Friday, February 26, 2010

Further Evidence that the Future Belongs to Statisticians

From The Economist:
EIGHTEEN months ago, Li & Fung, a firm that manages supply chains for retailers, saw 100 gigabytes of information flow through its network each day. Now the amount has increased tenfold. During 2009, American drone aircraft flying over Iraq and Afghanistan sent back around 24 years’ worth of video footage. New models being deployed this year will produce ten times as many data streams as their predecessors, and those in 2011 will produce 30 times as many. Everywhere you look, the quantity of information in the world is soaring. According to one estimate, mankind created 150 exabytes (billion gigabytes) of data in 2005. This year, it will create 1,200 exabytes. Merely keeping up with this flood, and storing the bits that might be useful, is difficult enough. Analysing it, to spot patterns and extract useful information, is harder still.
This is why Hal Varian is right when he says the sexy job in the next decade will be a statistician.

A Fat-Tail Event for U.S. Government Financing?

I recently argued that those observers who only see long-term structural budgetary problems, fail to consider the potential for a fat-tail event adversely affecting U.S. government financing in the near term. Clive Crook considers this possibility by asking whether the U.S. government might soon face a crisis of confidence like that of Greece:
It depends on what you mean by "soon." At the moment, the United States is borrowing with no great sign of stress. Far from coming under pressure, the dollar is still strong, and the cost of U.S. government borrowing (the interest rate on Treasury bonds) shows no sign of spiking. Greece, to be sure, has some problems all its own. Where it leads, the United States need not follow. Yet one should not dismiss the parallel too blithely. Sentiment in financial markets can change abruptly, and the differences between Greece's financial condition and America's are not as vast as one would wish.
Read the rest here.

Thursday, February 25, 2010

Revenge of the Balance Sheets

The U.S. economic crisis has been called by some observers a balance sheet recession given the deterioration of the balance sheets in the banking system and the household sector. The U.S. banking system's balance sheets certainly took a beating during the crisis, but some progress has been made in repairing them. The IMF, for example, shows in its latest Global Financial Stability Report (chapter 1, pp. 7-9) that 60% of needed writedowns of U.S. bank assets had already occurred by late 2009. The November 2009 OECD Economic Outlook notes similar improvements, including sizable capital injections. Of course, there are still more writedowns to do, bank lending is still anemic, and much of the banking system's balance sheet problems have only been transferred to the Fed's balance sheet. Still, there has been some meaningful repair to banking system's balance sheet and that is more than can be said for the household balance sheet. This can be seen by examining the flow of funds data for the households, specially household net worth (i.e. household assets minus household liabilities). The figure below graphs this series as a percent of disposable income (click on figure to enlarge):



Note that household net worth as a percent of disposable income reached its lowest point during the crisis in 2009:Q1 with a value of about 450%. At this point, household net worth was put back to where it was in late 1985! For the latest observation of 2009:Q3 household net worth is about 485%, which is approximately where it was on average for the entire 1987:Q1-1993:Q1 period. The bottom line is that household balance sheets have been put back almost two decades. This is both amazing and alarming.

Now repairing household balance sheets will not be an easy task. Here are the options: First, reduce household liabilities by (1) writing down claims against households and/or (2) wide-scale household bankruptcy. Second, increase household assets through (3) a new asset boom cycle and/or (4) increased household saving. Options (1) and (2) are undesirable since they would add further disruptions to an already weakened financial system. Option (3) seems unlikely unless there is some truly new innovation (e.g. green energy) that takes off. That leaves option (4) which is already happening as the U.S. personal saving (and overall private saving) rate has increased since the downturn. This approach to improving household balance sheets , however, creates its own set of problems. First, it is not a quick fix. It may take years this way to fully repair household balance sheets that have been put back two decades. Second, as noted by Martin Wolf, the higher household saving means a drop in total spending and ultimately broader economic activity. As a result, government spending has stepped in to fill the aggregate demand gap by running budget deficits. However, given that the decline in spending by households may last years the aggregate demand gap spending by government may also last years. This , in turn, raises the specter of sovereign bankruptcy. In short, in the absence of another asset boom the U.S. economy faces the possibility of wide-scale private sector bankruptcy or public sector bankruptcy. Martin Wolf agrees as does Paul Krugman. You can run but you cannot hide from the problems with household balance sheets.

Update:To be clear, U.S. sovereign bankruptcy may mean inflating away some of its debt. There need not be an explicit default.

