial market participant has trouble with it, and the average person on the street would be completely lost. Further, the forward guidance has not been consistent over time. The FOMC first specified an "extended period" of low interest rates, then calendar dates, then a threshold specified in terms of the unemployment rate. Now they are back to extended period language - roughly - along with words about what happens if the inflation rate is low for a long period of time. It's hard to see why more language in there - for example about the unemployment rate threshold - could make any difference.

Further, I think that the reason inflation is low now is because short-term interest rates have been low for a long time. The longer they stay low, the longer inflation will remain low. That sounds counter-intuitive, but I think it's right. One of the most astute things that Kocherlakota said in public is in this speech:

http://www.minneapolisfed.org/news_events/pres/speech_display.cfm?id=4525

That essentially makes the same point. The idea is that, the way the Fed thinks about the problem they're facing traps them in a low-inflation environment.

BA: You wrote in September, "Fed officials like Kocherlakota seem to want to argue that the failure of policy to 'cure the problem' is just a license for doing more." Kocherlakota, I think, would say that the Fed has a legal obligation to keep trying so long as inflation remains low. What is the downside to trying?

SW: The "legal obligation" i.e. the "dual mandate" is quite vague. For example, I think if you look at the FOMC statements during the Greenspan era (though granted that was fairly tranquil) you'll find little or no mention of anything to do with the "real" economy - e.g. the unemployment rate - in the policy statement. Greenspan was deliberately vague, and Congress never gave him a hard time about it. The danger of speaking too much to the real part of the mandate (i.e. "maximum employment") is that the Fed's ability to influence real activity is subject to considerable uncertainty, and no one thinks they can have an effect on real activity for long. If Fed officials continually make statements to the effect that they can do things which they cannot do, that is a problem.

BA: You wrote in 2010, "The Narayana I knew would have thought the worldview represented in standard Keynesian economics was hopelessly naive." How would you describe Kocherlakota's views on monetary policy before he joined the Minneapolis Fed? Are those views apparent in his work as an academic?

SW: As an academic, Narayana was a very sharp researcher, interested in a wide array of issues, few of which actually touched on monetary policy. So maybe I was just making inferences about what his views on policy would be, and how he might go about applying his knowledge in a policy setting. Suffice to say that I am very surprised by his current policy views and how he articulates them.

BA: Do you think his views have changed at the Minneapolis Fed, or that they were previously misunderstood?

SW: Actually, I don't think his views have changed. I think this is just a side of Narayana we didn't know was there.

BA: How do you think the Minneapolis Fed has performed as a research institution under Kocherlakota? Do you see evidence of a shift in the subjects under study, or in its perspective on those subjects? What is your understanding of the reasons for the termination of Pat Kehoe and the separation with Ellen McGrattan?

SW: To date, I don't think that the way Kocherlakota thinks about policy has mattered for how research is done at the Minneapolis Fed. Whatever is going on internally actually has nothing to do with economic ideas, as far as I can tell.

Where has Tobin Gone?

In 1937, was born the spawn of Satan, and he was named Robert E. Lucas Jr. On his scalp was etched the dreaded "666." In the 1960s, Robert attended the Academy of the Satanists, known to the public as the University of Chicago, where he was schooled in the ways of Lucifer (Milton Friedman). In the 1970s, Robert, the antichrist, decreed that there should be no more worship in the Church of the Keynesian Cross. A secret society was formed, and in the 1990s they didst make a pact with Michael Woodford. In return for his life, Woodford was sworn to use the Tools of Satan - the functional equation, the contraction mapping theorem, the dreaded Euler equation. Further, Woodford, his henchmen and henchwomen, were to appoint Satan's ministers to the key positions of power in the economics profession - journal editorships - where they were to enforce the use of the Tools of Satan. Publication of even one paper making use of the tools of the Church of the Keynesian Cross would mean banishment to the underworld forever.

Which seems to capture how Paul Krugman thinks about the economics profession. Here's the part of Krugman's post I want to focus on:

Let me offer an example of how this ended up impoverishing macroeconomic analysis: the strange disappearance of James Tobin. In the 1960s Tobin developed and elaborated a sophisticated view (pdf) of financial markets that offered insights into things like the role of intermediaries, the effects of endogenous inside money, and more. I’ve found myself using Tobinesque analysis a lot since the financial crisis hit, because it offers a sophisticated way to think about the role of finance in economic fluctuations.

