Is It Structural or Cyclical Unemployment?

The Economist magazine is asking whether there has been an increase in America's structural unemployment. If the answer is yes then macroeconomic policy may be limited in how much it can do to lower unemployment. Thus, even if the Fed further stabilized aggregate demand the benefits for the unemployed and  the broader economy may be muted.  My own view has been that both structural and cyclical unemployment have been important in this economic cycle. On one hand, the the rapid productivity gains in 2009 (they are down in 2010) point to increased structural unemployment, a point recently made by David Altig. On the other hand, there is evidence consistent with a slowdown in aggregate demand which points to increased cyclical unemployment.

So how important are these two forms of unemployment?  Justin Weidner and John C. Williams of the San Francisco Fed have a note that helps answer this question.  In the note the authors look at the various measures of the output gap and via Okun's Law, the implied natural rate of unemployment.  Now the natural rate of unemployment is the sum of frictional unemployment and structural unemployment.  Frictional unemployment, which is a function of search costs, most likely hasn't changed that much.  Thus, any change in the natural rate of unemployment is probably coming from changes in structural unemployment.  Below are unemployment tables constructed from the different measures of the output gap discussed in this note.  The first table shows the implied natural rate of unemployment and the second one shows the implied cyclical rate of unemployment (i.e. actual unemployment rate minus the natural rate of unemployment).  Click on the figure to enlarge it:

What this table indicates is that since 2008:Q4 cyclical unemployment has been hovering around 3.0% while the natural rate has been growing steadily and now is around 6.8%. This data, if correct, suggests that folks like me who call on the Fed to do more in terms of stabilizing aggregate demand should realize the limits of macroeconomic policy.  Still, providing a stable monetary and aggregate demand enironment in which the structural adjustments can take place should not be overlooked.

Religiosity and the Business Cycle, Again

Ryan Avent and and Ezra Klein both take note of this Lisa Miller article in Newsweek that discusses what appears to be countercyclical  religiosity.  Here, religiosity is measured by church attendance.  If you read the piece you may note that it addition to citing Daniel Hungerman, an economist who is known for his scholarly work on the economics of religion, it also briefly  quotes me.  If you noticed this quote in the article you  probably wondered to yourself "What the heck is Beckworth doing in this piece? Isn't he the Fed-criticizing, nominal GDP-target loving, saving-glut thesis critiquing macroeconomist who blogs from Texas?" Well, yes but it also just so happens that a few years ago I dabbled in the economics of religion where I specifically looked at the relationship between the business cycle and religiosity.  My timing was impeccable given the arrival of the Great Recession and as result my research got some media attention. That is why I got cited in the Newsweek piece. 

In my first foray into this issue I found that religiosity--as measured by weekly attendance and membership growth--was countercyclical especially for folks who hold more absolute beliefs. In my second foray I expanded my study of the business cycle-religiosity link by looking at manifestations of religiosity through both giving of time (e.g. church attendance) and giving of funds (e.g. tithes and offerings) to religious activities.  Here I found that for religious folks giving of time and money act as substitutes in response to economic shocks.  For example, if the economy is booming  and is making  one's time more precious then giving of funds to religious causes increases and giving of time decreases. On the other hand, during a downturn, time becomes less costly and financial giving more costly  so the opposite happens.  

Now the opportunity costs story outlined above is not the only way to interpret these findings. Another reason why church attendance may increase during recessions is that folks are engaged in consumption smoothing as religious communities can act as a form of social insurance. Individuals may turn to churches  for consumption needs such as shelter and groceries as well as intangible consumption needs such as a sense of certainty. Daniel Hungerman in the article mentions another reason may be an increased awareness of community during hard times that pulls people to church. I suspect there is some truth in all of these stories. Here is an earlier post I did on this issue.

Monetary Policy Dominates

Scott Sumner once used the analogy of arm wrestling with his daughter to describe why monetary policy always dominates fiscal policy.  Scott explained that no matter how hard his daughter tried to win the arm-wrestling contest he would always apply just enough pressure to offset her efforts and keep her in check.  Likewise, no matter how expansionary or contractionary fiscal policy may be, at the end of the day the Fed has the ability to offset such actions and place aggregate demand where it so chooses.  This point is vividly illustrated in the article titled Money Dominates by Steve Hanke. Read it.