Wednesday, February 17, 2010

Assorted Musings

Here are some assorted musings:

(1) Menzie Chinn does a one-year anniversary review of the evidence on Obama's fiscal stimulus and concludes that 1.6 to 2.5 million jobs were created. Given the poor state of the economy this conclusion is based on counterfactual analysis (i.e How much worse would the economy have been had there been no stimulus?). John Taylor says these results are built into the models that make them. Arnold Kling agrees and explains why from a Bayesian perspective:
In Bayesian terms, the weight of the modeler's priors is very, very high, and the weight of the data is close to zero. The data are essentially there just to calibrate the model to the modeler's priors.
This debate will not be settled anytime soon. It also ignores another important question that requires counterfactual analysis: how many jobs would have been saved or created had monetary policy been more aggressive? Recall that monetary policy does not lose its efficacy just because its policy rate hits zero: unconventional monetary policy can still affect aggregate demand in a meaningful way by altering inflation or price level expectations. If you are not convinced just ask Michael Woodford, Paul Krugman, or Scott Sumner for starters.

(2) Tyler Cowen makes the case for the value added tax (VAT) and then asks for good arguments against it. Here is a big one: the VAT does not allow the public to fully internalize the true cost of the federal government. This problem would be particularly pronounced now if the VAT were enacted since about half the the U.S. population pay no federal taxes. If we want voters to make informed decisions about government programs they need to know the true costs and benefits of those programs. While the VAT might widen the tax base and help shrink the deficit in the near term it would also serve to only further externalize the true cost of government spending. In turn, this may eventually lead to a further widening of the budget deficit.

(3) Nick Rowe addresses some of the problems with the Post Keynesian/Chartalist theory of money. As someone who was their poster boy of what is wrong with mainstream macro over the past weekend in the comment section of this post , it is refreshing to see Nick Rowe assess some of their views. Among other things, we learn that they lack a theory of the price level. (We also learned from the earlier post that the money supply and the monetary base are completely and always endogenous. Robert Mugabe, therefore, is a victim not the perpetrator of Zimbabwe's hyperinflation!)

(4) I am a parent of young children and am an economist. Here I learn that I can be a better parent by utilizing my skills as an economist! My wife will love this one.

(5) Who says brain drain in the developing world is a bad thing? Laura Freschi says brain drain has unfairly received a bad rap.

Martin Wolf, Niall Ferguson, James Kwak, and Fat Tail Events

Martin Wolf today gave Niall Ferguson a true smackdown on the U.S. budget deficit issue:
Niall Ferguson is not given to understatement. So I was not surprised by the claim last week that the US will face a Greek crisis. I promptly dismissed this as hysteria. Like many other high-income countries, the US is indeed walking a fiscal tightrope. But the dangers are excessive looseness in the long run and excessive tightness in the short run. It is a dilemma of which Prof Ferguson seems unaware.
Ouch, that has to hurt. Martin Wolf, however, is making a fair point that currently the real U.S. government solvency issue is a long-run one given the projected runaway growth of entitlement programs such as Medicare. As is well known, soaring health care costs are behind these projections and thus, one of the motivations for health care reform is a desire to maintain long-term U.S. government solvency. James Kwak has been making this point recently and like Wolf has been on the warpath to scalp those poor souls who fail to see the long-term issues here. His victims include Robert Samuelson and Greg Mankiw. While I agree with what Martin Wolf, Jame Kwak, and other observers like them are saying on the long-term problems, I believe they underestimate the potential for a fat-tail event in the short-run. As we learned from the emerging market crisis of the late 1990s and early 2000s, market moods can unexpectedly swing and create havoc for sovereign debt. There may even be no fundamental reason for the market mood swing; it could be a random event or series of random events that triggers a reevaluation of a government's creditworthiness. Imagine for example, the other rating agencies follow Moody's recent warning about the U.S. AAA rating with their own warnings, news reports say China and other major holders are selling off a sizable portion of their U.S. securities, and bond investor suddenly began questioning the ability of the U.S. political system to address the unfunded liabilities of the U.S. government. In such a scenario,the Obama deficits suddenly become terrifying to the market and the U.S. government gets hammered with much higher financing costs. This in turn leads to fears of contractionary fiscal retrenchment or a monetizing of the debt. Welcome to the U.S. banana republic. Okay, this scenario is far fetched, but if there is anything we learned from this crisis it is that we should not ignore the potential for such fat tail events.

