Farewell Secular Stagnation

Marc Andreessen recently looked at the arguments for and against secular stagnation. He cited my Washington Post article when examining the case against secular stagnation. One of the points I make in it is that the proponents of secular stagnation incorrectly invoke the long decline of real interest rates as prima facie evidence for their view. Where they go wrong is that they look at real interest rates without accounting for the long decline in the risk premium. Once the risk premium is stripped out of their real interest measure there is no downward trend in real interest rates. Rather, you get a stationary risk-neutral real interest rate measure that averages close to 2%. This can be seen in the figures below, drawn from my follow-up article with Ramesh Ponnuru:

Interestingly, this risk-neutral measure closely tracks the business cycle and suggests it was the severity of the Great Recession and not secular stagnation that explains the low interest rates over the past six years:

Given this business cycle-driven relationship, the recent spate of good economic news points to rising interest rates in 2015. In fact, the daily measure of the risk-neutral nominal 1-year and 10-year interest rates from Adrian, Crump, and Moench (2013) show just that. See the figure below and note that 2014 has seen a trend change in the path of neutral interest rates. If this continues--and the improved economic news suggests it will--then the Fed will have to raising its interest rate in 2015.

I bring all of this up as a way to motivate a prediction for 2015: secular stagnation will fade from the national conversation for the U.S. economy. Instead, the conversation will focus even more on how to handle the advent of an increasingly digitized, automated economy where productivity growth is rapid and neutral interest rates are rising. Secular stagnation, in other words, is about to experience the same fate it had when it was first pushed in the 1930s. Here is what Ramesh Ponnuru and I wrote about that experience:

"The business cycle was par excellence the problem of the nineteenth century. But the main problem of our times, and particularly in the United States, is the problem of full employment. . . . Not until the problem of the full employment of our productive resources from the long-run, secular standpoint was upon us, were we compelled to give serious consideration to those factors and forces in our economy which tend to make business recoveries weak and anaemic and which tend to prolong and deepen the course of depressions. This is the essence of secular stagnation— sick recoveries which die in their infancy and depressions which feed on themselves and leave a hard and seemingly immovable core of unemployment.” 

Thus wrote Alvin Hansen, a professor of economics at Harvard, in 1938. Slow population growth and the deceleration of technological progress, he argued, was leading to slow capital formation and weak economic growth. A program of public expenditures, though it had its dangers, was probably required to avoid this fate. 

Hansen’s article was of course spectacularly wrong as a guide to the next few decades. Instead of suffering through stagnation we entered an extended, broad-based, and massive economic boom. In hindsight we can see that his analysis, while thoughtful and intelligent, was unduly influenced by the depression he was living through, and can see as well that the depression was the result of specific policy mistakes rather than inexorable trends. Recent research by Alexander J. Field shows that the 1930s were actually a time of exceptionally high productivity growth. 

Hansen’s worry, some of his specific arguments, and his phrase “secular stagnation” are all making a comeback in our own day. Lawrence Summers, like Hansen an economics professor at Harvard, has sounded an alarm about the ability of industrial countries to achieve adequate economic growth. A new e-book, Secular Stagnation, includes chapters by Summers and other leading economists discussing the question. 

The fact that Hansen was wrong does not prove that contemporary stagnationists are. In this case, though, history is repeating itself rather exactly. We do not pretend to know what the future path of economic growth in the United States will be. But the case for stagnation is weak—and, as in the 1930s, it is getting undue credence because of a long slump caused by policy mistakes.

Farewell secular stagnation. Hello the second machine age.

Tinkering On the Margins

Paul Krugman disagrees with a point I made in my last post. Specifically, he takes issue with my claim that a monetary regime change is needed for both monetary policy and fiscal policy to effective at the zero lower bound (ZLB). To make my case, I gave as an illustration a scenario where the U.S. Treasury Department does a helicopter drop that is offset by the Fed tightening once the helicopter drop starts to raise inflation. I also said a helicopter drop in the Eurozone would face a similar fate from the ECB. Krugman thinks this is wrong: 

What Beckworth seems to be saying is that the Fed and the ECB are at their inflation target, and would therefore tighten policy if the economy were to expand and inflation to rise. But they aren’t at their inflation targets! The Fed has been below target for a number of quarters; the ECB is way below target. 

Krguman's argument, then, is that fiscal policy could raise aggregate demand up to the point where it raises inflation to its target. So why not have a helicopter drop? Surely it would do some good, says Krugman.

Okay, let say for the sake of argument Krugman is correct about the Fed not being able to hit its inflation target. If so, this still only amounts to fiscal policy tinkering on the margins. The Fed's preferred inflation measures, the PCE deflator and core PCE deflator, have both averaged about 1.4% since 2009. So we are talking about 60 basis points of wiggle room for fiscal policy to work. Do we really think that within this narrow window fiscal policy could have generated enough aggregate demand growth to close the output gap? 

To help us see that this is just tinkering on the margins, let us revisit the point Krugman and I agreed on in our previous posts: a monetary regime change is needed to make monetary policy effective at the ZLB. One example of such a monetary regime change would be a price level target that returns the PCE to its pre-crisis trend path. To return the PCE to its targeted path would require a temporary burst of higher-than-normal inflation. The expectation of and realization of this inflation burst would be the catalyst that spurred robust aggregate demand growth. 

Now let us pretend the Fed actually implemented a price level target back in 2010 when it began QE2. Specifically, imagine the Fed had made QE2 conditional on the PCE returning to its 2002-2008 trend path. The figure below shows this scenario with three different paths back to the price level target. Note that each path represents differing rates--5%, 4%, and 3%--of 'catch-up' inflation and for each path there is a significant amount of time--16 months, 26 months, and 49 plus months--involved to catch up to trend.

