How is Abenomics Doing?

In my previous post, I noted how the monetary policy portion of Abenomics (the "first arrow") appears to be working. Japan has grown more rapidly than the United States and the Eurozone. This success appears to be the result of its new found enthusiasm for monetary policy. And it is not just any kind of monetary policy, but one that signals a regime change at the Bank of Japan. This regime change commits the Bank of Japan to raising the nominal size of the economy by permanently expanding the monetary base. Martin Wolf agrees:

Of the three arrows, the first is most likely to hit the target. In January the Bank of Japan adopted an explicit target of 2 per cent consumer price inflation. But it was only after the appointment of Haruhiko Kuroda, an outsider, as governor that a new approach was born. Under his leadership, the bank announced its ambitious programme of “quantitative and qualitative easing”, or QQE. The aim is to deliver the inflation target “at the earliest possible time, with a time horizon of about two years”. The central bank committed to doubling its holdings of Japanese government bonds over two years and more than doubling the average maturity of those holdings. Christina Romer of the University of California, Berkeley, former chair of the US Council of Economic Advisers, hailed this as a “regime shift”, comparable to America’s decision to go off the gold standard in April 1933.

Ambrose Evans-Pritchard makes a similar point:

Japan, too, has grasped the nettle, breaking free of its deflation trap with the most radical policy experiment of modern era...After two decades of monetary tinkering the Bank of Japan is mopping up 7.5 trillion yen worth of bonds each month, almost as much as the Fed in an economy barely more than a third the size. It is buying long-term debt for the first time...

Japan was the fastest growing economy in the OECD bloc in the first half of this year. There was a hiccup in the third quarter, causing the faint-of-heart to write off Abenomics. Yet Nomura's Shuichi Obata says the December Tankan survey of business shows that confidence is at last spreading from big companies to small firms, with the services index rising above zero for the first time since 1991. 

Michael T. Darda, Chief Economist of MKM Partners, tells us that not only has Japan done well so far, it looks set to do well again next year:

Leading indicators in Japan have been on the upswing. The OECD’s Leading Index and the Tankan business sentiment survey have been in multi-month upswings, suggesting faster future growth. 

 

In other words, Abeonomics is working. One reason that the previous round of QE in Japan didn’t lift growth much is that it was expected to be temporary and proved to be temporary as occasioned by a 20% collapse in the monetary base in 2006. This time, however, at least part of the increase in the base is expected to be permanent, hence the new 2% inflation target. In short, the BoJ has to do enough to satiate a broad money demand function that has been growing 2-3% per annum.  (DB: for more on the importance of permanent monetary injections see here)

Reflation should help to ease Japan’s debt and fiscal burden. One reason for Japan’s high debt ratio (perhaps the main one) is that nominal GDP growth has been trending at zero for more than 15 years. That means at any positive nominal bond yield, the debt ratio is likely to rise. Thus, restoring at least moderate NGDP growth should help Japan’s budgetary fortunes. This is one reason that the rise in Japan’s inflation breakeven spreads has been inversely related to credit default swap spreads on Japan’s debt. 

Broad money growth in Japan has begun to recover convincingly, which should also be bullish for the equity market. Broad money growth now has exceeded to growth rates last seen during Japan’s multi-year growth period of the early 2000s. Milton Friedman would be proud, as he advocated the policies now going into place back in 1998. We believe Japan equities have 20-40% upside, assuming the valuations seen back in the early 2000s are met or exceeded.  

  

This is great news for Japan. However, as Martin Wolf notes, this first arrow only addresses the cyclical portion of the Japanese economy. There are still huge structural problems that seem unlikely to be resolved anytime soon. Still, this is one big step forward for an economy burdened by malign deflation for the past few decades. 

The QE Block versus the EMU Block

 Source

The always colorful Ambrose Evans-Pritchard has done it again. He has cleverly framed the varying monetary policy responses in the advanced economies as falling under either the QE block or the EMU block. As he notes, the evidence is clear as to which block has done better:

The US, UK and Japan are all recovering, moving closer to "escape velocity". The Swiss National Bank - that bastion of orthodoxy - has kept its economy on an even keel by quietly amassing a bond portfolio equal to 85pc of GDP.

The crippled eurozone alone has chosen to stagger on defiantly without monetary crutches. The result has been a double-dip recession of nine quarters, the longest since the Second World War. The austerity regime has been self-defeating even on its own crude terms. Debt ratios have ratcheted up even faster.

[...]

 
The diverging fortunes of the QE bloc and the EMU bloc prove beyond doubt that monetary stimulus packs a powerful punch. Without becoming entangled in the vendetta between Friedmanites and Keynesians - I value the insights both in the post-bubble phase, as well as "Austrian" insights before the bubble builds - the central bank experiment of 2008-2013 shows that blasts of money can greatly offset the pain of budget cuts, even when interest rates are zero.

This is a point I have repeatedly made on this blog. The more intense the monetary policy response, the greater has been the economic recovery. That is why over the past year the recovery in Japan has outpaced the one in the U.S. which, in turn, has outpaced the recovery in the Eurozone. This pattern can be seen in the figure above.

Evans-Pritchard goes on to describe the QE critique coming out of the EMU block:

You hear a refrain in Berlin and Brussels that the recovery of the QE bloc is somehow feckless, phony and illegitimate, that the money printers are just building up more debt, putting off their day of reckoning while Europe takes its punishment early. Nothing could be further from the truth. 

I agree, but for a different reason than Evans-Pritchard lays out in his piece. Specifically, those who see a debt crisis in Europe are only seeing a symptom of a more fundamental problem: a collapse in nominal income. This is a problem that the ECB could have prevented. The collapse in Eurozone nominal income created the debt crisis, not the other way around. The ECB allowed this collapse to emerge because its policies have been, until recently, effectively geared toward Germany. This is a point Ramesh Ponnuru and I have made before:

[Observers] tend to think of Europe’s current crisis as the result of overspending welfare states. And these states would indeed be better off with lower spending levels and less regulated labor markets. But many of the nations swept up in the euro-zone crisis, such as Spain and France, had spending and tax revenues well aligned before it hit. The true problem has again been monetary. Europe has for a decade had a monetary policy well suited to the circumstances of Germany but not to those of the rest of the euro zone and especially its periphery. Nominal income in Germany has stayed on a fairly steady trend line. In the periphery, however, it first went way up and then crashed. For the euro zone as a whole, nominal spending has fallen far below its previous trend—and has been continuing to fall farther away from it. Monetary policy therefore remains very tight in the euro zone overall. One effect of that drop-off, in Europe and in the U.S., has been to make debt burdens more onerous.