Update I: One thing Martin Wolf gets very wrong in his article is that monetary policy was tapped out and there was nothing more it could do. Hence, expansionary fiscal policy was needed. This is incorrect. There was and is much monetary policy can do even when its policy rate hits zero. Primarily, if the Fed would permanently change inflationary expectations (or the expectation of the future price level or better yet, the future path of nominal GDP) it could significantly affect current aggregate demand. See this Michael Woodford paper or Scott Sumner's blog for more.

Update II: On a related note, The Economist discusses sovereign debt domino theories. This is another reason we should be mindful of fat tail events.

Monday, February 15, 2010

More on the Eurozone Challenges

Ambrose Evans-Pritchard reports on the latest challenge in the Greek bailout:
The EU has issued a political pledge to rescue Greece – and by precedent, all Club Med – without first securing a mandate from the parliaments of creditor nations.

Holland's Tweede Kamer has passed a motion backed by all parties prohibiting the use of Dutch taxpayer money to bail out Greece, either through bilateral aid or EU bodies. "Not one cent for Greece," was the headline in Trouw. The right-wing PVV proposed "chucking Greece out of EU altogether".

Germany's Bundestag has drafted an opinion deeming aid to Greece illegal. State bodies may not purchase the debt of another state, in whatever guise.The EU is entering turbulent waters by defying these irascible and sovereign bodies...
This is why a common treasury is essential to any currency union. Imagine Texas refusing to allow its tax revenues to flow to the union-laced Michigan economy. Or the state of New York not allowing its taxes to support the bigoted folks in certain parts of the country. The dollar currency union would be in trouble too. Fortunately, there is a federal treasury. In Europe they are not so fortunate. Here is Evans-Pritchard:
The last two weeks have cruelly exposed the Original Sin of monetary union: that EMU was launched without an EU treasury or debt union. This will be tested again and again by bond vigilantes until such a mechanism is created.
I have my doubts about a EU Treasury being created. It is possible, though, that this crisis could be the catalyst that makes it happen. Finally, here he is explaining why the Eurozone is not an optimal currency area:
Europe's leaders still refuse to face the awful truth: that monetary union is unworkable as constructed. That different labour markets, different sensitivities to interest rates, different economic structures, have caused the gap between North and South to grow ever wider...
Sometimes a one-size-fits-all monetary policy does not work.

Global Debt Hangover

From Barrons:
There are credit-default swaps on 50 countries, and all but three have seen widening spreads, notes James Bianco, CEO of Bianco Research. "The whole planet's ability to pay its debt is being questioned," he says.
What a great thought with which to start the week.

Thursday, February 11, 2010

The Fed's Exit Strategy

So Ben Bernanke confirmed that the Fed may have to turn to interest paid on excess reserves as its main policy tool rather than targeting the federal funds rate. Bernanke says such a move would only last until normalcy returns to the Fed's balance sheet or, equivalently, excess reserves return to their pre-crisis levels. Mark Thoma provides an informative discussion of this process that shows how the discount rate, federal funds rate, and interest paid on excess reserves interact in a supply and demand graph for bank reserves. Here is what some Wall Street economists had to say about this potential change in Fed policy. And here is what Josh Hendrickson had to say on the matter:
As I previously discussed, the interest on reserves methodology is a rather crude way to solve the problem. If the problem is with excess reserves, then the reserves should be removed from the system using normal open market operations. So why isn’t the Fed employing this method? Well, I have long suspected that the reason the Fed was employing this strategy was because of the change in the composition in the Fed’s balance sheet away from traditional Treasury holdings and toward mortgage backed securities. This view is confirmed in the WSJ:

Plans for the Fed’s portfolio of mortgage-backed securities are another element of the internal debate over the exit strategy from super-cheap money. The Fed is on course to buy up to $1.25 trillion of the securities, in an effort to hold down mortgage rates and buoy housing.

Over time, officials want to reduce these holdings and return to holding U.S. Treasury securities as the Fed’s primary asset. But they are reluctant to take steps that might push mortgage rates higher and damage the still-fragile housing market. Eventually, they could gradually sell mortgage securities, but such a move would be unlikely in the early stages of tightening.

So, ultimately, the Fed is conducting fiscal policy by subsidizing mortgage rates. What’s more, given that open market operations would necessarily require not only open market sales of Treasury securities, but also mortgage backed securities, the Fed finds itself in a position in which open market operations are politically and practically infeasible.