But Tobin, as far as I can tell, disappeared from graduate macro over the course of the 80s, because his models, while loosely grounded in some notion of rational behavior, weren’t explicitly and rigorously derived from microfoundations. And for good reason, by the way: it’s pretty hard to derive portfolio preferences rigorously in that sense. But even so, Tobin-type models conveyed important insights — which were effectively lost.

Then came the financial crisis, and many economists apologetically admitted that they had erred by not incorporating finance into their models, and announced plans to try to do that in the future.

Tobin has indeed disappeared from the curriculum in any PhD programs in economics that I know about. I work in the field of money and banking, go to conferences, publish papers, edit papers, referee papers, and I have never come across a paper in the mode of Tobin (1969) in my whole professional career - I got out of graduate school in 1984. I have certainly read Tobin's stuff. There was a set of papers that I read while in graduate school that I thought were interesting, including the 1969 paper that Krugman mentions.

To understand why Tobin's work has disappeared from modern discourse in macroeconomics, a good starting point is Sargent's 1982 paper on "Beyond Demand and Supply Curves in Macroeconomics." In 1982, there was a budding literature on the foundations of monetary exchange, and explicit models of financial intermediation. Sargent discusses Tobin's work directly, points out what the insights were from that work, and goes on to explain how the new literature deepened our understanding of Tobin's insights, and gave us new insights. In the 1980s, there was extensive work on financial intermediation models - Diamond and Dybvig's work (banking panics) and Diamond's delegated monitoring work. Yours truly, Bruce Smith, and Bernanke and Gertler, among others, thought about how to integrate some of those ideas into general equilibrium frameworks. There has been a wide-ranging program in monetary economics for the last 35 years or more, including work by Kiyotaki and Wright, Rocheteau, Lagos, yours truly (again), and many others. As one example of what you can do with those types of models, you can look at some of my papers (this one, or this one). As well you can look up some of the work of Randy Wright (Wisconsin), Ricardo Lagos (NYU), Guillaume Rocheteau (UC Irvine), Mark Gertler (NYU), Nobu Kiyotaki (Princeton), or Markus Brunnermeir (Princeton).

Why did Tobin's work disappear from discussion? It was superceded. We now have better models, that are much richer in their implications. Tobin was fine for his time, but why drive on the freeway in a golfcart, when you can drive a Ferrari (as one of my friends once said)? Krugman should read this stuff. I think he would like it. I, my colleagues, coauthors, and students, have not been "apologetically admitting that we erred by not incorporating finance into our models." That's what we do, and some of us have been doing it for a long time. As Krugman says, "it’s pretty hard to derive portfolio preferences rigorously..." So, I guess we must be pretty smart, as we can do some of that.

Idiots?

I have the distinction of having made Brad DeLong's Thursday idiot rollcall. For the uninitiated, here's what being labeled an idiot by Brad DeLong means. From DeLong's vantage point, the world looks like this:

In DeLong world, there are in fact genuine crackpots in that large idiot set. There are also genuine crackpots in the small "friends of Brad" set. Having Brad put you in the large idiot set is really not informative.

But we should see what Brad has on his mind. Maybe he has a point? Brad's complaint regards this post of mine, where I discuss a New York Times article on Narayana Kocherlakota. The latter part of the post used this quote from Ed Prescott as a launching point:

It is an established scientific fact that monetary policy has had virtually no effect on output and employment in the U.S. since the formation of the Fed.

It was obvious to me that this would set some people off. Indeed, Prescott likes to say things like this for that purpose (though not for that purpose only). And, indeed, it set people off.

But, the point I wanted to make is that what Prescott said is not obviously kooky. For example, if we take the statement apart and ask what it means, we have to ask what exactly "monetary policy" connotes. Does this mean the systematic element of policy, or are these the "surprises" in monetary policy? Prescott's statement says that, since 1913, monetary policy was unimportant for the time series of employment and output. Does that mean that monetary policy could not have an effect on real variables? Prescott's statement certainly does not say that the Fed cannot control inflation, or that inflation does not matter. So, there are a lot of things to consider. I thought this could be thought-provoking, and commenters had some interesting things to say. I certainly learned something.