My Reply to Bruce Bartlett

Bruce Bartlett has a new piece summarizing his views on what monetary policy can and can't do for the U.S. economy. Although no names are listed I suspect the excerpt below from his piece is directed to folks like Scott Sumner and me:

From the beginning of the crisis there have been economists who said that monetary policy was sufficient to stem the deflation and turn the economy around without fiscal stimulus. Just pump up the money supply, they said; that will stem the deflation all by itself and save the country from a destabilizing increase in debt, a lot of wasteful pork barrel spending, and avoid an implicit tax increase via Ricardian equivalence...  The problem is that the Fed did increase the money supply a lot... Of course, there has been no inflation because deflation remains the economy’s central problem.That is because all the money created by the Fed never got spent; it just piled up in bank reserves. I explained this problem in my July 16 column. This was the fallacy of the monetarist view. Monetarists just assumed that increases in the money supply would be spent.

While it is true that Scott Sumner and me have argued that there would be little need for fiscal policy had monetary policy been doing its job all along, no where have we said it was simply a case of further increases to the money supply.  Rather we have been making a more nuanced case for further Fed action.  Below is my reply to him.

Bruce,

You underestimate the ability of the Fed to stabilize spending. Yes, the Fed has increased the monetary base with little to show but this is very different from what folks like Scott Sumner and me have been arguing.  Nowhere have we said that further increases to the monetary base alone will cause everything to fall into place in the economy. Our message has been more nuanced than that. We have argued primarily for the Fed to adopt an explicit nominal target that would help shape expectations and thus stabilize velocity. We have also argued the Fed should abolish the interest paid on excess reserves and engage in further quantitative easing (i.e. expansion and alteration of the its balance sheet) as needed to hit its nominal target.  Then, and only then, you would see some real traction.

Let me present our case--the way I see it anyhow--using the expanded equation of exchange. First take the regular equation of exchange, MV=PY (where M = money supply, V=velocity, and PY = nominal GDP or aggregate demand) and expand the money supply term, M, such  that M=Bm where B = monetary base and m = money multiplier. This expanded version of the equation of exchange can be stated as follows:

BmV = PY

In this form, the equation says (1) the monetary base times (2) the money multiplier times (3) velocity equals (4) nominal GDP or total spending (i.e. aggregate demand). The Fed has complete control over the monetary base, B. It has less control over the money multiplier,m, but still can shape it to some degree as it is currently doing by paying banks interest payments to sit on excess reserves. (Imagine what might happen to m if the Fed started charging a penalty for holding excess reserves? We saw how excited the stock market got just at the idea of dropping interest paid on excess reserves.) The Fed can also influence V by setting an explicit nominal target (e.g. inflation, price level or nominal GDP target--the latter being my first choice). In short, the Fed has enough influence that if it really wanted to it could do much to stabilize BmV (or MV).  And all of this could happen without resorting to more fiscal policy.

This is not just a theory. Christina Romer and others have shown it was the reason for the rapid recovery of 1933-1936.  Have some faith Bruce. There is much moneary policy can still do.

By the way, given the identity M=Bm we can see that technically the Fed has not increased the money supply a lot, it has only increased the monetary base a lot.  In fact, if one looks at MZM or M3 they are actually down for the year.

Update: Matthew Yglesias also responds to Bartlett. 

Ambivalence is Not a Good Sales Pitch

I really wish Paul Krugman would not be so be tepid in his pronouncements of the efficacy of monetary policy.  His recent articles on what monetary policy can do have been less than inspiring and leave great uncertainty in the mind of the reader as to whether the Fed can actually do anything.   Here is a prime example:

The zero lower bound on short rates really does matter...  So it’s not safe to assume that the Fed can, for example, hit any target for nominal GDP that it chooses...The Fed deserves to be chastised for not doing more...

So, on one hand the Fed needs to be doing more, but on the other hand we don't really know whether it will matter.  I am no expert on sales, but I do know a bad sales pitch when I see one and this is one of them.  Wishy-washy calls for more Fed action like the above will not convince anyone, let alone the Fed. Now readers of this blog know that unlike Krugman I do believe the Fed can, for the most part, hit any nominal GDP target that it wants if it so desired.  The reasons for this belief are threefold: (1) Ben Bernanke and other fed officials believe that the Fed could do more; (2) monetary policy was shown to be highly effective in the early-to-mid 1930s, a far worse economic environment than today; and (3) many top economists believe the Fed could do more.  One of these top economists, who happened to win the Nobel Prize for economics, went so far as to argue monetary policy and not fiscal policy is the key to economic  recovery in a depressed economy:

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.

Yes this is Paul Krugman and yes, he is arguing that the first best solution to a depressed economy is more active monetary policy. Now he does go on to note in the same piece that the key here is for the central bank to permanently alter inflationary expectations and doing so may be challenging in practice. Krugman, however, is doing nothing to promote this approach by having columns drenched with ambivalence about the efficacy of monetary policy.  If one wants to sell something one need to convince potential buyers in what they are selling.  Being ambivalent about your product will not do that. 

