The Weak Recovery is a Policy Failure

In my last post I argued that nominal GDP targeting does not depend on bank lending to work.  Instead, its success depends on the Fed using the nominal GDP target to manage expectations such that the portfolios of the non-bank sector rebalance in a manner that shores up aggregate demand.  Bank lending may respond to this process, but is not essential to it. I mention this again because I just came across an interesting paper by Edward Nelson and David Lopez-Salido that lends support to this view.  The authors show that, contrary to the claims of Reinhart and Rogoff (2009), recoveries following financial crises are not inherently weaker. Rather, they depend on policy.  From their abstract [emphasis mine]:

We find that the regularity that recoveries are systematically slower in the aftermath of financial crises does not hold for the postwar United States. The pace of the expansion after recessions seems to reflect deliberate aggregate demand policy. A weak lending outlook does not appear to pose an insurmountable obstacle to the functioning of stimulative aggregate demand policies.

The implication of this paper and my previous post is that the weak economic recovery is a failure of policy to fully restore aggregate demand, nothing more.  All the talk about how recoveries following financial crises are typically weaker and that we are now in a balance sheet recession distracts from this fact. There was nothing inevitable about the Great Recession and subsequent lack of robust recovery.  A nominal GDP level target is the best way to fix this policy failure.

P.S. Edward Nelson also has a recent paper on Milton Friedman that provides a nice discussion of the portfolio channel. 

The Market Monetarist, MMT, and Austrian Lovefest

The Economist magazine has a new article on the rising popularity of Market Monetarism, MMT, and Austrian economics.  The article notes that all of these schools of thought have benefited immensely from the blogosphere and have each provided a critique of how macroeconomic policy has been conducted over the past few years.  It was an interesting article, though as Scott Sumner notes the piece is wrong in its implication that nominal GDP targeting requires significant activism by the Fed.  If implemented properly, nominal GDP targeting would require less activism since it focuses the Fed on a single, explicit mandate.  In the case of Scott Sumner's nominal GDP futures targeting, this approach would actually put the Fed on automatic pilot.  (It would also put many Fed economists out of work and make the Fed far less important, so do not bet on it happening!)

One point I want to stress here is that contrary to claims of some MMT advocates, the success of nominal GDP targeting does not depend on increased bank lending or on a naive belief in a simple money multiplier story where increased bank reserves lead to increased bank lending.  In fact, the MMT emphasis on bank lending being influenced by capital considerations, credit worthiness of borrowers, and the demand for credit is entirely consistent with the Fed using a nominal GDP target to manage expectations such that portfolios are rebalanced in a manner that sparks a recovery.  Here, bank lending responds to the improvement in current and expected economic activity brought about by nominal GDP targeting.  This is how I explained the process before:

The ability of the Fed to influence total current dollar spending does not depend on banks creating more loans. Rather, it depends on the Fed's ability to change expectations so that the non-bank public rebalances their portfolios appropriately.  Recall that a nominal GDP level target means the Fed makes an unwavering commitment to buy up assets until some pre-crisis nominal GDP trend is hit.  As Nick Rowe notes, just the threat of the Fed doing this would cause the public to expect higher nominal spending growth and higher inflation.  This change in expectations, in turn, would cause investors to rebalance their portfolios away from liquid, lower-yielding assets (e.g. deposits, money market funds, and treasuries) toward higher-yielding assets (e.g. corprate bonds, stocks, and capital).  The shift into higher-yielding assets would directly affect nominal spending through purchases of capital assets and indirectly through the wealth effect and balance sheet channels.  The resulting increase in nominal spending would increase real economic activity, improve the economic outlook, and thus further reinforce the change in expectations.

Bank lending would probably respond to these developments, but it would not be driving them.  It is interesting to note that FDR did something similar to nominal GDP level targeting in 1933 and it sparked a sharp recovery that lasted through 1936.  Bank lending, however, did not recover until 1935.  Bank lending, therefore, was not essential to that recovery.  That may be less true today, but in any event the key point here is that if bank lending does increase it would do so as a consequence of the improved economic conditions brought about by the change in economic expectations.

There is more here on how this transmission mechanism works. The real critique, then, is whether a change in  nominal expectations can really affect current spending decisions by firms and households.  I have an earlier post that shows inflation and nominal GDP expectations (as proxied by a survey of forecasters) do in fact influence spending decisions.  Josh Hendrickson and I also show in this recent working paper that shocks to inflation expectations cause households to adjust their portfolios in the manner outlined above.  Finally, as shown by Gautti Eggertson, a sudden change in nominal expectations was also key to FDR's 1933-1936 recovery.  If the MMTers (and Austrians) could come to accept this evidence, then we could truly have a deficient aggregate demand lovefest.  

Beckworth Smackdown

Arpit Gupta pushes back on my post about why safe assets matter.  He invokes Jeffrey Friedman and Vladimar Kraus' argument that implies regulatory arbitrage created by the Basel reforms can explain the demand for safe assets. Here is Gupta:

If a bank decided to hold a AAA-rated sovereign bond, for instance, they typically had to hold zero excess capital to meet regulatory standards. However, if they held an equivalent amount of an unsecured private loan, they were required to hold substantially more capital in response.  The net effect of these capital regulatory standards is that safe assets came to be valued not just for their economic riskless value — but also for how alter bank capital requirements. Banks that face fewer capital requirements can be more levered, risky, and potentially profitable than banks whose assets force them to raise substantial amounts of additional capital. This motive, arguably, is why banks around the world are eager to purchase safe assets — not because they are useful in conducting repo. 

Gupta also makes some other points, but this is his main one.  His point sounds reasonable, but I wonder how important this effect is explaining the overall trend.  As I mentioned in my previous post, this shortage of safe assets can arguably be traced all the way back to the bursting of Japan's asset bubble.  It is also influenced by the gap between the rapid economic growth in the emerging world and their own inability to produce safe assets.  And then there is the demographic challenge: all the baby boomers in the rich world are shifting out of riskier assets into safer ones as they retire.  Is Basel really more important than all these other factors? 

