I talked with Kathleen Hays and Michael McKee on Bloomberg Radio last week, and they asked (twice!) a question that comes up often in thinking about Fed policy: shouldn't the Fed raise rates now, so it has some "headroom" to lower them again if another recession should strike?
I could only answer with my standard joke: That's like the theory that you should wear shoes two sizes too small because it feels so good to take them off at the end of the day.
But the question comes up so often, it's worth thinking about a little more seriously. Under what views about the economy does this common idea make any sense?
One way to think about the question: is the effect of interest rates on the economy path-dependent, so that a given level of short-term interest rates has more "stimulative" effect if it comes from a previously high value than if short-term interest rates were zero all along?
The usual answer is no. The model is usually a linear system, in which lowering the rate from a high value has the same effect as raising to the same rate coming from a low value. In fact, the usual model goes the other way: If, say, a new recession hits in June 2017 and you want more stimulus then, having had rates at zero all along is more "stimulative" than having raised them to 3% between now and then, and lowering rates all of a sudden. In equations, if \(y_t = \sum \theta_j i_{t-j} + \varepsilon_{t} \) with \(\theta_j \ge0 \) then the partial derivative of any \(y_t\) with respect to any \(i_{t-j}\) is the same no matter what the path of interest rates before time \( t-j\), and raising \( i_t \) today lowers future \( y_{t+j} \) given any set of shocks \(\{\varepsilon_t\}\) You need some sort of nonlinear system where a higher interest rate today \(i_t\) makes \( y_{t+j}\) more sensitive to some future rate \(i_{t+k} \).
Another way to think about this question is to think about what sort of state variables the interest rate affects. If the Fed raises rates now, the economy will be in a different state in June 2017. So in what view of things does raising rates now put the economy in state such that the economy can better weather a shock, or, more to the point, a state in which lowering rates back to zero will be more "stimulative" than if rates were zero all along? People usually think that raising rates between now and May 2017 would lower inflation, output and employment over what they would have been otherwise. Then, once rates go to zero again in June 2017, inflation, output, and employment will be lower than if interest rates had been zero all along.
If the economy were to boom on its own, with inflation, output and employment rising, and the Fed were to follow that good news by raising rates, then yes the Fed would have more "headroom." But that's not an argument that the Fed can get the "headroom" by acting now.
In fact, the opposite story has been told by those who advocate forward guidance and raising the inflation target. They argue that the Fed should keep rates lower and for longer, in order to raise inflation (the "state variable"). Higher inflation then indeed gives the Fed "headroom" to lower real rates by lowering nominal rates in the next recession.
What does it take to turn this around, and to justify the idea that raising rates gives "headroom" to lower them in the future? The main answer I can think of is to turn the conventional stories around. Suppose that raising interest rates raises inflation, as I have speculated before (here). The desired "headroom" is the desire to raise inflation, so that when June 2017 comes around the same nominal rate (0) corresponds to a lower real rate. I doubt many people articulating the policy view want to travel to Fisher-land and reverse the effect of interest rates on inflation.
You still need a second belief: that despite the wrong sign on inflation the conventional theory has the right sign on output: That lowering rates in June 2017 will fight that recession, even as it will lower inflation again. My little model didn't deliver that. Maybe other models do.
Loud disclaimer: I'm not advocating any position here. I'm just thinking out loud about what kind of views, if any, lie behind this common idea that raising rates now gives the Fed some sort of "headroom" to stimulate the economy in the event of a future recession.
This is a good case for real economic models. There is a lot of cause and effect chat surrounding monetary policy and financial policy that is way ahead of (if you're being polite) or outside of (if you're being accurate) any well-understood or even well-articulated economic model. By tying ideas together, perhaps a policy belief ("headroom") can open one's mind to an interesting causal channel (Fisher equation), or perhaps seeing that channel needed can reverse a policy belief.
Showing posts with label Stimulus. Show all posts
Showing posts with label Stimulus. Show all posts
28 May 2015
15 April 2015
Blanchard on Countours of Policy
Olivier Blanchard, (IMF research director) has a thoughtful blog post, Contours of Macroeconomic Policy in the Future. In part it's background for the IMF's upcoming conference with the charming title Rethinking Macro Policy III: Progress or Confusion?” (You can guess my choice.)
Olivier cleanly poses some questions which in his view are likely to be the focus of policy-world debate for the next few years. Looking for policy-oriented thesis topics? It's a one-stop shop.
Whether these should be the questions is another matter. (Mostly no, in my view.)
As a blogger, I can't resist a few pithy answers. But please note, I'm mostly having fun, and the questions and essay are much more serious.
Olivier cleanly poses some questions which in his view are likely to be the focus of policy-world debate for the next few years. Looking for policy-oriented thesis topics? It's a one-stop shop.
Whether these should be the questions is another matter. (Mostly no, in my view.)
As a blogger, I can't resist a few pithy answers. But please note, I'm mostly having fun, and the questions and essay are much more serious.
Financial regulation
... Where do we stand? Are some dimensions of systemic risk easier to measure (e.g., leverage in the banking sector vs. interconnectedness of banks and non-banks or risks outside the banking sector)? How should we assess the experience with stress-tests? And have we made enough progress in reducing systemic risk since the crisis, e.g., with Dodd-Frank, the Vickers commission, the Financial Stability Board, etc?
Answer: "Systemic risk" is barely defined. The idea that regulators will, this time, really really, understand risks taken by the big banks, see trouble ahead, and stop the banks from failing, is a triumph of hope over repeated experience.
The only progress -- and it's big -- is the slow realization that banks can and should issue lots more equity.
Answer: "Systemic risk" is barely defined. The idea that regulators will, this time, really really, understand risks taken by the big banks, see trouble ahead, and stop the banks from failing, is a triumph of hope over repeated experience.
The only progress -- and it's big -- is the slow realization that banks can and should issue lots more equity.
Macro Prudential Policies
... Do we have or can we develop tools to deal with the different types of risk, from high housing prices, to insufficient capital in some financial institutions, to sudden drops in liquidity in some financial markets?
Using these tools ...raises political economy issues. In a housing boom, increasing the loan to value ratio may be politically difficult. Questions: Given these issues, when should we use macro prudential tools, or should we use tougher, non contingent financial regulation? To be concrete, should we aim for variable capital ratios and decide when to adjust them, or just give up on the variable part, and aim for high but constant capital ratios?
Answer: The hubris that the Davos set will be able to figure out just the right amount of capital, and then fine-tune that month-to-month and bank-to-bank is astounding. "Political economy concerns" is putting it mildly. The IMF's "bubble" or "imbalance" is the local Congressman's boom, and he or she will be hopping mad if the Fed restricts credit to his district or pet industry in favor of another.
The fact that our regulators are still talking about liquidity betrays a fundamental confusion of individual vs. systemic risks. Liquidity is the plan, "if we lose money we'll sell assets." To who? Regulators demanding liquidity to plan for a financial crisis is like the FAA making sure everyone on the plane has enough money to buy a parachute in case of engine failure.
Answer: The hubris that the Davos set will be able to figure out just the right amount of capital, and then fine-tune that month-to-month and bank-to-bank is astounding. "Political economy concerns" is putting it mildly. The IMF's "bubble" or "imbalance" is the local Congressman's boom, and he or she will be hopping mad if the Fed restricts credit to his district or pet industry in favor of another.
The fact that our regulators are still talking about liquidity betrays a fundamental confusion of individual vs. systemic risks. Liquidity is the plan, "if we lose money we'll sell assets." To who? Regulators demanding liquidity to plan for a financial crisis is like the FAA making sure everyone on the plane has enough money to buy a parachute in case of engine failure.
