Matt Yglesias

The Three Percent Solution

Building on yesterday’s idea, borrowed from Brad DeLong, that the Fed could stimulate the economy by raising its long-term inflation target from two percent to three percent it’s worth noting that there are other arguments for thinking that this would be a good idea. First off, it’s worth noting that three percent inflation is still pretty low. There’s nothing magical about the two percent number, and a somewhat higher figure is still very much consistent with the basic idea that low inflation is good.

Second, a higher inflation rate would speed the process by which households climb out from over-indebtedness. Third, a higher inflation rate would ensure that in the future the Fed has more “running room” for conventional monetary policy before hitting the zero bound and getting into this madness. Fourth, a higher inflation rate would speed the process by which real wages and prices adjust to whatever real shocks the economy may or may not be suffering from.

This course of action seems to be anathema to the powers that be, but it seems strongly preferable to a prolonged period of ten percent unemployment and a possible series of trade wars and the like.

What The Fed Can Do

I wrote earlier this week that based on his own analysis of the situation, Ben Bernanke has an obligation to provide more monetary expansion. A bunch of people responded to that by asking what, exactly, the Fed can do and I didn’t have a great explanation of the details for them. But the answer was well-put by Brad DeLong in a post from last week:

Quantitative easing—pouring a whole bunch of cash in the system with the idea of never reversing the money stock expansion could boost spending and employment considerably by creating expectations of inflation and so reducing the spread—but the Federal Reserve is not going there, and regards the idea with horror, shock, and shame.

We can’t be sure that would work, but there’s some decent theoretical reasons to think it would. It’s also arguably the available step that’s most similar to what really worked for FDR in 1933—dropping the gold standard.

Brad, and Paul Krugman who also agrees with this analysis, seem to have made the political calculation that it makes sense to sort of mention this as an aside, say it’s not going to happen, and then move on to trying to persuade congress to enact more fiscal policy expansion. I think that’s backwards. I don’t want to let congress off the hook, but like Ryan Avent “I think it will probably be easier to sway Fed officials (who are more likely to be impressed by economic arguments) than it will be to convince Congress to pass any kind of fiscal package large enough to have an effect despite the too-tight nature of monetary policy.”

DeLong comments:

I do wonder how much good would be done if the FOMC were simply to stand up and announce that they were raising their long-term GDP-deflator inflation target from 2% to 3%. It might do a lot of good. And it is certainly something the Fed could do without cracking its credibility as committed to low inflation.

But they won’t. We would need a very different FOMC than the one we have to consider such a move.

By the same token, however, I think we would need a very different US congress to get further fiscal stimulus. And I don’t think we should reconcile ourselves to the idea of “third best” direct labor market interventions . . . there are much better possibilities out there and Bernanke hasn’t so much as tried to address why he isn’t moving in this direction.

Bernanke: No Jobs for You

The good news about this Ben Bernanke speech to the Economic Club of New York is that he shows no sign of wanting to join David Ignatius in tightening monetary policy. The bad news is that he sounds awfully blasé about the prospect of a prolonged period of double digit unemployment:

Jobs are likely to remain scarce for some time, keeping households cautious about spending. As the recovery becomes established, however, payrolls should begin to grow again, at a pace that increases over time. Nevertheless, as net gains of roughly 100,000 jobs per month are needed just to absorb new entrants to the labor force, the unemployment rate likely will decline only slowly if economic growth remains moderate, as I expect.

The outlook for inflation is also subject to a number of crosscurrents. Many factors affect inflation, including slack in resource utilization, inflation expectations, exchange rates, and the prices of oil and other commodities. Although resource slack cannot be measured precisely, it certainly is high, and it is showing through to underlying wage and price trends. Longer-run inflation expectations are stable, having responded relatively little either to downward or upward pressures on inflation; expectations can be early warnings of actual inflation, however, and must be monitored carefully. Commodities prices have risen lately, likely reflecting the pickup in global economic activity, especially in resource-intensive emerging market economies, and the recent depreciation of the dollar. On net, notwithstanding significant crosscurrents, inflation seems likely to remain subdued for some time.

