All posts tagged macroeconomics

Scott Sumner asks whether those of us[1] who talked about a housing bubble are predicting another one now.

Sumner asks “Is it possible that the housing boom was not a bubble?”.

It’s certainly possible to define the word bubble so that it wasn’t. But I take the standard meaning of bubble in this context to mean something like a prediction that prices will be lower a few years after the time of the prediction.

Of course, most such claims aren’t worth the electrons they’re written on, for any market that’s moderately efficient. And we shouldn’t expect the news media to select for competent predictions.

Sumner’s use of the word “bubble” isn’t of much use to me as an investor. If prices look like a bubble for a decade after their peak, that’s a good reason to have sold at the peak, regardless of what happens a decade later.

If I understand Sumner’s definition correctly, he’d say that the 1929 stock market peak looked for 25 years like it might have been a bubble, then in the mid 1950s he would decide that it had been shown not to be a bubble. That seems a bit strange.

Even if I intended to hold an investment for decades, I’d care a fair amount about the option value of selling sooner.


The U.S. is not currently experiencing a housing bubble. I can imagine a small housing bubble developing in a year or two, but I’m reasonably confident that housing prices will be higher 18 months from now than they are today.

Several signs from 2005/2006 that I haven’t seen recently:

I mostly used to attribute the great recession to the foolish leverage of the banking system and homebuyers, who underestimated the risks of a significant decline in housing prices.

I’ve somewhat changed my mind after reading Sumner’s writings, and I now think the Fed had the power to prevent most of the decline in gdp, unless it was constrained by some unannounced limit on the size of its balance sheet. But I still think it’s worth asking why we needed unusual Fed actions. The fluctuations in leverage caused unusual changes in demand for money, and the Fed would have needed to cause unusual changes in the money supply to handle that well. So I think the housing bubble provides a good explanation for the timing of the recession, although that explanation is incomplete without some reference to the limits to either the Fed’s power or the Fed’s competence.

[1] – he’s mainly talking about pundits who blamed the great recession on the housing bubble. I don’t think I ever claimed there was a direct connection between them, but I did imply an indirect connection via banking system problems.

Book review: The Midas Paradox: Financial Markets, Government Policy Shocks, and the Great Depression, by Scott B Sumner.

This is mostly a history of the two depressions that hit the U.S. in the 1930s: one international depression lasting from late 1929 to early 1933, due almost entirely to problems with an unstable gold exchange standard; quickly followed by a more U.S.-centered depression that was mainly caused by bad labor market policies.

It also contains some valuable history of macroeconomic thought, doing a fairly good job of explaining the popularity of theories that are designed for special cases (such as monetarism and Keynes’ “general” theory).

I was surprised at how much Sumner makes the other books on this subject that I’ve read seem inadequate.
Continue Reading

[See my previous post for context.]

I started out to research and write a post on why I disagreed with Scott Sumner about NGDP targeting, and discovered an important point of agreement: targeting nominal wages forecasts would probably be better than targeting either NGDP or CPI forecasts.

One drawback to targeting something other than CPI forecasts is that we’ve got good market forecasts of the CPI. It’s certainly possible to create markets to forecast other quantities that the Fed might target, but we don’t have a good way of predicting how much time and money those will require.

Problems with NGDP targets

The main long-term drawback to targeting NGDP (or other measures that incorporate the quantity of economic activity) rather than an inflation-like measure is that it’s quite plausible to have large changes in the trend of increasing economic activity.

We could have a large increase in our growth rate due to a technology change such as uploaded minds (ems). NGDP targeting would create unpleasant deflation in that scenario until the Fed figured out how to adjust to new NGDP targets.

I can also imagine a technology-induced slowdown in economic growth, for example: a switch to open-source hardware for things like food and clothing (3-d printers using open-source designs) could replace lots of transactions with free equivalents. That would mean a decline in NGDP without a decline in living standards. NGDP targeting would respond by creating high inflation. (This scenario seems less likely and less dangerous than the prior scenario).

Basil Halperin has some historical examples where NGDP targeting would have produced similar problems.

Problems with inflation forecasts?