What this illustrates is that to get the kind of robust aggregate demand growth needed to close the output gap back in 2010, there needed to be a sustained (but ultimately temporary) period of higher-than-normal inflation. Doing more fiscal policy to squeeze out the last 60 basis points of the Fed's 2% inflation target would not cut it. Again, it would be tinkering on the margins. If fiscal policy really wanted to close a large output gap at the ZLB it too needs the support of monetary regime change.

Now in the Eurozone it is true that the ECB is further from its inflation target so that would give fiscal policy more wiggle room. But there is also a larger output gap in the Eurozone. So I think the tinkering on the margins critique applies there too. The Eurozone also need a monetary regime change to make fiscal policy really pack a punch.

But there is more. I think a reasonable case can be made that inflation is actually in the range where the Fed wants it to be. If so, then even the wiggle room is gone. Krugman anticipated this response from me:

The Fed has been below target for a number of quarters; the ECB is way below target. And don’t say that the failure to raise inflation rates shows that they must be happy with where they are. The whole point of our previous discussion has been that monetary policy is ineffective under zero-interest conditions unless you are willing to change regimes! 

Yes, in general, we need a monetary regime for monetary policy to be effective at the ZLB. However, there is compelling evidence the Fed has been doing QE to keep inflation in a range where it is comfortable. In fact, a number of observers have come to the conclusion that the Fed does not have a 2% inflation target but a 2% inflation ceiling. They note that a 2% target would be an average, and the Fed should be willing to allow inflation go above 2% as often as it is below. But that is not the case as noted below: 

[I]t turns out that the Fed’s 2 percent target for core inflation is not a target, it’s an upper bound. 

That’s not supposed to be how it works. If you really think that around 2 percent inflation is right... you’re supposed to view 1 percent inflation as being just as bad as 3 percent; in a situation in which inflation is below the target rate, you’re supposed to see a rise in that rate as a good thing. And correspondingly, if you’re where we are now, with below target core inflation and high unemployment, all lights should be flashing green for expansion. 

Instead, however, it’s clear that below-target inflation is considered no big deal, but that the Fed is extremely averse to seeing inflation rise above target, even temporarily.

That comes from none other than Paul Krugman. If this understanding is correct, then the Fed actually is targeting a range of inflation and is not undershooting its target. I previously presented evidence that this range falls between 1% and 2%. Let me briefly review it.

First, the timing of the Fed's QE programs suggests that the FOMC initiates them when core inflation is under 2% and has been falling for at least six months. It also indicates the FOMC tends to end QE programs when core inflation is above 1% and has been rising for at least six months. This can be seen in the figure below:

Second, the central tendency ranges of inflation forecasts provided by members of the FOMC consistently show 2% as an upper bound. Below are projections for 1-year and 2-years out:

It is remarkable that FOMC members are predicting inflation no higher than 2% two years out. Since the FOMC has meaningful influence on inflation this far out, this forecast reflects FOMC members' beliefs about current and expected Fed policy. They see the Fed doing just enough to keep core PCE inflation under 2%.

Fed Chair Janet Yellen admitted as much in her last post-FOMC press conference:

But it’s important to point out that the Committee is not anticipating an overshoot of its 2 percent inflation objective (p.13). 

In short, inflation is below 2% in the United States because the Fed is happy with it being there. Fiscal policy is not going to change that and even if it could it would amount to tinkering on the margin.

A stronger case can be made that inflation is below the ECB's target. However, it is not clear how much it is below target since the ECB's definition of price stability is inflation under 2%. So maybe there is some wiggle room for fiscal policy, but nothing close to what is needed to close the output gap. 

Follow-Up to the Fed's Dirty Little Secret

My last post made the argument that monetary base injections at the zero lower bound (ZLB) can be effective if they are permanent. I also noted that this understanding is a standard view in macroeconomics and that it implies the Fed's QE programs were muted from the beginning given their temporary nature. The post generated further discussion from Paul Krugman, David Glasner, Scott Sumner, and Bill Woolsey. In addition, others responded in the comments sections of their blogs as well in twitter. I want to respond several of the issues raised in these discussions.

First, some commentators were confused by the notion of a permanent monetary base injection. What is important is the commitment to permanently expand the monetary base. The actual expansion may not be needed or be very small if this commitment is credible. To see this, imagine the Fed targets the growth path of nominal GDP (i.e. a NGDP level target). If the public believes the Fed will permanently expand the monetary base if NGDP is below its targeted growth path, then the public would have little reason to increase their holdings of liquid assets when shocks hit the economy. That is, if the public believes the Fed will prevent the shock from derailing total dollar spending they would not feel the need to rebalance their portfolios toward safe, liquid assets. This, in turn, would keep velocity from dropping and therefore require minimal permanent monetary injections by the Fed to hit its NGDP level target. Michael Woodford made this point in his famous 2012 Jackson Hole speech:

A commitment not to let the target path shift down means that, to the extent that the target path is undershot during the period of a binding lower bound for the policy rate, this automatically justifies anticipation of a (temporarily) more expansionary policy later, which anticipation should reduce the incentives for price cuts and spending cutbacks earlier, and so should tend to limit the degree of the undershooting. 

Based on this understanding, the Fed has taken the wrong approach. It could have had a much smaller balance sheet expansion with far more effect on the economy than what actually took place over the past six years. Instead, the Fed failed to take advantage of it and instead relied upon the segmented markets-portfolio channel to work its magic. 

This leads me to my second comment. My critique of the QE programs should not be construed to mean these large scale asset programs did nothing. There is plenty of empirical evidence they had positive but modest effects on the economy. My view is that they they put a floor under the economy and prevented it from getting worse. A casual reading of the evidence suggests the QE programs were turned on when core inflation started to drift toward 1% and turned off as it drifted toward 2%. So while they provided a floor on the economy, they were never allowed to reach their full potential as argued in my previous post. 