Now if you were just asking my opinion, I’d say something very similar to what Bernanke is saying here. But Bernanke isn’t just offering an opinion, he’s the country’s top monetary policymaker. And he’s telling us that his vision of recovery involves a long period of labor market weakness and low inflation. He says that this situation is “likely to warrant exceptionally low levels of the federal funds rate for an extended period” but the very high level of unemployment seems to clearly militate in favor of further easing. Bernanke acknowledges that he has a “dual mandate to foster both maximum employment and price stability” but he’s also acknowledging in this piece that he hasn’t fostered anything close to full employment, and doesn’t think his policies are likely to achieve anything close to full employment any time soon.

But then why isn’t he doing more?

With Great Political Independence Comes Great Responsibility not to Mire the Country in Double-Digit Unemployment

Yesterday David Ignatius accused Chris Dodd of wanting to politicize the Federal Reserve’s control of monetary policy. Kevin Drum points out that Ignatius has this wrong. But it’s worth noting something deeper about Ignatius’ concerns:

The political challenge to the central bank’s authority comes at an especially delicate moment — as the economy begins to rebound and the Fed considers future tightening of monetary policy. It will need public support to combat inflation. But as the New York Times noted in a front-page article last week, the Fed is “under more intense attack than at any time in decades,” from both left and right.

This is nuts. Unemployment is over ten percent. And unemployment is rising! There’s no inflation happening. It would be good for the Fed to have public support in combating inflation if combatting inflation were a good idea. But it’s not a good idea. Not a good idea at all. To repeat, unemployment is at 10 percent and rising. All the evidence suggests that the Fed ought to be attempting additional monetary expansion to return the economy to an acceptable growth path, not tightening monetary policy to combat inflation. In fact, the expectation that if inflation emerges the Fed will stamp it out immediately has become a source of economic problems.

Conventional wisdom is in favor of central bank independence. But insofar as that CW has validity, it’s because it’s been our experience that independence leads to good monetary policy. A prolonged period of double-digit unemployment would mean, almost by definition, that your monetary policy is not good. But none of the world’s major central banks seem to feel that additional monetary expansion would be a good response to massive joblessness and sluggish growth. But if massive joblessness isn’t a good time for monetary expansion then when is? If Ignatius and Ben Bernanke don’t like the populist agitation happening right now, they’re really going to hate the populist agitation that’ll be happening after 12 more months of sustained high unemployment.

Expectations-Management

Paul Krugman has spent a lot of time writing about the desirability of more expansionary fiscal policy, but yesterday he seemed to say that this is a second-best alternative to his real preference of something like a Scott Sumner approach to monetary policy:

The first-best answer — that is, the answer that economic models, like my old Japan’s trap analysis, suggest would be optimal — would be to credibly commit to higher inflation, so as to reduce real interest rates.

But the key thing to recognize about this answer is that it’s all about expectations — the central bank only has traction over expected inflation to the extent that it can convince people that it will deliver that inflation after the liquidity trap is over. So to make this policy work you have to (i) convince current policymakers that it’s the right answer (ii) Make that argument persuasive enough that it will guide the actions of future policymakers (iii) Convince investors, consumers, and firms that you have in fact achieved (i) and (ii).

In reality, we haven’t even gotten anywhere near (i): the conventional wisdom is still that any rise in expected inflation above 2 percent is a bad thing, when it’s actually good.

But Krugman thinks this isn’t going to happen. He doesn’t focus on this solution because “I don’t think I’ll get anywhere, at least not until or unless the slump goes on for a long time.” Hence, the focus first on expansionary fiscal policy and now increasingly on direct support for employment.

But if this political analysis is correct, then aren’t the monetary authorities going to end up undermining anything that can be done on the fiscal side? You can see how fiscal policy could be effective as an adjunct to monetary efforts, but if fiscal and monetary policymakers try to work at cross-purposes, then my understanding is that monetary policy wins.

Unemployment Passes 10 Percent

More bad news on the labor market front:

Takeaways: One, people need to stop worrying about inflation. Two, the federal government should deploy more aid to state and local governments. Three, instead of easing up on the easing of monetary policy the Fed needs to ease even more, probably by taking some advice from Scott Sumner about ways this is possible.