P.S. Gupta also has an interesting post on whether deleveraging matters, which is timely once again given Richard Koo has a new paper pushing his balance sheet recession view.  My view is that deleveraging can have dire consequences as described by Koo, but only if monetary policy is failing to do its job.  Look no further than Sweden which has a lot of household debt, but managed to restore nominal incomes following the financial crisis and thus keep debt burdens manageable.  Monetary policy was also not limited in the United States when it was tried during the Great Depression, a time of high debts too. If only balance sheet recession advocates would spend as much time gazing at the asset side of the household balance sheets as they do the liability side they might see the potential for monetary policy.  Oh, and don't forget this Scott Sumner smackdown of the balance sheet recession view.

P.P.S.  Matthew Yglesias does a better job than me summarizing why safe assets matter.

What Really Caused the Crisis?

I was looking at some employment data and was reminded of this figure:

This figure shows that construction employment reached a peak in April, 2006 and started descending thereafter.  The housing recession was on, but remarkably employment in the rest of the economy continued to grow through early 2008.  In fact, layoffs and discharges did not dramatically change during this almost 2-year period as seen below:

In other words, the Great Recession did not emerge because of the collapse of the housing market in early 2006.  Something else had to happen about 2 years later to turn a sectoral recession turn into the Great Recession.  As the figure above suggests, I see the evidence pointing toward a failure by the Federal Reserve to stabilize nominal spending and by implication nominal income. This failure meant that nominal income growth expectations of about 5% a year assumed by household and firms when they signed nominal debt contracts would not be realized.  A debt crisis was therefore inevitable. 

This understanding is corroborated by the data on personal income. The figure below shows that despite the fall in the growth rate of personal income from construction and real estate services that began in early 2006, personal income in the rest of the economy continued to grow at about 5% a year up through mid-2008.  The Fed was able to stabilize nominal incomes overall for almost two years while structural changes were taken place in those sectors closely tied to the housing boom. 

This stabilization between early 2006 and mid-2008 was no small feat given the problems in the financial system.  The figure below shows that the rise in financial distress in mid-2007, as indicated by the Ted Spread, did not stop the nominal GDP from growing for about another year.  Again, a remarkable performance.  However, what this figure also shows is that once the Fed allowed nominal GDP to fall and made no effort to reverse it the financial crisis intensified.  Thus, the Fed's failure to act and prevent the fall in nominal income meant, just as it did during the Great Depression, a systematic financial crisis was going to happen.  

This is an argument I and others have made many times before, but it is worth repeating. It is also a story that can be told for the Eurozone crisis. Another way of saying this is that central banks are just as responsible for passive tightening as they are for active tightening.  They should be held accountable for both. 

The Real Negative Real Shock

Are all the problems in the U.S. economy nominal?  Robert Gordon implicitly says no in a new paper on the long-run outlook for U.S. productivity (hat tip Reihan Salam).  He makes the case that rapid productivity gains from 1995-2005 will not persist going forward:

The 20‐year period 1987‐2007 combines the inexplicably slow productivity growth of 1987‐95, the temporarily ebullient period 1995‐2000, and the interesting 2000‐07 period that in some dimensions looks like more normal behavior.  The seven years between 2000:Q4 and 2007:Q4 were neatly divided in half, with extremely rapid productivity growth between 2000:Q4 and 2004:Q2 (2.68 percent), and much slower growth from 2004:Q2 to 2007:Q4 (1.36 percent), averaging out to 2.02 percent for the seven‐year interval.   As argued above the productivity growth “explosion” of 2001‐04 rested on a combination of savage corporate cost cutting and delayed learning from the internet revolution.  Once profits had recovered the pressure for cost cutting disappeared, and eventually the delayed learning subsided as well.   

[...]

The paper approaches the task of forecasting 20 years into the future by extracting relevant precedents from the growth in labor productivity and in MFP over the last seven years, the last 20 years, and the last 116 years.  Its conclusion is that over the next 20 years (2007-2027) growth in real GDP will be 2.4 percent (the same as in 2000‐07), growth in total economy labor productivity will be 1.7 percent...

So over the next two decades Robert Gordon sees labor productivity growing at annual average rate of 1.7% compared to about 2.5% for 1995-2004.  If his view is widely held then that means firms will expect lower returns to investment and household will expect lower incomes.  Such lower expectations, in turn, would translate into lower investment and consumer demand today.  This, then, may account for some of the prolonged slump. 

So is Gordon's view widely held?  Is the forecast for productivity falling?  The Quarterly Survey of Professional Forecasters can answer these questions.  It asks forecasters what they expect the average annual productivity growth rate to be over the next 10 years.  The data starts in 1992 and is at an annual frequency.  Here is a figure of the data:

So yes, the consensus forecast is that productivity growth is expected to decline over the next 10 years.  It is hard not to look at this figure and conclude at least some of the ongoing slump can be attributed to it.  However, this does not necessarily mean it is the most important factor.  And I do not think it can be because we do not see a sustained uptick in the inflation rate, something that should be present if the permanently lower productivity growth rate were the main culprit.  Rather we see muted inflation since 2007 with the core inflation rate actually falling, something far more consistent with a large amount of insufficient aggregate demand.   And there is the negative output gap.  I still believe that the failure by the Fed to return nominal spending to its pre-crisis trend is the most important reason for shortage of aggregate demand.

Update:  Bill Woolsey notes that the lower expected productivity growth should only affect real variables but have no bearing on nominal expenditures if properly stabilized. 

More on the Shortage of Safe Assets

As a follow up to my earlier piece on the shortage of safe assets, I direct you to Rebecca Wilder's post where she documents the broad decline of investment grade sovereign debt.  As I mentioned before, this increasing shortage of safe assets matters because many of these assets serve not just as a store of value but as transaction assets that  either back or act as a medium of exchange. In other words, this problem matters because it adversely affects the demand for money and therefore nominal spending. 

One solution is for producers of truly safe assets, primarily the U.S. Treasury, to create more safe assets.    Brad DeLong takes this view.  This approach, however, worsens the Triffin dilemma for the world's go-to safe asset, U.S. Treasury debt.  Another solution is for the Fed and the ECB to restore nominal incomes to pre-crisis trends. Doing so would spur a sharp recovery that would lower the demand for safe assets and increase the stock of safe assets.  Both of these developments would reduce the excess money demand problem and avoid worsening the Triffin dilemma for U.S. treasury debt.  See my previous post for more.

