New Paper on the Greenspan and Bernanke Fed

John Ryan and Ryan Koronowski have a nice survey paper on the Greenspan and Bernanke Fed (Hat tip to Mark Thoma). The paper explains in a straightforward manner how the Fed works and considers its policy actions during the tenure of Greenspan and Bernanke. The paper draws upon the work of William White, Claudio Borio, and the other folks at the BIS as well as Martin Wolf. It provides a nice complement to David Wessel's "In Fed We Trust" and, among other things, would work well in a money and banking course.

Here is one excerpt from the paper that sounds like something I would say:

White argues that price stabilization which tries to avoid periods of deflation (what is characteristic for definitions of price stability as a central bank’s target) sometimes may be too expansionary and it may lead to an asset price bubble. This may happen in a situation of “good deflation” when prices decrease as an effect of some positive supply shocks such as rapid growth of productivity or – as recently – globalization. However, it is interesting in this context to ask to what degree monetary policy should be more accommodative in case of “bad deflation” – one induced by a financial crisis and falling demand - without risking it may turn out to have been too easy.

Another way of saying this is that the Fed should stabilize nominal spending. Rapid productivity gains create deflationary pressures. If such productivity gains are accompanied by an easing of monetary policy to offset the downward price pressures there will be a surge in nominal spending. On the other hand, deflationary pressures could also arise from a collapse in nominal spending. Fed policy should avoid both types of swings in nominal spending because such swings in conjunction with nominal rigidities (e.g. sticky prices) would cause output to move outside its sustainable or natural rate level. As I have noted before, though, the Fed failed to do this in the 2003-2005 period and more recently in the late 2008-early 2009 period. Stabilize nominal spending or more macroeconomic bust!

Making the Case for Financial Innovation

In a refreshing change, Robert Shiller makes the case for financial innovation. Along the way he lists some ideas about where financial innovation could go. I like this one in particular:

I have proposed the idea of “continuous workout mortgages”, motivated by basic principles of risk management. The privately issued mortgage would protect against exigencies such as recessions or drops in home prices. Had such mortgages been offered before this crisis, we would not have the rash of foreclosures. Yet, even after the crisis, regulators seem to be assuming a plain vanilla mortgage is just what we need for the future.

Financial innovation may one day actually serve to prevent financial crisis from ever emerging

Putting Klingonomics to the Test

Arnold Kling has been promoting a macroeconomic theory he calls "Recalculation" which takes a controversial view on the efficacy of monetary policy. You can read his discussion of recalculation macro here, here, and here. Within these discussions he summarizes his view of monetary policy as follows:

In the short run, the economy is going its own way, regardless of monetary policy. Higher M leads to lower V, and vice-versa. In the long run, a significant change in the rate of money creation causes a similar change in the rate of inflation. However, the lag is long and the effect on the rate of Recalculation is small and of indeterminate sign[.]

As this and other passages from his postings show, Kling makes three controversial assertions about monetary policy in his recalculation macro theory. They are as follows:

(1) Monetary policy has no effect on expectations in the short-run.

(2) Monetary policy has no effect on nominal economic activity in the short run.

(3) Monetary policy has no effect on real economic activity in the short run.

Bill Woolsey has been all over Kling's case for making these assertions and the assumptions behind them. I will speak in a moment to Woolsey's critique but for now I want to see what the data says about the assertions (1) - (3).

Number (1) touches on an important question: can the Fed influence expectations about the future in such a way as to shape current economic behavior? Standard macro theory says yes--it is the reasoning behind the current arguments for why the Fed should be explicitly targeting some positive rate of inflation now. Kling, however, does not buy it. In order to test this question empirically, I took the monthly expected inflation series implied by the difference between the nominal 10-year Treasury yield and the 10-year TIPs yield and put it in a vector autoregression (VAR) along with the monthly GDP series from macroeconomic advisers. Nominal GDP was turned into an annualized monthly growth rate and the data used runs from 1999:1 through 2007:9. More data would have been helpful, but TIPs only start in the late 1990s. (Technical note: both series were in rates so no unit root problems, 13 lags were used to eliminate serial correlation, and corporate bond spreads were included as a control variable for the financial crisis). The two figures below show what the typical responses of expected inflation and nominal GDP to the typical sudden change or shock to expected inflation over the sample. The solid line shows the point estimate while the dashed lines show two standard deviations around the point estimate. Upon impact, the shock causes expected inflation to jump 16 basis points and occurs as the level of nominal GDP increases by 1.16 percent. In other words, a sudden positive change in expected inflation is associated with an increase in current nominal spending. Both effects persist but eventually become insignificant about 14-15 months later. (Click on figures to enlarge.)