So, this is what DeLong says about Prescott's statement:

Everyone else simply says: "Prescott is wrong: that's not an established scientific fact at all."

I guess the problem DeLong is having here is with the words "established," and "fact." Those words make the statement seem grandiose. But if we were to be charitable to Ed, we might say that by "established" he means "the best evidence we have tells us," and by "scientific fact" he means "the fact is that the science tells us the following." But this is semantics, and is not very illuminating. Here's what one of my commenters said:

There is a very clear and uncontrovesial interpretation of what Prescott was saying: Milton Friedman was wrong in that, if you do an analysis of variance of which shocks explain most of U.S. GDP and inflation fluctuations, monetary shocks will explain a tiny fraction of either. This is not a radical, out of mainstream view, it is in fact what comes out of SVAR studies and of DSGE estimation. If you want to see for yourself, open Smets and Wouter's AER and look for the table with the analysis of variance.

What this doesn't mean (and this is where Prescott was too vague and open to attack), is that monetary policy is impotent if a Central Banker decides to use it in an unexpected way, or that monetary policy rules don't matter, since they may affect how macroeconomic aggregates react to real shocks. But if you want to know the source of fluctuations, you are better off looking elsewhere.

I thought that was pretty good.

So, here's a blog post of Brad's from 2010 in which he approvingly quotes Narayana Kocherlakota, as follows:

Why do we have business cycles? Why do asset prices move around so much? At this stage, macroeconomics has little to offer by way of answer to these questions. The difficulty in macroeconomics is that virtually every variable is endogenous – but the macro-economy has to be hit by some kind of exogenously specified shocks if the endogenous variables are to move. The sources of disturbances in macroeconomic models are (to my taste) patently unrealistic. Perhaps most famously, most models in macroeconomics rely on some form of large quarterly movements in the technological frontier. Some have collective shocks to the marginal utility of leisure. Other models have large quarterly shocks to the depreciation rate in the capital stock (in order to generate high asset price volatilities). None of these disturbances seem compelling, to put it mildly. Macroeconomists use them only as convenient short-cuts to generate the requisite levels of volatility in endogenous variables...

In my opinion, that's being too negative about what we actually know, but the point is that Brad seemed to agree with that. And what Kocherlakota was commenting on was the best available science, and he says the best available science doesn't tell us a lot about what is going on. My commenter above says that the best available science - the same science Kocherlakota is discussing - tells us monetary policy is not so important. So, we're at least talking about the same science here, which seems to conclude something that is not so far off what Prescott is claiming.

So, it seems Brad is not being entirely consistent. Asking questions is important. Good scientists should not cut off discussion by calling people idiots when what they're saying appears not to be entirely orthodox.

Allan Meltzer on QE

Allan Meltzer has a post on the effects of QE. Quantitative easing (QE) has its problems, but I don't agree with much of what Meltzer is saying. See for example my post on Ben Bernanke's legacy.

Here's something I disagree with, which is Meltzer's last paragraph:

The Fed should rethink its strategy. It should ask what is the best, conditional, multi-year strategy to eliminate the massive overhang of idle reserves. I am sure the answer will not be to watch the noisy, frequently-revised labor market data on unemployment. It is long past time to announce a strategy that puts the Fed on a path that reduces the idle reserves at lowest social cost and gradually restores a pre-announced rule based monetary policy. The way to start that journey is to end QE.

It gives entirely the wrong message to call the existing stock of reserves a "massive overhang," or "idle." In the same sense, there is a massive overhang of Treasury bills in the economy. That wouldn't be correct either.

Macroeconomics in the Blogosphere

A couple of months ago, I wrote a critical post about how the economics blogosphere dealt with a murky event - the recent turmoil at the Minneapolis Fed. Basically, bloggers got some basic facts wrong, made things up, and were willing to make strong inferences based on little evidence. In terms of basic reporting standards, it was a pretty poor performance.

Here's another example of poor blogging performance. In this case, the underlying facts are not murky. Kartik Athreya has published a book, Big Ideas in Macroeconomics, and the facts are plain. All you have to do is read the book to know what they are. Basically, Kartik has written a 400+ page book with the intention of explaining modern macroeconomics to the layperson - with no symbols or mathematics and only the occasional diagram.