A third comment is that I do not think Paul Krugman, Simon Wren-Lewis, and other fiscal policy fans appreciate the implications of this critique for fiscal policy. We agree that monetary policy can only work at the ZLB with a commitment to a permanent monetary base injection. We also agree that it would require monetary policy to adopt something like a price level target--a monetary regime that would allow reflation of a depressed economy. But this is also true for fiscal policy to work, yet they push for more of it without calling for the needed regime change to make it work. Paul Krugman, for example, in his response to my post said this:

[E]ffective monetary policy in a liquidity trap requires both an actual and a perceived regime change, and that’s very hard to engineer. Japan may be pulling it off now, but only after 15 years of deflation — and even so the achievement is very fragile, vulnerable to fiscal tightening. Was there ever a realistic possibility of getting that in America, this time around? I wrote about this back in 2011, explaining why I devoted my efforts in 2009 to pushing for fiscal stimulus.

Okay, monetary regime change is hard. But why do we think that fiscal policy would work any better given the Fed's dedication to its low inflation target? For example, if the U.S. Treasury Department sent $5000 checks to every household and if they began to spend it as many helicopter drop advocates claim they would, then we would begin to see inflation go up. And at that point the Fed would tighten policy and snuff out the recovery. The response from the ECB to a similar helicopter drop in the Eurozone would be even more forceful. 

In other words, for the same reason QE was limited from the beginning it also true that fiscal policy was limited from the beginning. With highly-credible inflation targeting central banks, both monetary and fiscal policy require monetary regime change to work at the ZLB. So I am puzzled as to why Krugman put his energy into drumming up support for more fiscal policy rather than drumming up support for a change in monetary regimes.

My final comment is to respond to this from Paul Krugman:

David Beckworth has a good post pointing out that the Fed has been signaling all along that the big expansion in the monetary base is a temporary measure, to be withdrawn when the economy improves. And he argues that this vitiates the effectiveness of quantitative easing, citing many others with the same view. My only small peeve is that you might not realize from his list that I made this point sixteen years ago, which I think lets me claim dibs. Yes, I’m turning into one of those crotchety old economists who says in response to anything, “It’s trivial, it’s wrong, and I said it decades ago.”

Okay, I could have done a better job organizing that table in way to reflect his seminal contribution. I did, however, sort of acknowledge it in the cartoon at the bottom of the post. Look carefully at the message on his t-shirt.

Update: Paul Krugman responds to this post and I respond to him here.

The Federal Reserve's Dirty Little Secret

The Fed has a dirty little secret, one it has closely guarded over the past six years of unconventional monetary policy. This secret has eluded many journalists, commentators, and economists and led to much confusion over monetary policy. If it were widely known it would create far more criticism of Fed policy. For Fed officials, then, it is a secret better left unsaid. So what is this dirty little secret? To answer this question, we need to review two underappreciated facts about the Fed's quantitative easing (QE) programs.  

The first underappreciated fact is that the large expansion of the monetary base under QE is temporary. The Fed has always planned to eventually return its balance sheet and, by implication, the monetary base back to the trend path it was on prior to the QE programs. This point has been communicated in several ways. First, the Fed issued exit strategy plans in its June, 2011 and September, 2014 FOMC meetings that point to a reduction in the monetary base. Here is an excerpt from the latter meeting:

The Committee intends to reduce the Federal Reserve’s securities holdings in a gradual and predictable manner...The Committee intends that the Federal Reserve will, in the longer run, hold no more securities than necessary to implement monetary policy efficiently and effectively. 

Second, Fed officials, including Ben Bernanke and Janet Yellen, have reiterated these plans in speeches, talks, and Op-Eds. In short, the Fed's exit strategy was widely publicized.

Third, several official Fed studies have examined what these exit strategies mean for the Fed's balance sheet and find that it puts the future path of the monetary base close to its pre-crisis trend. This 2013 Board of Governors study, for example, shows this projected path:

Similarly, a 2014 New York Fed study comes up with this future path for the Fed's balance sheet: 

Fourth, the Fed signaled its intention to normalize the size of the monetary base by refusing to raise its inflation target even though some Fed officials believed it could have helped the economy. (See the last question in this exchange between former Fed Chairman Ben Bernanke and Senator David Vitter where Bernanke acknowledges potential benefit of higher inflation). By explicitly committing to not raise the inflation target, the Fed was implicitly committing to only a temporary expansion of the monetary base.

Finally, and most importantly, bond markets have signaled they take seriously the Fed's commitment to normalizing the size of its balance sheet. This is evidenced by the relatively stable expected inflation implied by asset prices in the treasury market. If this group--the one that has the most skin in the game--believes the Fed's expansion of the monetary base expansion is temporary it should be a signal to the rest of us that the Fed is truly committed to doing so.

The second underappreciated fact is that in order for QE to have made a meaningful difference in aggregate demand growth at the zero lower bound (ZLB) the associated monetary base growth needed to be permanent. This understanding is the standard view in modern macroeconomics. The reasoning behind it is that a permanent expansion of the monetary base implies in the long-run a permanent rise in the price level (even with with interest on reserves as shown by Peter Ireland). In turn, a permanently higher price level in the future creates the incentive to start spending more in the present when goods are cheaper. Or, from a Wicksellian perspective, it would imply a temporary surge in expected inflation that would lower real interest rates to their market clearing level.

Below is a table that highlights a few prominent economists who speak to the importance of permanent monetary base injections at the ZLB. Given this understanding, many of them advocate some form of level targeting (either a price level or NGDP level target) as way to credibly commit the central bank to permanently expanding the monetary base in a depressed economy.