Critics of inflation targeting point to problems associated with oil shocks or with strange ways of calculating housing costs. Those cause many inflation measures to temporarily diverge from what I want the Fed to focus on, which is the problem of sticky wages interacting with weak nominal wages to create unnecessary unemployment.

Those problems with measuring inflation are serious if the Fed uses inflation that has already happened or uses forecasts of inflation that extend only a few months into the future.

Instead, I recommend using multi-year CPI forecasts based on several different time periods (e.g. in the 2 to 10 year range), and possibly forecasts for time periods that start a year or so in the future (this series shows how to infer such forecasts from existing markets). In the rare case where forecasts for different time periods say conflicting things about whether the Fed is too tight or loose, I’d encourage the Fed to use its judgment about which to follow.

The multi-year forecasts have historically shown only small reactions to phenomena such as the large spike in oil prices in mid 2008. I expect that pattern to continue: commodity price spikes happen when markets get evidence of their causes/symptoms (due to market efficiency), not at predictable future times. The multi-year forecasts typically tell us mainly whether the Fed will persistently miss its target.

Won’t using those long-term forecasts enable the Fed to make mistakes that it corrects (or over-corrects) for shorter time periods? Technically yes, but that doesn’t mean the Fed has a practical way to do that. It’s much easier for the Fed to hit its target if demand for money is predictable. Demand for money is more predictable if the value of money is more predictable. That’s one reason why long-term stability of inflation (or of wages or NGDP) implies short-term stability.

It would be a bit safer to target nominal wage rate forecasts rather than CPI forecasts if we had equally good markets forecasting both. But I expect it to be easier to convince the public to trust markets that are heavily traded for other reasons, than it is to get them to trust a brand new market of uncertain liquidity.

NGDP targeting has been gaining popularity recently. But targeting market-based inflation forecasts will be about as good under most conditions [1], and we have good markets that forecast the U.S. inflation rate [2].

Those forecasts have a track record that starts in 2003. The track record seems quite consistent with my impressions about when the Fed should have adopted a more inflationary policy (to promote growth and to get inflation expectations up to 2% [3]) and when it should have adopted a less inflationary policy (to avoid fueling the housing bubble). It’s probably a bit controversial to say that the Fed should have had a less inflationary policy from February through July or August of 2008. But my impression (from reading the stock market) is that NGDP futures would have said roughly the same thing. The inflation forecasts sent a clear signal starting in very early September 2008 that Fed policy was too tight, and that’s about when other forms of hindsight switch from muddled to saying clearly that Fed policy was dangerously tight.

Why do I mention this now? The inflation forecast dropped below 1 percent two weeks ago for the first time since May 2008. So the Fed’s stated policies conflict with what a more reputable source of information says the Fed will accomplish. This looks like what we’d see if the Fed was in the process of causing a mild recession to prevent an imaginary increase in inflation.

What does the Fed think it’s doing?

  • It might be relying on interest rates to estimate what it’s policies will produce. Interest rates this low after 6.5 years of economic expansion resemble historical examples of loose monetary policy more than they resemble the stereotype of tight monetary policy [4].
  • The Fed could be following a version of the Taylor Rule. Given standard guesses about the output gap and equilibrium real interest rate [5], the Taylor Rule says interest rates ought to be rising now. The Taylor Rule has usually been at least as good as actual Fed policy at targeting inflation indirectly through targeting interest rates. But that doesn’t explain why the Fed targets interest rates when that conflicts with targeting market forecasts of inflation.
  • The Fed could be influenced by status quo bias: interest rates and unemployment are familiar types of evidence to use, whereas unbiased inflation forecasts are slightly novel.
  • Could the Fed be reacting to money supply growth? Not in any obvious way: the monetary base stopped growing about two years ago, M1 and MZM growth are slowing slightly, and M2 accelerated recently (but only after much of the Fed’s tightening).

Scott Sumner’s rants against reasoning from interest rates explain why the Fed ought to be embarrassed to use interest rates to figure out whether Fed policy is loose or tight.

Yet some institutional incentives encourage the Fed to target interest rates rather than predicted inflation. It feels like an appropriate use of high-status labor to set interest rates once every few weeks based on new discussion of expert wisdom. Switching to more or less mechanical responses to routine bond price changes would undercut much of the reason for believing that the Fed’s leaders are doing high-status work.