Jan Hatzius Interview on NGDP Targeting

The FT interviews Jan Hatzius of Goldman Sachs and spends time discussing, among other things, the Fed adopting a nominal GDP level target.

Much Ado About Nothing: Financial Repression Edition

There has been a lot of discussion on financial repression emerging in advanced economies as way for governments to handle the looming debt crisis.  According to some, financial repression is already in play in the United States as the Federal Reserve is keeping long-term interest rates artificially low to minimize financing costs to the Treasury.  Advocates of this view go on to note that the lowering of long-term interest rates is narrowing the net interest margins for banks and reducing the incentive for savers to fund the shadow banking system.  Financial repression, therefore, is causing financial intermediation to fall and is preventing a robust recovery. 

There is a big problem with this view: it wrongly assumes that the drop in long-term interest rates over the past few years is solely the result of the Fed's large scale asset purchases (LSAPs).  While it is true that there has been a spate of empirical studies showing the LSAPs have lowered the term premium portion of long-term interest rates, most of these studies only show modest effects.  It is unlikely, for example, that the LSAPs can account for much of the 300 basis points plus drop in the 10-year treasury interest rate since 2007.  The financial repression advocates, however, want to attribute all of this decline to the Fed's actions.

A far better explanation for the large drop in long-term interest rates is one, the growing global demand for safe assets and two, the ongoing slump in the economy.   The first of these factors is about the increasing scarcity of safe assets in the world economy even as the global demand for them grows.   U.S. treasuries remain the go-to safe asset for the world.  As I discussed previously, there are both structural and cyclical factors behind this shortage of safe assets with both implying a reduction in the term premium for U.S. public debt.  The second factor is that since the current and expected economic outlook continues to look bleak, the current and expected path of the short-term natural interest rate is low.  With the short-term natural interest rate expected to remain low, actual short-term interest rates will be expected to remain low too and thus pull down the long-term interest rate. Some observers seem to forget that the natural interest rate itself is determined by the state of the economy.

Another problem with the financial repression view is that the Fed's LSAPs, while very imperfect, were never explicitly intended to keep down government financing costs.  They were always about either saving the financial system (e.g QEI) or more recently the broader economy (eg. QEII and Operation Twist).  These programs had serious flaws--they should have explicitly targeted the level of nominal spending  without committing dollar sums upfront--but to attribute to them a motive of repressing the financial system to help save public finances seems unfair.   

For these reasons the financial repression view seems untenable to me.   It is much ado about nothing.

Bill Gross Forgets About the Natural Interest Rate

Like Paul Krugman, I am am puzzled by Bill Gross' Op-Ed in the Financial Times.  Gross argues that the low interest rates of the Federal Reserve are causing the financial system to deleverage.  Thus, he concludes that Fed policy is actually hampering the recovery of the U.S. economy.  Now I agree with Gross that Fed policy is hampering the recovery, but it is not because monetary policy has been too loose.  Rather, it has been too tight.   

What Gross fails to consider is that interest rates would be low now even if there were no Fed. This is because the economy is weak and as a result the natural interest--the interest rate consistent with economic fundamentals--is low.  As I constantly tell my students, never draw any conclusions about the stance of monetary policy by looking just at the target policy interest rate.  Instead, I tell them, look at the policy interest rate relative to the natural interest rate over the entire term structure.  Given the large output gap and the economic uncertainty, the natural interest rate is currently low and may even be lower than the actual federal funds rate.  

Now this discussion should not be a surprise for Bill Gross.  PIMCO previously published a nice piece by Paul McCulley and Ramin Toloui on the neutral interest rate--another way of saying the natural interest rate--back in 2008 that argued the Fed may be slow to act and thus end up chasing down the neutral interest rate without ever getting to it.  Here is an excerpt:

If the central bank does not act quickly enough – and financial conditions deteriorate further – the central bank may end up just chasing the neutral rate down without ever reaching the level needed to provide monetary stimulus to the economy.

In short, even though the Fed may lower its policy interest rate monetary policy may still be tight.  And that is exactly how I view the current situation.  By failing to prevent the collapse of aggregate demand  in late 2008 and having failed to restore it to since then, the Fed has passively tightened monetary policy.  This passive tightening of monetary policy is the reason for the sluggish economy and the low interest rates.  The financial deleveraging that has Bill Gross so worked up is therefore the result of tight monetary policy, not loose.  If Gross really wants to stop the deleveraging then he needs to be calling for something like a nominal GDP level target.

Update: John Carney and David Glasner make similar observations.

Why the Global Shortage of Safe Assets Matters

One of the key problems facing the world economy right now is a shortage of assets that investors would feel comfortable using as a store of value.  There is both a structural and cyclical dimension to this shortage of safe asset problem, with the latter being particularly important now given the recent spate of negative economic shocks to the global economy.  These shocks have elevated the demand for safe assets and, as David Andolfatto argues, is probably the key reason why we see such low yields on U.S. treasuries.  Of course, these same shocks have also destroyed many of the once-safe assets (e.g. European sovereign bonds) adding further strain to this asset-shortage problem.  This shrinking stock of safe assets can seen in the figure below created by Credit Suisse (ht FT Alphaville):

This figure shows that if one does not count French bonds as safe assets (a reasonable assumption), then about half of the safe assets disappeared by 2011. That is a tremendous drop and, as I see it, matters for two reasons.  Before getting into them, though, it is worth briefly reviewing the structural and cyclical dimensions to the asset-shortage problem.   

The structural dimension is that global economic growth over the past few decades has outpaced the capacity of the world economy to produce truly safe assets.   Ricardo  Caballero, the author of this view, argues that it probably started with the collapse of Japaneses assets in the early 1990s, was exacerbated  by emerging market crises throughout the 1990s, and got heightened by the rapid economic growth of the Asia in the early-to-mid 2000s. These developments along with the fact that most of the fast growing countries have lacked the capability to produce safe assets made the assets shortage a structural problem.