Now presumably the change in 10-year expected inflation comes from a expected change in monetary policy, but just to be sure and to fully address (2) and (3) I have posted below some figures from another VAR I did that looks at the effect of unexpected changes or shocks to the monetary base for the period 1960:3 - 2008:2. This is a larger VAR that controls for more things. (This figure is actually an excerpt from a series of VARs I did in response to Nick Rowe's post on monetary policy and debt.) Here, the monetary base is shocked 1%. Note how all the real variables increase on impact. In other words, an unexpected positive increase in the monetary base historically has led to an increase in the short run of real economic variables. As predicted by theory, the effect of the monetary base shock eventually wears out--money becomes neutral. (Note that the price level is implicitly in these figures too: it is difference between real money and money. Here, there is a permanent effect)

So the assertions (1), (2), and (3) are empirically falsified. Of course we did not need my VARs to know this. There is already a lot of empirical evidence out there that reaches a similar conclusion. Moreover, Bryan Caplan notes numbers (1) and (2) fly in the face of everything we know from hyperinflation experiences. So why make such assertions? Bill Woolsely explains that Kling's assertions can work if prices are sticky in the short run, real income is determined by productive capacity, and real money demand is not affected by real income. As Bill Woolsely notes, this last assumptions is incredibly wrong, as many empirical studies have demonstrated over the past 50 years.

In light of the evidence I say it is time for Arnold Kling to join the ranks of the monetary disequilibrium bloggers.

Update 1:Here are some definitions to add clarity to the figures above. The real stock price series is the real S&P 500, the debt series is financial sector debt to GDP, the money supply is the monetary base, and the real money balance series is the monetary base divided by the CPI.

Update 2: Josh Hendrickson provides a nice follow up to the issues raised here while Arnold Kling assails my use of the "Dark Age Macroeconomic"-based VAR.

Should Monetary Policy "Lean or Clean"?

That is the title of a new paper by William White, one of the few influential economists who saw the crisis coming and tried to warn others. Here is the abstract:

It has been contended by many in the central banking community that monetary policy would not be effective in "leaning" against the upswing of a credit cycle (the boom) but that lower interest rates would be effective in "cleaning" up (the bust) afterwards. In this paper, these two propositions (can't lean, but can clean) are examined and found seriously deficient. In particular, it is contended in this paper that monetary policies designed solely to deal with short term problems of insufficient demand could make medium term problems worse by encouraging a buildup of debt that cannot be sustained over time. The conclusion reached is that monetary policy should be more focused on "preemptive tightening" to moderate credit bubbles than on "preemptive easing" to deal with the after effects. There is a need for a new macrofinancial stability framework that would use both regulatory and monetary instruments to resist credit bubbles and thus promote sustainable economic growth over time.

Does the Equation of Exchange Shed Any Light on the Crisis?

James Hamilton thinks the answer is no. In his reply to Scott Sumner's lead article at Cato Unbound, he questions Sumner's use of the identity MV = PY to explain the collapse of nominal spending over the past year. (In this equation M = money supply, V = velocity or the average number of times a unit of money is spent, P = price level, Y = real GDP, and PY = nominal GDP.) Hamilton contends the only meaningful use of the identity is to determine velocity (i.e. V=PY/M) and even then it is not totally reliable since it can vary based on the measure of money one uses. I believe, however, Hamilton under appreciates the insights this identity can shed on the crisis. It may not provide precise policy recommendations, but it does provide a starting point from which to think analytically and empirically about recent economic developments.