The figure below illustrates this point. It shows that below-trend growth in Eurozone nominal income--as measured by how far NGDP is from its pre-crisis trend path--has been matched by a similar rise in Eurozone government debt. The Eurozone crisis, then, is a nominal GDP crisis, not a debt crisis.

The QE programs have been far from perfect, but they seem to have made a difference. Consequently, my bet is that history will be kind to policy makers in QE Block and frown upon those in the EMU Block.

QE, Rising Yields, and the Right Way to Taper

Matthew O'Brien of The Atlantic gives us the 41 most important economic charts of 2013. The figures come from various contributors, including me. My figure is borrowed from chief economist Michael T. Darda of MKM Capital and shows that long-term treasury yields generally have risen under the QE programs. This pattern runs contrary to the stated objectives of the Fed and is also inconsistent with those who claim the Fed's large scale asset purchases (LSAPs) are draining the financial system of safe assets. Fortunately, there is a way to make sense of these developments.

The chart I borrowed from Darda came from a longer note that had other interesting charts and comments. I thought you might like seeing the rest of them, especially his thoughts on how to taper without tightening monetary policy. Here is Darda:

Most observers continue to (falsely) believe that QE works by lowering long rates and flattening the yield curve. However, a quick look at the data suggests this is not the case.

The Great Macroeconomic Experiment of 2013

In early 2013, Mike Konczal wrote the following:

In late 2011, the economist David Beckworth and the writer Ramesh Ponnuru wrote an editorial in the New Republic on how “both liberals and conservatives are wrong about how to fix the economy.” How were they wrong? Conservatives were wrong because, contrary to common belief on the right, the Federal Reserve wasn’t in fact doing enough to boost the economy. Liberals, however, were wrong in opposing austerity and calling for more fiscal stimulus in the form of stimulus spending or temporary tax cuts.

In Beckworth and Ponnuru’s view, the Federal Reserve still had plenty of room to boost the economy. Not only would fiscal tightening be good over the long haul, but it would force the Fed to act. And they argued that as long as the Fed is working to offset austerity, the country “won’t suffer from spending cuts.

We rarely get to see a major, nationwide economic experiment at work, but so far 2013 has been one of those experiments -- specifically, an experiment to try and do exactly what Beckworth and Ponnuru proposed. If you look at macroeconomic policy since last fall, there have been two big moves. The Federal Reserve has committed to much bolder action in adopting the Evans Rule and QE3. At the same time, the country has entered a period of fiscal austerity. Was the Fed action enough to offset the contraction? It’s still very early, and economists will probably debate this for a generation, but, especially after the stagnating GDP report yesterday, it looks as though fiscal policy is the winner.

So how has this experiment unfolded since then? Has the Fed been able to offset the fiscal drag? Michael Darda, Chief Economist of MKM Partners, has the answer:

Despite a two-year contraction in nominal federal outlays for the first time in more than five decades and a raft of tax hikes starting in early 2013, job gains are running slightly ahead of the 2012 pace. Non-farm payrolls (+203K in November and 200K in October) have averaged 189K during the first 11 months of 2013, ahead of the 179K 11-month average in November 2012 and the 170K average for November 2011. Over the last 12 months, non-farm payrolls have averaged 191K, also above the 12-month averages for the last three years. Indeed, year-to-year gains for overall payrolls and private sector jobs have been very steady despite the most intense fiscal consolidation since the Korean War demobilization. Many observers late last year were of the mindset that the fiscal cliff and/or sequester would either throw the U.S. economy back into recession, or slow it materially. It has done neither because, in our view, the Fed has offset it. Although monetary policy has beenfar from perfect, allowing the financialsystem to crash in 2009 (instead of doing QE1), allowing low inflation to morph into deflation in 2010 (instead of initiating QE2) and allowing the full force of the sequester/tax hikes to hit in 2013 (rather than rolling out QE3) do not seem like particularly desirable outcomes. The Fed has managed much better than the ECB and that is the proper counterfactual.

Several points to note. First, the Fed has been offsetting since 2010 a tightening of the structural budget balance as a percent of potential GDP. In my opinion, that is an even more impressive feat. Second, its ability to do so demonstrates that monetary policy is still effective at the zero lower bound. Third, it is amazing that so many people were predicting a recession in 2013 because of the sequester. They did not take seriously the possibility QE3 could offset the fiscal drag. I am waiting for their mea culpa.

The Wrong Debate: Helicopter Drops vs. Quantative Easing

A central theme of this blog is that the economy is still starved of the monetary assets needed to restore full employment. That is, the ongoing shortfall of aggregate demand is at its core caused by a shortage of money and money-like assets relative to the demand for them. The question, then, is what can be done about this problem.

I have long argued, along with other Market Monetarists, that the Fed could solve this problem by adopting a NGDP level target. Why would this help? The key reason is that it would create an expectation that some portion of the monetary base growth from the asset purchases would be permanent (and non-sterilized by IOER). That, in turn, would mean a permanently higher price level and nominal income in the future. Such knowledge would cause current investors to rebalance their portfolios away from highly liquid, low-yielding assets towards less liquid, higher yielding assets. The portfolio rebalancing, in turn, would raise asset prices, lower risk premiums, increase financial intermediation, spur more investment spending, and ultimately catalyze a robust recovery in aggregate demand. (One could also tell a New Keynesian story where the higher future price level implies a temporary bout of higher-than-normal inflation that would lower real interest rates down to their market clearing level.)

The key to the above story is that some portion of the monetary base expansion is expected to be permanent. If the public believes the Fed's asset purchases are not going to be permanent and therefore the price level and nominal income will not be permanently higher, the rebalancing will not take place. I bring this up because this same point applies to helicopter drops or any other kind of fiscal policy stimulus. Yet many of my fiscalist friends miss it. They seem to think that helicopter drop will solve the excess money demand problem, period. That is not the case if the Fed continues to hit its inflation target.