The cyclical dimension is that the demand for and disappearance of safe assets was intensified by the failures of the Fed and the ECB over the recent business cycle.  In the early-to-mid 2000s, the Fed exacerbated the asset-shortage problem as its loose monetary policy got exported via fixed exchange rates to much of the emerging market world which in turn recycled it back to the U.S. economy via the "global saving glut" demand for safe assets.  (For more on this point see this post and my paper with Chris Crowe.)  Since late 2008, both the Fed and the ECB have worsened the asset-shortage problem by failing to first prevent and then restore nominal income in each region to its expected path.  In other words, since 2008 both the Fed and the ECB have passively tightened monetary policy and this has caused some of the AAA-rated securities to disappear. (Yes, some of the AAA-rated MBS and sovereign debt would have defaulted on their own, but some of them like French sovereigns would have maintained their safe asset status were it not for insufficient aggregate demand caused by passively tight monetary policy.)

Okay, so why does this safe asset shortage ultimately matter?  The first reason is that many of these safe assets serve as transaction assets and thus either back or act as a medium of exchange.  AAA-rated MBS or sovereigns have served as collateral for repurchase agreements, which Gary Gorton has shown were the equivalent of a deposit account for the shadow banking system.   The disappearance of safe assets therefore means the disappearance of money for the shadow banking system.  This creates an excess money demand problem for institutional investors and thus adversely affects nominal spending.  The shortage of safe assets can also indirectly cause an excess money demand problem at the retail level if the problems in the shadow banking system spill over into the economy and cause deleveraging by commercial banks and households.  All else equal, such retail level deleveraging causes bank assets like checking and money market deposits to fall relative to the demand for them.  In other words, the broad money supply falls relative to the demand for it.  The scarcity of safe assets matters, then, to the extent it creates an excess money demand problem that  adversely affects nominal spending. 

The second reason the assets shortage matters is that it creates a Triffin dilemma for the producers of safe assets.  The original Triffin dilemma says that a country with the reserve currency of the world has to produce more money than is needed domestically to meet the global demand for it.  This, however, requires running  current account deficits that over time may jeopardize the very reserve currency status driving this dynamic.  Francis Warnock summarizes this paradox nicely: 

To supply the world’s risk-free asset, the country at the heart of the international monetary system has to run a current account deficit. In doing so, it becomes more indebted to foreigners until the risk-free asset ceases to be risk-free.

Now apply this reasoning to the U.S. government that currently seems to be the preferred producer of safe assets for the world. If it is to meet the excess demand for safe assets it must run a larger budget deficit, a point made recently by David Andolfatto: 

[G]iven the huge worldwide appetite for U.S. treasury debt (as reflected by absurdly low yields), this is the time to start accommodating this demand. Failure to do so at this time will only drive real rates lower.

But running larger budget deficits over time may jeopardize the safe-asset status of U.S. treasury debt, the very thing currently driving the insatiable demand for it. The global economy thus faces a Triffin dilemma for  the U.S. treasury, its go to safe asset.

There is way out of these problems.  Both the Fed and the ECB need to return aggregate nominal incomes in their regions to their pre-crisis trends and do so using a nominal GDP level target.  Being a level target it would keep long-run inflation expectations anchored while still allowing for an aggressive monetary stimulus in the short-run (i.e. until the pre-crisis trends were reached).  It would also stabilize nominal spending expectations and add more certainty to long-run forecasts.  More importantly, it would spur a sharp recovery that would that would lower the demand for safe assets and increase the stock of safe assets.  Both of these developments would in turn reduce the excess money demand problem and minimize the problems with the Triffin dilemma for U.S. treasury debt.  Unfortunately, we are a long way from either central bank adopting nominal GDP level targets.

Which Graph Best Summarizes the Eurozone Crisis?

Niklas Blanchard sends us to the BBC where "top economists" are sharing their most important economic graphs of the year.  Here, for example, is an interesting graph from Vicky Price of FTI Consulting:

Price explains its importance:

"For a long time the perception was that the creation of the euro meant sovereign risk was effectively the same across all countries. That of course proved to be wrong. The Lehman's crisis and financial meltdown that followed affected the deficits and debt levels of different countries in different ways. Interestingly it is much the same countries now with very high yields as it was pre-euro, suggesting little has changed fundamentally in a decade."

I agree that long-term interest rates should not have converged across all sovereign debt in the Eurozone, but I also believe that the huge spreads that have now emerged are more than risk premiums simply returning to their normal levels.  Rather, they are the result of effectively tight monetary policy that has caused public finances to worsen and that, in turn, is driving the sharp rise in spreads.  Nicklas Blanchard agrees and notes that one graph conspicuously absent from the BBC feature is the one that shows the all-important deviation of actual nominal income from its expected path.  That graph shows the main story behind the crisis. 

My BBC Interview

As part of BBC Radio's coverage of the big Eurozone summit yesterday, I was interviewed by the BBC's Stephen Evans.  We talked about Germany's role in the crisis and what it and the ECB could do if they really wanted to save the Eurozone.  And yes, I was able to mention nominal GDP level targeting a few times on air (though I wish I had explained it better).  

My part starts around 8 minutues into the show, but there are other interesting segments on his show.  First, Stephen interviews some average Germans who all applaud Chancellor Angela Merkel's actions and seem blithely unaware that an economic disaster could be right around the corner for them too. He then interviews a consultant to Merkel whose advice is ignored and finally, plays the ECB's own online monetary policy game and learns that is rigged with a low-inflation-at-any-cost bias. 

Here is the link to the podcast of the show. [Update: The link is now directly connected to a permanent MP3 file.]

Update: One thing I mentioned in the interview is there is a lack of urgency for most Germans regarding the crisis  because they are in better economic shape, a point I have made before.  Now Floyd Norris makes a similar point n the  New York Times: 

For Germany and, to a lesser extent, the countries that some have speculated could join it in a new common currency if the euro zone collapses, recent years have been a time of relative prosperity. At the end of 2006, the unemployment rate in Germany was 9.6 percent and nearly four million people were out of work. Now the rate is down to 5.5 percent and just 2.3 million people are classified as out of work. 

[...] 