Finally, it is clear that both financial regulation and macro prudential tools are likely to lead financial actors to adjust and explore ways of getting around them. Questions: In this game of cat and mouse, can the macro prudential regulators hope to win? Or will regulation and tools become increasingly complex and possibly counterproductive?
That's easy. No and Yes. Actually I'm being too pessimistic. Regulatory capture works both ways. An easy forecast: Stress-testers at the Fed will be getting lucrative salary offers to move to the private sector and help pass stress tests. Which they will increasingly do.
That's easy. No and Yes. Actually I'm being too pessimistic. Regulatory capture works both ways. An easy forecast: Stress-testers at the Fed will be getting lucrative salary offers to move to the private sector and help pass stress tests. Which they will increasingly do.
Monetary Policy
... Questions: Under the highly realistic assumption that financial regulation and macroprudential tools do not fully take care of financial stability, [Highly realistic indeed! You just answered the first set of questions as I did!] should monetary policy take financial stability into account? And if so, how? Can the interest rate or other monetary policy tools reduce financial risk? How should macro prudential tools and monetary policy be coordinated? Should they both be under the responsibility of the central bank?
Let's remember that the crash of 1929 was, at least in the standard history, sparked by the Fed trying to restrain what they saw as the bubble in the stock market.
If this is the case, and central banks have tools which can have effects on very specific sectors of the economy, can they retain full independence?
No. In a democracy, independence comes with limited authority. The financial central planner cannot and will not long stay independent.
If this is the case, and central banks have tools which can have effects on very specific sectors of the economy, can they retain full independence?
No. In a democracy, independence comes with limited authority. The financial central planner cannot and will not long stay independent.
The zero ... lower bound on the interest rate set by central banks was thought to be a theoretical curiosum, unlikely to happen, and, in any case, easy to combat if reached. If reached, central banks could, through announcements of future monetary policy, increase expected inflation and achieve large negative interest rates. We have learned that this was simply wishful thinking. The zero lower bound could be reached, inflation expectations are not easy to manipulate, and it may take a very long time to exit.
Three cheers. Wow, Olivier, who wrote one of the most influential calls for announcements of higher inflation targets, looks at the data and calls it "wishful thinking." Bravo.
.. Quantitative Easing,... Questions: ...should central banks eventually return to the traditional mode of intervening at the short end of the market, or should they continue to buy and sell longer maturity sovereign or corporate bonds? Should the balance sheets of central banks return to their pre-crisis size, or remain permanently larger? If the central bank intervenes along the yield curve, how should monetary policy and debt management by the Treasury be combined?
Three cheers. Wow, Olivier, who wrote one of the most influential calls for announcements of higher inflation targets, looks at the data and calls it "wishful thinking." Bravo.
.. Quantitative Easing,... Questions: ...should central banks eventually return to the traditional mode of intervening at the short end of the market, or should they continue to buy and sell longer maturity sovereign or corporate bonds? Should the balance sheets of central banks return to their pre-crisis size, or remain permanently larger? If the central bank intervenes along the yield curve, how should monetary policy and debt management by the Treasury be combined?
Large balance sheet, interest-paying reserves, open to everyone. Some crisis interventions reveal very desirable permanent states of affairs. Stop fooling around with direct intervention in long-term debt, mortgage-backed security markets, and don't follow other central banks to buying and selling stocks, foreign exchange, etc.
Fiscal Policy
Fiscal Policy
... Questions: What is a dangerous level of debt? That which markets doubt you can repay. Seriously, if you're growing fast with a good long run plan for containing expenditures and raising revenue without ruinous taxation, a lot. If not, a lot less. ... What do we know about confidence effects? You mean statements by officials that "engender confidence?" Go back to the Romans, burn incense at the Temple of Jupiter. More seriously, we've learned that speaking loudly with no stick doesn't work. ...Should the old idea of the fiscal golden rule, the separation of a current and of a capital account, be resurrected? Separating two sides of an accounting identity sounds like an interesting golden rule. I think it would be golden to separate the current account and capital account I run down at the apple store -- they give me stuff, I don't have to give them money. Olivier surely has something more sophisticated in mind, and I'm revealing I'm a rube at this policy-speak coded language.
Most observers agree that the fiscal stimulus early in the crisis was instrumental in limiting the decrease in output. I'm glad he said "most" not "all"....
Capital inflows, exchange rate management and capital controls
The crisis has reinforced the notion that international capital flows can be very volatile, with emerging markets being particularly vulnerable. Back to previous comment. Capital can try to flow, but unless goods flow in the other direction, all it does is to lower prices. Unless you can pass a rule to get rid of accounting identities. See above. Policy makers have responded with a panoply of tools, from capital controls A polite word for expropriation to macro prudential measures aimed at shaping flows, What a lovely little policy-ese phrase and FX intervention. .... And what does the experience since the crisis say about the optimal opening of the capital account, even in the long run? Translated to English, back to the de-globalized protectionist world. If capital can't flow, neither can goods.
The International Monetary and Financial System
.... Questions: ... Should we reexamine the rules of the game for exchange rates? How can we improve on the process of sovereign debt restructuring?
As Olivier's essay moves on, and gradually reverts to the obfuscatory Orwellian prose of the international policy world, I get more and more animated. I mean just who is this "we?" Who is going to tell you you're not allowed to buy euros for your vacation this summer ("capital controls"), tell your bank not to give you a loan ("macro-produential policy"), decide how many billions to siphon from your pocket to the owners of large banks ("recapitalization" "process of sovereign debt restructuring"), not allowed to expand your business in a new country ("macro prudential measures aimed at shaping flows") and so forth? When there even is a "we," unlike most sentences with no subjects, like "the optimal opening of the capital account."
What should be the role of international forums such as the G20?
Aha, now I get it.
As Olivier's essay moves on, and gradually reverts to the obfuscatory Orwellian prose of the international policy world, I get more and more animated. I mean just who is this "we?" Who is going to tell you you're not allowed to buy euros for your vacation this summer ("capital controls"), tell your bank not to give you a loan ("macro-produential policy"), decide how many billions to siphon from your pocket to the owners of large banks ("recapitalization" "process of sovereign debt restructuring"), not allowed to expand your business in a new country ("macro prudential measures aimed at shaping flows") and so forth? When there even is a "we," unlike most sentences with no subjects, like "the optimal opening of the capital account."
What should be the role of international forums such as the G20?
Aha, now I get it.
19 March 2015
Levine on the Keynesian Illusion
David Levine has a very nice post on the Keynesian Illusion.
Some big themes: Standard Keynesian economics violates budget constraints. He explains it well, but it is sure to occasion the usual venom from with the "Say's law fallacy" brigade that has a lot of trouble understanding the difference between budget constraints and equilibrium conditions.
David does a lot without equations. That broadens the appeal, but equations can be useful. For example equations clarify that crucial difference between budget constraints and equilibrium conditions. Equations can put to rest silly controversies. We might not still be writing papers, books, and blog posts about what "Keynes really meant," 80 years after the fact, or using "Say's law" as rotten tomatoes, if Keynes had written some equations. Cynically, maybe the lesson is that lack of equations -- or even an equations appendix or citation -- keeps debate going and your name in the papers.
I also fear that his lovely anecdote about people each of whom wants what others produce will lead readers a bit astray. Keynesian economics is about lack of "demand," sticky prices not absent prices. It's not about absence of money, double coincidence of wants, and so forth.
David goes beyond the usual IS/LM formalism, to explain some of the "coordination failure" interpretations of Keynes. He also references Axel Leijonhufvud's "great and famous work" describing a mismatch between saving, a desire for generic future consumption, and the demand for specific goods that firms need to invest.