Imagine, for example, that Congress approved a $10,000 check be sent to every household. Even in a non-Ricardian world where households are liquidity- and credit-constrained, the increased private sector spending created by the checks would be offset by monetary policy if it started to push inflation above its target.

This is why helicopter drops by themselves are not a fix. Nor or large scale asset purchases. As noted by Christina Romer, there has to be a regime change in how monetary policy is conducted, one that signals a commitment to a permanent expansion of the monetary base (via a commitment to a higher price level and nominal income). From this perspective, it does not matter whether one does helicopter drops or large scale asset purchases. They would have the same effect if tied to the same target, such as a NGDP level target. 

Michael Woodford has made this point before:

It is possible for exactly the same equilibrium to be supported by a policy of either sort. On the one hand (traditional quantitative easing), one might increase the monetary base through a purchase of government bonds by the central bank, and commit to maintain the monetary base permanently at the higher level. On the other (‘helicopter money’), one might print new base money to finance a transfer to the public, and commit never to retire the newly issued money. Suppose that in either case, the path of government purchases is the same, and taxes are raised to the extent necessary to finance those purchases and to service the outstanding government debt, after transfers of the central bank’s seignorage income to the Treasury. Assuming the same size of permanent increase in the monetary base, the perfect foresight equilibrium is the same in both cases...

However, he notes the two approaches would have different effects if the public thought the permanency of the monetary base injections differed:

The effects could be different if, in practice, the consequences for future policy were not perceived the same way by the public. Under quantitative easing, people might not expect the increase in the monetary base to be permanent – after all, it was not in the case of Japan’s quantitative easing policy in the period 2001-2006, and US and UK policymakers insist that the expansions of those central banks’ balance sheets won’t be permanent, either – and in that case, there is no reason for demand to increase. 

In other words, we should not be surprised that the Fed's QE programs have not packed more of a punch. U.S. monetary authorities have clearly indicated the programs are temporary. (QE3, though, has added some permanency with its data-dependent nature and appears to have offset much of the 2013 fiscal drag.) We should also, then, not be surprised that Abenomics--which has signaled a permanent expansion of the monetary base--is doing so much better than the original Bank of Japan QE program of 2001-2006. Finally, we should also not be surprised as to why FDR's 1933 decision to go off the gold packed such a punch. It permanently raised the monetary base. All of these experiences paint a picture of the relationship between the expected permanency of monetary base injections and aggregate demand growth. This relationship is sketched in the figure above.

So stop worrying about whether large scale asset purchases or helicopter drops are more effective. This is the wrong debate. Instead, start worrying about how we can change the Fed's target to something like a NGDP level target.

P.S. Paul Krugman's 1988 article also implies that the temporary versus permanent distinction is important in determining the efficacy of monetary policy, particularly at the ZLB.

P.P.S. The above discussion is why I have previously argued for helicopter drops to be tied to NGDP level targets.

Update: Compare this picture of Japan's monetary base to those of the U.S. monetary base in 1933.

 

Taking the Model to the Data

Stephen Williamson has generated something of a firestorm by arguing the Fed's QE programs have actually been lowering inflation over the past three years. His argument is based on a new paper of his that builds upon the monetary search framework of Lagos-Wright (2005). I actually like this approach to modeling money-like assets, but the implications Williamson draws about QE has Nick Rowe, Brad DeLong, Paul Krugman, and Scott Sumner up in arms. David Andolfatto valiantly rides to Williamson's defense (update: so does Noah Smith) only to be rebuffed again by Nick Rowe.

I do not want to rehash their arguments here, but I do want to respond to a challenged made by David Andolfatto:

It seems to me that the critics should have instead attacked his results and interpretations with empirical facts (or am I too old-fashioned in this regard?).

Okay, David wants us to take Stephen Williamson's model to the data. Stephen probably thinks he has already done so with this figure of PCE inflation. However, one cannot really draw any conclusion using headline PCE inflation because it has embedded in it supply shocks and other temporary perturbations completely unrelated to monetary policy. This is why the Fed and others look at core PCE inflation. For these reasons, I too will use the core PCE inflation measure here as we empirically examine Williamson's claims.

Below is the figure for core PCE inflation. Williamson's argument is premised on inflation falling over the past three years. This figure suggests something else has been happening: it has been bouncing between 1% and 2%. Ryan Avent argues this is intentional. The Fed's 2% inflation target is actually an upper bound. According to this view, the Fed is more concerned about preserving its inflation-fighting credibility than it lets on in public and effectively is keeping one foot on the brake and one on the gas pedal so that inflation stays in the 1%-2% range. In any event, the point here is it is not clear that inflation has been trending down for the past three years.

Williamson's bigger claim, though, is that the Fed's purchases of treasuries are actually driving down the inflation rate. If this is the case, then we would expect to see a negative relationship between the growth in its holdings of treasuries and the inflation rate. The data, though, suggest otherwise. The figure below shows the year-on-year growth rate of treasuries held by the Fed plotted against the core PCE inflation rate. It appears that Fed's purchases of treasuries leads core inflation by about six to nine months. [Update: here is the figure for longer-term treasuries--it is even stronger.]

To verify this 'eye-ball test', I put the two series in a vector autoregression (VAR) and estimated it once with 6 lags and once with 12 lags. The data was monthly and I estimated the model for the 12/2007-9/2013 period. Below is the Core PCE inflation impulse response function (i.e. typical response) to a positive standard deviation shock to the year-on-year growth rate of the Fed's treasury holdings.The first figure shows the response for the 6-month lag VAR and the second figure for the 12-month lag VAR. In both cases core PCE inflation responds in the same direction as the shock with a lag.

Now these effects are modest, but they go in the opposite direction of that predicted by Williamson. So the data seem to be telling a different story. The Fed's treasury purchases do lead to modestly higher inflation. It is nothing to write home about, but it is definitely not disinflationary.

