The Weak Recovery is a Policy Failure

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

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

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

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

The Market Monetarist, MMT, and Austrian Lovefest

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

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

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

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

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

Beckworth Smackdown

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

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

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

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

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

What Really Caused the Crisis?

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

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

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

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

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

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

The Real Negative Real Shock

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

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

[...]

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

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

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

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

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

More on the Shortage of Safe Assets

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

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

Jan Hatzius Interview on NGDP Targeting

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