The news media storytellers would have trouble finding entertaining ways of reporting adjustments that consisted of small hourly responses to bond market changes. Whereas decisions made a few times per year are uncommon enough to be genuinely newsworthy. And meetings where hawks struggle against doves fit our instinctive stereotype for important news better than following a rule does. So I see little hope that storytellers will want to abandon their focus on interest rates. Do the Fed governors follow the storytellers closely enough that the storytellers’ attention strongly affects the Fed’s attention? Would we be better off if we could ban the Fed from seeing any source of daily stories?

Do any other interest groups prefer stable interest rates over stable inflation rates? I expect a wide range of preferences among Wall Street firms, but I’m unaware which preferences are dominant there.

Consumers presumably prefer that their banks, credit cards, etc have predictable interest rates. But I’m skeptical that the Fed feels much pressure to satisfy those preferences.

We need to fight those pressures by laughing at people who claim that the Fed is easing when markets predict below-target inflation (as in the fall of 2008) or that the Fed is tightening when markets predict above-target inflation (e.g. much of 2004).

P.S. – The risk-reward ratio for the stock market today is much worse than normal. I’m not as bearish as I was in October 2008, but I’ve positioned myself much more cautiously than normal.


[1] – They appear to produce nearly identical advice under most conditions that the U.S. has experienced recently.

I expect inflation targeting to be modestly safer than NGDP targeting. I may get around to explaining my reasons for that in a separate post.

[2] – The link above gives daily forecasts of the 5 year CPI inflation rate. See here for some longer time periods.

The markets used to calculate these forecasts have enough liquidity that it would be hard for critics to claim that they could be manipulated by entities less powerful than the Fed. I expect some critics to claim that anyway.

[3] – I’m accepting the standard assumption that 2% inflation is desirable, in order to keep this post simple. Figuring out the optimal inflation rate is too hard for me to tackle any time soon. A predictable inflation rate is clearly desirable, which creates some benefits to following a standard that many experts agree on.

[4] – providing that you don’t pay much attention to Japan since 1990.

[5] – guesses which are error-prone and, if a more direct way of targeting inflation is feasible, unnecessary. The conflict between the markets’ inflation forecast and the Taylor Rule’s implication that near-zero interest rates would cause inflation to rise suggests that we should doubt those guesses. I’m pretty sure that equilibrium interest rates are lower than the standard assumptions. I don’t know what to believe about the output gap.

Book review: Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis, by John B. Taylor.

This book contains a few good ideas, expressed simply and clearly. It explains some of what caused the 2008 financial crisis. But he exaggerates a good deal when he claims he has “provided empirical proof that monetary policy was a key cause of the boom”.

He provides clear evidence that counterparty risk was a more important problem than lack of liquidity, and has some hints about how counterparty risk could have been handled better. But that doesn’t say much about whether policies to deal with liquidity problems were mistaken – I doubt that many of the people pushing those liquidity related policies were denying that counterparty risk was a problem.

I’ve been convinced since before the crisis that having the Fed follow the Taylor Rule would have been better than the monetary policy that we actually had. But the details of the rule seem somewhat arbitrary, and I’m disappointed that the book doesn’t provide much explanation of why the Taylor Rule is better than alternative rules.

I’ve found a link on Taylor’s blog to an article (The Taylor Rule and QE2 By David Papell) which compares it to some alternatives which seem motivated primarily by a desire to rationalize more monetary or fiscal stimulus. But what I want to know is whether it’s possible to create a rule that is more countercyclical without being more inflationary.

I have an intuition that it’s not too hard to improve on the inflation component of the rule. The CPI seems to have many drawbacks, such as being slow to reflect changes. I suspect Taylor’s inflation coefficient of 1.5 is larger than what an ideal rule would use in order to make up for the delays associated with using the CPI. When I’m estimating inflation for my investment decisions, I pay more attention to the ISM price index, the money supply (MZM), commodity prices, and stock prices. And the ISM Purchasing Managers Index should provide more up to date evidence of the “output gap” than GDP figures. A version of the Taylor Rule which emphasized those should react more quickly to changes in the economy.