Again, I like the Lagos-Wright (2005) approach promoted by Williamson. In fact, Josh Hendrickson and I have a paper built on it. In our extension of the model, QE programs can pack a real economic punch if the monetary base injections are expected to be permanent. This is because a permanent injection is expected to permanently raise future nominal income which in turn relaxes current borrowing constraints. The implications of our model, then, is that the Fed's QE programs have not been as effective as they otherwise could be, because all along the Fed has signaled its asset purchases are temporary (though QE3 has added some permanence with its conditional nature). This point about permanent monetary injections is not novel. It has been made many times before by Paul Krugman, Michael Woodfod, Scott Sumner, Bill Woolsey, and others. It is also a point I repeatedly make on this blog. Finally, it is why so many of us are big supporters of level targeting.

P.S. The success of monetary policy in Japan under Abenomics is also hard to reconcile with Williamson's model. Here too, I believe the results are due to the expected permanence of the monetary base expansion.

Update: Mark A. Sadowski provides further empirical evidence that runs contrary to Williamson's claims.

Three Questions Janet Yellen Should Have Asked the Senators

Janet Yellen's confirmation hearing was today and, as expected, she got asked tough questions. It would be nice if she could return some of her own tough questions to the Senators. Here are three questions that would challenge the thinking of many and hopefully start a productive conversation on Capitol Hill. The questions are presented in graphical form, followed by a few comments:

Comment: Since most of the marketable public debt was not purchased by the Fed, it is not the main reason for the long decline in treasury yields. The Fed may have pushed down the term premium a bit, but overall the weak economy is the culprit. This can be seen, for example by looking to the decline in real interest rates that occurred after QE2 ended and before QE3 started. Even the Fed's forward guidance is itself a function of expected growth rate of the economy. So no, the Fed did not enable the large federal budget deficits with low financing costs.

Comment: If anything, the Fed has been systematically undershooting its 2% inflation target as seen above. It seems the Fed views it inflation target as an upper bound to an 1-2% target range. Yes, the Fed has been creating a lot of monetary base, but it also clearly signaled this expansion is temporary. Only a permanent, unsterilized expansion of the monetary base would make a difference. The Fed's inflation-fighting credibility is so strong that absent a major regime shift, like the introduction of Abenomics in Japan, one should not expect the current expansion of the Fed's balance sheet to create a surge in inflation.

 

Comment:  The absence of robust broad money supply growth means the economy is still starved of the monetary assets needed to restore full employment. The Fed could be doing more to correct this shortfall. No, the Fed does not directly create inside money assets, but it can meaningfully influence their production by making the right signals about the future path of monetary policy. For example, a regime change to a nominal GDP level target that required aggressive catch-up growth would do just that. It would signal that the Fed plans to allow some of the Fed's expanded balance sheet to become permanent. That matters, because it means a higher-than-expected price level in the long-run. A higher-than-expected price level in the future means investors will begin adjusting their portfolios today. The portfolio rebalancing, in turn, will mean more aggregate demand today. So yes, the Fed has not unloaded both barrels of the gun when it comes to supporting broad money supply growth. (Wonkish note: this understanding is theoretically and empirically shown here.)

If You are Going to Criticize QE...

Do not do it this way or you might face the combined firepower of Caroline Baum, Scott Sumner, Jim Pethokoukis, and Joe Weisenthal. No one could survive that onslaught. But this does not mean the Fed's large-scale asset purchasing programs are perfect. There are legitimate critiques one can make about the QE programs.

One might, for example, criticize how the QE programs have been incredibly ad-hoc and unpredictable. Even with the new "data dependent" approach of QE3, there is still confusion as to how the Fed will respond to the incoming data. A great example of this is the FOMC's decision not to taper in September. It came as complete surprise to the market. The Fed's clarity has not gotten any better since then. There is now talk of the Fed changing its "thresholds" for action. But no one knows for sure. This confusion does not help an economy struggling to get out of a slump. This is a good critique.

One could also critique the Fed for claiming it is using QE a way to restore full employment while at the same time it systematically keeps inflation below its target. The Fed's large-scale asset purchases will never gain full traction if the Fed continues to place one foot on the gas and one foot on the brake. This is definitely worthy of a critique.

One might also critique the Fed for not learning from FDR in 1933 or Abenomics in 2013 that QE can be very effective if done right. These experiences show that QE-type programs work when monetary base injections are expected to be permanent. Temporary or sterilized injections, on the other hand, are ineffective. Though QE3 can be viewed as introducing some permanence to the injections, the Fed has clearly indicated it plans to wind down most of the growth in its balance sheet. Long-run inflation forecasts indicate the public believes it. The Fed doing QE wrong is is also worthy of a critique.

But do not criticize the QE programs by saying you are sorry they ever happened. Yes, the Fed could have let the payment system crash as it did in the 1930s instead of doing QE1. And yes, the Fed could have let the economy continue to drift into deflationary territory in 2010 instead of doing QE2. And yes, the Fed could have let the economy continue to stumble in 2012 and face the sequester in 2013 alone instead of doing QE3. Very few observers would explicitly make these arguments, but one implicitly does if they question the inherent worthiness of the QE programs.

So if you are going to criticize QE do it right.

Endogenous Aggregate Supply

A recent Federal Reserve paper makes the case that potential GDP is to some extent endogenous to aggregate demand shocks:

The recent financial crisis and ensuing recession appear to have put the productive capacity of the economy on a lower and shallower trajectory than the one that seemed to be in place prior to 2007... [We] argue that a significant portion of the recent damage to the supply side of the economy plausibly was endogenous to the weakness in aggregate demand—contrary to the conventional view that policymakers must simply accommodate themselves to aggregate supply conditions. Endogeneity of supply with respect to demand provides a strong motivation for a vigorous policy response to a weakening in aggregate demand.

One example of this phenomenon would be workers who had up-to-date skills and were productive, but lost their job because of the Great Recession. Over time, their skills became obsolete and they went from being cyclically unemployed to structurally unemployed. What started as an aggregate demand problem slowly became an aggregate supply one. It is therefore important to respond to aggregate demand shocks quickly and thoroughly to prevent this from happening.