More Inflation Needed

Alex Tabarrok noted this morning:

I wish Arnold Kling were correct that inflation is around the corner. We could use some inflation to get back on track. Nominal wages are simply not flexible enough to get the job done in short order and there is much to fear from populist backlash.

I wish Tabarrok could do more to convince his fellow free market types that this is correct. Because instead the political system seems to be dangerously obsessed with the idea that we need to start fighting inflation.

Another data point in the inflation-would-be-good direction comes from this recent Wall Street Journal article on how businesses have started hoarding cash. The idea of “risky investments” has come to be associated with financial firms gambling on financial assets, and now there’s a backlash against the very concept. But the reality is that for the economy to grow, businesses need to be making investments in their own capacity. And all such investments always involve some risk. One problem with these traumatic downturns is that everyone starts getting extremely risk-averse and hoards money out of fear that investments won’t pay off. That belief becomes, in turns, self-justifying since with so little investment happening there’s little growth and investments don’t pay off.

One way to alleviate the cycle, however, is to have some inflation. Inflation makes it very costly to sit on piles of cash, and makes it look better to go out and do something with it instead. A period of zero or falling inflation, by contrast, makes hoarding look like a pretty reasonable course of action.

More Growth Needed

Paul Krugman posts a chart illustrating that 3.5 percent growth is not going to result in a rapid fall in the unemployment rate:

Ryan Avent offers more context:

And consider this: the last time the unemployment rate hit its current level was during the recession of 1981-1982 (during which the unemployment rate actually peaked at 10.8% during the final quarter of the recession). Here are the quarterly growth rates for the six quarters immediately following the end of that recession: 5.1%, 9.3%, 8.1%, 8.5%, 8.0%, 7.1%. And at the end of that period, the unemployment rate was still above 7%.

As he says, this implies that even if worried about the sustainability of the Q3 growth pattern prove misguided and we can keep growing at 3.5 percent, “American unemployment will remain near 10% through the end of 2010, at least.”

Two points: One is that incumbent members of congress need to get their heads out of the sand and recognize that they’re likely to be kicked out of office by angry mobs if this comes to pass. A lot of politicians and political operatives in DC are very impressed by polling that shows people concerned about the budget deficit. I think it would be really politically insane for people to take that too literally. If congress makes the deficit even bigger in a way that helps spur recovery, then come election day people will notice the recovery and be happy. If, by contrast, the labor market is still a disaster then people will be pissed off. It’s true that they might say they’re pissed off at the deficit, but the underlying source of anger is the objective bad conditions.

The other point is that we’re largely at the mercy of the Federal Reserve here. And this worries me. Ben Bernanke is a good economist with a good reputation. He’s also a conservative Republican appointed to his job by George W. Bush after loyal service in a previous government job to which he was appointed by George W. Bush. It seems extremely plausible to me that a scenario in which the US experiencing three years of modest economic growth, high unemployment, rising productivity, flat wages, rising corporate profits, and GOP election victories is one he’d consider just fine.

Romer on GDP

CEA Chief Christina Romer blogs on the GDP numbers:

After four consecutive quarters of decline, positive GDP growth is an encouraging sign that the U.S. economy is moving in the right direction. However, this welcome milestone is just another step, and we still have a long road to travel until the economy is fully recovered. The turnaround in crucial labor market indicators, such as employment and the unemployment rate, typically occurs after the turnaround in GDP. And it will take sustained, robust GDP growth to bring the unemployment rate down substantially. Such a decline in unemployment is, of course, what we are all working to achieve.

One of the things that makes American politics weird is that nobody in the administration is really supposed to talk about the fact that this is much more up to Ben Bernanke than it is up to Barack Obama. There’s disagreement as to whether expansionary monetary policy should be halted as soon as GDP starts growing or else should be continued until we have unemployment a few percentage points lower. This is a very important debate. But it’s a debate over which the country’s elected officials have extremely little formal influence.