The Eurozne Problem in One Picture

Stephanie Flanders directs us to to this picture from HSBC which nicely summarizes the problems the Euro has created for Greece over the past decade:


It is striking how the Eurozone periphery has lost so much competitiveness as indicated by the real exchange rate appreciation. Stephanie Flanders also makes the point that even if the European bail-out of Greece takes place it only buys time and does not address the real problems: Greece's debt overhang and its inability to restore fiscal order. Flanders recommends a more radical but meaningful solution of (1) restructuring Greece debts and (2) setting a higher inflation target for the ECB. She acknowledges these are "unthinkable" options, but when the alternative could be a Lehman II why not consider the "unthinkable"?

Wednesday, February 10, 2010

Eurozone Periphery and the Euro

After reading Paul Krugman's anatomy of a Euromess, I thought I would look take a quick look at the Eurozone countries through the prism of the optimal currency area (OCA) framework. So what is the OCA framework? Here is my discussion of the OCA from a previous post modified to fit the Eurozone:
Is [Europe] best served by a single central bank conducting countercyclical monetary policy? According to the optimal currency area (OCA) criteria, the answer is yes if the various regions of the Europe (1) share similar business cycles or (2) have in place flexible wages and prices, factor mobility, fiscal transfers, and diversified economies. In the former case, similar business cycles among the regions mean that a [European] monetary policy, which targets the aggregate business cycle, will be stabilizing for all regions. In the latter case, dissimilar business cycles among the regions make a [European] monetary policy destabilizing—it will be either too stimulative or too tight—for some regions unless they have in place the above listed economic shock absorbers.
If a region's economy is not in sync with the currency union's business cycle and the above listed shock absorbers are absent then it does not makes sense for a country to be a part of the currency union. Instead, the country should keep its own currency which itself will act as a shock absorber.

So where does the EU stand with regards to the OCA criteria? I went to the OECD database for some quick answers and here are some interesting data points I found. First, I looked at the correlation between the industrial production growth rate in the regional economies and the Eurozone. This reveals how similar the regional business cycles are with the broader European economy: (Click on figure to enlarge.)


Greece, which is at the center of the current Euro crisis, is notably less in sync with the rest the of European economy. In terms of price flexibility I examined the average annual inflation rate over the 1998-2008 period. To the extent that higher inflation reflects the rigidity of downward price adjustment, it should provide some sense of price flexibility:



Here the periphery countries have the highest inflation rates. (This also means that they have also had a significant real exchange rate appreciation against the core Eurozone countries.) Next, I looked for some measure of labor market flexibility and the closet proxy I could find is the OECD's employment protection strictness (EPS) measure. Presumably, the greater the EPS the more rigid is the labor market. Below is the measure for 1998-2008:


Here, Portugal, Spain, and Greece have the most stringent EPS over this time. If we add to the above findings the fact that there is no EU treasury providing fiscal transfers and that labor mobility is not where it should be then it seems reasonable to conclude some of the Eurozone periphery should not be in the currency union. Taking this quick analysis one step further, I rescaled the inflation and EPS measures and then took the average of them to create a shock absorber index where increases in its value indicate a greater shock absorbing ability. I then plotted this shock absorber index for each country against its industrial production correlation with the Euro industrial production:


To make the graph complete, I added the red line which shows a hypothetical OCA boundary where countries on the outside of it have a sufficient mix of business cycle coordination and economic shock absorbing ability to be a part of the Euro OCA. This red line is purely a conjecture and used only to illustrate that somewhere there is a marker that separates those countries that are truly a part of the Euro OCA. Where it exactly falls is unclear. What does seem clear, though, is that some of the Eurozone periphery falls inside of it.

Monday, February 8, 2010

Janet Yellen: the Fed is a Monetary Superpower

Federal Reserve Bank of San Francisco President Janet Yellen makes the case for the Fed as a monetary superpower, at least in Asia:
For all practical purposes, Hong Kong delegated the determination of its monetary policy to the Federal Reserve through its unilateral decision in 1983 to peg the Hong Kong dollar to the U.S. dollar in an arrangement known as a currency board. As the economist Robert Mundell showed, this delegation arises because it is impossible for any country to simultaneously have a fixed exchange rate, completely open capital markets, and an independent monetary policy. One of these must go. In Hong Kong, the choice was to forgo an independent monetary policy.

[...]

As in Hong Kong, Chinese officials are concerned about unwanted stimulus from excessively expansionary policies of the Fed and in other developed economies. Like Hong Kong, China pegs its currency to the U.S. dollar, but the peg is far less rigid.

[...]