In recent months, the euro crisis has led some depositors to move their euros to German banks out of fear that other countries might leave the zone and convert to a less valuable currency. That has helped to lower borrowing costs for German companies while raising them for foreign competitors, if they can borrow at all.

Evidence for the Monetary View of the Eurozone Crisis

Some observers argue that the current problems in the Eurozone are actually the result of a monetary crisis not a sovereign debt crisis.  They acknowledge there are structural problems with European currency union but point back to the failure of the ECB to stabilize and restore nominal spending to expected levels during the crisis of 2008-2009 as the real culprit behind the Eurozone crisis.  This failure to act by the ECB--a passive tightening of monetary policy--has been devastating because it means nominal incomes are far lower than were expected when borrowers took out loans fixed in nominal terms.  European borrowers, both public and private, are therefore not able to pay back their debt and the result is a fiscal crisis.

But it gets worse.  The reduced ability for Europeans to payback debt also means that risk premiums on countries with lots of debt or ones perceived to have debt problems increases, further raising these country's debt burden with higher financing costs.  The fiscal crisis gets bigger, and being easy to observe, gets wrongly credited as the cause of the Eurozone's problems.  Consequently, the Eurozone crisis is prescribed with the fiscal solution of austerity.  The real solution, however, implied by the monetary view of crisis is restoring nominal incomes to their originally expected values. Thus, David Glasner argues that "Europe is having a NGDP crisis not a debt crisis" and Ambrose Evans-Pritchard claims that the Eurozone crisis "is a monetary crisis caused  by a jejune central bank [.]"

I find this monetary view a compelling explanation--though there are deeper structural and political problems that make me question the long-term viability of the Eurozone--for the current crisis in Europe.  It can be summed up in one figure:

This figure shows a remarkably strong relationship between (1) the deviation of nominal income from its expected level and (2) the growth of the debt burden lagged by four quarters.  Thus, if European nominal incomes are less than expected then eventually higher debt burdens increase for the reasons outlined above.

Now lest you think the strong relationship is simply the result of nominal GDP being in the denominator of the the debt burden measure take a look at the following figure.  It shows actual  nominal GDP for the Eurozone and its trend for 1995:Q1-2006:Q4 which are used to construct the percent deviation of nominal income from its expected level in the figure above.  The trend provides an indicator of what nominal income growth expectations were prior to the 2008-2009 crisis.

Note that nominal income falls sharply between 2008:Q2 and 2009:Q3, but actually grows thereafter.  Thus, the ongoing rise in the debt-to-GDP ratio (see figure below) is not just because of the sharp fall in nominal income.  It is because monetary policy has not allowed nominal income to grow fast enough to restore it to expected levels where the debt burden is more manageable.  This in turn, has caused Eurozone debt burden to take off with no end in sight as seen in the figure below of the government debt-to-GDP ratio for the Eurozone:

So yes, the Eurozone crisis is a monetary crisis, a crisis catalyzed by the failure of the ECB to stabilize and restore nominal spending to its expected level.  Again, though, there are longer-term structural and political problems with the Eurozone that arguably are behind the monetary crisis.  Still, if the Eurozone experiment is to be salvaged, then a proper monetary diagnosis of the current crisis has to be realized so that the currency union can survive long enough for it to be salvagable.

Update I: Martin Wolf similarly notes that for many of the crisis-stricken countries in the Eurozone, their fiscal positions did not look that bad prior to the crisis:

Take a look at the average fiscal deficits of 12 significant (or at least revealing) eurozone members from 1999 to 2007, inclusive. Every country, except Greece, fell below the famous 3 per cent of gross domestic product limit. Focusing on this criterion would have missed all today’s crisis-hit members, except Greece. Moreover, the four worst exemplars, after Greece, were Italy and then France, Germany and Austria. Meanwhile, Ireland, Estonia, Spain and Belgium had good performances over these years. After the crisis, the picture changed, with huge (and unexpected) deteriorations in the fiscal positions of Ireland, Portugal and Spain (though not Italy). In all, however, fiscal deficits were useless as indicators of looming crises (see charts).

Now consider public debt. Relying on that criterion would have picked up Greece, Italy, Belgium and Portugal. But Estonia, Ireland and Spain had vastly better public debt positions than Germany. Indeed, on the basis of its deficit and debt performance, pre-crisis Germany even looked vulnerable. Again, after the crisis, the picture transformed swiftly. Ireland’s story is amazing: in just five years it will suffer a 93 percentage point jump in the ratio of its net public debt to GDP.

 So most of the fiscal problems are a result, not the cause, of the Eurozone crisis.

Update II:  Ezra Klein also shows that the Eurozone crisis at its core is not a debt crisis.  

The Merkelian Reich

We learn that Mario Draghi, head of the ECB, has made a deal with Germany that would allow the central bank to open the monetary spigot only if Germany gets its desired fiscal union.  This development reinforces the widely held view that the Germans are playing the Eurozone crisis to their benefit.  Of course, the evidence suggests that the Germans have always been playing the currency union to their liking, but the Eurozone crisis is a chance for Germany to take this game to another level.  Tony Corn makes this point in an very interesting article titled "Toward a Gentler, Kinder German Reich?"  Here are some excerpts:

For the third time in less than twenty years, Germany is trying to force down the throat of Europe a federal “political union” which, in the eyes of too many European observers, eerily resembles a gentler, kinder Anschluss.  While Europeans were able to push back against the first two attempts, the two-year long financial crisis has created within Europe a “German unipolar moment” and provided the kind of leverage that had eluded Germany earlier. With the German Chancellor as a de facto “EU Chancellor,” German elites are leveraging the crisis by playing a game of chicken in order to make their federal vision prevail. 

Demographically and economically, Germany is one third larger than either Britain or France. In the past ten years, this predominance has already been reflected in EU institutions, both quantitatively (Germany has the largest representation in the EU parliament) and qualitatively (the European Central Bank is a clone of the Bundesbank).  But that’s apparently not good enough for Berlin, who has deliberately let the crisis move from the periphery (Greece and Portugal) to the center (Italy and France) in order to extract the maximum of concessions from the rest of Europe. 