I believe another example of this endogenous aggregate supply response is the decline of expected productivity growth. This can be seen in the figure below. It comes from the Survey of Professional Forecasters and shows the expected average productivity growth rate over the next 10 years. It reveals a run-up in the expected growth rate in the late 1990s and early 2000s that corresponds to the technological advances and opening up of Asia during that period. Since 2006 it has persistently declined. This is a big deal since a decline in expected productivity growth means firms will come to expect lower returns on capital expenditures and households will come to expect lower future income growth. Firms and households will cut spending accordingly. But this expected decline in aggregate supply growth is probably an overreaction. It is hard to believe that all the productivity advances from technology and the opening up of the global economy permanently disappeared because of the Great Recession. Rather, I see it as an endogenous aggregate supply response that should largely self-correct as the economy returns to full employment.¹

The Fed paper behind this is getting a lot of attention, but it is important to note that Mark Thoma made the same point almost a year and half earlier. He does a good job illustrating the idea with the following figure. Here, Y*_SR is short-run endogenous aggregate supply, while Y*_LR is the long-run or full potential amount of aggregate supply:

Here is how Thoma describes it:

Up until the point where the line splits into three pieces, assume the economy is in long-run equilibrium with output at the natural rate...Then, for some reason, aggregate demand falls leading the economy into a recession. As AD falls, people are laid off, equipment is stored, factories are shuttered, and so on and the economy's capacity to produce falls in the short-run as shown by the blue line on the diagram.

But this is a temporary, not a permanent situation. Eventually people will be put back to work, trucks in parking lots will be back on the road, factories will reopen -- you get the picture -- and productive capacity will grow as the economy recovers. I believe many people are treating what is ultimately a temporary fall in capacity as a permanent change, and they are making the wrong policy recommendations as a result.

In fact, there's no reason to think productive capacity can't return to its long-run trend just as fast or faster than output can recover. If so, then it would be a mistake to do as many are doing presently and treat the blue short-run y* line as a constraint for policy, conclude that the gap is small and hence there's nothing for policy to do. Capacity will recover...

In terms of our earlier examples, this understanding means the now structurally unemployed individuals will find it far easier to retool and get back into the labor force if the economy is humming at full employment. And the existing productivity gains will be better appreciated in a robust economy, thereby raising long-run expected growth.

There are, though, potential drags on the aggregate supply that could prove more lasting. For example, the ACA may have non-trivial effects on the labor supply according to Casey Mulligan. The question is how big of an effect developments like these will have on trend growth. Even if large, they still could be offset by further productivity gains. Ultimately, this is an empirical question.

The GOP's Golden Opportunity on Monetary Policy

One of the most remarkable developments of the past few years has been how the U.S. economy has steadily grown--albeit slower than needed--despite a  tightening of fiscal policy. This tightening has been happening since 2010, but kicked into higher gear in 2013. Many observers predicted this fiscal tightening would be disastrous. For example, some claimed the sequester in 2013 would cause anywhere from 500,000 to 700,000 jobs to be lost in 2013. And yet, as noted by Michael Darda, this has not happened because the Fed has successfully offset it:

Non-farm payroll growth surprised to the upside in October (rising 204K vs. expectations of 120K), but the data simply have returned to the 12-month average, in line with the message of a host of leading labor market indicators. The key take-away from the data so far for 2013 is that the Fed, unlike the ECB, has offset the sharpest fiscal consolidation since the 1950s, despite the zero lower bound (ZLB) on short rates and a widespread (but false) view that QE only lifts asset prices and not the real economy. Year-to-year trends in aggregate hours worked and nominal wage rates have been moderate but steady, reinforcing the argument that the Fed has thus far offset any demand side fallout from the sequester and 2013 tax hikes.

This story is a big deal, one that the GOP and other conservatives should be pushing every day in the media. They should be taking the offense and heralding its implications: U.S. government budget deficits can be easily shrunk, even at the ZLB, if we have offsetting actions by the Fed. They could note how this strategy worked before in Canada and the UK. More generally, they could make the point that if you want to minimize federal government interventions into the economy, have the Fed do its job. Just imagine how different the 1930s and the past five years would have been had the Fed stabilized total current dollar spending during these times. This is such low hanging fruit for the GOP.

Instead of running with it, however, the GOP and its thought leaders instead have fretted for five years over an inflation threat that has not materialized and now worry over asset bubbles that one has to strain to see amidst a depressed economy. This recent George Will column is a great example of this myopic vision of money. Instead of seeing how the Fed has offset fiscal austerity and therefore could stave off more if further budget cuts were made, George Will instead focuses on unfounded fears of loose monetary policy. This is why folks like Jim Pethokoukis are pulling their hair out.

The GOP needs a serious rethink on monetary policy. Some of us on the right have been trying for the past few years to awaken the GOP to this golden opportunity. We write op-eds, articles, and even travel to Capitol Hill. But sadly, the GOP continues to sabotage itself on monetary policy. It pushes for hard money policies that weaken the economy and, in turn, open door for other policies they detest. Imagine if the Fed had not allowed the sharp collapse in aggregate demand in late 2008, early 2009. It is less likely that many of President Obama's policies would have been supported and therefore enacted. As Scott Sumner once said, monetary policy is the Achilles Heel of the right.

This would be almost comical if it were not so serious. So come on GOP, run with the amazing story of fiscal austerity since 2010 and steady growth nonetheless. Do not waste this golden opportunity.

Why Counterfactual Thinking Is Important

I recently made the case that many observers are not thinking properly about the Fed's Quantitative Easing (QE) programs. Using the analogy of George Bailey's life in the film It's a Wonderful Life, I argued that the critics who question the efficacy of the QE programs are doing the wrong counterfactual. Today, Barry Ritholtz makes the same point:

One of the analytical errors I seem to constantly come across is what I call the non-result result. It goes something like this: If you do X, and there is no measurable change, X is therefore ineffective.

The problem with this analysis is the lack of a control group, If you are testing a new medication to reduce tumors, you want to see what happened to the group that did not get the tested therapy. Perhaps their tumors grew and metastasized. Hence, no increase in tumor mass or spreading is considered a very positive outcome.

This seems to get loss in the debate over QE. The debate — either ignorantly or disingenuously — makes claims such as “Look how few jobs have been created, and look how high unemployment is.”

Understanding this logic, and lacking a control group, we must employ a counter-factual. The question one should be asking is “How many less jobs would have been created?;  How much higher would unemployment be?”