Overall, we encountered concerns about U.S. monetary policy, and considerable interest in understanding the Federal Reserve's exit strategy for removing monetary stimulus. Because both the Chinese and Hong Kong economies are further along in their recovery phases than the U.S. economy, current U.S. monetary policy is likely to be excessively stimulatory for them. However, as both Hong Kong and the mainland are currently pegging to the dollar, they are both to some extent stuck with the policy the Federal Reserve has chosen to promote recovery.
I am glad to see such a high-ranking Fed official agrees with me that the Fed is a monetary superpower. Now that we have this common understanding let us explore its implications for the saving glut theory. Let us do so by referencing an older post of mine:
[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. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

Given the Fed's role as a monetary hegemon the inevitability theme [i.e. the Fed had no choice but to accommodate the excess savings coming from Asia] underlying the saving glut view begins to look absurd. Moreover, the Fed's superpower status raises an interesting question: what would have happened to global liquidity had the Fed run a tighter monetary policy in the early-to-mid 2000s? There would have been less need for the dollar bloc countries to buy up dollars and, in turn, fewer dollar-denominated assets. As a result, less savings would have flowed from the dollar block countries to the United States. In short, some of the saving glut would have disappeared.
I wonder what Yellen would say to the above paragraphs. More pointedly, I would love to ask her the following question: If the Fed can influence global liquidity conditions now why not in the early-to-mid 2000s? (I would also enjoy hearing Ben Benanke's answer to this question.) If so, then surely the Fed had some role in the global housing boom. Chris Crowe of the IMF and I are working on a paper that documents this superpower status of the Fed and will be sure to send Janet a copy when it is done.

Hayek and the Stabilization of Nominal Spending

Russ Roberts did an interesting interview with Larry H. White on F.A. Hayek. Among other things, we are reminded that Hayek actually favored stabilizing nominal spending as a policy goal. Stated differently, he was for stabilizing input prices (or factor income) but not for stabilizing output prices. Such a policy would lead to the anchoring of nominal spending but allow the price level to move in response to productivity changes. If that sounds familiar, it should. It is the basis of the George Selgin's Productivity Norm Rule. Note that such a rule would have meant a reigning in of nominal spending during the housing boom and a more aggressive response by the Fed to the collapse of aggregate demand in late 2008, early 2009. When this latter point was brought up by Larry White in the interview, Russ Roberts expresses some skepticism by asking how could the Fed have prevented the collapse in velocity in 2008. Scott Sumner would say target the forecast of nominal spending. I agree with him.

One implication of Hayek's view is that the Fed should have been more vocal during the Great Depression. Larry White, however, notes that Hayek failed to push this point in the 1930 because he wanted (1) to use the deflation at that time to loosen the nominal rigidities in order to restore more flexibility to the economy and (2) simply was complacent. One wonders where nominal income targeting rules would be today had Hayek maintained his relevance by calling for the stabilization of nominal spending during the Great Contraction.

For more on Hayek's view on stabilizing nominal spending see Larry White's JMCB article or this post.

Shorting the Euro Big Time

Okay, maybe I should not put too much faith in the intrade.com contract on the Euro's future. Based on this FT article, Gregory White says the real action on the Euro is in Chicago:
The Chicago Mercantile Exchange has taken on more short bets on the Euro than ever before in the currency's history. According to FT $7.6 billion in Euro shorts have piled up over the past couple of weeks as there is increasing worry about how the currency area is going to deal with the debt problems of many of its members.

Now over 40,000 contracts against the currency have been taken out on the CME, putting even further downward pressure on the troubled currency.

Spain has been in the headlines today trying to come out on the offensive over concerns their debt will be the next to burst. They are even going so far as to label the the current downward pressure on the Euro and on their sovereign debt as a conspiracy or attack.

Wow.

The Eurozne: Deja Vu Argentina 2001 & Other Thoughts

The sovereign debt problems in the Eurozone periphery and the implications of this development for the future of the currency union attracted a lot of attention over the weekend. Here is the New York Times on the problems facing Greece and the Eurozone more generally. Carmen Reinhart, meanwhile, tells us that Greece has been in a state of default about 50% of the time since the 1830s (Why then, was it ever allowed to join the Eurozone?). More importantly, she indicates that if some of the Eurozone's periphery goes under then the problems in Eastern Europe become more severe. Here is CNN quipping that Europe's PIGS (i.e. Portugal, Italy, Greece, and Spain) don't fly. Here is Paul Krugman lamenting the monetary stratightjacket that is the Euro. Finally, here is Simon Johnson pulling a Roubini by forecasting these problems, if not addressed, risk causing another global depression. After reading all these pieces, here are some thoughts:

(1) I couldn't help but think of Argentina's crisis in 2001-2002. It too had a sovereign debt problem, an overvalued real exchange rate, and was effectively part of a currency union that did not meet the optimal currency area criteria. It too tried to cut wages and prices but found the deflationary price too high. Ultimately Argentina defaulted and broke the peso-dollar link, even though the currency board linking the two currencies was almost a decade old and considered an important institution. It seems possible some of the PIGS could go the way of Argentina.