Economist(s)	Permanent Monetary Base Injection Quote	Source
Michael Woodford	The economic theory behind QE has always been flimsy...The problem is that, for this theory to apply, there must be a permanent increase in the monetary base… The Fed has given no indication that the current huge increases in US bank reserves will be permanent. It has also promised not to allow inflation to rise above its normal target level. So for QE to be effective the Fed would have to promise both to make these reserves permanent and also to allow the temporary increase in inflation that would be required to permanently raise the price level in that proportion.	Source: Financial Times. See also his comments at this Vox article or the bottom of page 237 through 239 of his famous Jackson Hole article.
Lars Svensson	[I]n a liquidity trap… an expansion of the monetary base would increase inflation expectations and reduce the real interest rate only if it is seen as a permanent expansion.	Source: Escaping from a Liquidity Trap
Alan Auerback and Maurice Obstfeldt	[O]ur analysis shows... that credibly permanent open- market operations will be beneficial as a stabilization tool as well, even when the economy is expected to remain mired in a liquidity trap for some time. That is, under the same conditions on interest rates that make open- market operations attractive for fiscal purposes, a monetary expansion that markets perceive to be permanent will affect prices and, in the absence of fully flexible prices, output as well...Our analysis suggests that Japanese policymakers should underscore the permanence of past operations, perhaps through an announced inflation target range including positive rates, and may need to increase the monetary base even more.	Source: American Economic Review (2005)
Paul Krugman	[W]hen you’re at the zero lower bound, the size of the current money supply does not matter at all…what the models actually say is that doubling the current money supply and all future money supplies will double prices. If the short-term interest rate is currently zero, changing the current money supply without changing future supplies — and hence raising expected inflation — matters not at all… Central banks can change the monetary base now, but can they commit not to undo the expansion in the future, when inflation rises? Not obviously.	Source: The Conscience of a Liberal. See also his post on helicopter drops here.
Willem Buiter	A permanent helicopter drop of irredeemable fiat base money boosts demand both when Ricardian equivalence does not hold and when it holds. It makes the deficient demand version of secular stagnation a policy choice, not something driven by circumstances beyond national policy makers’ control. It boosts demand when nominal risk-free interest rates are positive and when they are zero – and even in a pure liquidity trap when nominal interest rates are zero forever	Source: The Simple Analytics of Helicopter Money.
Scott Sumner	Monetary policy is never very effective if the injections are temporary, and (almost) always very effective if permanent.	Source: TheMoneyIllusion.
Simon Wren-Lewis	Printing base money under quantitative easing does not imply hyperinflation because the expansion in the monetary base will be reversed once the recession is over.	Source: Mainly Macro. Also see his helicopter drop discussion here.

A good example of the importance of a permanent monetary base expansion at the ZLB can be seen in the Great Depression. As seen in the figures below, the monetary base grew rapidly between 1929 and early 1933 compared to previous growth. Yet during this time the money supply and nominal GDP continued to fall. The reason is that the monetary base was still tied to the gold standard and therefore not expected to be permanent. But that changed in 1933. FDR created what Christy Romer calls a "monetary regime shift" both by signalling a desire for a higher price level and by abandoning the gold standard which led to even more rapid monetary base expansion. This shift is apparent in the figures below. FDR's actions caused the public to expect a permanent monetary base expansion that would raise future nominal income. A sharp real recovery followed in 1933. Though this real recovery was later stalled by other New Deal programs, it did permanently raise aggregate demand.

By  now you have probably noticed an inherent tension between these two underappreciated facts. On the one hand, the Fed never intended the expansion of the monetary base under the QE programs to be permanent. On the other hand, the monetary base injections needed to be permanent for the QE programs to really spur aggregate demand growth. And therein lies the Fed's dirty little secret: the Fed's QE programs were muted from the beginning. They never could on their own create the amount of catch-up aggregate demand growth needed to restore full employment. So despite all the Fed has said over the past six years, it made an explicit policy choice to avoid fully restoring aggregate nominal expenditures. 

The Fed, in short, never chose to unload both barrels of its gun. And the QE barrel that it did unload depended on a portfolio channel that could only promise modest benefits at best. Had it committed to a permanent expansion of the monetary base via a level target, the Fed would have unloaded both barrels of its guns and made the QE programs far more effective.  Instead, the Fed opted for bird shot when it could have used a slug. This is the dirty little secret Fed officials would rather leave unsaid.

Update I: Permanent monetary base injections are also important for fiscal policy to generate aggregate demand growth. This point is often overlooked by advocates of helicopter drops. See Paul Krugman, Simon Wren-Lewis, and myself for more on this point. If you are going to do helicopter drops, you need to do it the right way.

Update II: This post should not be construed as me advocating a monetary aggregate or monetary base target for the Fed. I want to see the Fed adopt a NGDP level target which would imply a commitment by the Fed to permanently increase the monetary base if necessary to hit the target. The commitment is what matters, not whether it actually has to do so since a credible belief in it may cause the the public to do the heavy lifting via changes in velocity.

Inflation Targeting's Big Wrinkle

Inflation-targeting central banks are in an awkward position. Their objective is to stabilize the rate of inflation, but they now face a development that could jeopardize it: the surge in oil production that is driving down oil prices. The decline in oil prices is a much-needed boon to the global economy, but it may also mean inflation temporarily drops beneath its targeted value.  What to do? David Wessel calls this development a wrinkle for central bankers:

On balance, falling oil prices are welcomed by the world’s major central banks, but there is a wrinkle. Lower oil prices are good for growth in the U.S., Europe, and Japan. But they’ll also reduce the headline inflation rate at a time when the central banks, particularly the Bank of Japan and the European Central Bank, are struggling toraise the underlying inflation rates in their economies and keep public and investor expectations of inflation from falling. That involves a lot of psychology as well as economics. While central bankers often look beyond volatile food and energy prices to gauge the underlying inflation rate, they know that ordinary consumers don’t. “It’s important that [the drop in oil prices] … doesn’t get embedded in inflation expectations,” the ECB’s Mario Draghi said last week.

This wrinkle has generated a lot discussion on how the Fed should respond. As noted by Cardiff Garcia, both Fed officials and commentators are divided over it. This wrinkle, in short, is adding some uncertainty about the future path of monetary policy.