He has a nice personal story of his Keynesian upbringing, which reminds me of my own. And
The last paragraph is a gem:
 |
| David Levine's analogy for Stimulus |
David does a lot without equations. That broadens the appeal, but equations can be useful. For example equations clarify that crucial difference between budget constraints and equilibrium conditions. Equations can put to rest silly controversies. We might not still be writing papers, books, and blog posts about what "Keynes really meant," 80 years after the fact, or using "Say's law" as rotten tomatoes, if Keynes had written some equations. Cynically, maybe the lesson is that lack of equations -- or even an equations appendix or citation -- keeps debate going and your name in the papers.
I also fear that his lovely anecdote about people each of whom wants what others produce will lead readers a bit astray. Keynesian economics is about lack of "demand," sticky prices not absent prices. It's not about absence of money, double coincidence of wants, and so forth.
David goes beyond the usual IS/LM formalism, to explain some of the "coordination failure" interpretations of Keynes. He also references Axel Leijonhufvud's "great and famous work" describing a mismatch between saving, a desire for generic future consumption, and the demand for specific goods that firms need to invest.
He has a nice personal story of his Keynesian upbringing, which reminds me of my own. And
Knowledge of Keynesianism and Keynesian models is even deeper for the great Nobel Prize winners who pioneered modern macroeconomics - a macroeconomics with people who buy and sell things, who save and invest - Robert Lucas, Edward Prescott, and Thomas Sargent among others. They also grew up with Keynesian theory as orthodoxy - more so than I. And we rejected Keynesianism because it doesn't work not because of some aesthetic sense that the theory is insufficiently elegant.The constant refrain that critics "don't know" Keynesian economics is an ingorant (I mean that not an insult, but in its literal meaning, ignoring the facts) calumny. Sargent's first book "Macroeconomic Theory" is a great example of a modern economists wrestling hard with Keynes.
The last paragraph is a gem:
Keynes own work consists of amusing anecdotes and misleading stories. Keynesianism as argued by people such as Paul Krugman and Brad DeLong is a theory without people either rational or irrational, a theory of graphs pulled largely out of thin air, a series of predictions that are hopelessly wrong - together with the vain hope that they can be put right if only the curves in the graphs can be twisted in the right direction. As it happens we have developed much better theories - theories that do explain many facts, theories that provide sensible policy guidance, theories that work reasonably well, theories that are not an illusion. The current versions of these theories are very unlike caricature theories of hopelessly rational people who are all identical. Current theories are not perfect - but unlike the Keynesian theory of perpetual motion machines they explain a great deal and have a great deal of truth to them. A working macroeconomist reading Krugman and DeLong feels as a doctor would if the Surgeon General got up and said that the way to cure cancer was to draw blood using leeches.
05 February 2015
Bachmann, Berg and Sims on inflation as stimulus
Rüdiger Bachmann, Tim Berg, and Eric Sims have an interesting article, "Inflation Expectations and Readiness to Spend: Cross-Sectional Evidence" in the American Economic Journal: Economic Policy.
Many macroeconomists have advocated deliberate, expected inflation to "stimulate" the economy while interest rates are stuck at the lower bound. The idea is that higher expected inflation amounts to a lower real interest rate. This lower rate encourages people to spend today rather than to save, which, the story goes, will raise today's level of output and employment.
As usual in macroeconomics, measuring this effect is hard. There are few zero-bound observations, fewer still with substantial variation in expected inflation. And as always in macro it's hard to tell causation from correlation, supply from demand, because from despite of any small inflation-output correlation we see.
This paper is an interesting part of the movement that uses microeconomic observations to illuminate such macroeconomic questions, and also a very interesting use of survey data. Bachman, Berg, and Sims look at survey data from the University of Michigan. This survey asks about spending plans and inflation expectations. Thus, looking across people at a given moment in time, Bachman, Berg, and Sims ask whether people who think there is going to be a lot more inflation are also people who are planning to spend a lot more. (Whether more "spending" causes more GDP is separate question.)
The answer is... No. Not at all. There is just no correlation between people's expectations of inflation and their plans to spend money.
In a sense that's not too surprising. The intertemporal substitution relation -- expected consumption growth = elasticity times expected real interest rate -- has been very unreliable in macro and micro data for decades. That hasn't stopped it from being the center of much macroeconomics and the article of faith in policy prescriptions for stimulus. But fresh reminders of its instability are welcome.
At first blush, this just seems great. Finally, micro data are illuminating macro questions.
It's cleaner than the Hagedorn, Manovskii and Mitman paper I blogged last week, because many of the aggregation issues are absent. There, I complained that employment in one state might be gained by business moving from another, which would not be an available channel for the whole economy. Here, if we know that people who expect more inflation spend more, it's an easier jump that if we all expect more inflation we all want to spend more. This aggregation problem is usually one of the biggest stumbling blocks for the project to measure macro effects from micro data.
Now, for a little whining. This isn't really criticism as I don't know how to do any better. But it does make for a very well-done example in which to ponder the limitations of the micro evidence on macro questions methodology.
Here are Table 1 and 2, the "baseline specification."
It's a probit regression. The left hand variable is whether a person answered yes or no to the question,
So far, so good. But what are all those other numbers in the table? Well, these are "controls," extra right hand variables in the regression.
What in the world are they doing there? The fact is not "people with higher inflation expectations don't plan to spend any less." The fact is that "people with higher inflation expectations, holding constant their expected financial situation and income, their expected change in nominal interest rate and aggregate business conditions, ..., a long vector of aggregate variables, and then the whole Table 2 of demographic variables, don't plan to spend any less." Hmm.
The long list of "controls" brings back memories of all the regression horror stories I was taught in graduate school (thank you Tom Rothenberg).
(In case the latter isn't obvious: including industry helps a lot to "explain" wages and raise R2. But the point of education is to let you change industries from fast food to computers, so you absolutely do not want to "control" for industry!)
What are all the controls doing here? Could we not at least start with OLS, a clean digestible fact, or a graph so that poor bloggers have something to brighten up posts?
I asked the correspondent who sent me the paper (thanks) who opined that the referees probably made the authors do it, and out of a reasonable concern. Maybe the correlation between inflation expectations and spending plans across people does not measure the causal effect, what if we change inflation and leave other things constant? It could well be that the correlation of expectations across people is zero, reflecting other forces at work, but if we raise everyone's inflation expectations, then we would raise everyone's spending.
Most simply, just because we put inflation expectations on the right hand side of a regression and spending on the left, does not mean that changes in inflation expectations across people cause their spending plans to change.
Demographic controls seem reasonable. Suppose the fact was that women all expected higher inflation and planned to spend a lot, while men expected low inflation and did not plan to spend a lot. One would not want to use that correlation to measure how increasing expected inflation for all of us would affect our spending. Such a demographic correlation is much more likely a result of other causes affecting both variables (inflation expectations and spending). This really remains the deep issue of micro to macro implications: Does a correlation across people tell us what happens if something affects all of us?
But if demographic controls changed the result a lot over OLS, one would be very suspicious. A correlation that survives controls is a lot more persuasive than a correlation that only emerges with controls. It's much nicer to say there is a raw correlation, and verify that it is not the result of differences between demographic groups, than to say the correlation is only measured after demographic controls. Because no set of controls is perfect. (The implicit assumption "my controls perfectly capture all the reverse causation or all third variable influences" pervades regression analysis.)
Many of the controls are macro variables. There are almost as many controls here as time data points. Year dummies would have removed all the time-series variation and left us the pure cross section a lot more simply.
The first set of controls for other expectations strikes me as the most fishy. Why would we measure the effect of a change in expected inflation holding constant expected unemployment? The whole point of the macro experiment is to raise both expected inflation and to lower expected unemployment.