Graduating During a Recession Has Big, Long-Lasting Negative Consequences

Over the summer, there was a tendency for rising senior interns to ask me if I had any advice for someone set to be graduating into the face of a horrible recession. Unfortunately, the best advice I can think of is “hope the United States rapidly becomes more committed to equality and social justice” because the empirical evidence is that you’re screwed. Peter Orszag at the OMB Blog reminds us:

The chart below illustrates this effect: a one percentage point increase in the national unemployment rate is associated with a 6 to 7 percent loss in initial wages. The annual wage loss declines over time, but is still statistically significant 15 years later. Comparing the wages earned by the class of 1982 (a peak unemployment year) with the wages of the class of 1988 (a peak employment year) over the first 20 years of a career, the wage difference resulted in a difference of nearly $100,000 in cumulative earnings in net present value.

The long-term effect isn’t just a residual of low first-year wages: the author suggests that poor job match, lower prestige placements, and fewer opportunities for training and promotion also play a role. Other researchers have found similar effects: Oreopolous et al find persistent wage effects for Canadian college graduates; Bowlus and Liu find persistent wage effects for high school graduates moving directly into the work force, and other studies assess how the macroeconomy affects impact newly minted MBAs and economics PhDs.

Fifteen years later! If you’re graduating from college this spring, you’ll be sitting around at the age of thirty-five still suffering from the fact that Susan Collins, Olympia Snowe, Ben Nelson, and Kent Conrad decided to make the stimulus bill stingier in order to better bolster their credentials as preening centrists. When thinking about short-term inflation-unemployment tradeoffs, this sort of thing is crucial to keep in mind. Inflicting a high unemployment rate on the population has incredibly punitive and deleterious long-run consequences for young people.

Reality-Based Conservatism: Frum on the Gold Bugs

David Frum has a nice column starting with the weirdness of the upsurge in cable news and talk radio ads for gold, and pivoting to the phantom menace of inflation:

That may be a price worth paying for a hedge against inflation. At today’s prices, however, investors should ask themselves some hard questions about how real the inflation risk is — and how much it is worth paying to insure against that risk.

Most U.S. indices continue to warn of deflation ahead, not inflation.

Consumer price indexes are dropping, not rising. Average weekly wages are dropping too. For the first time since 1975, there will be no cost-of-living increase in U.S. Social Security payments to retirees. (President Obama is proposing to distribute an additional $250 per retiree anyway, but this largesse will require a vote in Congress.)

This Planet Money chart nicely illustrates the inflation we’re not experiencing:

The inflation fears we’re seeing are some kind of macroeconomic moral panic. Surely we’re going to reap the whirlwind for all this spending! But the evidence suggests that we’re not. And the very same evidence also suggests that it’s not the case that we’re in some kind of special kind of business cycle downtown that can’t be remediated through stimulation of aggregate demand. As long as inflation is abnormally low, we need to (a) stop worrying about inflation (b) engage in more expansion.

What is the European Central Bank Thinking?

Willem Buiter has an excellent post up at the FT asking, basically, why on earth the European Central Bank is sitting on its hands while the Euro area undergoes inflation. He points out that its attitude toward deflation is both dumb and in violation of its legal mandate under the treaty establishing it:

The asymmetry in the response of the ECB to inflation rates above the level deemed consistent with price stability in the medium term, as opposed to inflation rates below that level is staggering and poses a material risk to the independence of the institution. [...] The ECB is violating its price stability mandate by tolerating, aiding and abetting deflation in the Euro Area.

Buiter observes that recent changes in the relative position of the “core” vs “headline” inflation rate give us a case study in this asymmetry:

When the headline rate was high but the core rate was below the ECB’s long-term 2 percent target, the ECB emphasized the headline rate and tightened monetary policy. But now that the headline rate is negative, the ECB chooses to emphasize the core rate and decline to ease further. I would note, in addition, that even the core rate is substantially below the ECB’s self-proclaimed target.