Germany’s ideal, if unstated, goal? A constitutionalization of the EU treaties, which would irreversibly institutionalize the current “correlation of forces,” and allow German hegemony in the 27-member European Union to approximate Prussian hegemony in the 27-member Bismarckian Reich.  German elites have become so fixated on this goal that they are now talking about changing the German constitution itself in the event the German Constitutional Court decides to get in the way of the New European Order. 

From a socio-political standpoint, to be sure, this would-be Merkelian Reich would have none of the negative features associated with the autocratic Bismarckian Reich.  In all likelihood, the new Reich would be a benign, metrosexual, post-modern (pick your favorite) polity, one that would not be any less “democratic” than the technocratic European Union of today. And from a monetary-fiscal standpoint, one could argue that a Merkelian Reich would probably represent a significant improvement over existing “hybrid” arrangements. 

I am less certain than the author that a Merkelian Reich would really lead to better monetary policy given the vast differences in the European economies.  The Eurozone is not an optimal currency area and Germany has consistently shown itself to care more about domestic monetary conditions than European monetary conditions.  Still, if this is the path the European Union is headed then creating the fiscal union would be a step in the right direction toward making the Eurozone a functional currency union.  

HT Milan Brahmbhatt

The Eurozone Crisis is a Monetary Crisis, Not a Fiscal One

So argues Ambrose Evan-Pricthard:

This is a monetary crisis, caused by a jejune central bank that aborted a fragile recovery by raising rates earlier this year, allowed the money supply to collapse at vertiginous rates in southern Europe, and caused a completely unnecessary recession — and a deep one judging by the collapse in the PMI new manufacturing orders in November.

Needless to say, drastic fiscal austerity is making matters a lot worse. You cannot push two-thirds of the eurozone into synchronized fiscal and monetary contraction without consequences.

Another way of saying this is that the ECB allowed nominal spending and thus nominal incomes to drastically fall in the Eurozone--a passive tightening of monetary policy--and this, in turn, made it difficult for European countries to service their debt. As a result, a fiscal crisis has emerged in the Eurozone.  To make matters worse, the fiscal crisis is viewed as the cause of the Eurozone's problems and is therefore being treated with the fiscal solution of austerity.  The fiscal crisis should, instead, be viewed as a symptom of tight money and treated appropriately with monetary easing.

 Here, again, is, Evan-Pritchard:

This crisis can be stopped very easily by monetary policy, working through the old-fashion Fisher-Hawtrey-Friedman method of open-market operations to expand the quantity of money, ideally to keep nominal GDP growth on an even keel. 

[...] 

What they should be doing is quantitative easing, which is perfectly legal under EU treaty rules and the bank's mandate. Doesn't the ECB's twin pillar doctrine say that M3 money should be growing at 4.5pc? Well it is not doing so. It contracted in October, month-on-month. So get on with it.

The crisis canundoubtedly be halted immediately by the ECB. The bank can reflate Club Med off the reefs. It chooses not to act for political reasons because this mean higher inflation for Germany. That is the dirty secret. Everybody must be crucified to keep German internal inflation under 2pc.

Yes, nominal GDP is crashing in Eurozone's periphery while it is close to trend in Germany.  This is nothing new for Germany which has a history of maintaining stable monetary conditions at home no matter the cost to the rest of the Europe.  The question now is whether Germany values the Eurozone project enough to allow the monetary solution to be implemented.  So far it has not been terribly interested in the monetary solution.

The Great Diversion

George Selgin makes an important point:

We should not wish to see spending stabilized as a rough-and-ready means for "getting at" stability of P or stability of y or stability of some weighted average of P and y: we should wish to see it stabilized because such stability is itself the very desideratum of responsible monetary policy.

In other words, monetary policy should aim to stabilize aggregate demand and not worry about how it breaks down into changes in output and inflation.  This has always made sense to me.  Why focus on inflation, a symptom of aggregate demand, when one can directly stabilize aggregate demand?  Moreover,  inflation is at best a sometimes-indicator of aggregate demand since inflation can be contaminated by aggregate supply shocks.  

Most macroeconomists, however, are fixated on the inflation-output breakdown of aggregate demand.  Selgin considers this to be one of the great diversions in modern macroeconomics.

The belief, on the other hand, that stability of either P or y is a desirable objective in itself is perhaps the most mischievous of all the false beliefs that infect modern macroeconomics. Some y fluctuations are "natural," in the sense meaning that even the most perfect of perfect-information economies would be wise to tolerate them rather than attempt to employ monetary policy to smooth them over. Nature may not leap; but it most certainly bounces. Likewise, some movements in P, where "P" is in practice heavily weighted in favor, if not comprised fully, of prices of final goods, themselves constitute the most efficient of conceivable ways to convey information concerning changes in general economic productivity, that is, in the relative values of inputs and outputs. A central bank that stabilizes the CPI in the face of aggregate productivity innovations is one that destabilizes an index of factor prices.

A great example of how this mischevious belief causes problems can be seen in how the Fed acted in its September, 2008 FOMC meeting. Instead of attempting to stabilize aggregate demand, the Fed was more concerned about balancing the trade-off between growing inflation and falling output.  The Fed ignored the forward-looking indicators that were signalling aggregate demand was falling and decided to do nothing. And we all know what happened next.

Maybe one day the Fed will start targeting nominal GDP and do so using nominal GDP futures.  What a better world this would be. In the mean time, go read the rest of George Selgin's article.

Ramesh Ponnuru Responds to the FOMC's NGDP Discussion

Ramesh Ponnuru has a new Bloomberg article where he responds to the FOMC's discussion on nominal GDP Targeting.  Some excerpts:

NGDP targeting seeks to stabilize expectations about the future path of the economy, making it easier for people to make long-term plans. Keeping nominal spending, and thus nominal income, on a relatively predictable path is especially important because most debts, such as mortgages, are contracted in nominal terms. If nominal incomes swing wildly, so does the ability to service those debts.

[...]

From the standpoint of macroeconomic stability, then, NGDP targeting is superior because it allows inflation to accelerate and slow to counteract fluctuations in productivity. It moves the money supply only in response to changes in the demand for money balances, and not to supply shocks that mimic the effect of these changes on prices but call for a different monetary response.