This is the hard nut of all regression analysis: why does the right hand variable vary? People spend a lot of effort on the left hand variable, but that's actually less important. What caused the variation in your data? We don't have randomized experiments. Why is it that households have such widely (insanely!) varying expectations of inflation? Until we know that, it's really going to be hard to tell whether their similarly widely varying spending plans are because of higher inflation expectations, or because inflation and spending plans are both results of some third cause.
The paper isn't much help on this issue. At least I wish they (or much of any regression work) at least asked the question. They don't even really discuss the "controls" in this way; why expected inflation varies, and then control for determinants of expected inflation that are correlated with determinants of spending.
The discussion of the control variables sounds a lot like the habit of assuming everything on the right is a "cause," and fishing for R2, like left shoes in the right shoe equation, and industry in the wage equations.
But I don't think I could have done better, as making sense of why people's expectations are as widely dispersed as they are seems a big challenge.
It's still a powerful observation, and I trust it's there in the OLS with minimal controls. People who expect more inflation do not plan to spend more. If you think raising all our expected inflation will make us all spend more, you have some creative explaining to do.
Update: Eric responds:
Many macroeconomists have advocated deliberate, expected inflation to "stimulate" the economy while interest rates are stuck at the lower bound. The idea is that higher expected inflation amounts to a lower real interest rate. This lower rate encourages people to spend today rather than to save, which, the story goes, will raise today's level of output and employment.
As usual in macroeconomics, measuring this effect is hard. There are few zero-bound observations, fewer still with substantial variation in expected inflation. And as always in macro it's hard to tell causation from correlation, supply from demand, because from despite of any small inflation-output correlation we see.
This paper is an interesting part of the movement that uses microeconomic observations to illuminate such macroeconomic questions, and also a very interesting use of survey data. Bachman, Berg, and Sims look at survey data from the University of Michigan. This survey asks about spending plans and inflation expectations. Thus, looking across people at a given moment in time, Bachman, Berg, and Sims ask whether people who think there is going to be a lot more inflation are also people who are planning to spend a lot more. (Whether more "spending" causes more GDP is separate question.)
The answer is... No. Not at all. There is just no correlation between people's expectations of inflation and their plans to spend money.
In a sense that's not too surprising. The intertemporal substitution relation -- expected consumption growth = elasticity times expected real interest rate -- has been very unreliable in macro and micro data for decades. That hasn't stopped it from being the center of much macroeconomics and the article of faith in policy prescriptions for stimulus. But fresh reminders of its instability are welcome.
At first blush, this just seems great. Finally, micro data are illuminating macro questions.
It's cleaner than the Hagedorn, Manovskii and Mitman paper I blogged last week, because many of the aggregation issues are absent. There, I complained that employment in one state might be gained by business moving from another, which would not be an available channel for the whole economy. Here, if we know that people who expect more inflation spend more, it's an easier jump that if we all expect more inflation we all want to spend more. This aggregation problem is usually one of the biggest stumbling blocks for the project to measure macro effects from micro data.
Now, for a little whining. This isn't really criticism as I don't know how to do any better. But it does make for a very well-done example in which to ponder the limitations of the micro evidence on macro questions methodology.
Here are Table 1 and 2, the "baseline specification."
It's a probit regression. The left hand variable is whether a person answered yes or no to the question,
Q1: “About the big things people buy for their homes—such as furniture, a refrigerator, stove, television, and things like that. Generally speaking, do you think now is a good or a bad time for people to buy major household items?”The main right hand variable, ("Inflation expectations (1Y)") is the answer to the question,
Q2: “By about what percent do you expect future prices to go (up/down) on the average, during the next 12 months?”The main fact is that the top row of numbers are all essentially zero, decently well measured, and nonetheless statistically insignificant. Where it is significant, in the zero-bound years, it's negative -- higher inflation expectations are associated with plans to spend less, not more!
So far, so good. But what are all those other numbers in the table? Well, these are "controls," extra right hand variables in the regression.
What in the world are they doing there? The fact is not "people with higher inflation expectations don't plan to spend any less." The fact is that "people with higher inflation expectations, holding constant their expected financial situation and income, their expected change in nominal interest rate and aggregate business conditions, ..., a long vector of aggregate variables, and then the whole Table 2 of demographic variables, don't plan to spend any less." Hmm.
The long list of "controls" brings back memories of all the regression horror stories I was taught in graduate school (thank you Tom Rothenberg).
Left shoe sales = a + b price + c right shoe sales + error.
Wage = a + b education + c industry + error.
(In case the latter isn't obvious: including industry helps a lot to "explain" wages and raise R2. But the point of education is to let you change industries from fast food to computers, so you absolutely do not want to "control" for industry!)
What are all the controls doing here? Could we not at least start with OLS, a clean digestible fact, or a graph so that poor bloggers have something to brighten up posts?
I asked the correspondent who sent me the paper (thanks) who opined that the referees probably made the authors do it, and out of a reasonable concern. Maybe the correlation between inflation expectations and spending plans across people does not measure the causal effect, what if we change inflation and leave other things constant? It could well be that the correlation of expectations across people is zero, reflecting other forces at work, but if we raise everyone's inflation expectations, then we would raise everyone's spending.
Most simply, just because we put inflation expectations on the right hand side of a regression and spending on the left, does not mean that changes in inflation expectations across people cause their spending plans to change.
Demographic controls seem reasonable. Suppose the fact was that women all expected higher inflation and planned to spend a lot, while men expected low inflation and did not plan to spend a lot. One would not want to use that correlation to measure how increasing expected inflation for all of us would affect our spending. Such a demographic correlation is much more likely a result of other causes affecting both variables (inflation expectations and spending). This really remains the deep issue of micro to macro implications: Does a correlation across people tell us what happens if something affects all of us?
But if demographic controls changed the result a lot over OLS, one would be very suspicious. A correlation that survives controls is a lot more persuasive than a correlation that only emerges with controls. It's much nicer to say there is a raw correlation, and verify that it is not the result of differences between demographic groups, than to say the correlation is only measured after demographic controls. Because no set of controls is perfect. (The implicit assumption "my controls perfectly capture all the reverse causation or all third variable influences" pervades regression analysis.)
Many of the controls are macro variables. There are almost as many controls here as time data points. Year dummies would have removed all the time-series variation and left us the pure cross section a lot more simply.
The first set of controls for other expectations strikes me as the most fishy. Why would we measure the effect of a change in expected inflation holding constant expected unemployment? The whole point of the macro experiment is to raise both expected inflation and to lower expected unemployment.
This is the hard nut of all regression analysis: why does the right hand variable vary? People spend a lot of effort on the left hand variable, but that's actually less important. What caused the variation in your data? We don't have randomized experiments. Why is it that households have such widely (insanely!) varying expectations of inflation? Until we know that, it's really going to be hard to tell whether their similarly widely varying spending plans are because of higher inflation expectations, or because inflation and spending plans are both results of some third cause.
The paper isn't much help on this issue. At least I wish they (or much of any regression work) at least asked the question. They don't even really discuss the "controls" in this way; why expected inflation varies, and then control for determinants of expected inflation that are correlated with determinants of spending.
The discussion of the control variables sounds a lot like the habit of assuming everything on the right is a "cause," and fishing for R2, like left shoes in the right shoe equation, and industry in the wage equations.
With respect to the coefficients on the economic control variables, we obtain for the most part plausible and significant estimates,... the expected financial situation of the household and its real income, the expected business conditions (idiosyncratic and aggregate), the current financial situation, and the current real household income all have significantly positive effects on the reported spending readiness. In addition, a positive judgement of US economic policy also affects spending dispositions positively. Moreover, an expected increase in future nominal interest rates makes people want to spend more today, while higher economic uncertainty in the form of stock market volatility, inflation volatility and higher unemployment rates (both current and expected) decrease the probability that people find buying conditions favorable ...But enough whining. My point is that micro, regression-based analysis has its limitations too. This seemed like a good example on which to remind graduate student readers of common regression pitfalls: Always ask what caused the variation in the right hand variable. Use minimal controls, not the kitchen sink. Make sure the partial effects of your regression (move x holding z constant) make sense. And so on.