Book review: This Time is Different: Eight Centuries of Financial Folly by Carmen M. Reinhart and Kenneth S. Rogoff.

This book documents better than any prior book the history of banking and government debt crises. Most of it is unsurprising to those familiar with the subject. It has more comprehensive data than I’ve seen before.

It is easier reading than the length would suggest (it has many tables of data, and few readers will be tempted to read all the data). It is relatively objective. That makes it less exciting than the more ideological writings on the subject.

The comparisons between well governed and poorly governed countries show that governments can become mature enough that defaults on government debt and hyperinflation are rare or eliminated, but there is little different in banking crises between different types of government / economies.

They claim that international capital mobility has produced banking crises, but don’t convince me that they understand the causality behind the correlation. I’d guess that one causal factor is that the optimism that produces bubbles causes more investors to move money into countries they understand less well than their home country, which means their money is more likely to end up in reckless institutions.

The book ends with tentative guesses about which countries are about to become mature enough to avoid sovereign debt crises. Among the seven candidates is Greece, which is now looking like a poor guess less than a half year after it was published.

Book review: Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse by Thomas E. Woods Jr.

This book describes the Austrian business cycle theory (ABCT) in a more readable form than it’s usually presented. Its basic idea that malinvestment creates business cycles, and that central bank manipulation of interest rates can cause malinvestment, is correct. But when Woods tries to argue that only errors by a government can cause business cycles, his ideological blinders become obvious. He’s mostly right when he complains about government mistakes, and mostly wrong when he denies the existence of other problems.

He asks why businesses made a “cluster of errors” that added up to a big problem rather than independent errors which mostly canceled each other out. The only answer he can find is misleading signals sent by the Fed’s manipulation of interest rates. He doesn’t explain why businessmen fail to learn from the frequent and widely publicized patterns of those Fed actions. It’s unclear why groupthink needs a strong cause, but one obvious possibility that Woods ignores is that most people saw a persistent trend of rising housing prices, and didn’t remember large drops in housing prices over a region as large as the U.S.

He shows no understanding of the problems associated with sticky wages which are a key part of the better arguments for Keynesian approaches.

He wants to credit ABCT with having predicted this downturn. If you try to figure out when was the last time it didn’t predict a downturn (the early 1920s?), this seems less impressive than, say, Robert Shiller’s track record for predicting when bubbles burst.

His somewhat selective use of historical evidence carefully avoids anything that might present a picture more complex than government being the sole villain. He describes enough U.S. economic expansions to present a clear case that credit expansion contributed to the ensuing bust, and usually points to a government activity which one can imagine caused excessive credit expansion. But he’s unusually vague about the causes of the expansion that led to the panic of 1857. Could that be because he wants to overlook the role that new gold mining in California played in that inflationary cycle?

He mostly denies that free market approaches have been tested for long enough to see whether we would avoid business cycles under a true free market. He points to a few downturns when he says the government followed a wise laissez faire policy, and compares the shortness of those downturns with a few longer downturns where the government made some attempts to solve the downturns. When doing this, he avoids mention of the downturns where massive government actions were followed by mild recessions. Any complete survey comparing the extent of government action with the ensuing economic conditions would provide a much murkier picture of the relative contributions of government and market error than Woods is willing to allow.

The most interesting claim that I hadn’t previously heard is that a large decrease in the money supply in 1839-1843 coincided with healthy GNP growth, which, if true, is hard to explain without assuming Keynesian and monetarist theories explain a relatively small fraction of business cycle problems. My attempts to check this yielded a report at saying GDP in 2005 dollars rose from $31.37 in 1839 to $34.84 in 1843, but GDP per capita in 2005 dollars dropped from $1884 in 1839 to $1869 in 1843. Declining GDP per capita doesn’t sound very prosperous to me (although it’s a mild enough decline to provide little support for Keynesians/monetarists).

He tries to blame the “mistakes” of credit rating agencies on an SEC-created cartel of rating agencies. That “cartel” does have some special privileges, but he doesn’t say what stops bloggers from expressing opinions on bond risks and developing reputations that lead to investors using those opinions in addition to the “cartel”‘s ratings (Freerisk is a project which is planning a sophisticated alternative). I say that anyone who understands markets would expect the yield on the bonds to provide as good an estimate of risk as any alternative. Credit rating agencies must be performing some other function in order to thrive. An obvious function is to mislead bosses and/or regulators who don’t understand markets into thinking that the people making investment decisions are making choices that are safer than they actually are. It appears that the agencies performed that function well, and helped many people avoid being fired for poor choices.