When I was in Germany, my group had the opportunity to speak with Bundesbank President Alex Weber. Unfortunately, the discussion was off the record. But suffice it to say that in keeping with stereotype, rather than in keeping with the actual legal mandate of the ECB, Weber’s point of view is very much that this kind of asymmetry is appropriate and he was very committed to the idea that the purpose of central bank independence is to allow one to be indifferent to the human consequences of this kind of commitment to low inflation at all costs. That really doesn’t seem correct to me. Among other things, as Buiter says it seems to me that this behavior is actually threatening the ECB’s independence. It’s one thing to go against a plain reading of your legal mandate. And it’s one thing to allow employment and production to become depressed. But to do the two simultaneously is willfully playing with fire.

The rubber hasn’t really hit the road on this issue yet since the recession’s not that bad in France and Germans are maniacal about inflation. But things are really falling apart in Spain and Ireland and the Germans are probably looking at a big run-up in unemployment soon, too.

Market is Anticipating Low Inflation

Martin Wolf’s latest column manages to pack a staggering quantity of different ideas together. But this is a blog, so let’s just stick to one point—not only are the inflation hawks wrong to be worrying about inflation, they seem to be wrong that there’s any plausible high inflation scenario:

Higher prices of gold reflect fear, not fact. This fear is not widely shared. The US government can borrow at 4.2 per cent over 30 years and 3.4 per cent over 10 years. During the crisis, the inflation expectations implied by the gap in yields between conventional and inflation-protected securities collapsed. These have since recovered – yet another sign of policy success. But they are still below where they were before the crisis. The immediate danger, given excess capacity, in the US and the world, is deflation, not inflation.

Yes. Pre-crisis inflation expectations were low. Today’s inflation expectations are lower. And yet post-crisis the case for low inflation is weaker than it was pre-crisis. What we really should be worried about is that the rising volume of pay cuts will lead to unbalanced deflation and an unbearable debt load. Better to see a cheaper dollar and a modest level of inflation let us adjust in a balanced way.

Canadians Not Happy About US Dollar Fall

Toonie

A cheaper US dollar is almost certainly in the short-term interests of the United States as it will boost employment and help us get out of the recession. But perhaps more importantly, it’s in the medium-term interests of just about everyone, since it would set the stage for a rebalanced global economy. The problem is that it’s very hard to find any examples out there of “matching” countries whose leaders are excited about the prospect of more-expensive currencies and the enhanced consumption possibilities that would be opened up. For example, the Canadian economy has been a good deal stronger than the American over the past 18-24 months so the Loonie has shot up relative to the Greenback. This means Canadian citizens can afford more goods and services than would otherwise be possible, but it has PM Stephen Harper worried:

Some of the Canadian dollar’s sharp climb is justified by fundamentals but too rapid a rise could damage the country’s economic recovery, Prime Minister Stephen Harper said Tuesday.

“Obviously, it is a concern,” Harper told reporters, noting that Bank of Canada Governor Mark Carney had also worried about volatility in the currency.

He’s not wrong, exactly. Unfortunately with employment looking weak in pretty much every country around the world, no leader anywhere seems to believe that his country can withstand a large short-term increase in value. But eventually the shift has to happen, and I don’t really see what the way out is.

The Falling Dollar

There’s a lot of heartburn in Europe over the recent slide in the value of the dollar. American journalists traveling in very expensive Denmark are also generally unhappy about this situation. But it’s hard to see what the alternative is. For years the United States has been running an unsustainable trade deficit. What “unsustainable” means is that it’s not possible for it to be sustained. And the way you would stop sustaining it would be for the dollar to fall in value. American consumers will buy fewer imports if imports become more expensive. And American exporters will sell more to markets abroad if US-produced goods get cheaper. Foreigners will become more inclined to visit the United States, and Americans will become less inclined to travel abroad. That will even out the flows, and stabilize the currency markets.

Asian central banks are trying to prop the dollar up but this is like trying to roll a gigantic boulder uphill. The level of global demand for US-made goods at the dollar’s current price simply isn’t high enough to justify the current value of the dollar.

Meanwhile, the interests of American tourists aside, a falling dollar is exactly what the American economy needs. It’s a way of, in effect, driving wage levels down to a level at which increasing employment is economical and getting us out of current sky-high unemployment. Of course for the same reason foreign central banks will want to bolster the value of the dollar in order to prevent unemployment from rising in Europe and Asia. I think the real risk here, however, is that foreigners will go to far in terms of trying to sustain an unsustainable situation and ultimately prompt a bigger breakdown.