But I don't think I could have done better, as making sense of why people's expectations are as widely dispersed as they are seems a big challenge.
It's still a powerful observation, and I trust it's there in the OLS with minimal controls. People who expect more inflation do not plan to spend more. If you think raising all our expected inflation will make us all spend more, you have some creative explaining to do.
Update: Eric responds:
On your point about all the control variables . . . we did (more or less) what you suggest in the blog post. If you look at Table 3, we drop all of the idiosyncratic control variables in one specification and get essentially the same results; also in Table 3 we do the version with time fixed effects instead of aggregate controls. If you go to the online appendix, in Table 8 we show raw correlations between expected inflation and buying attitudes. We also split the raw correlation by a large number of different demographics. In Figure 7 we show plots of time-varying raw correlations between expected inflation and spending attitudes -- it is the analog of Figure 6 in the main paper which plots a time-varying marginal effect based on the probit estimation. Basically this all shows exactly what you ask for in the blog post -- the correlation/coefficient between expected inflation and buying attitudes does not depend on the controls.I admit not reading all the way through or the online appendix. They also confirm that the early drafts started with raw correlations. There is an interesting writing (and editing and refereeing) conundrum, should a paper start with the "main" result, or should one start with suggestive robust facts and correlations and then address objections with a more sophisticated model. It's not an easy question -- Most papers drag you through 10 tables of motivation and summary statistics and suggestive correlations before getting to the point, and I really admire that this paper had the main result on Table 1. OTOH, by going the other way around busy bloggers miss the interesting correlations in online appendix Table 8!
22 January 2015
Autopsy -- the Op-Ed
This was an Op-Ed in the Wall Street Journal December 22 2014. WSJ asks me not to post them for a month, so here it is now. I was trying for something upbeat, and to counter a recent spate of opeds on how ISLM is a great success and winning the war of ideas.
An Autopsy for the Keynesians
This year the tide changed in the economy. Growth seems finally to be returning. The tide also changed in economic ideas. The brief resurgence of traditional Keynesian ideas is washing away from the world of economic policy.
No government is remotely likely to spend trillions of dollars or euros in the name of “stimulus,” financed by blowout borrowing. The euro is intact: Even the Greeks and Italians, after six years of advice that their problems can be solved with one more devaluation and inflation, are sticking with the euro and addressing—however slowly—structural “supply” problems instead.
U.K. Chancellor of the Exchequer George Osborne wrote in these pages Dec. 14 that Keynesians wanting more spending and more borrowing “were wrong in the recovery, and they are wrong now.” The land of John Maynard Keynes and Adam Smith is going with Smith.
Why? In part, because even in economics, you can’t be wrong too many times in a row.
Keynesians told us that once interest rates got stuck at or near zero, economies would fall into a deflationary spiral. Deflation would lower demand, causing more deflation, and so on.
It never happened. Zero interest rates and low inflation turn out to be quite a stable state, even in Japan. Yes, Japan is growing more slowly than one might wish, but with 3.5% unemployment and no deflationary spiral, it’s hard to blame slow growth on lack of “demand.”
Our first big stimulus fell flat, leaving Keynesians to argue that the recession would have been worse otherwise. George Washington’s doctors probably argued that if they hadn’t bled him, he would have died faster.
With the 2013 sequester, Keynesians warned that reduced spending and the end of 99-week unemployment benefits would drive the economy back to recession. Instead, unemployment came down faster than expected, and growth returned, albeit modestly. The story is similar in the U.K.
These are only the latest failures. Keynesians forecast depression with the end of World War II spending. The U.S. got a boom. The Phillips curve failed to understand inflation in the 1970s and its quick end in the 1980s, and disappeared in our recession as unemployment soared with steady inflation.
Still, facts and experience are seldom decisive in economics. Maybe Washington’s doctors are right. There are always confounding influences. Logic matters too. And illogic hurts. Keynesian ideas are also ebbing from policy as sensible people understand how much topsy-turvy magical thinking they require.
Hurricanes are good, rising oil prices are good, and ATMs are bad, we were advised: Destroying capital, lower productivity and costly oil will raise inflation and occasion government spending, which will stimulate output. Though Japan’s tsunami and oil shock gave it neither inflation nor stimulus, worriers are warning that the current oil price decline, a boon in the past, will kick off the dreaded deflationary spiral this time.
I suspect policy makers heard this, and said to themselves “That’s how you think the world works? Really?” And stopped listening to such policy advice.
Keynesians tell us not to worry about huge debts, or to default or inflate them away (but please, call it “restructuring” or “repairing balance sheets”). Even the Obama administration has ignored that advice, promising long-run solutions to the debt problem from day one. Europeans have centuries of memories of what happens to governments that don’t pay debts, or who need to borrow for a new emergency but have stiffed their creditors once too often. More debt? Nein danke!
In Keynesian models, government spending stimulates even if totally wasted. Pay people to dig ditches and fill them up again. By Keynesian logic, fraud is good; thieves have notoriously high marginal propensities to consume. That’s a hard sell, so stimulus is routinely dressed in “infrastructure” clothes. Clever. How can anyone who hit a pothole complain about infrastructure spending?
But people feel they’ve been had when they discover that the economics is about wasted spending, and infrastructure was a veneer to get the bill passed. And they smell a rat when they hear economic arguments shaded for partisan politics.
Stimulus advocates: Can you bring yourselves to say that the Keystone XL pipeline, LNG export terminals, nuclear power plants and dams are infrastructure? Can you bring yourselves to mention that the Environmental Protection Agency makes it nearly impossible to build anything in the U.S.? How can you assure us that infrastructure does not mean “crony boondoggle,” or high-speed trains to nowhere?
Now you like roads and bridges. Where were you during decades of opposition to every new road on grounds that they only encouraged suburban “sprawl”? If you repeat in your textbooks how defense spending saved the economy in World War II, why do you support defense cutbacks today? Why is “infrastructure” spending abstract or anecdotal, not a plan for actual, valuable, concrete projects that someone might object to?
Keynesians tell us that “sticky wages” are the big underlying economic problem. But why do they just repeat this story to justify inflation and stimulus? Why do they not advocate policies to undo minimum wages, labor laws, occupational licenses and other regulations that make wages stickier?
Inequality was fashionable this year. But no government in the foreseeable future is going to enact punitive wealth taxes. Europe’s first stab at “austerity” tried big taxes on the wealthy, meaning on those likely to invest, start businesses or hire people. Burned once, Europe is moving in the opposite direction. Magical thinking—that, contrary to centuries of experience, massive taxation and government control of incomes will lead to growth, prosperity and social peace—is moving back to the salons.
Yes, there is plenty wrong and plenty to worry about. Growth is too slow, and not enough people are working. Even supporters acknowledge that Dodd-Frank and ObamaCare are a mess. Too many people on the bottom are stuck in terrible education, jobless poverty, and a dysfunctional criminal justice system. But the policy world has abandoned the notion that we can solve our problems with blowout borrowing, wasted spending, inflation, default and high taxes. The policy world is facing the tough tradeoffs that centuries of experience have taught us, not wishing them away.
Mr. Cochrane is a professor of finance at the University of Chicago Booth School of Business, a senior fellow at Stanford University’s Hoover Institution and an adjunct scholar at the Cato Institute.
Update: "The Keynesian Shell Game" by Scott Sumner over at econolog has a nice collection of recent Keynesian doom-mongering, and makes the nice point that the definition of "G" shifts conveniently over time.