If only the Fed would listen to Ramesh Ponnuru and start targeting some pre-crisis trend path for nominal GDP.  Not only would it be good for the U.S. economy, it would also do wonders for the Eurozone economy. 

Maybe He Should Try the ECB Tranquilizer Gun

The Fateful Decision to Tighten ECB Monetary Policy

Paul Krugman notes that the Eurozone crisis began rearing its ugly head again back in April, the very time  the ECB decided to tighten monetary policy.  Krugman thinks these two developments are probably related:

By itself, that rate hike — although it was obviously, obviously a big mistake — should not have mattered that much. But maybe it acted as a signal of the ECB’s bloody-mindedness, and that’s what set off the panic.

I agree.  The market saw this interest rate hike as indicating the ECB would allow further weakening of aggregate demand in the Eurozone.  Consequently, the market lowered its forecast of nominal spending and, as a result, expected inflation started declining, the Euro began weakening, and sovereign spreads started increasing.  Here is the 10-year breakeven inflation expectation series for the Eurozone:    

Here is the nominal effective exchange rate for the Euro:

Finally, from Rebecca Wilder here are the surging spreads:

These figures show that these asset prices all took a marked change in trajectory at about the time the ECB tightened in April.  And all these asset price changes have been indicating tight monetary policy since that time, but no one at the ECB seems to be listening.  No one at the ECB seems to appreciate that by allowing aggregate demand to continue to weaken they are passively tightening monetary policy.  The Europeans seem to be repeating monetary history.

We Now Know What "Interesting Conversation" Means

Ben Bernanke said in his last post-FOMC press conference that the committee had an "interesting discussion" on nominal GDP targeting.  The FOMC minutes released today shed some light on this discussion:

The Committee also considered policy strategies that would involve the use of an intermediate target such as nominal gross domestic product (GDP) or the price level. The staff presented model simulations that suggested that nominal GDP targeting could, in principle, be helpful in promoting a stronger economic recovery in a context of longer-run price stability. Other simulations suggested that the single-minded pursuit of a price-level target would not be very effective in fostering maximum sustainable employment; it was noted, however, that price-level targeting where the central bank maintained flexibility to stabilize economic activity over the short term could generate economic outcomes that would be more consistent with the dual mandate. More broadly, a number of participants expressed concern that switching to a new policy framework could heighten uncertainty about future monetary policy, risk unmooring longer-term inflation expectations, or fail to address risks to financial stability. Several participants observed that the efficacy of nominal GDP targeting depended crucially on some strong assumptions, including the premise that the Committee could make a credible commitment to maintaining such a strategy over a long time horizon and that policymakers would continue adhering to that strategy even in the face of a significant increase in inflation. In addition, some participants noted that such an approach would involve substantial operational hurdles, including the difficulty of specifying an appropriate target level. In light of the significant challenges associated with the adoption of such frameworks, participants agreed that it would not be advisable to make such a change under present circumstances.

So there was a substantive discussion on nominal GDP targeting.  And it appears the staff and FOMC recognized the fatal flaw with price level targeting is supply shocks.  Good.

Still, some members of the FOMC remained concerned that such an approach may unmoor long-run inflation expectations and not be flexible enough to handle financial crisis.  A nominal GDP level target, however, would anchor long-run inflation expectations given a stable long-run real growth rate, something that has happened in the United States over the past century. That is, over the long-run real GDP growth has averaged around 3%.   Thus, a 5% nominal GDP target growth rate would lead over the long-run to 2% inflation.  There may be deviations in the short-run--for example, when a positive technology shock temporarily lowers inflation and increases real GDP growth--and maybe the optimal target nominal GDP growth rate is different than 5%. But a truly credible nominal GDP level target presents no problems for long-run inflation expectations.  

Also, if a nominal GDP level target is explicit and widely understood it would actually serve to mitigate the effects of financial shocks.  If the public understood the Fed would always return nominal GDP to its trend path, public expectations would be better anchored and thus be less susceptible to wide swings.  That means velocity (i.e. real money demand) would be more stable.  For these reasons, it is reasonable to conclude that had the Fed been targeting nominal GDP during the 2008-2009 financial crisis, the outcome would have been far milder.  And for the same reasons, the Fed should be targeting nominal GDP now given the looming financial threat coming from the Eurozone crisis.

Update:  See Scott Sumner for a more thorough assessment of the FOMC's discussion of nominal GDP level targeting.

If the Germans Were Serious About Stabilizing Aggregate Demand

Then they would be doing exactly what they are doing now, if their only concern were Germany.  Last week the Federal Statistics Office of Germany released third quarter nominal GDP data where we find relatively robust growth in aggregate demand:

This above-trend growth is entirely consistent with the reluctance of the Germans to open up the ECB monetary spigot.  Doing so would only serve to further raise aggregate demand above trend growth.  The Germans are probably concerned that the additional nominal spending stimulus would raise inflation uncomfortably high and create a positive output gap.  Maybe the Germans are hardcore nominal GDP targeters.  

But are the Germans really focusing on just their own aggregate demand growth?  It is a strange argument to make since the ongoing collapse in Eurozone aggregate demand (see figure below) will ultimately affect the German economy too.  Nonetheless, it is hard not to wonder these thoughts given the Eurozone seems to have been serving German interests all along and the recent reluctance of the Germans to meaningfully address the Eurozone crisis.  It is also not hard to think these thoughts when one comes across statements such as the rather cheery press release accompanying the third quarter GDP numbers (my bold):

Gross domestic product in 3^rd quarter of 2011: upswing continues

WIESBADEN – The German economy continues its growth: In the third quarter of 2011, the gross domestic product (GDP) rose 0.5% – upon price, seasonal and calendar adjustment – on the second quarter. In addition, the result for the second quarter of 2011 has been corrected upwards to +0.3%, as reported by the Federal Statistical Office (Destatis). This means that, following the strong growth at the beginning of the year (+1.3% in the first quarter), the upswing of the German economy continued in the course of 2011, with the growth rate slightly increasing in the reference quarter compared with the previous quarter.