The interesting thing about this wrinkle is that it is not a new problem. It is just the latest supply shock which always have been problematic for inflation-targeting central banks. Supply shocks push output and inflation in opposite directions and force central banks into these awkward positions. 

Supply shocks were an issue in 2002-2004 when the much-ballyhooed productivity boom (a positive supply shock) of that time made Fed officials worry about deflation. They consequently kept interest rates low even though the housing boom was taking off. Supply shocks were also an issue in the fall of 2008 when Fed officials were concerned about rising commodity prices (a negative supply shock) and, as a result, decided to do nothing at their September FOMC meeting despite the collapsing economy. 

Across the Atltantic, the ECB has struggled even more with supply shocks. The ECB raised interest rates multiple times in 2008 and 2011 in response to the commodity price shocks (negative supply shocks). Below is a figure from a Robert Hetzel paper on this crisis that shows how misguided the rate hikes were. They occurred even though spending was already falling. It is no wonder the Eurozone has struggled so much since 2008.

One can trace this wrinkle back further. Ben Bernanke, Mark Gertler, and Mark Watson argue the reason oil supply shocks have historically been tied to subsequent weak growth is not because of the shocks themselves, but because of how monetary policy responded to those shocks. That is, central banks typically responded to the inflation created by the supply shocks in a destabilizing manner. With the advent of inflation targeting in the early 1990s, this wrinkle has become institutionalized across most central banks.

Now in theory modern inflation targeting should be able to handle these shocks. For the modern practice is to do 'flexible inflation targeting' which aims for price stability over the medium term and therefore allows some wiggle room in responding to supply shocks. The problem, as demonstrated above, is that in practice it rarely works. Responding to supply shocks in real time requires exceptional judgement and usually some luck. In fact, as I note in this policy paper, some scholars think that the successes of inflation targeting prior to the crisis were due largely to luck. There were simply fewer supply shocks during the early years of inflation targeting. Going forward, this seems less likely given the rapid productivity changes of an increasingly digitized world. So this problem is not going away and is likely to get bigger.

What is needed, then,  is an approach to monetary policy that does not get hung up on supply shocks. It would fully offsets demand shocks, ignore supply shocks, while still maintaining a long-run nominal anchor...if only  there were such an approach. Oh wait, there is such an approach and it is called nominal GDP targeting.

Institutional Money Asset Growth Remains Weak and It Matters

Lawrence Goodman, head of the Center for Financial Stability, reminds us that institutional (or 'shadow banking' ) money growth remains weak. A large portion of these money assets disappeared during the crisis so this weak growth means there is still a sizable shortfall relative to its pre-crisis trend. Institutional money assets are an important part of the global financial system and there is a limit to how much of the shortfall can be offset by the growth in U.S. treasuries. So this is a big deal. 

One way to see its importance is to note that these assets function as an important input to economic activity--they reduce transaction and search costs via their medium of exchange role--and therefore their ongoing shortfall reflects a reduction in the productive capacity of the economy. In short, potential GDP may be less because of the shortage of institutional money assets.

Here is Goodman:

The tainted image of shadow banking along with the nefarious sounding name is a disservice to the U.S. economy. Shadow banking to a substantial degree is simply “market finance.” In fact, many cite access to “market finance” as essential to provide the U.S. financial system with strength and flexibility. This market or non-bank based finance provides a stark contrast with the more rigid and heavily bank dominated system in Europe. 

Over the last four decades, market finance has largely provided fuel for corporations in the form of commercial paper and money market funds as well as liquidity for financial markets (see Figure 1). Yet,it also played a central role in enabling many financial crises. In fact, the proliferation of market finance reached unforeseen highs prior to the recent crisis and facilitated numerous excesses. However, CFS data reveal that the reduction in the role of market finance in the economy is likely 

excessively steep and detrimental to future growth. The shadow banking system is under severe strain. Of course, market finance grew too large in advance of the recent financial crisis and the reduction in the sector provides a healthier base for the US economy and markets. Yet, the deterioration is unprecedented. Liquidity provided to corporations and financial market participants via market finance is down a stunning 45% in real terms since its peak in March 2008! In fact, the availability of market finance shows no sign of stabilization with a series of successive drops from the beginning of the crisis to the latest CFS monetary data available through October 2014. 

The shriveling nonbank financial sector threatens the health of the U.S. economy through the curtailment of funds available to corporations and liquidity for financial markets. Typically, the shadow banking system contracts coincident with recessions, but by an average of only 9% in contrast with the 45% witnessed through October 2014. Likewise, the decline from peak-to-trough in market finance is typically much faster at a scant 13 months later. 

The cyclical low in October 2014 marks the 79th month of crises in nonbank finance!

Now the U.S. economy does seem to be turning around despite this problem. Just look at last Friday's employment report. The question, then, is would the economy be doing even better if this shortfall of institutional money asset were not a problem?

Monday Morning 'Money Still Matters' Round Up

As part of my effort to start blogging more regularly again, I plan to post every Monday morning a round-up of articles that remind us money and monetary policy still matter. This is is the first installment.

The Jekyll and Hyde Monetary Views of the BIS. Ambrose Evans-Pritchard directs us to a recent BIS report that is concerned about what a Fed tightening cycle will do to the global economy. This is the same BIS that only a few months ago argued that the Fed's monetary policy was too loose and should be tightened. Yes, this is puzzling. Here is Evans-Pritchard summarizing the recent report:

Off-shore lending in US dollars has soared to $9 trillion and poses a growing risk to both emerging markets and the world's financial stability, the Bank for International Settlements has warned. The Swiss-based global watchdog said dollar loans to Chinese banks and companies are rising at annual rate of 47pc. They have jumped to $1.1 trillion from almost nothing five years ago. Cross-border dollar credit has ballooned to $456bn in Brazil, and $381bn in Mexico. External debt has reached $715bn in Russia, mostly in dollars... BIS officials are worried that tightening by the US Federal Reserve will transmit a credit shock through East Asia and the emerging world, both by raising the cost of borrowing and by pushing up the dollar.