This idea is nicely summarized by the QE counterfactual produced by Poltiical Calculations. It shows what would have happened to nominal GDP had there been no QE3. It is not a pretty sight:

I too ran a QE counterfactual in my George Bailey post. There I considered what would have happened to employment, the stock market, PCE core inflation, and the repo interest rate conditional on (1) the Fed not increasing its share of marketable treasuries starting in late 2010 and (2) the Eurozone crisis, China slowdown, and fiscal policy shocks still occurring as they did. The implications for the economy were the same as in the figure above. 

These counterfactual exercises serve as a nice complement to the on-going quasi-natural experiments that indicate monetary policy at the ZLB can still pack a punch. Yes, monetary policy is far from perfect. But it is also far from impotent as claimed by some QE skeptics.

Thoughts for the Weekend

First, don't be derpy. In my previous post I presented evidence that small business are very concerned about Obamacare and, as a result, are cutting back on employee hours. The evidence came from three surveys--NFIB, Gallup, and Foundation of Employee Benefit Plans--and a list of firms who have cut hours because of the ACA. Despite this evidence, some observers were feeling derpy and rationalized it away. As a follow up, Jed Graham sent me an article that further supports the claim that Obamacare is reducing hours worked. Specifically, it shows hours worked for low income workers starting to fall. Casey Mulligan makes a similar point here. The real question, in my view, is how big of an effect this will have on the labor market. Here I think reasonable people can disagree. Meanwhile James Pethokoukis summarizes we know so far about the implementation of the ACA.

Second, can you see what I see? Paul Krugman reminds us that we are coming up on the five year year anniversary of being at the ZLB. He tells us that in this strange world everything changes:

[Hitting] the zero lower bound changes everything. It’s not just that the rules change for monetary policy, although they do: some people have been warning for the whole five-year period that the surge in the monetary base will cause runaway inflation, and it keeps not happening. It’s also true that we enter the territory of paradoxes; the paradox of flexibility, but also, and more crucially, the paradox of thrift, in which attempts by some players in the economy to save more end up leading to less, not more, investment.

Okay I see a strange world too, but instead of seeing a 'paradox of flexibility' I see central bank incompetence.  And instead of seeing a 'paradox of thrift', I see an ongoing excess money demand problem that is summed up nicely in the following figure:

This figure shows that the BIS finance neutral output gap is negatively related to the share of liquid assets being held by households. This liquidity demand measure also tracks the inverted real SP500 closely as seen below. This figure illustrates the portfolio rebalancing channel: as households decrease their liquid assets holdings and shift to riskier assets, those riskier asset prices soar. The Fed job, then, is to conduct monetary policy so that the right amount of rebalancing (i.e. the amount the closes the output gap) take place.

One area where I concede that ZLB in and of itself matters is that it leads to market segmentation between transaction assets and other assets.  This is a big deal and explains why we still have a safe asset shortage problem.

Third, model this wise guy. Cardiff Garcia points us to a new paper by Ricardo Caballero and Emmanuel Farhi. They develop a model that, among other things, implies the Fed's treasury purchases are harming the economy because they are removing safe assets from the financial system. This is an increasingly popular critique that I believe is wrong and said so here and here. I now have a model that bears this out. Josh Hendrickson and I coauthored a paper where a monetary search model is used to motivate transaction assets. With this model, we show that by properly managing expectations, the Fed can increase the supply of private label safe assets and at the same time reduce the demand for public safe assets. In other words, the Fed can solve the safe asset problem by improving the economic outlook. This really should not be shocking, but it is implicit in many of the arguments against QE. We also do some cool counterfactual forecasts that show what would happen to the stock of safe assets if the Fed did a better job managing NGDP expectations. Check it out.

My Supply-Side Senses Are Starting to Tingle

One of the most contentious debates over the past few years has been whether the U.S. slump is the result of  an aggregate demand shortfall or a spate of negative supply shocks. Depending on which view you take, the policy implications are very different. In the former case, monetary policy could help by closing the output gap. In the latter case, it would only be 'pushing on string' and might even create more problems. 

I have argued that the slump has largely been the result of an aggregate demand shortfall. One piece of evidence for this view I have repeatedly pointed to is a question on the NFIB Small Business Economic Trends survey. This survey question asks firms what specific developments they see as the "single most important problem" they face. Answers to question include lack of sales, regulation, taxes, inflation, financing costs, quality of labor, insurance availability, competition from large business, and other. This question, therefore, allows us to see from a small firm's perspective how important supply shocks are--as measured by regulation, taxes, financing, and quality of labor--compared to demand shocks--as measured by a lack of sales. Since the crisis the started, a lack of sales has been the number one problem. This series has led changes in the unemployment rate in a remarkably consistent manner since the data starts, as seen below. The easiest and most straightforward interpretation of this relationship is that firms cut back on production and employment as a result of the expected weak sales. From the firm's perspective, this suggests an aggregate demand shortfall is the key driver behind the slump.

Now I still buy this story, but recent developments in the survey question suggest supply-side concerns are becoming a bigger deal. In fact, a lack of sales is no longer the number one problem. Rather, it is concerns about regulation, as seen below.

What is even more alarming about these regulation concerns is that they have consistently risen since 2009 and are now at their highest level since the previous peak in 1994. See the figure below:

 

So what possibly could be driving the rise in regulation concerns? I think the answer is obvious: Obamacare. And I think observers like Brad DeLong, Paul Krugman, and myself who have been so quick to use this NFIB data when it fits our views need to be honest and acknowledge what this data is saying now.

So how do we interpret the rising small business concerns about government regulation? One manifestation of these concerns might be the claim that some firms are cutting back employee hours to under 30 so that they do not have to offer them health insurance. This claims resonates with me since I know people in my community who have had their hours cut back for this reason. Brad DeLong, Jared Bernstein, Max Sawicky, and others say no way, there is no evidence of this in the employment data. They also ask why would firms start doing this now if this requirement does not become law for another year.

I acknowledge their point on the employment data, but would direct them to two polls that suggest firms are cutting back on hours in one form or another. The first one was a Gallup poll and reported on CNBC:

Small business owners' fear of the effect of the new health-care reform law on their bottom line is prompting many to hold off on hiring and even to shed jobs in some cases, a recent poll found.

"We were startled because we know that employers were concerned about the Affordable Care Act and the effects it would have on their business, but we didn't realize the extent they were concerned, or that the businesses were being proactive to make sure the effects of the ACA actually were minimized," said attorney Steven Friedman of Littler Mendelson. His firm, which specializes in employment law, commissioned the Gallup poll...