Bruce Bartlett on What the Fed Can Do

Bruce Bartlett has been discussing what the Fed can do to help stabilize aggregate demand.  In this piece he  joins the growing chorus of observers calling for the Fed to abolish paying interest on banks' excess reserves: 

[M]any economists believe that the Fed has unwittingly encouraged banks to sit on their cash and not lend it by paying interest on reserves. Eliminating interest on reserves would therefore encourage lending. A rumor that the Fed might do so caused the stock market to rise earlier this week, according to press reports. But the policy remains in place.

[...]

To use a hackneyed phrase, the Fed needs to think outside the box and be more innovative and aggressive about getting money to circulate, getting banks to lend, and raising inflationary expectations. Ending payments to banks on money they aren’t lending would be a step in the right direction.

I agree and have been making this same point since October 2008 when the Fed first started this policy. At this juncture, though, the Fed should also add some explicit nominal target--my favorite would be a nominal GDP target--to stabilize nominal expectations and shore up velocity.  As I have said before--and contrary to what Bruce Bartlett claims in his other Fed piece--there is a lot monetary policy can do now to stabilize aggregate demand if it wanted to do so.

The Fed's Balance Sheet: a Problem or an Opportunity?

(Click on figure to enlarge. Source: Cleveland Fed)

Is the Fed's expanded balance sheet a problem or an opportunity? It has grown from approximately $860  billion in early 2007 to about $2.3 trillion today.  That is an increase of over 250%. This enlargement of the Fed's balance sheet implies a corresponding increase in the monetary base.  Obviously, this large of an increase in the monetary base, if multiplied into increases in broader monetary aggregates like M1 or M2, has the potential to fuel spending and become highly inflationary.  But it hasn't happened as most of  the new monetary base is sitting in banks as excess reserves.  It is not being lent out and is far from living up to its reputation as  "high-powered money". Moreover, the market expects this to be the norm for years as inflation expectations across all horizons are falling.  The Fed's balance sheet, then, currently appears to be anything but a problem with regards to inflation.  Now someday it could be a problem, but right now it is not and that indicates the Fed is failing in its efforts to stabilize spending--the one thing the Fed can and should be doing.

Now since the Fed's balance sheet is not  currently a problem it actually has the potential to be useful.  In fact,  it presents a great opportunity to help change inflationary expectations and thus stabilize spending.  How so?  By publicly acknowledging  the inflationary potential of the Fed's expanded balance sheet.   Yes, this seems contrary to what I just wrote above, but that is exactly why it needs to be done.  If enough public officials and other influential observes express concern  about the Fed's balance sheet being inflationary and do it repeatedly then the public will become concerned too.  Inflationary expectations will then increase and  will thus lower current real interest rates, decrease the demand for money (i.e. increase velocity), and improve the outlook for the troubled household balance sheets (by increasing future asset values). 

Now inflationary expectations could overshoot using this approach and there are better ways to stabilize expectations like having the Fed explicitly commit to an inflation, price-level, or nominal GDP target.  But since the Fed seems reluctant to commit to an explicit target this seems like the next best approach.  So talk it up! Sound the alarm! Inflation is coming!

Smackdown of the Month

Compliments of Ken Houghton.

The Expected Inflation Curve

As a follow up to my recent post on the Cleveland Fed's update on its expected inflation series, I have graphed below the expected inflation curve.  This curve plots the average expected inflation rate at various yearly horizons using the Cleveland Fed data. This figure makes clear that inflation expectations are headed down across all horizons. (Click on figure to enlarge):

I Hope He is Wrong...

But I fear that Roger Lowenstein and his assessment on how long it will take the U.S. economy to return to normal may be right.  The crux of his analysis is that household balance sheets were decimated in this recession and to fix them will take years.  As part of this slow process households are deleveraging and saving more.  Though needed, these structural adjustments imply sluggish growth. And if this process takes years as indicated by Lowenstein then we are looking at sluggish growth for some time.  Here is Lowenstein:

Eschewing trips to the mall, Americans are paying off credit-card balances and home-equity lines. Despite low rates, mortgage demand has plummeted.

Some people have no choice but to pare their debts (indeed, some are being foreclosed on). For others, call it morning-after sobriety or late-blooming prudence. Losing income tends to bring on a case of the nerves, and half of American workers have suffered a job loss or a cut in hours or wages over the past 30 months. And, need we add, people’s stock portfolios are not what they were.