So what does this identity tells us about the crisis? To answer this question we first need to expand the identity a bit. To do so, note that the money supply is the product of the monetary base, B, times the money multiplier, m or

M = Bm.

Now substitute this into the equation of exchange to get the following:

BmV = PY.

Now we have an identity that says the sources of nominal spending are the monetary base, the money multiplier, and velocity. With this identity in hand we can asses the contribution of these three sources to the dramatic decline in nominal spending in the past year. Using MZM as the measure of money (see here for why MZM is preferred over M1 and M2) and monthly nominal GDP from Macroeconomic Advisers to construct velocity, the three series are graphed below in levels (click on figure to enlarge):

This figure indicates that declines in the money multiplier and velocity have both been pulling down nominal GDP. The decline in the money multiplier reflects (1) the problems in the banking system that have led to a decline in financial intermediation as well as (2) the interest the Fed is paying on excess bank reserves. The decline in the velocity is presumably the result of an increase in real money demand created by the uncertainty surrounding the recession. This figure also shows that the Federal Reserve has been significantly increasing the monetary base, which should, all else equal, put upward pressure on nominal spending. However, all else is not equal as the movements in the money multiplier and the monetary base appear to mostly offset each other. Therefore, it seems that on balance it has been the fall in velocity (i.e. the increase in real money demand) that has driven the collapse in nominal spending.

To get a better sense of what is happening with theses series note that log of the expanded equation of exchange can be stated as follows:

B+m+V = P+Y,

Now if we take first differences of the the quarterly log values of the series in the above identity we get a quarterly growth rate approximation. (Note, this approximation is not very good for large differences like the one for the monetary base in 2008:Q4.) Below is a table with the results in annualized values (Click to enlarge):

This table confirms what we saw in the levels: a sharp decline in velocity appears to be the main contributor to the collapse in nominal spending in late 2008 and early 2009 as changes in the monetary base and the money multiplier largely offset each other. It is striking that the largest run ups in the monetary base occurred in the same quarters (2008:Q3, 2008:Q4) as the largest drops in the money multiplier. If the Fed's payment on excess reserves were the main reason for the decline in the money multiplier and if the Fed used this new tool in order to allow for massive credit easing (i.e. buying up troubled assets and bringing down spreads) without inflation emerging, then the Fed's timing was impeccable. Unfortunately, though, it appears the Fed was so focused on preventing its credit easing program from destabilizing the money supply that it overlooked, or least underestimated, developments with real money demand (i.e. velocity). As a consequence, nominal spending crashed.

Now maybe this is self evident to some, but I find the above information from the equation of exchange useful as a starting point for discussing what went wrong and where to go from here.

Friends Don't Let Friends Mix Say's Law with Money

Nick Rowe recently noted that John Cochrane, in his rebuttal to Paul Krugman, effectively invokes Say's law with this sentence:

Paul’s Keynesian economics requires that people make plans to consume more, invest more, and pay more taxes with the same income.

Cochrane's point is that it is impossible to have total planned expenditures exceed total income. This line of thinking or Say's law, taken to its logical conclusion, implies it is impossible to have a general, economy-wide glut since (1) total income must equal total planned expenditures and (2) total income comes from the production of goods and services upon which total expenditures are spent. (i.e. total planned expenditures = total income = total value of production). Obviously, history has not been kind to this proposition. As Nick notes, this is because Say's law assumes a barter economy and ignores the complications found in a money economy. Here to explain these complications is Leland Yeager (Source: The Fluttering Veil: Essays on Monetary Disequilibrium, p.4-6):

Say's law, or a crude version of it, rules out general overproduction: an excess supply of some things in relation to the demand for them necessarily constitutes an excess demand for some other things in relation to their supply...

The catch is this: while an excess supply of some things necessarily mean an excess demand for others, those other things may, unhappily, be money. If so, depression in some industries no longer entails boom in others...

[T]the quantity of money people desire to hold does not always just equal the quantity they possess. Equality of the two is an equilibrium condition, not an identity. Only in... monetary equilibrium are they equal. Only then are the total value of goods and labor supplied and demanded equal, so that a deficient demand for some kinds entails and excess demand for others.