In a year-on-year comparison, too, the GDP grew strongly, although not as strongly as in the first half of the year: In the third quarter of 2011, the price-adjusted GDP was up 2.5% on a year earlier (calendar-adjusted: +2.6%).

And lest you think this is an isolated case, below is a recent AP story on consumer confidence in Germany:

BERLIN (AP) — A survey finds that consumer confidence in Germany, Europe's biggest economy, is holding up despite increasing worries about the economic outlook.  The GfK research institute said Tuesday that its forward-looking consumer confidence indicator for November stands at 5.3 points — up from 5.2 points in October.  GfK says that consumers "remain very optimistic" about income expectations and that their willingness to buy also is being helped by low unemployment and rising salaries.

Really?  German consumers remain very optimistic about income expectations and future spending despite the onward march to Eurogeddon?  Do they know something we do not know?  Or, are they so caught up in the relative successes of the German economy that they fail to fully appreciate what is happening in the rest of the Eurozone?  

In case there were any questions, what has happened to aggregate demand in the rest of the Eurozone can be seen below.  First, nominal spending has never recovered from its collapse in 2008 and 2009: 

Moreover, nominal spending has actually fallen over the past two quarters:

Now maybe the German public does appreciate what is going on in the Eurozone, but simply are not fazed by it.  One reason for this might be their belief that they can force the rest of the Eurozone to become more German-like as this "we have them by the balls" comment indicates.  A second reason is that in a worst-case scenario the Eurozone breaks up and they return to their beloved Deutsche Mark with a relatively resilient German economy.  Whatever the motivation may be, what we do know is that the Germans are doing a fine job stabilizing aggregate demand in Germany.  

The ECB Needs the Fed Now More Than Ever

And it is not because the ECB needs more currency swaps.  It is because the ECB needs the Fed for cover.  Here is why.  The Fed is a monetary superpower.  It manages the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. As a result, its monetary policy gets exported to much of the emerging world. This means that the other two monetary powers, the ECB and Japan, have to be 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. So, to some extent U.S. monetary policy also gets exported to the Eurozone and Japan too.  

This exporting of Fed policy to the Eurozone can be seen in the figures below.  The first figure shows the targeted policy interest rates for both the Fed and the ECB since the Euro's inception in 1999.  The figure shows that the ECB adjusted its target interest rate in a manner that seems to follow movements in the targeted federal funds rate, a response consistent with the Fed being a monetary superpower.  Even the ECB's attempt to break away and tighten in 2011 appears to be conforming to the irresistible pull of the Fed's power. 

The next figure shows the year-on-year growth rate for NGDP across the two regions.  The arrows highlight what appear here too to be a leading relationship for the USA: nominal spending first takes off in the USA then in Europe and then slows down in that order too.  

As a robustness check, the figure below shows the effect across both regions' NGDP growth rates of an unexpected change or shock to the US NGDP growth rate.*  The figure reveals that the typical shock to US NGDP during the 1999-2011 period created similar responses across both regions. 

 

Again, an easy way to explain these relationships is that the Fed is a monetary superpower and influences monetary policy in both the United States and the Eurozone.  Thus, when the Fed was too easy in the early-to-mid 2000s it fueled rapid nominal spending growth in both regions.  Likewise, when the Fed became passively too tight in 2008 it stalled nominal spending growth in both places too.  

The Fed, therefore, should be able to help spur nominal spending growth in the Eurozone by do something radical, like adopting a NGDP level target that would return U.S. NGDP to its pre-crisis trend.  This would imply aggressive monetary easing by the Fed that, in turn, would put downward pressure on the dollar.  This would create the incentive for the reluctant Germans--who seem to care as much about their exports as they do about inflation--and the ECB to get serious about opening their monetary spigots.  In other words, a sufficiently aggressive Fed would provide the cover for the ECB to do what it needs to have done all along.  

Of course, a more efficient way to do this would be a coordinated effort, such as the plan suggested by Lars Christensen, where the major central banks of the world work together to raise their nominal spending to pre-crisis trend levels.  But since this type of coordination does not seem likely anytime soon, it seems natural for the reigning monetary superpower to take the lead and start a global nominal spending recovery.

*These impulse response functions come from a VAR with just the two NGDP growth rates and a constant.  Five lags are used along with a Cholesky decompostion.

Conservatives for NGDP Targeting

Goldman Sachs has another research note out on NGDP  targeting and, among other things, has this to say:

NGDP target[ing] enjoys growing support from economists on both sides of the political aisle. Several prominent economists who have recently advocated NGDP targeting, including Paul Krugman, Christina Romer, and Bradford DeLong, lean toward the Democratic side. However, many of the long-standing “market monetarist” supporters of NGDP targeting such as Scott Sumner and David Beckworth identify themselves as political conservatives. Beckworth recently wrote an article advocating NGDP targeting with political journalist Ramesh Ponnuru in the conservative National Review. Gregory Mankiw, an adviser to Republican presidential candidate Mitt Romney, has in the past also published research favorable to NGDP targeting, although he has to our knowledge not weighed in on the current debate.

Actually, Greg Mankiw in a recent Brookings Paper argued for macroeconomic policy that amounts to a NGDP target.  In his own words: 

This policy might be interpreted, for example, as the central bank targeting a higher level of nominal GDP growth.

Other long-time, right-of-center proponents include Tyler Cowen and Alex Tabarrok--their Modern Principles of Macroeconomics textbook has an innovative AD-AS model that is conducive to making the case for a NGDP target--as well as the recently deceased William Niskanen  of Cato Institute.  National Review Senior Editor Ramesh Ponurru could also be considered a long-time advocate since he has supported George Selgin's NGDP target for some time. More recently, though, he has become very vocal in his calls for the loosening of monetary policy via a NGDP target (see here, here, here, and here) and has opened the pages of the National Review to us Market Monetarists (see here, here, here, and here).  More recent endorsements for a NGDP target come the CATO Institute's Tim Lee.  Bruce Bartlett and the folks at FrumForum are also in favor of something like a nominal GDP target.  And then there is all the blogging by the Market Monetarists who tend to be right-of-center.  So yes, there is growing political support from both sides. The problem, though, is that on the right we have a uphill battle against the hard-money view.