His discussion of whether WWII spending cured the Great Depression points out that mainstream theories falsely predicted a return to depression in 1946. But it’s unclear whether all versions of Keynesianism make that mistake, and it’s unclear how ABCT could predict the U.S. would be much more prosperous in 1946 than at the start of the war.
Here’s an alternative explanation that lies in between those theories: wages were being kept too high for supply and demand to balance through 1941. Inflation and changes in government policy toward wage levels during WW2 eliminated the causes of that imbalance.

Arnold Kling has a good quasi-Austrian alternative here and here.

Book review: The Return of Depression Economics and the Crisis of 2008 by Paul Krugman.

Large parts of this book accurately describe some processes which contribute to financial crises, but he fails to describe enough of what happened in crises such as in 2008 to reach sensible policy advice.

He presents a simple example of a baby-sitting co-op that experienced a recession via a Keynesian liquidity trap, and he is right to believe that is part of what causes recessions, but he doesn’t have much of an argument that other causes are unimportant.

His neglect of malinvestment problems contributes to his delusion that central banks reach limits to their power in crises where interest rates approach zero. The presence or absence of deflation seems to provide a fairly good estimate of whether liquidity trap type problems exist. If you recognize that malinvestments are part of the problem that caused crises such as that of 2008, the natural conclusion is that the Fed solved most of the liquidity trap type problem within a few months of noticing the severity of the downturn. There is ample reason to suspect that the economy is suffering from a misallocation of resources, such as workers who developed skills as construction workers when perfect foresight would have told them to develop skill in careers where demand is expanding (nurses?). Nobody knows how to instantly convert those workers into appropriate careers, so we shouldn’t expect a quick fix to the problems associated with that malinvestment. It appears possible for he Fed to make that malinvestment have been successful investment by dropping enough dollars from helicopters to create an inflation rate that will make home buying attractive again. Krugman’s suggested fiscal stimulus looks almost as poor a solution as that to anyone who sees malinvestment as the main remaining problem.

His claim that central bank policy is ineffective is misleading because he pretends that controlling interest rates is all that central banks do to “stimulate” the economy. If instead you focus on changes in the money supply (which central banks can sometimes cause with little effect on interest rates), you’ll see they have plenty of power to inflate.

He dismisses the problem of sticky wages as if it were minor or inevitable. But if you understand the role that plays in unemployment, and analyze Singapore’s policy of automatically altering payroll taxes to stabilize jobs, you should see that’s more cost-effective than the fiscal stimulus Krugman wants.

I’m not satisfied with his phrasing of lack of “effective demand” being caused by people “trying to accumulate cash”. If we apply standard financial terminology to changes the value of a currency (e.g. saying that there’s a speculative bubble driving up the value of the currency, or that there’s a short squeeze – highly leveraged firms have what amounts to a big short position in dollars), then it seems more natural to use the intuitions we’ve developed for the stock market to fluctuations in currency values.

He doesn’t adequately explain why most economists don’t want a global currency. He says labor mobility within the area that standardizes on a currency is important for it to work well. I’m unconvinced that much mobility is needed for a global currency to work better than the mediocre alternatives, but even if it is, I’d expect economists to advocate a combination of a global currency and reducing the barriers to mobility. How much of economists dislike for a global currency is due to real harm from regional fluctuations and how much is it due to politicians rewarding people like Krugman for biasing their arguments in ways that empower the politicians? Or do they not give it much thought because they’ve decided it’s politically infeasible even if desirable?

His description of the shadow banking system clarifies quite well how regulatory efforts to avoid crises failed. His solution of regulating like a bank anything that acts like a bank would work well if implemented by an altruistic government. But his “simple rule” is too vague for his intent to survive in a system where politicians want to bend the rules to help their friends.