"The appreciation of the dollar against the backdrop of divergent monetary policies may, if persistent, have a profound impact on the global economy. A continued depreciation of the domestic currency against the dollar could reduce the creditworthiness of many firms, potentially inducing a tightening of financial conditions," it said... 

So the strengthening dollar and related tightening of Fed policy could trigger problems for the global economy. Maybe, then, we should be less concerned about "currency wars". That leads us to the next piece.

It's the Domestic Demand Stupid! Ramesh Ponnuru reminds us why worrying about "currency wars" is misguided when economies are depressed. It completely misses the point:

Some practical people these days are fretting about "competitive devaluation" or "currency wars." The concern is that countries are engaged in a zero-sum game of devaluing their currencies to boost their net exports. This game can't help the world as a whole because the net exports of all countries have to add up to zero (excluding any trade with space colonies). "For every winner, there's a loser," writes Alen Mattich in the Wall Street Journal, though he allows that this may be true only in the short term...The economist Barry Eichengreen has been challenging this historical understanding for decades. He summarized his case in 2009: "In the 1930s, it is true, with one country after another depreciating its currency, no one ended up gaining competitiveness relative to anyone else. And no country succeeded in exporting its way out of the depression, since there was no one to sell additional exports to. But this was not what mattered. What mattered was that one country after another moved to loosen monetary policy because it no longer had to worry about defending the exchange rate. And this monetary stimulus, felt worldwide, was probably the single most important factor initiating and sustaining economic recovery." Eichengreen was still at it in 2013, calling fear of currency wars "the meme that will not die."

In the depressed conditions of recent years, expansionary monetary policies that cause currencies to devalue seem to have helped both the countries that undertook them and other countries. The International Monetary Fund concluded that the "spillover effects" of the first round of quantitative easing in the U.S. were positive. If the Federal Reserve had followed a monetary policy as tight as the European Central Bank's, our economy would be performing as poorly as the euro area -- and Europe wouldn't be better off for our joining its misery.

So it is not the depreciation that matters, but the boost to domestic demand from easing monetary policy. Unfortunately, not every central bank is interested in stabilizing domestic demand as noted next.

Monetary Policy Differences Explain a Lot. Martin Wolf looks across the global economy and finds a common factor behind the variation in economic growth: the stance of monetary policy.

Monetary policy provides the best key to understanding the variegated global picture. The central banks of the US, UK and Japan all adopted easier policies and were rewarded with an upturn. Given weak wage growth and a lack of fiscal support, such stimulus ought to continue.

Europe is an unhappy exception. Despite German misgivings, low interest rates are no evidence that money is too loose: nominal GDP growth stutters along at less than 3 per cent, a clear sign that the stance is much too tight. In recent years the ECB twice made the mistake of raising rates too soon, and thereby punished Europe with a deeper recession and a worse fiscal crisis. If its president Mario Draghi cannot ease policy further, the consequences will be just as serious.

He is sounding a lot like Scott Sumner here. Speaking of Scott, he had a recent post speaking to the question of why has not nominal GDP targeting swept the economics profession.

The Nominal GDP Targeting Glass is Half Full. This post was in response to a series of questions posed by Brad DeLong:

I'm not sure NGDP targeting has not "swept the economics community," at least in a sort of "glass half full" sense. Let's start with the initial position of market monetarists (MMs). I think I was pretty typical of my fellow MMs in not being very well known...Thus given the initial starting position of MM, I think endorsements of NGDP targeting by the likes of Woodford, Christy Romer, Jeffrey Frankel, and some other top people is pretty good. And of course there's Brad DeLong, who clearly is in the elite group, especially in the intersection of macro/macro history/history of thought. Then there are also lots of prominent economists in the "it's worth a shot" category, including (AFAIK) Paul Krugman. When I speak to various people at conferences and after talks, I find lots of people who tell me privately that they are on board. But they don't necessarily announce it in the New York Times, (as Romer did). So given our humble beginnings, I do see a lot of progress.

I would add that in my view I'm not even at the 50% mark in terms of my effectiveness. The NGDP futures market has been slow to materialize, but it will happen in 2015. Recent discussion with various think tanks has suggested to me that there is still a lot of interest in the NGDP targeting idea, and people are looking for ways to help. Hopefully these discussions will lead to something soon. And note that it's the conservative/libertarian think tanks that invite me---I see that as being really important, given that the names I mentioned above are all at least slightly left of center. Here's a question to think about:

Is there any monetary policy proposal other than NGDP targeting that has substantial support in the Keynesian, monetarist and Austrian communities?

Let's also not forgot that NGDP targeting was fashionable in the 1980s. Many top academics endorsed it back then. It fell by the way side once inflation targeting took off in the 1990s. Market monetarists have been trying to return NGDP targeting to its previous glory. Our work is still cut out for us, but like Scott I am optimistic. The glass is half full.

Free Banking and the Fiscal Theory of the Price Level. Last week I appeared on Boom-Bust with Erin Ade and had a great time discussing free banking, the fiscal theory of the price level, Abenomics, and some other issues. Our conversation starts at about 13 minutes into the video:

Are We Mismeasuring Productivity Growth?

I am in Washington, D.C. for the Future of U.S. Economic Growth conference at the CATO Institute. Brink Lindsey, the conference organizer, has put together a great group of speakers who will cover everything from secular stagnation to the singularity to the decline in economy dynamism. What makes this conference really interesting is that it has thoughtful participants on both sides of key issues. For example, there is an panel that  has both Erik Brynjolfsson and Robert Gordon on it. That should be fun to watch! I confess to coming in with strong priors on some of these issues--see my National Review article with Ramesh Ponnuru on secular stagnation--but look forward to being challenged and informed by the presenters.