Forty-one percent of the businesses surveyed have frozen hiring because of the health-care law known as Obamacare. And almost one-fifth—19 percent— answered "yes" when asked if they had "reduced the number of employees you have in your business as a specific result of the Affordable Care Act." 

A more telling survey was done by the Foundation of Employee Benefit Plans. They found that 15% of firm with 50 or more employees and 20% of firms with less than 50 employees had plans to adjust hours so that fewer employees qualify for full-time medical insurance under the ACA. The smaller firms also planned to make other changes in seen the figure below from their survey:

So according to these surveys and the data from the NFIB, Obamacare is now having an effect on labor markets. Now this evidence does not speak to the size or magnitude of this effect. The figure above suggests it is limited to smaller firms. Maybe that is why folks like Brad DeLong, Jared Bernstein, Max Sawicky, and others who are associated with big institutions have not met anyone adversely affected by the ACA. I too work at a large institution, but live in rural Tennessee where I have met people whose hours have been cut because of Obamacare. Further examples of people affected by the ACA can be found here in this Guardian article.

So yes, firms appear to be cutting back on employees and hours. And they are at a high point for concerns over regulations. This has my supply-side senses tingling. Your supply side senses should be tingling too. The only question is how big is this effect.

P.S. To be clear, I still view most of the lingering labor market weakness as a result of the ongoing shortfall in aggregate demand. However, the evidence above suggests supply-side concerns are increasingly becoming important.

Update: Jed Graham has compiled a list of firms who have cut hours or jobs because of the ACA.

Note to Fed: Get Out in Front of the Potential Debt Crisis.

The consequences of the U.S. government defaulting, even if for a few days, could be significant. The long-term effect is that the U.S. economy could lose some or all of its 'exorbitant privilege' which has allowed Americans for many years to live beyond their means. The short-term effect could be a major financial crisis as noted by Dick Bove over at FT Alphaville. Here is how he believe it could play out:

Money Market Mutual Funds
Should the United States government default virtually every money market mutual fund (MMMF) in the country would “break-the-buck” – i.e., be unable to pay investors 100 cents on every dollar invested. At present, MMMFs that do not actually earn enough money to pay back 100 cents on the dollar are subsidized by the fund management company. A Treasury default would make this virtually impossible and millions of Americans would lose billions of dollars.

Mutual Funds

The indentures of most bond and balanced mutual funds require that they immediately divest their holdings of defaulted securities. This could cause hundreds of billions in Treasuries to be sold immediately when the default was announced.

Depository Institutions
Let’s shift to another government document. This would be the FDIC’s aggregate balance sheet of the American banking industry... A reasonable estimate would be that the U.S. banking industry owns $1.85 trillion in government backed securities. It has $1.63 trillion in equity. If the Treasury and related securities were in default, one does not know what they would be worth. Assume a Latin American valuation of 10 to 20 cents on the dollar and an estimated $1.28 trillion in U.S. banking equity would be wiped out...In addition to the U.S. backed securities the banks own, they own an additional $1.27 trillion in other securities that would plunge in value... They have $7.73 trillion in loans which would also fall in value.

These developments would probably spill over into other markets. Such dire outcomes sound a lot like the concerns Fed Chairman Ben Bernanke had about the Eurozone Crisis back in 2011. Like now, I argued back then that Bernanke should get out in front of the Eurozone Crisis. Here is what I said:

So what can the Fed do? Here is a suggestion: the Fed could say if total current dollar spending begins to plummet because concerns about the financial system are causing investors to rapidly buy up safe money-like assets (time and saving accounts, money market accounts, treasuries, etc.) then the Fed would begin buying up less-safe and less-liquid assets until the investors' demand for money-like assets is satiated such that they return total current dollar spending to its previous level. The Fed would need to stress the "until" part means it would purchase as many trillions of dollars of assets as necessary to restore total current dollar spending. Since this  process would take place over time, the Fed would also want to set a target growth rate for where it wanted the level of total current dollar spending to go.    

If the above sounds reasonable to you, then you should be a fan of nominal GDP level targeting.  It is exactly what the U.S. economy needed in early 2008 when inflation expectations and velocity started falling.  And it is exactly what the  U.S. economy needs now.   

So if the Fed wants to get out in front of the potential debt crisis, one important step it could take is to announce a NGDP level target. The Fed's QE programs have been able to able to offset much of the fiscal drag over the past three years. A NGDP level target would step up the Fed's game and make it better able to deal with the fallout of debt default. It would not solve all problems--for example, the U.S. might face permanently higher risk premiums--but it at least could offset any drag it might create on aggregate nominal spending. Now would be a great time to act.

P.S. An interesting question raised by Jeffrey Frankel is if the default happens, will it create a financial crisis before or after October 17. 

More on George Bailey, QE, and the Shortage of Safe Assets

In my previous post I made the case that the Fed is not exacerbating the safe asset shortage problem. Rather, the Fed has actually prevented it from becoming far worse. Michael Darda, chief economist of MKM Partners, makes a great follow-up point in an email:

One thing that jumped into my mind when reading [your post] was the consistent tendency for the yields on safe assets to rise during “QE on” periods. We’ve now had three episodes of QE since 2009, and in each and every case, the 10-year yield has risen on net, only to fall when the Fed stopped too soon (after QE1 and QE2 came to a premature end, that is). This, I think, is a pretty airtight refutation that the Fed is somehow exacerbating the safe asset shortage; indeed, this alone suggests that QE is actually relieving it. And even with the recent pullback in rates, the 10-year yield is more than 100 bps above where it was before QE3 began (with the S&P 500 up 25% or so over the same timeframe). This, in my view, means it is working.

Ironically, one implication of this analysis is that the safe asset shortage problem exists, in part, because the Fed was not doing enough. Or at least, not doing it right. This a point I made in my last National Review article.

What George Bailey Can Teach Us About QE

Quantitative easing (QE) is a lot like George Bailey in the classic film It's a Wonderful Life. George was a man who began questioning his value to society. A number of cascading events--unfulfilled life dreams, a run on his bank, lost bank deposits, bank fraud charges--made it appear to hm that he was on balance a drag on his community. George decided it would be better for all if he 'tapered' or ended his life. Fortunately, an angel appeared at the last minute and revealed that despite his immediate problems, George's overall contributions to society were immense. Many lives were saved and changed because of his efforts. All that was needed to see this fact was a broader, longer perspective. George Bailey, in other words, was not doing the right counterfactual.