Glenn Beck, Goldbug

It seems that Glenn Beck has taken to advising his audience to invest in gold. At the same time, his remaining advertiser base consists primarily of gold merchants. Nice conflict of interest there.

But beyond the conflict of interest, it should be said that the whole idea of investing in gold as a hedge against the possible future decline in the value of the dollar is a bit bizarre. Currencies devalue relative to other currencies. If you think that in the future the dollar will be worth less (not a crazy prediction) the reasonable course of action isn’t to invest in gold, it’s to invest in some other currency. Buy Yen or Australian dollars or Norwegian krone or whatever you like.

Norwegian krone versus dollar and euro

Gold isn’t much of a pure currency play. Its price depends on things like discoveries of new gold, technological improvements in mining, the waxing and waning of demand for gold for industrial applications, etc. I would not, personally, be inclined to become a currency speculator. But if you do think you have special insight into the future movements of currencies, there are much more reasonable ways to put your money where your mouth is.

The Case for (a Moderate Amount of non-Accelerating) Inflation

Chris Hayes has a policy paper out for New America trying to drive an idea that’s been discussed a fair amount in academic circles but doesn’t seem to have gotten much political purchase, namely that we need some more inflation in the United States over the medium-term:

The idea is basically that if we could sustain a five or six percent inflation rate for a period of years, that would make it much easier to work off the debt overhangs—both in the public and private sectors—that otherwise threaten to hobble the economy for years. You would need, of course, to try to be sure that this doesn’t spiral into accelerating inflation. But the point is to move beyond the kind of anti-inflation hyper-vigilance that came into vogue after the Great Inflation of the 1970s. That mentality was an understandable reaction to what had happened, but the fact that an out-of-control wage-price cycle is a bad thing doesn’t mean that inflation should always be kept as low as possible. A moderate amount of inflation could do a great deal to help us.

The Perennial Fear of Inflation

(cc photo by tao_zhyn)

James Suroweicki has a great column about inflation fearmongering:

Then why are people afraid that inflation is about to get out of control? Because they’re always afraid that inflation is about to get out of control. Indeed, many of those arguing today that the Fed should place the threat of inflation front and center were saying the exact same thing last year—in the middle of a recession. [...] In a way, there’s something profoundly puritanical, in the original sense of that word, about the inflation hawks: we are always on the verge of sinning, always about to succumb to our worst impulses. Even the rhetoric of inflation—the “debasement” of the currency—carries a moralistic tinge.

Another thing I would note, however, is that if you listen to conservative talk radio there’s actually quite a lot of advertising for gold of various forms that directly preys on listeners’ fear of inflation.

Bernanke Reappointed

Surprising no one, Barack Obama will reappoint Ben Bernanke to a second term as Federal Reserve chair. Brad DeLong is enthusiastic about the choice. I have various doubts, including the fact that we’re now looking at a span of continued Republican Party control over this crucially important office that’s lasted over twenty years. Among other things, this seems to be entrenching some kind of precedent that only conservative Republicans are competent to do the job notwithstanding the fact that the most impressive monetary policy successes of the postwar decades were undertaken by Democrat Paul Volcker in the late 70s and early 80s.

Other concerns previously voiced here:

I would say that ever since some time last year when it become absolutely undeniable that Ben Bernanke was had been completely wrong about “The Great Moderation”, Bernanke has done an admirable job of trying to clean up the mess created by the errors of the school of thought to which he adhered. But like Kevin Drum I feel that this is a strange basis on which to rest the burgeoning Cult of Bernanke. In a reasonable world, I would think that Bernanke would probably fade away after his term ends to be replaced by someone else, and then return to the public eye a few years hence with an interesting memoir taking stock of the whole situation. Instead, he’s weirdly become an iconic figure and a shoo-in for another term.