One issue that is important to this debate and I hope to hear discussed is the issue of mismeasurement. It seems clear to me that economic activity is getting harder to properly measure. If so, then some of these debates may be moot. Below is an excerpt from an older post that makes this point for the measurement of productivity. Note in particular the figure below that shows the 'Great Flattening' in consumption productivity. It indicates there has been practically no productivity growth in consumption goods and services since the mid-1970s. That does not seem right and makes me skeptical that productivity is being properly measured:

[T]echnology growth appears to be rapidly growing but getting harder to measure. This point has been made recently by Joel Mokyr  in the Wall Street Journal and Erik Brynjfolsson and Andrea McAfee in The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies. Their basic point is that the economy is being radically transformed via smart machines and this will spur a period of great productivity growth, high returns to capital, and more investment. For example, imagine all the new infrastructure spending that will have to be done to support the increased use of driverless cars and trucks. Even over the past few decades there have been meaningful gains as illustrated by this hilarious spoof the show 24 being made in 1994. Noah Smith makes the case for big productivity gain even more recently. The secular stagnationists should take these developments more seriously. 

Probably one reason these developments get overlooked is that they are hard to measure. As I noted in my Washington Post piece, a good example can be found in your smartphone. It contains many items you had to formerly purchase separately--books, newspapers, cameras, scanners, bank ATMs, voice recorders, radios, encyclopedias, GPS systems, maps, dictionaries, etc.--and were counted part of GDP. Now most are free and not a part of GDP. My sense is this is not a recent phenomenon, but has been going on for sometime as the economy has become more service orientated. Measuring productivity in the service sector is notoriously hard. And it is only going to get harder.

Here is a great illustration of this measurement problem. Tyler Cowen has made the case that there has been a Great Stagnation in innovation that explains the observed slowdown in productivity data. I looked at the John Fernald TFP data and found this troubling chart. It seemed to confirm the Great Stagnation theory. It showed a sharp break in trend TFP growth starting around 1973:

Tyler Cowen approved of the chart, but Noah Smith raised some good questions about it. He observed that the Fernald TFP data can be decomposed into TFP in investment production and TFP in consumption production. TFP in investment looks better than the overall TFP:

While that is interesting, what is really striking is the TFP in consumption. It has basically flatlined since the early 1970s and is what is driving the Great Stagnation. In the spirit of Tyler Cowen, let's call this segment "The Great Flattening."

 

The Great Flattening does not seem reasonable. Has productivity growth in consumption really been flat since the early 1970s? No meaningful gains at all? This does not pass the smell test, yet this is one of the best TFP measures. This suggest there are big measurement problems in consumption production. And I suspect they can be traced to the service sector. I suspect if these measurement problems were fixed there would be less support for secular stagnation (and maybe for the Great Stagnation view too). 

If we want to have the right debate, we have to have right measures.

What Do John Cochrane, Paul Krugman, and Scott Sumner Have in Common?

What do John Cochrane, Paul Krugman, and Scott Sumner have in common? A lot more than you think. It would be easy to conclude otherwise based on the macroeconomic debates these three individuals have engaged in since the onset of the Great Recession. Each has certainly pushed a distinct policy objective, but underlying their macroeconomic prescriptions is an edifice of understanding that is complementary and points to a  fundamental agreement among them on the key determinants of aggregate demand.

This commonality among them became clear to me over the past few months as I was reading and thinking about what it takes to generate robust aggregate demand growth in a depressed economy. John Cochrane's 2011 European Economic Review article in particular helped me make the connections and was the inspiration for the above figure I sketched over the Thanksgiving holiday. This figure highlights the differences among them, but also points to their commonality via the two equations in the genie bottle. These equations come from the Cochrane paper and go a long way in helping one make sense of how monetary and fiscal policy interact and affect aggregate demand. Consequently, they help clarify some of the questions on Neo-Fisherism that have recently generated.

So what exactly do these two equations tell us? To answer this question let's look closer at these equations:

The first term is a stripped-down intertemporal government budget equation. The left-hand side shows the current monetary base (M_t) and current government bonds (B_t) divided by the price level (P_t). The right-hand side shows the discounted present value of all expected future government surpluses [i.e. it shows the present value of expected future tax revenues (T_t+i) minus expected future government expenditures (G_t+i)]. This equation tells us that in order for the current stock of government debt to maintain its value the public must expect future budget surpluses be large enough to pay it off.

The second term is the equation of exchange. It simply shows that the monetary base (M_t) times how often it is used [or its velocity (V_t)] equals total dollar spending on output (P_tY_t).

With these two equations one can demonstrate both the fiscal theory of the price level (FTPL) and the more common monetary theory of the price level (MTPL). Now John Cochrane uses this framework to motivate the FTPL view, but Scott Sumner could also use to think about the MTPL. Paul Krugman, who often invokes both views, could use it too. One of the big takeaways is that the FTPL and MTPL should be seen as complementary views of price level. This can be seen by taking a closer look at each theory.

Consider first the FTPL. This is how Cochrane summarizes this view in light of the two equations:

The fiscal equation affects prices in an intuitive way. If people start to think surpluses will not be sufficient to pay off the debt, they try to unload government debt now, buying other assets or goods and services. This is just “aggregate demand.”

In other words, if expected future budget surpluses suddenly decline, people will start unloading government bonds in anticipation of them loosing value. This will cause the velocity of money to increase as portfolios are rebalanced away from public debt and, in turn, cause the price level to raise. Note that the stock of money does not change (though its velocity does). Hence, its FTPL name. In terms of the equations,  The figure below shows the causality through the two equations.

Episodes of hyperinflation provide strong evidence for this view. John Cochrane, however, is concerned that this process might also unfold in the United States given the large run up of public debt over the past five years. He worries that the U.S. fiscal credibility might unravel if the growing public debt is left untouched. 