An Autopsy for the Keynesians
 |
| Source: Wall Street Journal |
No government is remotely likely to spend trillions of dollars or euros in the name of “stimulus,” financed by blowout borrowing. The euro is intact: Even the Greeks and Italians, after six years of advice that their problems can be solved with one more devaluation and inflation, are sticking with the euro and addressing—however slowly—structural “supply” problems instead.
U.K. Chancellor of the Exchequer George Osborne wrote in these pages Dec. 14 that Keynesians wanting more spending and more borrowing “were wrong in the recovery, and they are wrong now.” The land of John Maynard Keynes and Adam Smith is going with Smith.
Why? In part, because even in economics, you can’t be wrong too many times in a row.
Keynesians told us that once interest rates got stuck at or near zero, economies would fall into a deflationary spiral. Deflation would lower demand, causing more deflation, and so on.
It never happened. Zero interest rates and low inflation turn out to be quite a stable state, even in Japan. Yes, Japan is growing more slowly than one might wish, but with 3.5% unemployment and no deflationary spiral, it’s hard to blame slow growth on lack of “demand.”
Our first big stimulus fell flat, leaving Keynesians to argue that the recession would have been worse otherwise. George Washington’s doctors probably argued that if they hadn’t bled him, he would have died faster.
With the 2013 sequester, Keynesians warned that reduced spending and the end of 99-week unemployment benefits would drive the economy back to recession. Instead, unemployment came down faster than expected, and growth returned, albeit modestly. The story is similar in the U.K.
These are only the latest failures. Keynesians forecast depression with the end of World War II spending. The U.S. got a boom. The Phillips curve failed to understand inflation in the 1970s and its quick end in the 1980s, and disappeared in our recession as unemployment soared with steady inflation.
Still, facts and experience are seldom decisive in economics. Maybe Washington’s doctors are right. There are always confounding influences. Logic matters too. And illogic hurts. Keynesian ideas are also ebbing from policy as sensible people understand how much topsy-turvy magical thinking they require.
Hurricanes are good, rising oil prices are good, and ATMs are bad, we were advised: Destroying capital, lower productivity and costly oil will raise inflation and occasion government spending, which will stimulate output. Though Japan’s tsunami and oil shock gave it neither inflation nor stimulus, worriers are warning that the current oil price decline, a boon in the past, will kick off the dreaded deflationary spiral this time.
I suspect policy makers heard this, and said to themselves “That’s how you think the world works? Really?” And stopped listening to such policy advice.
Keynesians tell us not to worry about huge debts, or to default or inflate them away (but please, call it “restructuring” or “repairing balance sheets”). Even the Obama administration has ignored that advice, promising long-run solutions to the debt problem from day one. Europeans have centuries of memories of what happens to governments that don’t pay debts, or who need to borrow for a new emergency but have stiffed their creditors once too often. More debt? Nein danke!
In Keynesian models, government spending stimulates even if totally wasted. Pay people to dig ditches and fill them up again. By Keynesian logic, fraud is good; thieves have notoriously high marginal propensities to consume. That’s a hard sell, so stimulus is routinely dressed in “infrastructure” clothes. Clever. How can anyone who hit a pothole complain about infrastructure spending?
But people feel they’ve been had when they discover that the economics is about wasted spending, and infrastructure was a veneer to get the bill passed. And they smell a rat when they hear economic arguments shaded for partisan politics.
Stimulus advocates: Can you bring yourselves to say that the Keystone XL pipeline, LNG export terminals, nuclear power plants and dams are infrastructure? Can you bring yourselves to mention that the Environmental Protection Agency makes it nearly impossible to build anything in the U.S.? How can you assure us that infrastructure does not mean “crony boondoggle,” or high-speed trains to nowhere?
Now you like roads and bridges. Where were you during decades of opposition to every new road on grounds that they only encouraged suburban “sprawl”? If you repeat in your textbooks how defense spending saved the economy in World War II, why do you support defense cutbacks today? Why is “infrastructure” spending abstract or anecdotal, not a plan for actual, valuable, concrete projects that someone might object to?
Keynesians tell us that “sticky wages” are the big underlying economic problem. But why do they just repeat this story to justify inflation and stimulus? Why do they not advocate policies to undo minimum wages, labor laws, occupational licenses and other regulations that make wages stickier?
Inequality was fashionable this year. But no government in the foreseeable future is going to enact punitive wealth taxes. Europe’s first stab at “austerity” tried big taxes on the wealthy, meaning on those likely to invest, start businesses or hire people. Burned once, Europe is moving in the opposite direction. Magical thinking—that, contrary to centuries of experience, massive taxation and government control of incomes will lead to growth, prosperity and social peace—is moving back to the salons.
Yes, there is plenty wrong and plenty to worry about. Growth is too slow, and not enough people are working. Even supporters acknowledge that Dodd-Frank and ObamaCare are a mess. Too many people on the bottom are stuck in terrible education, jobless poverty, and a dysfunctional criminal justice system. But the policy world has abandoned the notion that we can solve our problems with blowout borrowing, wasted spending, inflation, default and high taxes. The policy world is facing the tough tradeoffs that centuries of experience have taught us, not wishing them away.
Mr. Cochrane is a professor of finance at the University of Chicago Booth School of Business, a senior fellow at Stanford University’s Hoover Institution and an adjunct scholar at the Cato Institute.
Update: "The Keynesian Shell Game" by Scott Sumner over at econolog has a nice collection of recent Keynesian doom-mongering, and makes the nice point that the definition of "G" shifts conveniently over time.
08 January 2015
Deflating Deflationary Fears
 |
| Source: Charles Plosser |
06 January 2015
Strange Bedfellows
Jeff Sachs has written a very interesting Project Syndicate piece on Keynesian economics. It's phrased as a critique of Paul Krugman, but his message applies much more broadly. Krugman was mostly articulating fairly standard views on stimulus, "austerity'' and so forth. (We need a better word than "Keynesian'' for what Jeff calls "crude aggregate-demand management.'' But I don't have one handy.)
This is a good example for people outside economics (and quite a few inside) who think all economists line up on an easy right-left divide. If you expected Sachs to support the standard Keynesian consensus because he's "liberal," or to use his words, in favor of "progressive economics," you would be wrong. He looks at the facts, the forecasts, and the Krugman's curious rewriting of history in a "victory lap," and comes to his own conclusions.
Needless to say, I'm happy to find someone else making many of the basic points in my
Autopsy for Keynesian Economics (ungated version). I'm even more happy that someone of a "progressive" political orientation comes to the same conclusions that I do from a more libertarian orientation. I'll be curious to see if Sachs comes in for the same sort of venomous personal attacks -- with essentially no attempt to argue the content -- as my piece attracted from the politicized lefty economics blogosphere. Do they treat "friends" more nicely, or "traitors" more harshly? We'll see.
On infrastructure, Sachs writes
This is a good example for people outside economics (and quite a few inside) who think all economists line up on an easy right-left divide. If you expected Sachs to support the standard Keynesian consensus because he's "liberal," or to use his words, in favor of "progressive economics," you would be wrong. He looks at the facts, the forecasts, and the Krugman's curious rewriting of history in a "victory lap," and comes to his own conclusions.
Needless to say, I'm happy to find someone else making many of the basic points in my
Autopsy for Keynesian Economics (ungated version). I'm even more happy that someone of a "progressive" political orientation comes to the same conclusions that I do from a more libertarian orientation. I'll be curious to see if Sachs comes in for the same sort of venomous personal attacks -- with essentially no attempt to argue the content -- as my piece attracted from the politicized lefty economics blogosphere. Do they treat "friends" more nicely, or "traitors" more harshly? We'll see.