The first mention of Kartik's book (other than my plug on January 10) seems to have been David Glasner's post on February 3. Though he gives Kartik some compliments, Glasner doesn't like the book. Kartik is in good company here, because apparently Glasner isn't too fond of modern macro in general. Though Glasner is confused, we can give him credit for politeness in this instance and, above all, he appears to have actually read the book.

After that, it gets more interesting. On February 10, a week after the Glasner post, there was a quick succession of blog posts, beginning with John Quiggin's. If you're familiar with Quiggin's book, Zombie Economics, you'll know that he hates modern macro with a passion. But, suffice to say, as I argued here, that Quiggin is poorly informed. We might say that Quiggin has high TFP - plenty of intellectual horsepower - but he's applied little labor input to understanding what modern macroeconomists do. Nevertheless he doesn't like us. Whatever.

In this instance, Quiggin's post appears to have more to do with reprising Zombie Economics than discussing Kartik's book. In his post, Quiggin claims to have the book in his hands, but I'm suspicious that he hasn't read it or, at best, he's spent little time delving into it. Why do I think that? Here's a quote from Quiggin's post:

The easiest way to see why the book is so striking is to list some topics that do not appear in the index (and are not discussed, or only mentioned in passing, in the text). These include: unemployment, inflation, recession, depression, business cycle, Phillips curve, NAIRU, Taylor Rule, money, monetary policy and fiscal policy.

By contrast, the book includes a lengthy treatment of such topics as Bayes-Nash equilibrium in game theory, intertemporal optimization of consumption and the theory of mechanism design.

Now compare that to what Glasner wrote:

The index contains not a single entry on the price level, inflation, deflation, money, interest, total output, employment or unemployment. Which is not to say that none of those concepts are ever mentioned or discussed, just that they are not treated, as they are in traditional macroeconomics books, as the principal objects of macroeconomic inquiry. The conduct of monetary or fiscal policy to achieve some explicit macroeconomic objective is never discussed. In contrast, there are repeated references to Walrasian equilibrium, the Arrow-Debreu-McKenzie model, the Radner model, Nash-equilibria, Pareto optimality, the first and second Welfare theorems. It’s a new world.

That's too similar to be a coincidence, so my best guess is that Quiggin got a bit of information (or none) from the book itself, and learned most of what he needed from Glasner's post. But note the difference between Glasner and Quiggin. Glasner says there are some things not in the index that he thought should have been there, and he says those things are actually discussed in the book. Quiggin claims those things are not discussed in the book. What's the truth? Well, there are extensive discussions about business cycles, unemployment, policy rules, monetary and fiscal policy, etc., in Kartik's book. There's certainly an extensive discussion of the theory, but of course that's necessary to get where the author wants to go, which is explaining how the theory is used as an input to policy, and to understand what we observe.

So apparently, Quiggin hasn't done his homework, but he's willing to make some bold conclusions:

The result is that there is almost zero intersection between Big Ideas in Macroeconomics and what I would think of as macroeconomics. It’s not so much that I think Athreya is wrong is that we are talking past each other. As Charles Goodhart said of DSGE, Athreya’s version of macro excludes everything in which I am interested.

So is this just "talking past each other." I don't think so. In my experience, Quiggin is not willing to engage. I took some trouble to write a defense of modern macro/critique of Zombie Economics, and Quiggin took note of that in some comments on a blog post of mine. Then he made excuses about being busy, and disappeared.

A typical criticism of modern macro is that it is too technical for a layperson to understand, and that macroeconomists make no effort at accessibility. Well, in this case, Kartik's goal is to be accessible. Certainly Glasner is not accusing him of being difficult to understand. Talking past each other? Baloney.

Shortly after Quiggin wrote his post, Noah Smith added his two cents' worth. He's certainly up front about how he researched his post:

I myself have not yet read the book, but David Glasner and John Quiggin have, so I'll be lazy and free-ride off of their effort.

So, Noah is freeriding on Quiggin and Glasner, but it seems likely that Quiggin knows no more about Kartik's book than what he read in Glasner's post. Further, though Glasner (to his credit) seems to have read the book, he's got some hostility toward modern macro - claims we're "methodologically arrogant," whatever that means - and his post glosses over some of the more important contributions to be found in Kartik's book.