(2) On the other hand, Tyler Cowen reminds us that there would be a great cost for Greece's banking system if the nation chose to leave the Eurozone. Barry Eichengreen lists other costly barriers any Euro nation would face in such a move. Maybe this is why the intrade.com contract on any country leaving the Eurozone in 2010 is hovering around 15% (down from a high of 40% in late 2008). Still, Argentina faced similar costs and it abandoned the dollar peg. Never say never.

(3) This New York Times article makes the case the ECB president, Jean-Claude Trichet, has more power because of this crisis. Since there is no EU Treasury to help Greece, the only institution capable of bailing out the PIGS is the ECB. According to the NYT, this makes Trichet the de facto president of Eurozone. Given all the animosity the Federal Reserve has generated for itself in the financial crisis from the new public awareness of its power, I wonder if something similar could happen to the ECB if it chooses to use its power for the PIGS. The U.S. public has always had some aversion to centralized monetary power (e.g. Andrew Jackson's Second Bank War, the hatred of Paul Volker in the early 1980s). Europe may be more open to such uses of monetary power given their longer history with central banking.

(4) Ultimately, this crisis speaks to the importance of a monetary union meeting the optimal currency area to be viable. I have made this point before, but will leave it with Paul Krugman to make the case here:
Spain is an object lesson in the problems of having monetary union without fiscal and labor market integration. First, there was a huge boom in Spain, largely driven by a housing bubble — and financed by capital outflows from Germany. This boom pulled up Spanish wages. Then the bubble burst, leaving Spanish labor overpriced relative to Germany and France, and precipitating a surge in unemployment. It also led to large Spanish budget deficits, mainly because of collapsing revenue but also due to efforts to limit the rise in unemployment.

If Spain had its own currency, this would be a good time to devalue; but it doesn’t.On the other hand, if Spain were like Florida, its problems wouldn’t be as severe. The budget deficit wouldn’t be as large, because social insurance payments would be coming from Brussels, just as Social Security and Medicare come from Washington. And there would be a safety valve for unemployment, as many workers would migrate to regions with better prospects. (Wages wouldn’t have gone up as much in the first place, because of in-migration)... what’s happening to Spain reflects the inherent problems with the euro, which now more than ever looks like a monetary union too far.


Monday, February 1, 2010

New Paper on Nominal Income Targeting and the Great Moderation

In a previous post I showed graphically how one could view the history of U.S. monetary policy through the changing trends in the growth rate of nominal spending. One of the striking features from this figure was the stabilization of the nominal spending growth rate around 5% during the Great Moderation period. This figure, therefore, indicates the Fed may have had an implicit nominal spending or nominal income target of 5% during this time. That interpretation is now confirmed in a new paper by fellow blogger Josh Hendrickson:
An Overhaul of Fed Doctrine: Nominal Income and the Great Moderation
Abstract: The Great Moderation is often characterized by the decline in the variability of output and inflation from earlier periods. While a multitude of explanations for the Great Moderation exist, notable research has focused on the role of monetary policy. Specifically, early evidence suggested that the increased stability has been associated with monetary policy that responded much more strongly to rising inflation. Recent evidence casts doubt on this change in monetary policy. An alternative hypothesis is that the change in monetary policy was the result of a change in doctrine; specifically the rejection of the view that inflation was largely a cost-push phenomenon. As a result, this alternative hypothesis suggests that the change in monetary policy beginning in 1979 is reflected in the Federal Reserve's response to movements in nominal income rather than inflation as previously argued. I provide evidence for this hypothesis by estimating the parameters of a monetary policy rule in which policy adjusts to forecasts of nominal GDP for the pre- and post-Volcker eras. Finally, I embed the rule in two dynamic stochastic general equilibrium models with gradual price adjustment to determine whether the overhaul of doctrine can explain the reduction in the volatility of inflation and the output gap.
Take a look at this important paper. I believe targeting nominal spending would go a long way in shoring up macroeconomic stability and hope that one day it is explicitly adopted as the policy goal for the Fed.