Say's law overlooks monetary disequilibrium. If people on the whole are trying to add more money to their total cash balances than is being added to the total money stock (or are trying to maintain their cash balances when the money stock is shrinking), they are trying to sell more goods and labor than are being bought. If people on the whole are unwilling to add as much money to their total cash balances as is being added to the total money stock (or are trying to reduce their cash balances when the money stock is not shrinking), they are trying to buy more goods and labor than are being offered.

The most striking characteristic of depression is not overproduction of some things and underproduction of others, but rather, a general "buyers' market," in which sellers have special trouble finding people willing to pay more for goods and labor. Even a slight depression shows itself in the price and output statistics of a wide range of consumer-goods and investment-goods industries. Clearly some very general imbalance must exist, involving the one thing--money--traded on all markets. In inflation, an opposite kind of monetary imbalance is even more obvious.

Also see Brad DeLong's comments on this issue.

Targeting the Forecast

Over at Cato Unbound, Scott Sumner is leading a discussion on the conduct of monetary policy during this crisis. True to form, he is arguing the Fed was effectively too tight in the second half of 2008 and, as a result, caused aggregate demand to collapse during that time. He also makes the case that the nominal spending collapse of 2008 could have been avoided if the Fed had been targeting the forecast. His argument for targeting the forecast is posted below. Jim Hamilton, George Selgin, and Jeffrey Hummel are scheduled to reply to Sumner's lead article.

Lars Svensson has advocated a policy of targeting the forecast — setting the central bank’s policy instrument at the level most likely to hit its policy goal. Thus, if a central bank had a goal of two-percent inflation, it should set the fed funds rate at a level where its own forecasters were forecasting two-percent inflation. Once one starts to think of monetary policy this way, any other policy seems unacceptable. After all, why would any central bank ever want to adopt a policy stance that was expected to fail.

[...]

I have advocated a policy where the Fed pegs the price of a 12-month forward NGDP futures contract and lets purchases and sales of that contract lead to parallel open market operations. In essence, this would mean letting the market determine the monetary base and the level of interest rates expected to lead to five-percent NGDP growth. When I first proposed this idea in the 1980s, I envisioned the advantage in terms of traders observing local demand shocks before the central bank. The logic behind this idea is often called “the wisdom of the crowds.” But I no longer see this as its primary advantage. Although last fall the market forecast turned out to be far more accurate than the Fed’s forecast, in general the Fed forecasts pretty well.

This crisis has dramatized two other advantages to futures targeting, each far more important that the “efficient markets” argument. One advantage is that the central bank would no longer have to choose a policy instrument. Their preferred instrument, the fed funds rate, proved entirely inadequate once nominal rates hit zero. Under futures targeting each trader could look at their favorite policy indicator, and use whatever structural model of the economy they preferred. A few years ago I published this idea under the title “Let a Thousand Models Bloom.” I am not an “Austrian” economist, but this proposal is very Austrian in spirit. (And my preferred policy target, NGDP, is also the nominal aggregate that Hayek thought was most informative.)

Only last fall did I realize that there was another, even more powerful advantage of futures targeting-credibility. The same people forecasting the effects of monetary policy would also be those setting monetary policy. Under the current regime, the Fed sets policy and the market forecasts the effects of policy. To consider why this is so important, consider the Fed’s current dilemma. They have already pumped a lot of money into the economy, but prices have fallen over the past year as base velocity plummeted. Certainly if they pumped trillions more into the money supply at some point expectations would turn around. But when this occurred, velocity might increase as well, and that same monetary base could suddenly become highly inflationary. This problem does not occur under a futures targeting regime. Rather, the market forecasts the money supply required to hit the Fed’s policy goal, under the assumption that they will hit that goal. Today we have no idea how much money is needed, because the current level of velocity reflects the (quite rational) assumption that policy will fail to boost NGDP at the desired rate.

I especially look forward to Selgin's reply since he too is an advocate of nominal income targeting.