On infrastructure, Sachs writes
To be clear, I believe that we do need more government spending as a share of GDP – for education, infrastructure, low-carbon energy, research and development, and family benefits for low-income families. But we should pay for this through higher taxes on high incomes and high net worth, a carbon tax, and future tolls collected on new infrastructure. We need the liberal conscience, but without the chronic budget deficits.Here too, we can almost agree. We can agree on the principle that infrastructure spending is important, and should be evaluated on the basis whether its benefits exceed its costs, not on the "stimulative" powers of its spending. Then we can go back to evaluating whether all of these particular investments have benefits greater than costs, and whether those particular taxes merit their distortions.
22 December 2014
Autopsy
Autopsy for Keynesian Economics. (I don't get to pick the titles BTW) A Wall Street Journal Oped. I'm trying for something cheery at Christmas, and a response to the many recent opeds that ISLM is just great and winning the battle of ideas. As usual, the whole thing will be here in a month.
Update: Hoover has an ungated version here; Cato has an ungated version here.
This year the tide changed in the economy. Growth seems finally to be returning. The tide also changed in economic ideas. The brief resurgence of traditional Keynesian ideas is washing away from the world of economic policy.
No government is remotely likely to spend trillions of dollars or euros in the name of “stimulus,” financed by blowout borrowing. The euro is intact: Even the Greeks and Italians, after six years of advice that their problems can be solved with one more devaluation and inflation, are sticking with the euro and addressing—however slowly—structural “supply” problems instead.Read more at WSJ...
Update: Hoover has an ungated version here; Cato has an ungated version here.
20 December 2014
Deflation links
Commenter Zack sent the following Paul Krugman links and quotes, which deserve promotion from the comments section.
"But deflation is a huge risk — and getting out of a deflationary trap is very, very hard. We truly are flirting with disaster."
http://krugman.blogs.nytimes.com/2009/02/04/about-that-deflation-risk/
"So we're really heading into Japanese-style deflation territory"
http://krugman.blogs.nytimes.com/2009/07/02/smells-like-deflation/
"So tell me why we aren’t looking at a very large risk of getting into a deflationary trap, in which falling prices make consumers and businesses even less willing to spend." http://krugman.blogs.nytimes.com/2009/01/10/risks-of-deflation-wonkish-but-important/
"But the risk that America will turn into Japan — that we’ll face years of deflation and stagnation — seems, if anything, to be rising."
http://www.nytimes.com/2009/05/04/opinion/04krugman.html
"What I take from this is that deflation isn’t some distant possibility — it’s already here by some measures, not far off by others."
http://krugman.blogs.nytimes.com/2010/07/11/trending-toward-deflation/
"Worst of all is the possibility that the economy will, as it did in the ’30s, end up stuck in a prolonged deflationary trap."
http://www.nytimes.com/2009/02/06/opinion/06krugman.html?partner=permalink&exprod=permalink&_r=0
As we know, it didn't turn out that way. We have had positive inflation for 6 years.
Why does this matter? Normally, it doesn't and it shouldn't.
To repeat points made earlier, economics should be science, not witchraft. We do not say "the witch doctor said it would rain, and it did!," and follow him for a while. At a minimum, we measure a forecaster's ability by collecting all his or her forecasts, not just the good ones -- or the bad ones. More deeply, personal prognostication is a nearly useless test of economic models. Prognostication mixes judgement, opinion, forecasts of what politicians will do and what shocks will hit the economy, along with economic models, in ways that tell you little about the models. If a climate scientist tells you he thinks it will rain this weekend and it's sunny instead, we do not say "well, climate science is bunk." You can only "test" a model once it is written down in a way that anyone operating the model can agree what its prediction is. Finally, there are a lot of other shocks hitting the economy; a forecaster that was right 60% of the time would be a genius in this business, so one blown forecast is meaningless. If anyone else had written these, they could reasonable respond "it's still a danger, we only avoided it by the Fed's QE and huge deficits."
But I don't write endless posts excoriating "inflationistas" for the lack of their largely mischaracterized inflation forecasts, crowing about how I'm always right about everything, damning others for failing to learn from evidence, and Bulverizing (look it up, here too, a great word) about their evil motives. So a few look-in-the-mirror-why-don't-you quotes are appropriate. I've been too lazy to look up these quotes, so I thank Zack for doing it.
This also will matter Monday -- I have a piece coming out that mentions the failure of the widespread "deflationary spiral" forecast. These quotes offer a nice documentation.
By the way, yes, at the time I warned of the risk of inflation, and that didn't happen either. I was quite clear it was a risk not a forecast. California has a risk of earthquakes. And the failure to see one in six years does not prove geologists are all mendacious morons. There are precedents for the inflation risk. Reinhart and Rogoff pointed to quite a few cases in which after a "quiet period," banking crises are followed by sovereign debt crises or defaults.
As I see it, that risk remains, though it has declined a lot. The reason it declined is that our government, and the European governments, kept their eyes on long-term budget issues. Our Administration has from the beginning always promised long-term budget repair, despite Keynesian theory that says if you want to stimulate, you keep quiet about future taxes or spending reductions. No point in waking up the Ricardian genie. You might complain the Administration wasn't serious enough, but they were always saying there would be a long term plan, and bond markets evidently bought it. Many in Congress too have had their eyes on long-term budgets, and long-term fiscal solvency depends if anything more on Congress than on this Administration.
The Europeans have gone through several rounds of "austerity," despite Keynesian and especially Krugmanian excoriation. (True, they started with counterproductive high-marginal-tax austerity, but Europe seems quickly to have learned that less spending and structural reform are a better path.) They came darn close. If Italy and Spain had defaulted, we would likely be having a different conversation today.
Doing so, our and Europe's governments persuaded bond markets that the currency and debt are safe -- maybe even too safe - -and avoided, for now, the sovereign debt fate Reinhart and Rogoff warned about. If I erred in overestimating the inflationary risk, I erred in underestimating the fiscal sobriety of all our governments, and I overestimated the extent to which they believed the Keynesian advice to ignore, default, devalue, or inflate away debt. That's why no earthquake in 6 years hasn't changed all that much my views on the "model," in this case of underlying causes of inflation.
On the "spiral" or "vortex." Perhaps there are a few true-blue Keynesians reading who can help me out. I understand the idea that deflation leads to high real rates leads to lower demand leads to lower output leads to more deflation. ("Understand" ≠ "Agree".) I don't see how the model ever predicts this to end. Is there some clear "and it bottoms out when x y z?" In my model, it bottoms out when you hit the top of the present value Laffer curve, and future taxes cannot hope to pay back the deflationary increase in the real value of the debt. But I don't know where it ends in the standard old-Keynesian model. Positive eigenvalues are positive eigenvalues. Maybe some wealth effect of government bonds (Another way to put "my model")? But why doesn't that stop the spiral in the first place? Is it right to characterize the model's prediction as an endless spiral to zero? If not why not?
Update: Commenter JZ sends the following link, and it's only fair to include it.
" ... back when the crisis started, I did expect to see deflation, Japanese style, if it went on for an extended period. I was wrong ... "
http://krugman.blogs.nytimes.com/2013/03/05/why-dont-we-have-deflation
"But deflation is a huge risk — and getting out of a deflationary trap is very, very hard. We truly are flirting with disaster."
http://krugman.blogs.nytimes.com/2009/02/04/about-that-deflation-risk/
"So we're really heading into Japanese-style deflation territory"
http://krugman.blogs.nytimes.com/2009/07/02/smells-like-deflation/
"So tell me why we aren’t looking at a very large risk of getting into a deflationary trap, in which falling prices make consumers and businesses even less willing to spend." http://krugman.blogs.nytimes.com/2009/01/10/risks-of-deflation-wonkish-but-important/
"But the risk that America will turn into Japan — that we’ll face years of deflation and stagnation — seems, if anything, to be rising."
http://www.nytimes.com/2009/05/04/opinion/04krugman.html
"What I take from this is that deflation isn’t some distant possibility — it’s already here by some measures, not far off by others."
http://krugman.blogs.nytimes.com/2010/07/11/trending-toward-deflation/
"Worst of all is the possibility that the economy will, as it did in the ’30s, end up stuck in a prolonged deflationary trap."
http://www.nytimes.com/2009/02/06/opinion/06krugman.html?partner=permalink&exprod=permalink&_r=0
As we know, it didn't turn out that way. We have had positive inflation for 6 years.