The economic term is “deleveraging”; it means that, as opposed to the normal state of affairs, in which, each quarter, people borrow more money and banks issue more loans, credit in the economy is shrinking. Remarkably, this deleveraging has been going on for nearly two years.

[...]

To return to the status quo of before the housing boom — say, back to debt to income ratios prevailing in 2000 — it would take five more years of deleveraging at the current rate. Deleveraging cycles are rare, notes David Rosenberg, an economist with the Toronto firm Gluskin Sheff, but five to seven years is typically what they take.

I really hope this assessment is wrong.  Looking to the data, though, on household balance sheets does seem to lend itself to Lowenstein's dour assessment. Below is household net worth (i.e. assets minus liabilities) as a percent of disposable income up through 2010:Q1.  The data comes from the Flow of Funds table B.100.  (Click on figure to enlarge.)

Household net worth is close to what it was in the late 1980s, early 1990s.  Obviously, most of the fall in household net worth has come from a decline in asset values. Liabilities have not change much.  This is very evident in if one looks specifically at residential real-estate assets versus residential mortgage debt. Truly this is the revenge of the balance sheets.

The Cleveland Fed and Expected Inflation: It's Getting Worse

The Cleveland Fed has updated it expected inflation series.  Here is the lead paragraph from their July 16 update:

The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.69 percent. In other words, the public currently expects the inflation rate to be less than 2 percent on average over the next decade.

Recall, that at the end of June the same paragraph read as follows:

The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.84 percent. In other words, the public currently expects the inflation rate to be less than 2 percent on average over the next decade.

As I have said before, the way I interpret these numbers is that aggregate demand is expected to weaken in the future.*  Since the Fed can largely shape aggregate demand (i.e. total current dollar spending) if it wanted to do so this amounts to an expected tightening of monetary policy going forward. 

*One does have to be careful, though, since positive aggregate supply shocks could be pushing down inflation too. Given the current economic conditions it seems to me the negative aggregate demand shocks are the driving force. 

More on the Fed's Power

James Hamilton adds to the growing chorus of observers who are arguing the Fed can do more if it really wanted to do so.  He makes the same argument made here and in other places that the Fed still has the ability to (1) enlarge and alter its balance sheet and (2) change expectations: 

The claim that a central bank could become completely unable to debase the currency if it wanted has always seemed odd to me. Even if reserves and T-bills become equivalent assets (and at the moment they surely are), reserves are not equivalent to any number of other assets. Nothing prevents the Fed from buying longer-term assets, continuing to create reserves at will for the purpose until the yields on those assets adjust...

Or for that matter, the Fed could start buying goods directly, or equivalently, let the Treasury buy the goods and have the Fed simply buy up all of the debt that the Treasury cares to issue. That the price of goods would be unaffected regardless of the quantity purchased seems quite implausible.

And even if we limit ourselves to conventional open market operations, the fact that banks are currently satiated with reserves does not mean that the Fed has no powers to affect current economic activity. As long as we believe that at some future date we will have moved away from the satiation point and return to a regime in which short-term interest rates are once again meaningfully positive, open market operations at that future date will have their usual power to affect interest rates and prices. Those future price levels and interest rates are in turn tied to current prices and long-term rates through expectations. So, the theory goes, by signaling today an intention of delivering higher inflation rates in the future, the Fed could help stimulate economic activity in the here and now.

He then goes on to note the although the Fed could be doing more as articulated above, it is not doing so.  In fact, it is letting inflationary expectations falls:

The gap between the yield on 5-year nominal Treasuries and Treasury Inflation-Protected Securities has decreased rather than increased compared with the levels before the crisis, and has been declining again recently. According to this measure, the market expects less rather than more inflation.

In short, the Fed is not stabilizing aggregate demand and consequently deflation is on the horizon.  Here is a figure I often use that shows the spread Hamilton mentions above. It is for the period January 4, 2010 - July 15, 2010: (Click on figure to enlarge.)

 Encouraging, isn't it?

Making a NGDP Targeting Fashion Statement

All the fans of NGDP targeting out there can now make a fashion statement about their beliefs. Will Luther has created  t-shirts that advocate stabilizing aggregate demand (i.e. total current dollar spending) as the policy goal for monetary policy. For those coming late to this discussion this approach amounts to the Fed adjusting the M and Vpart of the MV=PY equation such that PY is stabilized in some fashion (e.g. PY grows according to to some target rate).  And yes, the Fed has enough power to adjust both M and V if it really wanted to do so.  Here are the shirts (click on figures to enlarge):

e

These t-shirts speak to the increasing popularity of targeting NGDP.  I just hope all the new converts realize and support all the implications--e.g. sometimes deflation is appropriate--of this approach to monetary policy.