Book review: The Age of Turbulence: Adventures in a New World by Alan Greenspan.
The first half of this book provides a decent history of the past 40 years, with a few special insights such as descriptions of how most presidents in that period worked (he’s one of the least partisan people to have worked with most of them). The second half is a discussion of economics of rather mixed quality (both in terms of wisdom and ability to put the reader to sleep).
He comes across as a rather ordinary person whose private thoughts are little more interesting that his congressional testimony.
One of the strangest sections describes the problems he worried would result from a projected paydown of all federal government debt. He does claim to have been careful not to forget the possibility those forecasts could be mistaken. But his failure to mention ways that forecasts of Social Security deficits could be way off suggests he hasn’t learned much from that mistake.
He mentions a “conundrum” of falling long-term interest rates in 2004-2005, when he had expected that rising short-term rates would push up long-term rates. I find his main explanation rather weak (it involves technology induced job insecurity leading to lower inflation expectations). But he then goes on to describe a better explanation (but is vague about whether he believes it explains the conundrum): the massive savings increase caused largely by rapid growth in China. I suspect this is a powerful enough force that Deng Xiaoping deserves more credit than Greenspan for the results that inspired the label Maestro.
The book is often more notable for what it evades than what it says. It says nothing about his inflationary policies in 2003-2004 or his favorable comments about ARMs and how they contributed to the housing bubble.
He gives a brief explanation of how Ayn Rand converted him to an Objectivist by pointing out a flaw in his existing worldview, but he is vague about his drift away from Objectivism. His description of the 1995 government “shutdown” as a crisis is fairly strong evidence of a non-Randian worldview, but mostly he tries to avoid controversies between libertarianism and the policies of politicians he likes.
He often praises markets’ abilities to signal valuable information, yet when claiming that the invasion of Iraq was “about oil”, he neglects to mention the relevant market prices. Those prices appear to discredit his position (see Leigh, Wolfers and Zitzewitz’ paper What do Financial Markets Think of War in Iraq?).
He argues against new hedge fund regulations on the grounds that hedge funds change their positions faster than regulators can react. He is right about the regulations that he imagines, but it’s unfortunate that he stops there. The biggest financial problems involve positions that can’t be liquidated in a few weeks. It seem like it ought to be possible for accounting standards to provide better ways for institutions to communicate to their investors how leveraged they are and how sensitive their equity is to changes in important economic variables.
He argues against using econometric models to set Fed policy, citing real problems with measuring things like NAIRU and GDP, but if he was really interested in scientifically optimizing Fed policy, why didn’t he try to create models based on more relevant and timelier data (such as from the ISM?) the way he did when he had a job that depended on providing business with useful measures? Maybe he couldn’t have become Fed chairman if he had that kind of desire.
I listened to the cd version of this book because I got it as a present and listening to it while driving had essentially no cost. I wouldn’t have bought it or read the dead tree version.

Early this week, the Federal Reserve Board lowered interest rates at an unexpected time by a surprisingly large amount.
I see three possible explanations, which I think are about equally likely.

  • The Fed has evidence that the economy is slowing more than markets have realized.
  • The Fed has evidence that some big financial institutions have troubles that are endangering the careers of some influential people, and is bailing out those institutions in hopes that those people will use their influence to enhance the job security of the people in charge of the Fed.
  • Bernanke isn’t interested in the kind of publicity he can get by maximizing the total number of rate cuts. He realizes that a steady, predictable series of small rate cuts doesn’t stimulate the economy as well as cutting rates far enough that it isn’t easy to predict that more rate cuts will be needed (for one thing, making further rate cuts predictable creates incentives to postpone borrowing to when rates are lower). If that’s what’s happening, it’s not going to work as well as he would like this time, because the markets think the Fed is following the predictable rate cut strategy that gives them publicity for doing something at the time that the average person is most concerned about recession.

In related news, Singapore has a system which is designed to stabilize the economy rather than to provide politicians with opportunities to claim credit for doing something about the economy.
China is imposing widespread price controls and suffering power shortages which hinder production. If China were like the U.S., I’d say it’s trying to recreate the experience the U.S. had in the early 1970s. But the way Chinese politics work, the central government probably will allow local authorities to use a lot of discretion in enforcing the price controls, so the price controls will probably only produce shortages in a few industries that are dominated by large state-owned firms.