That said, it seems like he’ll do fine in the job. One irony of the reappointment is that, as explained on NPR this morning, the announcement is being made this early in the process because the Obama administration appreciates that financial markets are unsettled by uncertainty. That kind of thing is a commonplace of the policy dialogue, and yet at the same time appears to rely on assumptions that are completely at odds with the strong faith in financial market efficiency and rationality that have typically driven financial policy over the past few decades.

Reapppointing Bernanke

Kevin Drum observes that Ben Bernanke’s reappointment seems extremely likely:

Ain’t the intertubes great? On a more substantive note, not a single one of the panelists was opposed to reappointing Ben Bernanke. Not even Dean Baker! Et tu, Dean? This suggests to me that Bernanke is a shoo-in for winning a second term. If you can’t even get a bunch of liberals at Netroots Nation to oppose him, what are the odds that anyone else is going to lead the fight?

Apparently not. I have to say, though, that the whole reappointment sweepstakes seems to me to seriously undermine the notion of the Fed’s independence. Why not give the Chairman five or six years, a non-renewable term, a generous pension, and a ban on going to a post-Fed job in finance? Since Volcker, the Fed’s worked quite well, but pre-Volcker it was working very badly so I don’t think we should acquire a false sense of confidence in the system.

Fed Sacrificing Independence to Avoid “Perceived Loss of Independence”

Via Felix Salmon, some troubling reporting from Greg Ip about the Fed’s quantitiative easing programs:

If the programmes are doing some good, why is the Fed not expanding them? The outlook has improved, for one thing: America’s economy is levelling out, it noted on August 12th. But the main reason is political, not economic. The Fed’s Treasury-purchase plan prompted charges that it was inviting hyperinflation and had subordinated itself to the government’s deficit needs. Alan Greenspan, a former Fed chairman, says inflation will exceed 10% if the Fed fails to shrink its balance-sheet and raise rates, and 3% for a time even if it does.

Needless to say, that is not the Fed’s view: it still foresees rising unemployment and falling inflation. But many officials have concluded that, for now, the benefits of buying more Treasuries do not outweigh the costs of a damaging rise in inflation expectations and a perceived loss of independence.

The point of central bank independence, of course, is precisely to avoid making decisions such that “the main reason is political, not economic.” When that starts happening, something’s gone wrong. And it seems to me that something’s gone doubly wrong when decisions are being made for political reasons not because other elements of the government are infringing on the Fed’s independence, but because Fed decision-makers feel that they should take a specific wrong-on-the-merits course of action in order to avoid “a perceived loss of independence.” After all, now they’ve lost the real thing!

Salmon tries to cash this out in a way such that it might make sense:

I think that what Ip is trying to say is that central banks have a lot of independence so long as inflation expectations are low, but if they’re perceived to have lost their grip on inflation, then that perceived independence can evaporate very quickly. (This is all about perceptions, interestingly enough: inflation expectations, rather than actual inflation and perceived independence, rather than actual independence.) And so in order to maintain a reputation for independence, they will be inclined to favor the arguments of political hawks. It’s a way of second-guessing themselves into having less independence in reality, just for the sake of keeping more independence in the public mind. Or something.

“Or something,” indeed. The fact of the matter is that too much attention to perceptions undermines independence, and undermining your independence is bound to lead to the perception that your independence has been undermined.

Productivity Surged in Quarter 2

Looks like productivity surged in the second quarter up at a 6.4 percent annual rate. Rising productivity is basically good, but it means that either the economy is going to grow very rapidly because we’re now so productive, or else that modest growth is going to be accompanied by massive unemployment. And I don’t really know anyone who’s expecting very rapid growth in the near term.

The takeaway point, I think, is that the case is strong for the Fed and other central banks to continue dramatic measures aimed at boosting recovery.