hat tip: Scott Sumner

What Real Financial Reform Might Look Like

I recently received my copy of Laurence Kotlikoff's new book Jimmy Stewart is Dead. In this book Kotlikoff calls for limited purpose banking. I was initially skeptical of the idea, but I am warming up to it as I read more. My initial fear was that that limited purpose banking would turn the banking system into nothing more than a vault and therefore reduce financial intermediation. However, this is not the case with this approach as banks would still provide financial intermediation through mutual funds. Checking accounts, however, would be fully backed by cash or t-bills. Interestingly, this would eliminate the money multiplier and thus give the Fed more control over the money supply. I still have some questions on this approach, but can see how it could bring greater financial stability. I would love to hear your thoughts on this approach. 

Below the fold is an long excerpt from one of Kotlikoff's articles on limited purpose banking.

Update: Tyler Cowen discusses limited purpose banking.

Further Evidence on the Fed's Power

Menzie Chinn directs us to a paper by Christopher Neely that shows (1) the Fed is far from powerless when it policy rate is at the zero bound and (2) the Fed is a monetary superpower:

The Federal Reserve’s large scale asset purchases (LSAP) of agency debt, MBS and long-term U.S. Treasuries not only reduced long-term U.S. bond yields but also significantly reduced long-term foreign bond yields and the spot value of the dollar. These changes were much too large to have been generated by chance and they closely followed LSAP announcement times. These changes in U.S. and foreign bond yields are roughly consistent with a simple portfolio choice model. Likewise, the exchange rate responses to LSAP announcements are roughly consistent with a UIP-PPP based model. The success of the LSAP in reducing longterm interest rates and the value of the dollar shows that central banks are not toothless when short rates hit the zero bound.

This means the Fed is still capable of influencing domestic and global demand. The question, then, is whether the Fed wants to stabilize demand. Unfortunately, there is no consensus on this issue in the Fed.

Losing One's Faith Because of the Liquidity Trap

Just a few days after getting all religious about monetary policy, Paul Krugman now seems to be losing his faith as he wallows in liquidity trap-driven doubt:

[w]hen you have bought so much debt and created so much money that rates are near zero, the public is saturated with liquidity; from that point on, they’re holding money simply as a store of value, which makes it no different from bonds — and hence a perfect substitute for bonds. And at that point further open-market operations do nothing — they just swap one zero-interest asset for another, with no effect on anything.
So why not forget about open-market operations, and just drop the stuff from helicopters? Well, remember that at this point cash and short-term bonds are equivalent. So a helicopter drop is just like a temporary lump-sum tax cut. And we would expect people to save much or most of such a tax cut — all of it, if you believe in full Ricardian equivalence.

Wow, someone is really in a liquidity-trap funk. Luckily for Krugman and other depressed doubters, the righteous reverend of monetary policy efficacy, Tyler Cowen, is here to restore the faith:

First, cash and short-term bonds may be near-substitutes but they are not literally, strictly equivalent. The nominal rate on T-bills is not exactly zero and furthermore you can't use a T-bill for every retail purchase. The demand curve for real cash need slope down only slightly for a quantity theory result to hold. After everyone spends the new cash balances, and prices rise, people end up with the quantity of real balances which they initially desired. These equilibria have "knife-edge" properties, where "identical to T-Bills" and "nearly identical to T-Bills" do not bring the same results. Tsiang showed this in a very good JMCB article on Friedman's optimum quantity of money, in the early 1970s and you might regard it as implicit in Bewley's Econometrica article on Friedman.
Second, after a helicopter drop no one need expect future taxes to be raised to retire the money (although maybe a sufficiently credible government could create such an expectation). So there is no Ricardian motive to save the new cash, as Brad DeLong points out. Indeed, if you think there is some chance that others will spend the money, raising the price level, you will want to spend your new cash soon, so as to preserve its value against forthcoming price inflation. The resulting game-theoretic equilibrium, applying dominant strategies, again leads to higher prices, higher aggregate demand, and the desired quantity of real cash balances held.

In short, the liquidity trap is a much overrated idea so don't get all worked up over it. Monetary policy can still be highly effective in the current economic environment.

Thinking of Grad School?

You may want to reconsider.