The same is true for skeptics of QE. Many point to the apparent flaws of the Fed's large scale asset purchases (LSAPs), but fail to step back and consider the counterfactual of what would have happened in their absence. This point is particularly poignant to those observers who claim the Fed's LSAPs of treasuries are particularly bad because they drain the financial system of safe assets. These critics note that these safe assets serve as collateral in the shadow banking system and thus facilitate transactions. Therefore, when the Fed increases its balance sheet it is actually restricting the funding capabilities of the shadow banking system and creating a drag on the economy. A growing number of smart people are making this point, including Izabella Kaminski, Tyler Cowen, Peter Stella, Arvind Krishnamurthy and Annette Vissing-Jorgensen, and Michael Woodford. I contend that while correct on the immediate effect of LSAPs, these critics like George Bailey are doing the wrong counterfactual. The right counterfactual is what would have happened had there been no QE2 and QE3 at all.

Before delving deeper into this counterfactual, I want to mention two other points about this critique. First, most of the safe asset shortage was created by factors other than the Fed's LSAPs. On the supply side, there was the destruction and subsequent anemic recovery of private-label safe assets as seen in this figure. On the demand side, the financial crisis and then a spate of subsequent bad economic news--Eurozone crisis, China slowdown concerns, debt limit talks, fiscal cliff talks--has kept the demand for safe asset elevated. Also, new regulatory requirements requiring banks to hold more safe assets is keeping safe asset demand elevated. 

Consequently, forces other than QE2 and QE3 have been driving much of the safe asset shortage. This can be seen in the figure below which shows the treasury general collateral repo rate and the Fed's share of marketable treasury securities. Note that the largest drop in the repo rate (reflecting the reduced supply and increased demand for treasuries collateral) occurred between late 2007 and early 2009, the very time the Fed was releasing treasury securities back into the market.

Second, even though the LSAPs do cause an immediate drain of safe assets, they potentially lead to more private safe asset creation. As I noted before:

The LSAPs, if done right, should raise expected economic growth going forward and cause asset prices to soar. This, in turn, would increase the current demand for and supply of financial intermediation. For example, AAA-rated corporations may issue more bonds to build up productive capacity in expectation of higher future sales growth. Financial firms, likewise, may start providing more loans as the improved economic outlook makes households and firms appear as better credit risks.

There is some evidence this is happening with QE2 and QE3. Even if these private safe assets are not used as collateral in the repo markets they will be used elsewhere to satiate liquidity demand. That, in turn, should free up more treasuries for use in the repo market. Both of these points are often overlooked by QE critics.

Now back to the counterfactual point. Are QE critics really making the same mistake as George Bailey? To answer that question, let's think through the counterfactual of no QE2 and QE3. First, assume the Fed's share of marketable treasuries was constant over this period. Also, assume that the shocks from the Eurozone crisis, China slowdown, debt limit and fiscal cliff talks still buffeted the U.S. economy during this time. What would have happened to the U.S. economy? Could the U.S. economy have been as resilient to these shocks had the Fed not been supporting it? If not, then imagine the mess in the financial system and what that would have done to the demand for safe assets. Repo markets, for example, would probably be facing an even larger collateral shortage. A reasonable counterfactual, then, is that the safe asset problem would be greater were it not for the Fed's QE programs. 

I took this idea to the data. I estimated a vector autoregression (VAR) over the 2003:1 to 2013:8 period and used it to create a counterfactual path for the 2010:10 to 2013:8 period.¹ This corresponds to the QE2 and Q3 periods. VARs are great for this type of exercise because one, they allow the variables in the model to interact and two, you can do dynamic forecast with them. The only twist here is that I did a conditional dynamic forecast. Specifically, I dynamically forecasted what would happen to employment, the stock market, PCE core inflation, and the repo rate conditional on (1) the Fed not increasing its share of marketable treasuries and (2) allowing the Eurozone crisis, China slowdown, and fiscal policy shocks to still affect the economy. For the latter, I used the actual, realized values of the economic policy uncertainty index over the forecasted period as a way to summarize and include these shocks in the VAR. The results can be seen in the figures below.

The first figure shows counterfactual path for the Fed's share of marketable treasuries used in the forecast.

The next figure shows what happens to the stock market. It declines over much of the period.

The following figure reports the counterfactual path for employment. Again, not a pretty picture.

This next figure shows that core PCE inflation stays around 1% and never recovers. So QE is inflationary, at least relative to where inflation would be in its absence.

Finally, this figure shows that the repo rates would have gone negative. Now this would not happen in practice because of the ZLB. But the VAR does not know the ZLB and simply forecasts based on estimated relationships. The fact, though, that it goes significantly negative is instructive. It indicates the repo markets would have faced even greater collateral shortages had the Fed not done QE2 and QE3.

Now we do not want to read too much into these results. They come from a forecasting model that is far from perfect. Still, they indicate that a proper counterfactual of the QE programs requires more than just narrowly looking at the immediate impact of LSAPs on the collateral asset supply. We do not want to be like George Bailey and do the wrong counterfactual. Neither should the Fed. Otherwise, it too may be tempted to pull the trigger and taper too soon.

My assessment is that QE2 and QE3 has done more to shore up the U.S. economy than many observers realize. We do not know how much worse the economy would be in their absence, but the analysis above suggests it could have been ugly. With that said, the QE programs have been flawed because of their ad-hoc, make-it-up-as-we-go-along approach that until recently was not tied to any explicit target. Tying the LSAP more firmly to conditional outcomes would do much to improve them. The more rule-like and predictable the better.  I think George Bailey would agree.

Update: Michael Darda provides some follow-up comments here.

¹The VAR was estimated with the Fed share of market treasuries, the log of SP500, the log of employment, the core PCE inflation rate, the repo rate, and the economic policy uncertainty index. Six lags were used on the monthly data. The results were generally robust to longer lag lengths, but due to limited data six lags were chosen. The conditional forecast was created by imposing fixed values for the Fed share and the uncertainty index as noted above.