Markus Brunnermeier on Bubbles

This kind of bubble we know how to pop (wikimedia)

Why do financial bubbles arise? And what can we do about it? Brad DeLong recommends these thoughts from Markus Brunnermeier:

In my view these frictions are also the root cause for the failure of the efficient market hypothesis (EMH). For example, bubbles can emerge and persist due to limits to arbitrage. Of course, as Bob Lucas points out, when it is commonly known among all investors that a bubble will burst next week, then they will prick it already today. However, in practice each individual investor does not know when other investors will start trading against the bubble. This uncertainty makes each individual investors nervous about whether he can be out of (or short) the market sufficiently long until the bubble finally bursts. Consequently, each investor is reluctant to lean against the wind. Indeed, investors may in fact prefer to ride a bubble for a long time such that price corrections only occur after a long delay, and often abruptly. Empirical research on stock price predictability supports this view. Furthermore, since funding frictions limit arbitrage activity, the fact that you can’t make money does not imply that the “price is right”.

This way of thinking suggests a radically different approach for the future financial architecture. Central banks and financial regulators have to be vigilant and look out for bubbles, and should help investors to synchronise their effort to lean against asset price bubbles. As the current episode has shown, it is not sufficient to clean up after the bubble bursts, but essential to lean against the formation of the bubble in the first place.

This calls on us economists to further develop our tools (including mathematical tools) to integrate the insights financial economists have developed on frictions and the formation of bubbles into the fully fledged dynamic stochastic general equilibrium macro and monetary models that macroeconomists have been working with. Bringing financial economists, macro- and monetary economists together to take on this challenge of building a new workhorse model that incorporates financial frictions would be a great first step in this important (and exciting) endeavor.

I concur.

Bernanke Versus the Inflation People

Currently, the US unemployment rate stands at 9.5 percent. With the unemployment rate at 9.5 percent it’s difficult for the majority of workers to argue for a raise. This is definitely true when we consider that millions of additional Americans are currently only working part-time even though they’d like full-time hours. What’s more, Ben Bernanke is forecasting that the unemployment rate will eventually rise to over 10 percent and that by the end of 2011—18 months from now—it will still be over eight percent. Under those circumstances we’re looking at a protracted period of flat or falling wages.

And yet somehow we still have people like Cato’s Doug Bandow darkly warning about the threat of inflation. But where is this inflation going to come from? And if it does miraculously arise, why can’t the Fed start reducing liquidity then? There’s something very strange about the inflation people’s outlook and their insistence that we should ignore the problem of actual mass unemployment right now in favor of the hypothetical problem that anti-unemployment policies might generate inflation at some future point. It’s like they’re standing outside a burning building worrying that the fire department’s hoses are going to ruin the furniture.

I think it’s pretty problematic that we have people arguing that with the Fed Chair job held by Republicans for 22 straight years, only extending the streak to 28 years can establish the Fed’s “political independence.” But that said I’m definitely glad that we got Bernanke rather than some of these other cranks who seem to be kicking around in right-of-center circles these days.

Fed Independence and Inflation

The Eccles Building (wikimedia)

Making the case for Central Bank independence, Megan McArdle says:

So there is something magical about bank independence. It lets Congress cut against its basically populist political interests. You may think that makes it too bank-friendly. But it also means we don’t have double-digit inflation, which is where we were headed before Volcker.

But of course the Fed had its statutory independence before Volcker. And yet inflation went from “a bit high” in the late sixties to “out of control” in the seventies precisely because the Fed was making monetary policy in the early 1970s with an eye toward ensuring Richard Nixon’s re-election in 1972. Nothing about Fed “independence” actually prevented the very politicization of monetary policy that it’s supposed to prevent. And by somewhat the same token, I think there’s some reason to believe that Alan Greenspan kept monetary policy so loose in 2004 precisely because, given his belief that tax cuts for rich people and dismantling Social Security benefits for old people constituted a sure path toward prosperity, he wanted to help George W. Bush’s re-election campaign.

Which isn’t to say that having Congress set monetary policy would be better. A point Megan makes earlier in the post is that Congress pretty clearly doesn’t actually want to set monetary policy. But that’s about what Fed independence consists of, the fact that key political actors would rather distance themselves from monetary policy decisions than have the power to make them. Nothing’s actually stopping Congress from making the Fed do what it wants, and Fed decisions and Presidential politics are inextricably intertwined. What wards off inflation probably isn’t procedural rules, it’s the existence of a pretty firm political consensus against inflation. At times in American history we’ve had explicit pro-inflation political movements; if we had another one today, the Fed would probably start to look different.