Texas versus California

The regional variation in economic performance during this Great Recession has been fascinating to watch, especially here from Texas where the economic slowdown has been relatively mild. This state's economic performance has been especially remarkable compared to other big states like California. In this case, the contrast can be easily seen by comparing total employment in California and Texas. Below are the employment numbers for the two states along with some added commentary. First up is Texas:

Now California:


These striking differences naturally lead to discussions of why so much regional variation? Awhile back, The Economist magazine tackled this question for the two states of California and Texas. Now, Fortune magazine has joined the discussion. It argues that (1) Texas has a more diversified economy than California, (2) Texas has more business friendly environment, (3) Texas has done better relying on sales tax rather than on income and capital gain taxes found in California, and (4) the power of the people has backfired in California. In addition to these structural differences maybe California needs its own monetary policy.

Update: In the comments Muirego wonders if Texas is a net recipient of federal tax dollars and whether this explains the discrepancy.  According to the Tax Foundation the answer is no: between 1981 and 2005 Texas on average received 90 cents of federal expenditure for every federal tax dollar paid. See here for more.

It's Gone Global

Rebecca Wilder alerts us to the fact that the drop in inflation expectations is not limited to the United States:

[I]nflation expectations are falling globally. The chart [below] illustrates the 10-yr break-even expected inflation rates for the UK, Germany, Canada, Italy, and the US using their respective inflation-indexed bond markets (TIPS in the US). Notably, declining inflation expectations is not specific to the US.

Here is her chart:


What this chart says to me is that not only is the Fed allowing U.S. aggregate demand to slip, but it is also allowing global aggregate demand to falter. How so? It all goes back to the Fed's role as a monetary hegemon. As I noted earlier:

[T]he Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well.

The Fed's monetary hegemon status in conjunction with its loose monetary policy during the early-to-mid 2000s helped create the global liquidity glut at that time. As a consequence, there was an unsustainable boom in global aggregate demand. Now the Fed's superpower status is working in the opposite direction: it is allowing to global demand to slow down. Focus, Ben, Focus!

Daniel Gross on the Types of Deflation

Amidst all the chatter about deflation, Daniel Gross over at Newsweek reminds us that deflation can emerge for two very different reasons: (1) a collapse in aggregate demand or (2) a surge in aggregate supply. This distinction is an important one that is often overlooked when it comes to conduct of monetary policy. Before getting into the policy implications, though, let's look at how these two forms of deflation are different. Here is how Gross describes deflation coming from a collapse in aggregate demand:

Bad deflation is the kind we had in the Great Depression. "The last time we really had significant deflation in the U.S. was in the 1930s," notes Michael Bordo, professor of economics at Rutgers University. "Between 1929 and 1933, prices fell on average by 15 percent." This deflation was driven by a decline in output, demand, and credit—too little money and wages chasing too many goods and workers. The Depression-era cratering of wages and prices was disastrous because it rendered companies and consumers less able to pay their debts.

There is no question this is type of deflationary pressures we experienced during the first half of 2009 and now face again in late 2010. The key to preventing such deflation is to stabilize aggregate demand via monetary policy. Lately, it appears the Fed has been failing to do just this.

The second type of deflation is the result of positive aggregate supply shocks. Here is how Gross explains this form:

But there have been periods of good deflation, in which prices fell even as the economy boomed. In the 1920s, known to this day as the roaring '20s because of the decade's economic vibrancy, prices fell about 1 percent per year. Between 1870 and 1896, prices fell consistently amid rapid economic growth—with plenty of booms and busts along the way. The reason: innovations like the railroad, the telegraph, electricity, and the assembly line helped farmers, entrepreneurs, and manufacturers to produce and ship their goods more cheaply and efficiently.

As mentioned above, the distinction between these two forms of deflation is important when it comes to policy implications. The harmful form of deflation requires aggressive monetary easing to stabilize aggregate demand while the benign form does not. In fact, the benign form of deflation if driven by rapid productivity growth would imply, cetersis paribus, a higher neutral interest rate. Lowering the policy interest rate here would push market interest rates below the neutral rate, lead to excessive monetary easing, and too much current dollar spending. So no need for monetary or aggregate demand stimulus here. In short, both forms of deflation call for stabilizing aggregate demand.

I bring these differences up because it seems clear to me that one of key reason we are this mess now is that the Fed in the early-to-mid 2000s failed to make this distinction. It saw the deflationary pressures of that time as indicating the harmful, demand-induced form when in fact they were the result of the rapid productivity gains at that time. Here is one graph the makes my point:

This figure shows that the growth rate of domestic demand started accelerating in mid-2002 and continued increasing through late 2004. There were no signs of collapsing demand here. Yet the Fed still saw a threat of demand-induced deflation at least through late 2003. As a result, the Fed continued to push the federal funds rate lower and held it low until mid-2004. What the Fed ignored was that the productivity gains at the time were pushing down the inflation rate. The rest is history. (The Fed also got hung up on the negative output gap. But like the deflationary pressures, much of this gap was being driven the rapid productivity gains not a collapse in demand.)