So, having not read the book, but rather the Cliff's Notes version filtered through Glasner and Quiggin, Noah is ready to state the following:

Possibility 1: Athreya is trying to balance out the public discussion of macro. He knows that a lot of lay people and bloggers already talk about Keynes and Friedman, monetary policy and fiscal policy. His intent was to write a book about all the other macro stuff that the public doesn't know about - general equilibrium and game theory, incomplete markets and search frictions, and so on.

Possibility 2: Athreya just doesn't care that much about the stuff he leaves out. He's not interested in the history of economic hypotheses, only in the history of economic methodology. He cares vaguely about policy and about the economy itself, but only insofar as it's an interesting application of his beloved methodology. The ideas he thinks are "big" are ideas about how to make macro models, not about what assumptions go in the models or what conclusions come out of the models.

I don't know Athreya, but my intuition is that whether Possibility 1 is true or not, Possibility 2 is true - Athreya seems to be in love with modern macro methodology. If he were just trying to balance out the public discussion, he would probably have been more explicit about that goal. Also, the fact that he doesn't seem to talk much about evidence is telling. "Big ideas" apparently doesn't mean ideas that are successful in explaining the data, it means ideas that are neato and cool.

So, Noah's first big mistake is taking Quiggin at his word. Quiggin's claim that Kartik left out discussion of unemployment, policy, etc. is false. But of course Noah goes further. He doesn't know Kartik, as he points out, and he hasn't read his book, but he's going to use his intuition to look inside Kartik's head and tell us how he thinks. Basically, Noah is going to make up some stuff. Very un-neato and un-cool, Noah. On the disgusting side, actually.

So, we know that when this crew gets together, Paul Krugman can't be far behind. It's clear that Krugman didn't read the book either. He only read what Quiggin wrote. Further, we know Quiggin's post is more about Zombie Economics than about Kartik's book, and to the extent it deals with the book, falsely represents what is in it. So this has become a game of telephone, where whatever was stated in Kartik's book comes out in Krugman's blog as

John Quiggin looks at a recent book that purports to explain the big ideas in macroeconomics, but doesn’t contain any, well, macroeconomics.

And, well, that is one big falsehood.

It's now been more than four years since Krugman wrote How Did Economists Get It So Wrong? If you remember, these were the instructions Krugman gave us in 2009, in that piece:

So here’s what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit — and this will be very hard for the people who giggled and whispered over Keynes — that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they’ll have to do their best to incorporate the realities of finance into macroeconomics.

So, let's go through the checklist.

1. Sure, financial markets are imperfect. This was something that we knew in 2009. By then, macroeconomics was replete with work on incomplete markets, financial contracts, banking, credit market frictions, etc. Krugman didn't have to tell us to think about those things. As to "delusion and madness of crowds," we have Shiller to tell us about delusion, and the "madness of crowds" is Roger Farmer's territory.

2. Is Keynesian economics the "best framework for making sense of recessions and depressions?" If by "Keynesian economics" we mean the version of Keynesianism that is practiced by current researchers, i.e. New Keynesian economics, and if making sense means that a baseline NK model with sticky prices and wages can explain all the macroeconomic phenomena we might be interested in, then the answer the profession has delivered is a resounding no. The interests of macroeconomists have shifted, naturally of course, to work on financial frictions of various kinds. In the work of freshly-minted PhDs in economics, there is distinctly less work on sticky prices than was the case before the financial crisis. I think a typical modern macroeconomist understands that there is a wide array of frictions that we want to think about when explaining what is going on in the world and understanding the role for economic policy. For some problems (perhaps all - we're really not sure) sticky prices and wages may be peripheral or totally unimportant. I don't get the same feeling of Keynesian religious fervor that used to exist among some people.

3. The realities of finance? I think we've made a lot of progress but, again, it wasn't like we were finance dummies before the financial crisis.

So, what effect has Paul Krugman had? Has Krugman changed how macroeconomics is done? Have we taken his messages to heart? Hardly. For your average working economist, what Paul Krugman thinks is irrelevant. But John Quiggin claims that Krugman and Brad DeLong are "setting the terms" of at least some elements of the debate on public policy. Here's my conjecture. I think it's likely that Kartik Athreya has had a larger effect on macroeconomic policy in the United States of America than Paul Krugman and Brad DeLong put together. Kartik is a Vice President at a Federal Reserve Bank, and his views affect those of the President of the Richmond Fed with regard to both monetary policy and banking regulation. Krugman and DeLong are journalists. Have their views helped to persuade anyone about anything that had any tangible effect on a policy decision? I'm not sure.