Paul Krugman shares Cochrane's belief in the FTPL, but notes that it also implies that there could too much fiscal credibility. If so, it would be creating a drag on aggregate demand growth (i.e. higher expected future surpluses imply lower velocity today and, in turn, mean lower aggregate demand growth). While this argument may apply to the United States, Krugman is certain it applies to Japan. Here is Krugman discussing the proposed tax hikes in Japan:

I see no prospect that Japan will put off the tax hike forever. But even if it were true, this is credibility Japan wants to lose.

After all, suppose investors conclude that Japan will never raise taxes enough to service its debt. What would they think would happen instead? Not default — Japan doesn’t have to default, because its debts are in its own currency. No, what they might fear is monetization: Japan will print lots of yen to cover deficits. And this will lead to inflation. So a loss of fiscal credibility would lead to expectations of future inflation, which is a problem for Abe’s efforts to, um, get people to expect inflation rather than deflation, because … what?

Long ago I argued that what Japan needed was a credible promise to be irresponsible. And deficits that must be monetized are one way to make that happen...

Interestingly, John Cochrane the made the same point in his 2011 paper:

The last time these issues came up was Japanese monetary and fiscal policy in the 1990s... Quantitative easing and huge fiscal deficits were all tried, and did not lead to inflation or much‘‘stimulus’’. Why not? The answer must be that people were simply not convinced that the government would fail to pay off its debts. Critics of the Japanese government essentially point out their statements sounded  pretty lukewarm about commitment to the inflationary project, perhaps wisely. In the end their ‘‘quantitative easing’’ was easily and quickly reversed, showing those expectations at least to have been reasonable.

As I said earlier,  Paul Krugman and John Cochrane have a lot more in common than you think. Along these lines, one can see why the modest tax increase this year could had such large effect on the Japanese economy. The tax hike signaled the government's commitment to future surpluses and that, rather than the tax hike itself, may have stalled aggregate demand.

Even though Krugman and Cochrane may agree on the mechanism and its potential to raise aggregate demand, their policy prescriptions are different. Krugman would like to have countries like the United States and Japan ease up a bit on fiscal credibility as a way to shore up aggregate demand growth, whereas as Cochrane sees such discretionary moves as potentially destabilizing. Cochrane is concerned doing so might let the aggregate demand genie out of the bottle in an uncontrollable manner.

That it is where Scott Sumner and his push for level targeting becomes important. A level target, specifically a NGDP level target, would get Krugman the aggregate demand growth he wanted without letting the aggregate demand genie out of the bottle in an uncontrollable manner. A NGDP level target, in a depressed economy, would temporarily allow rapid catch-up growth in aggregate demand until it hit its targeted growth path. And since a NGDP level target would be radical regime change for monetary policy, its adoption would require enough political consensus such that fiscal policy would play a supportive role. 

This takes us to the standard MTPL. It says that independent of what fiscal policy is doing, the path of the price level is also determined by permanent changes to the monetary base. It would causally operate through the two equations as follows (note the equality still holds in the first equation):

Scott Sumner's call for NGDP level targeting is implicitly a call for a permanent expansion of the monetary base if needed. Paul Krugman has also explicitly called for a permanent expansion of the monetary base. These calls are endorsements of the MTPL. Note that the Fed's QE programs have not been permanent expansions of the monetary base and this explain why their effect on aggregate demand has been muted. 

John Cochrane also believes that a permanent increase in the monetary base would raise aggregate demand and the price level. He, however, only believes this is possible if the monetary policy is allowed to permanently monetize the debt. And that decision, he says, is really a fiscal one. Hence, he sees the MTPL as just a special case of FTPL. Here he is explaining this point in the context of helicopter drops:

Suppose a helicopter drop is accompanied by the announcement that taxes will be raised the next day, by exactly the amount of the helicopter drop. In this case,everyone would simply sit on the money, and no inflation would follow. The real-world counterpart is entirely possible. Suppose the government implemented a drop, repeating the Bush stimulus via $500 checks to taxpayers, but with explicit Fed monetization. However,we have all heard the well-explained ‘‘exit strategies’’ from the Fed, so supposing the money will soon be exchanged for debt is not unreasonable. And suppose taxpayers still believe the government is responsible and eventually pays off its debt. Then, this conventional implementation of a helicopter drop,in the context of conventional expectations about government policy, will have no effect at all.

Thus, Milton Friedman’s helicopters have nothing really to do with money.They are instead a brilliant psychological device to dramatically communicate a fiscal commitment, that this cash does not correspond to higher future fiscal surpluses, that there is no ‘‘exit strategy’’, and the cash will be left out in public hands... The larger lesson is that, to be effective, a monetary expansion must be accompanied by a credibly communicated non-Ricardian fiscal expansion as well. People must understand that the new debtor money does not just correspond to higher future surpluses. This is very hard to do—and even harder to do just a little bit.

So here again Cochrane is speaking to Krugman's concerns about there being too much fiscal credibility. In this case it is preventing the Fed from doing what needs to be done to get out of a recession. 

I disagree with Cochrane that the MTPL is just a special case of the FTPL. First, on a practical level the Fed has effectively been doing one long helicopter drop since its inception and never has had to worry about fiscal policy. Over time as the economy has grown the Fed has permanently increased the monetary base and done so through permanent open market operations. That is, it has permanently expanding its balance sheet as seen in the figure below. So it is not clear that should the Fed attempt to permanently increase its monetary base (say as part of a transition to a NGDP level target or a higher inflation target) that fiscal policy would offset it. 

Second, the Fed is not limited to purchasing just treasury securities. It can also buy foreign exchange, among other assets. So even if expected future budget surpluses were increasing the Fed could still increase the monetary base through foreign exchange purchases. This is what the Bank of Israel did during the crisis.

In short, the FTPL and MTPL can be seen as separate but complementary determinants of the price level working through common mechanisms. And this is why John Cochrane, Paul Krugman, and Scott Sumner have much more in common than you might imagine.