Now in real time it may be hard to distinguish between aggregate demand-induced deflation and aggregate supply-induced deflation. For example, since the U.S. economy had just come out of the 2001 recession it is understandable why the Fed misread the deflationary tea leaves over 2002-2003. Fortunately, there is a way that makes it possible for monetary authorities to avoid making such mistakes: target aggregate demand or some measure of total spending. Stabilize this and the deflation distinction becomes a moot issue.

Read here for more on this issue.

Jim Hamilton's Sobering Thought

A sobering thought from Jim Hamilton:

So I can see who bought the $2.7 trillion in net new Treasury debt issued between 2007 and 2009. What I'm having more trouble seeing is who is going to buy the additional $8 trillion in net new debt that would be issued over the next decade under the CBO's alternative fiscal scenario.

Hamilton notes that over half of the new debt between 2007 and 2009 went to foreigners. Can the rest of the world continue to absorb this large of a share of the projected $8 trillion shortfall? The only way I see this happening is that the rest of the world has rapid economic growth over the next decade and during this time there is no alternative treasury or other safe asset market that emerges to compete with the U.S. treasury market. What do you think?

Krugman is Finally Beating the Right Drum

After year or so of beating his fiscal stimulus drum, Paul Krugman is finally starting to pound on his monetary policy drum. It is about time. There is reason to believe that had influential observers like Krugman been making the case sooner for unconventional monetary policy that aims to shape expectations--versus Ben Bernanke's narrow focus on "credit easing"--we would not be currently discussing the imminent threat of deflation. As I mentioned in my previous post, the one time unconventionally monetary policy was truly tried it was very effective. Krugman himself admitted last year that the first-best option for a situation like ours today is not fiscal policy but unconventional 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)

So why has Krugman been pushing expansionary fiscal policy so heavily up til now? Here is his answer:

So some readers have asked why I’m not making the same arguments for America now that I was making for Japan a decade ago. The answer is that I don’t think I’ll get anywhere, at least not until or unless the slump goes on for a long time. OK, so what’s next? The second-best answer would be a really big fiscal expansion, sufficient to mostly close the output gap.

In short, Krugman settled for a second-best economic solution because he thought it was a first-best political solution. So much for that strategy. I should not complain too much, though. He seems to be getting on board now and for that I am grateful. Here he is making the case for unconventional monetary policy in his latest column:

But here we are, visibly sliding toward deflation — and the Fed is standing pat.

What should it be doing? Conventional monetary policy, in which the Fed drives down short-term interest rates by buying short-term U.S. government debt, has reached its limit: those short-term rates are already near zero, and can’t go significantly lower. (Investors won’t buy bonds that yield negative interest, since they can always hoard cash instead.) But the message of Mr. Bernanke’s 2002 speech was that there are other things the Fed can do. It can buy longer-term government debt. It can buy private-sector debt. It can try to move expectations by announcing that it will keep short-term rates low for a long time. It can raise its long-run inflation target, to help convince the private sector that borrowing is a good idea and hoarding cash a mistake.

Keep beating that drum Krugman.

What Can the Fed Do Now?

A lot, actually. We know this because (1) Fed officials believe there is much more they could do if they wanted and (2) monetary policy has been shown to be highly effective in far worse situations. The problem is the Fed has been reluctant to act so far. It has failed to pull out all of its big guns though there are some rumblings it may be considering doing so.

So what exactly are the big guns the Fed could employ in our current situation? According to these Fed economists there are three big guns that could be used:

(1) [S]haping the expectations of the public about future settings of the policy rate, (2) increasing the size of the central bank’s balance sheet beyond the level needed to set the short-term policy rate at zero (“quantitative easing”); and (3) shifting the composition of the central bank’s balance sheet in order to affect the relative supplies of securities held by the public.

The first big gun is in my view the most important one and can be restated as shaping expectations in general, not just expectations about the policy interest rate. Here the main idea is to convince the public that Fed is committed to a higher inflation rate or price level for the foreseeable future. This would lower current real interest rates, decrease the demand for money (i.e. increase velocity), and help stabilize (and maybe even restore) household and other troubled balance sheets. Currently, however, this big gun is just sitting in the Fed's arsenal collecting dust. The other two big guns, as is well known, have been used as seen by the enlargement and asset alteration of the Fed's balance sheet. While these big guns have been effective in stemming the credit crisis they have been less effective in stabilizing velocity. What has been frustrating about the Fed's choice of the big guns to use so far is that there is reason to believe the first big gun by itself would have accomplished as much or more than what the second two big guns have done. This first big gun was used during the Great Depression by FDR with much success and suggests it should have been tried already by the Fed. Here are those same Fed economists on this experience:

An historical episode that may illustrate this channel at work (although the policymaker in question was the executive rather than the central bank) was the period following Franklin Roosevelt’s inauguration as U.S. president in 1933. During 1933 and 1934, the extreme deflation seen earlier in the decade suddenly reversed, stock prices jumped, and the economy grew rapidly. Romer (1992) has argued persuasively that this surprisingly sharp recovery was closely associated with rapid growth in the money supply that arose from Roosevelt’s devaluation of the dollar, capital inflows from an increasingly unstable Europe, and other factors... Temin and Wigmore (1990) [argue] that the key to the sudden reversal was the public’s acceptance of the idea that Roosevelt’s policies constituted a “regime change.” Unlike the policymakers who preceded him showing little inclination to resist deflation and, indeed, seeming to prefer deflation to even a small probability of future inflation, Roosevelt demonstrated clearly through his actions that he was committed to ending deflation and “reflating” the economy. Although the president could have simply announced his desire to raise prices, his adoption of policies that his predecessors would have considered reckless provided a powerful signal to the public that the economic situation had fundamentally changed. If one accepts the Temin-Wigmore hypothesis, then it appears that the signal afforded by Roosevelt’s exchange rate and monetary policies were central to the conquest of deflation in 1933-34.

So altering expectations here required both substantive action--actual sharp increase in the monetary base--as well as a public perception of a regime change by FDR. These actions worked and according to Christina Romer were the main reason for the robust recovery of 1933-1936. This experience suggests something similar should be done by the Fed today. So how could Fed employ this first big gun now? First, the Fed needs to to introduce an explicit inflation, price level , or nominal GDP target (my preference is for the later) and say that it is committed to this target no matter what it takes. Second, it needs to accompany this move with a PR blitzkrieg that makes it very clear this is a game changer, a real regime change. Of course, all this assume that the Fed decides that it wants to make such changes. Currently it is not clear that all Fed officials would welcome such changes.

Hopefully there are some folks inside the Fed who are listening. At a minimum I hope the Fed economists cited above are listening. One of them happens to lead the Fed.

Meanwhile, Back in the Eurozone...

the legal noose tightens on Europe's monetary union according to Ambrose Evans-Pritchard:

The plot continues to thicken at Germany’s constitutional court, a body with power of life or death over Europe’s monetary union.

Contrary to general belief, Germany’s eurosceptic professors have not abandoned their legal efforts to block the EU rescues for European banks exposed to Greek debt, and since May 7 for banks exposed to debt from Spain, Portugal, and Ireland as well.

Should they succeed, of course, the eurozone risks disintegration within days, and perhaps hours. I am not sure that investors in New York, London, Tokyo, Beijing, or indeed Frankfurt quite understand this.

I certainly was not aware this German court had the Eurozone in its sights. Developments like these only serve to reinforce Kati Suominen's claim that the dethroning of the dollar as the main reserve currency will not happen anytime soon.

What is the Current Stance of Monetary Policy?

Mathew Yglesias is making the case that the current stance of monetary policy is effectively tight. He invokes the term structure of interest rates to make his case. While I share his view, I believe a far more intuitive and convincing way to make this point is to look at the difference between the nominal interest rates on regular treasury securities and the real interest rates on treasury inflation protected securities (TIPS). The difference or spread between these two series is the market's expectation of future inflation.* To the extent changes in expected inflation are being shaped by monetary policy via its influence on aggregate demand, this measure provides a real time indicator on the stance of monetary policy. This indicator is graphed below using daily data on 5-year treasuries for the period January 4, 2010 - July 8, 2010: (Click on figure to enlarge.)

There is a clear downward trend. Now changes in expected inflation can come from both aggregate supply (AS) shocks and aggregate demand (AD) shocks. But given the Eurozone uncertainty, weak economic data, and all the austerity talk of late, the most obvious way to interpret this declining trend is that the market expects aggregate demand to weaken. This interpretation is also consistent with all the chatter about deflation noted by Mark Thoma. And since monetary policy has been doing nothing to stop this implied plunge in AD it is effectively tightening.

Now it is possible that an increase in the liquidity premium coming from the heightened uncertainty is driving some of this decline, but even if true it only serves to strengthen my interpretation. For in that case their is an increased demand for liquid assets of which money is the most liquid. Money demand, therefore, would be rising and velocity falling. So no matter what path you follow you end finding weakening AD and an effective tightening of monetary policy.

*This is because of the fisher equation that says nominal interest rates = real interest rates + expected inflation.