Why does this matter? Normally, it doesn't and it shouldn't.
To repeat points made earlier, economics should be science, not witchraft. We do not say "the witch doctor said it would rain, and it did!," and follow him for a while. At a minimum, we measure a forecaster's ability by collecting all his or her forecasts, not just the good ones -- or the bad ones. More deeply, personal prognostication is a nearly useless test of economic models. Prognostication mixes judgement, opinion, forecasts of what politicians will do and what shocks will hit the economy, along with economic models, in ways that tell you little about the models. If a climate scientist tells you he thinks it will rain this weekend and it's sunny instead, we do not say "well, climate science is bunk." You can only "test" a model once it is written down in a way that anyone operating the model can agree what its prediction is. Finally, there are a lot of other shocks hitting the economy; a forecaster that was right 60% of the time would be a genius in this business, so one blown forecast is meaningless. If anyone else had written these, they could reasonable respond "it's still a danger, we only avoided it by the Fed's QE and huge deficits."
But I don't write endless posts excoriating "inflationistas" for the lack of their largely mischaracterized inflation forecasts, crowing about how I'm always right about everything, damning others for failing to learn from evidence, and Bulverizing (look it up, here too, a great word) about their evil motives. So a few look-in-the-mirror-why-don't-you quotes are appropriate. I've been too lazy to look up these quotes, so I thank Zack for doing it.
This also will matter Monday -- I have a piece coming out that mentions the failure of the widespread "deflationary spiral" forecast. These quotes offer a nice documentation.
By the way, yes, at the time I warned of the risk of inflation, and that didn't happen either. I was quite clear it was a risk not a forecast. California has a risk of earthquakes. And the failure to see one in six years does not prove geologists are all mendacious morons. There are precedents for the inflation risk. Reinhart and Rogoff pointed to quite a few cases in which after a "quiet period," banking crises are followed by sovereign debt crises or defaults.
As I see it, that risk remains, though it has declined a lot. The reason it declined is that our government, and the European governments, kept their eyes on long-term budget issues. Our Administration has from the beginning always promised long-term budget repair, despite Keynesian theory that says if you want to stimulate, you keep quiet about future taxes or spending reductions. No point in waking up the Ricardian genie. You might complain the Administration wasn't serious enough, but they were always saying there would be a long term plan, and bond markets evidently bought it. Many in Congress too have had their eyes on long-term budgets, and long-term fiscal solvency depends if anything more on Congress than on this Administration.
The Europeans have gone through several rounds of "austerity," despite Keynesian and especially Krugmanian excoriation. (True, they started with counterproductive high-marginal-tax austerity, but Europe seems quickly to have learned that less spending and structural reform are a better path.) They came darn close. If Italy and Spain had defaulted, we would likely be having a different conversation today.
Doing so, our and Europe's governments persuaded bond markets that the currency and debt are safe -- maybe even too safe - -and avoided, for now, the sovereign debt fate Reinhart and Rogoff warned about. If I erred in overestimating the inflationary risk, I erred in underestimating the fiscal sobriety of all our governments, and I overestimated the extent to which they believed the Keynesian advice to ignore, default, devalue, or inflate away debt. That's why no earthquake in 6 years hasn't changed all that much my views on the "model," in this case of underlying causes of inflation.
On the "spiral" or "vortex." Perhaps there are a few true-blue Keynesians reading who can help me out. I understand the idea that deflation leads to high real rates leads to lower demand leads to lower output leads to more deflation. ("Understand" ≠ "Agree".) I don't see how the model ever predicts this to end. Is there some clear "and it bottoms out when x y z?" In my model, it bottoms out when you hit the top of the present value Laffer curve, and future taxes cannot hope to pay back the deflationary increase in the real value of the debt. But I don't know where it ends in the standard old-Keynesian model. Positive eigenvalues are positive eigenvalues. Maybe some wealth effect of government bonds (Another way to put "my model")? But why doesn't that stop the spiral in the first place? Is it right to characterize the model's prediction as an endless spiral to zero? If not why not?
Update: Commenter JZ sends the following link, and it's only fair to include it.
" ... back when the crisis started, I did expect to see deflation, Japanese style, if it went on for an extended period. I was wrong ... "
http://krugman.blogs.nytimes.com/2013/03/05/why-dont-we-have-deflation
26 November 2014
Sequester, growth, and the deflation that did not bark.
 |
| Multiplier? What multiplier? |
The economy expanded at its fastest pace in more than a decade during the spring and summer,... Gross domestic product...grew at a seasonally adjusted annual rate of 3.9% in the third quarter... combined growth rate in the second and third quarters at 4.25%, affirming the best six-month pace since the second half of 2003."
The upward revision to overall growth, driven by [sic] stronger consumer and business spending and a smaller drag from inventory investment, surprised economists...Paul Krugman, February 22 2013, "Sequester of Fools"
The sequester, by contrast, will probably cost “only” around 700,000 jobs.New York Times, Februrary 21 2013, "Why Taxes Have to Go Up"
Democrats and Republicans remain at odds on how to avoid a round of budget cuts so deep and arbitrary that to allow them now could push the economy back into recession. The cuts, known as a sequester, will kick in March 1 [my emphasis]
Paul Krugman, March 10, 2013: "Sequester Cuts Will Be Felt in Time"
..it will start to build, and it won't just be White House tours, it will be air traffic delays, ...as the effects kick in, it will remind people why we actually need a government that does its job.(Actually, manifest failures of government to do its job lately are pretty depressing. But not for lack of money.)
Meanwhile back in the worryzone
 |
| Deflationary Vortex? |
Europe, which is doing worse than it did in the 1930s, is clearly in the grip of a deflationary vortex,Really, "worse than the 1930s???" We're watching different versions of the History Channel.
Paul Krugman, undated,
... if the economy ... has excess capacity, and also ...i = 0 ...- it cannot get out. The output gap feeds expectations of deflation, and since the nominal interest rate cannot fall this implies a rising real interest rate, worsening the output gap. The economy, in short, falls into a deflationary spiral.This prediction of a "deflation spiral" once we hit the zero bound with huge "output gaps" has to stand as a stark failure of Keynesian economics, on a par with its grand failure to predict inflation in the 1970s. Only, predicting a catastrophe that did not happen doesn't attract quite as much attention as failing to predict one that did.
If you're not getting the point, look at the graph. Let me remind you "deflation" means numbers less than zero, a lot less than zero. And "spiral" or "vortex" means getting steadily more negative, not asymptoting to zero. And if you patch a model ex-post and ad-hoc not to produce a spiral, then that model no longer predicts that inflation is a danger.
To be sure, I am being inconsistent today -- I have staunchly maintained that "models" must exist on paper or in computers, in objectively verifiable forms, with "predictions" that any operator can make, not in soothsayer's heads. I have staunchly maintained that evaluating economic theories by pundit prognostication is completely meaningless.
But I also don't make it my business to vilify other people from misquoted opinions on current dangers. (Though I'm indeed pulling Paul's leg a bit, please notice the absence of "evil," "vile," "mendacious idiot," "corrupt," "stupid," "doesn't know economics," and so on from this post.)
So just this once I will give in to grumpy temptation.
Subscribe to:
Posts (Atom)