Kartik is a serious macroeconomist. As is typical in regional Federal Reserve Banks now, and at the Board of Governors, Kartik is expected to be engaged in research at the level of academic economists. Here's his CV, which includes work on credit, bankruptcy, default, public insurance - a lot of things that critics of modern macro seem to think we don't do. Part of Kartik's job is also to do policy, and at the Richmond Fed there is a lot to think about. In addition to monetary policy issues, the Richmond Fed district includes Charlotte, NC, where Bank of America is headquartered. So bank regulation is a big deal for the Richmond Fed economists. Kartik thus has a wealth of experience, which he has used to write a book which explains modern macro and how we do it. Pay special attention to Chapter 6, where he discusses how the available tools can and were used to make sense of the financial crisis. Big Ideas in Macroeconomics, is an excellent book, and I think John Quiggin, Noah Smith, and Paul Krugman should read it. You should too.

Financial Times Post

Gavyn Davies, who writes for the Financial Times, has a blog post related to what I was discussing in my last post.

The Low-Inflation Policy Trap

Some central bankers in the world seem surprised that they are seeing low rates of inflation.

The chart shows headline CPI inflation for Canada, Germany, Italy, Japan, the UK, and the US. Except for Japan, all of these countries experienced the most recent peak in the inflation rate about mid-2011, and their inflation rates today are lower than they were then. All of the central banks responsible for monetary policy in these countries have an inflation target of 2%. But, except for the UK, which is now hitting the 2% target, all have fallen short, and two (Canada and Italy) have inflation below 1%.

As I have stated before, (here and here), for the U.S., the current policy stance is a trap. The Fed clearly intends to maintain its policy interest rate target at essentially zero, possibly well into 2016. But, particularly as the economy continues to strengthen, most forces are pushing short-term real rates of return up. With short-term nominal rates of return pegged at zero by the central bank, the inflation rate has nowhere to go but down. But central bankers appear only to understand the short-term liquidity effects of central bank actions. They seem to think that a low short-term nominal interest rate must mean high inflation, even if the nominal interest rate is persistently low. Though real rates of interest are certainly not constant, and there can be persistence in deviations of real rates of interest from long-run averages, if the short term nominal interest rate is low for a long period of time, then the inflation rate is guaranteed to be low.

The most recent FOMC statement contains exactly that confusion between the short-run and long-run effects of monetary policy:

The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal.

So, if inflation continues to be low, the policy interest rate will continue to be low, which implies a low inflation rate...

The ECB President seems to suffer from the same confusion. See this story on how he has pledged to keep nominal interest rates low in the face of low inflation:

Draghi reiterated his commitment to keeping borrowing costs low “for an extended period of time” as policy makers continue their deliberations over whether they have done enough to prevent deflation...

This is not exactly a quote from Mark Carney, the Governor of the Bank of England, but he seems to think the same thing:

Low inflation also meant that raising interest rates became less urgent even though the economy is growing.

With Carney, we'll have to see what he says if the inflation rate falls below his 2% target. My guess is that he'll fall into line with Yellen and Draghi.

Finally, this comes from a speech by Steve Poloz, the Governor of the Bank of Canada, who discussed current risks in Canadian central banking, including the possibility of deflation:

Let’s switch gears and look at the risk of outright deflation. Like out-of-control inflation, deflation can become a spiral, but a downward one. Expectations become unanchored on the downside, and people put off their purchases because they expect things to be less expensive later. Demand declines with prices, while the weight of debt on the economy grows.

In the Great Depression, consumer prices in Canada fell 25 per cent, and national output dropped by almost a third. The human cost was staggering, with unemployment reaching 20 per cent. A milder form of deflationary trap has nagged Japan for the past 20 years.

What I am describing is an economy-wide process of deflation, which is quite different from individual prices falling because of improved competitiveness in an economy that is still growing strongly.

Today, the concern is that even though policy-makers were successful in avoiding global deflation in the wake of the 2008 crisis, there is still a risk that inflation could creep down into deflationary territory as the aftershocks of this crisis persist. It is, at least in part, to counter that risk that central banks in a number of countries have kept interest rates very low and used unconventional monetary policies, such as quantitative easing, to provide additional stimulus to their economies.

History has taught us that deflation usually comes in the wake of a financial crisis. This was true of the Great Depression, and of the Japanese deflation of the 1990s. Perhaps the most important lesson of the crisis, then, is that a stable financial system is necessary to keep inflation low, stable and predictable - and limit the risk of falling into a deflationary trap.

The first part is a standard story one hears about deflation. As the story goes, the economy can enter a "deflationary trap" in which expenditure is indefinitely postponed, and things get generally awful. As far as I know, there is no sound theory that actually delivers such a phenomenon. We certainly have multiple equilibrium models in which the economy can be stuck forever in a Pareto-dominated equlibrium, but I don't know of a model like that in which a bad equilibrium is associated with deflation (maybe you do?). Indeed, in a wide class of models, deflation can be associated with Pareto optima - that's the logic of the Friedman rule (not that I'm endorsing that).

Poloz goes on to discuss the empirical relationship between deflation and poor performance on the real side of the economy. But it's quite possible that we associate low inflation, or deflation, with bad outcomes on the real side because those outcomes make the central bank respond with zero short-term nominal interest rates at zero for long periods of time, which in turn produces low inflation. But that wouldn't entirely explain the behavior of a Poloz central bank, as he also thinks good insurance against low inflation is a low policy interest rate for the central bank - sustained, apparently.

We can find a related type of argument in the minutes of the December FOMC meeting:

A few participants raised the possibility that recent declines in inflation might suggest that the economic recovery was not as strong as some thought.

We could call this the "hidden output gap argument." These FOMC participants are hardcore Phillips curve adherents. In the face of what appears to be a declining output gap, by any measure, they insist that the output gap must be rising, because inflation is falling.

One feature that sticks out in the chart at the top of the page is the behavior of inflation in Japan - obviously it's very different from the inflation behavior in the other countries. Part of what's interesting about this is that the increase in the inflation rate in Japan, by about two percentage points, coincides with the Bank of Japan's "Qualitative and Quantitative Monetary Easing" policy, which commenced in April 2013. Details of this program are in the April 2013 policy statement of the Bank of Japan. Basically, the B of J intends to double the size of its balance sheet over a period of about two years, by purchasing longer-maturity Japanese government bonds and private assets (exchange-traded funds). A curious part of the policy is the following:

With a view to pursuing quantitative monetary easing, the main operating target for money market operations is changed from the uncollateralized overnight call rate to the monetary base.

The B of J pays interest on excess reserves and, under this policy, the interest rate on reserves (IROR), is a key part of its policy. It's not clear whether the officials at the B of J understand this or not. Though rules for how the IROR should be set are not addressed in any policy statements of the B of J post-April 2013, as far as I can tell, arbitrage tells us that the overnight call rate is equal to the IROR. Here's the overnight rate:

Since April 2013, this overnight rate has been exactly .07%. So, the IROR is .07%. The key question is: How is the B of J going to set the IROR going forward?

My advice to the B of J would be the following. The QE policy is just foreplay. Get to the main event. The B of J cannot sustain 2% inflation if it keeps the IROR at .07% for the next two years. That policy will make it likely that the B of J will fall short of its 2% inflation target, just as is happening in the Euro zone, the U.S., Canada, and - shortly - the U.K.

Here's the same scatter plot I constructed in this post for the U.S., but in this case for Japan, using data from 1985-2013, plotting the overnight call rate vs. the CPI inflation rate.

That's roughly the same thing as what you see for the U.S. There's a clear Fisher relation in the data, with some tendency for the real rate to be low at low inflation rates.

If inflation in Europe, North America, Japan, and elsewhere stays low - or falls into negative territory, that's not a disaster, I think. I don't think there is any serious economics that supports the conventional deflationary-trap-as-black-hole idea. But the policy trap that exists at the zero lower bound is a genuine trap, and it even has some genuine theory behind it, as Jim Bullard pointed out. I'm interested in watching how central bankers dig themselves out.