The Lucas Roundtable

I wasn’t invited to participate, but since I have a blog I’ll put in my 2 cents worth anyway. In my view both sides of the debate are wrong. I disagree with pundits like DeLong, Krugman and Skidelsky, who have used this crisis to argue that mainstream macroeconomics is fundamentally flawed. Of course there are a few things I’d like to tweak, NGDP targeting rather than inflation targeting, for instance, but the basic building blocks of modern macro are sound. These include the need for explicit nominal targets for monetary policy, an assumption of efficient markets, and skepticism about using fiscal stimulus as a countercyclical tool. But what this crisis did clearly demonstrate is that most mainstream economists, indeed nearly all of them, do not know how to apply these tools to a real world crisis. Here are ten ideas from modern macro that were either mostly ignored, or almost universally ignored during the recent crisis. The first, third, and fourth are taken verbatim from Mishkin’s textbook summary of the “lessons” we have learned from modern macroeconomics:

1. It is dangerous always to associate the easing or the tightening of monetary policy with a fall or a rise in short-term nominal interest rates. (Mishkin, p. 606)

I think it’s fair to say that almost all economists, regardless of their ideological persuasion, agreed that monetary policy was “easy” or “accommodative” during late 2008. Not all did so because of low interest rates, but this was the most common piece of evidence that economists cited.

2. Because velocity can be erratic, the monetary aggregates are not a reliable indicator of the stance of monetary policy.

Friedman and Schwartz showed that money was extremely tight during the early 1930s, despite the fact that the monetary base rose sharply. And the broader monetary aggregates were discredited as policy indicators during the 1980s. It is not surprising that during a financial crisis there would be an increased demand for FDIC-insured deposits. And yet despite the fact that it is generally understood that neither interest rates nor the money supply are reliable policy indicators, almost all economists did rely on one or both in reaching a tragically misguided consensus that the stance of monetary policy was expansionary in 2008. So what does modern macro say are more reliable indicators?

3. Other asset prices besides those on short-term debt instruments contain important information about the stance of monetary policy because they are important elements in various monetary policy transmission mechanisms. (Mishkin p. 606)

During the crucial period from July to November 2008 almost all other policy indicators were signaling loud and clear that money was far too tight. Most importantly, the so-called TIPS spread, which is the gap between the yields on conventional and inflation indexed bonds, fell sharply. By September 15th, just before the fateful meeting where the Fed decided not to ease monetary policy, this spread had fallen to only 1.23% over 5 years, far below the Fed’s implicit inflation target. Even worse, the reason the Fed cited for inaction was that the risk of recession and high inflation were roughly balanced. So even though the Fed’s dual mandate means that in practice they focus on both inflation and real growth, and even though real growth was obviously slowing sharply, the Fed ignored market warnings of dramatically lower inflation and based its action on the assumption that the real risk was high inflation.

There were plenty of other indicators that the Fed also ignored during late 2008. Real interest rates rose sharply between July and November, stock prices crashed, as did commodity prices. The dollar soared in value against the euro. Indeed during this period it is difficult to find a single asset price that wasn’t telling the Fed that policy was far too contractionary for the needs of the economy.

4. Monetary policy can be highly effective in reviving a weak economy even if short term rates are already near zero. (Mishkin p. 606)

Because I have been teaching this idea from the most popular money book on the market, I was stunned when the crisis hit to discover that very few economists actually believed what Mishkin wrote. Over and over again we heard that because monetary policy was no longer effective, we needed to resort to fiscal stimulus. John Cochrane effectively summarized my bewilderment:

Some economists tell me, “Yes, all our models, data, and analysis and experience for the last 40 years say fiscal stimulus doesn’t work, but don’t you really believe it anyway?” This is an astonishing attitude. How can a scientist “believe” something different than what he or she spends a career writing and teaching? At a minimum policy-makers shouldn’t put much weight on such “beliefs,” since they explicitly don’t represent expert scientific inquiry.

And in my case it wasn’t just fiscal policy, the profession ignored much of what we know about a whole range of issues. Indeed when I debated John Cochrane recently he seemed to accept the widespread assumption that monetary policy was easy last fall, despite all the key indicators showing exactly the opposite.

5. The decision to double reserve requirements in 1936-37 delayed the recovery from the Great Depression. This shows that during a depression the Fed should never institute a policy that has the effect of increasing the demand for reserves.

All economists who study monetary economics are exposed to this famous example from Friedman and Schwartz’s Monetary History. And yet for some inexplicable reason when the Fed started a policy of paying banks to hold on to excess reserves last October 6th, there was hardly a murmur of protest from academic economists. A few economists such as Robert Hall, James Hamilton and Earl Thompson did discuss the potential contractionary impact of the plan, and Hall and Woodward even called the Fed’s explanation “a confession of contractionary intent.” That is, the Fed began paying interest on reserves in an attempt to prevent the fed funds rate from falling below their target of 2%. In fact, the Fed still pays interest on bank reserves at a rate higher than they can earn on 3 month T-bills, which insures that any quantitative easing will have little impact on aggregate demand. Not surprisingly, the program has led banks to hoard almost all of the money that the Fed has injected into the economy over the past year.

6. Monetary policy should “target the forecast.”

Lars Svensson is the economist most associated with this eminently practical suggestion. The basic idea is that since both nominal interest rates and the money supply are not reliable policy indicators, and since monetary policy affects the broader economy with a lag, the Fed should always set policy such that their forecast of the goal variable is equal to their target for the goal variable. Bernanke has expressed similar views for the Fed’s longer term forecasts. Earlier I mentioned that TIPS spreads signaled money was too tight in mid-September. Not all economists favor targeting market forecasts. But surely no one could disagree with Svensson’s view that policy should never be set at a level where the policymakers themselves expected it to fail? Unfortunately, that is in fact exactly what the Fed has done since late September last year. The expected growth in prices and output, or nominal GDP, is far below any reasonable estimate of the Fed’s implicit policy target or targets. Even though we don’t know precisely what the Fed is aiming for, once Bernanke called for fiscal stimulus there can be little doubt that he expected aggregate demand to fall far short of the Fed’s goals. And of course he was right. But then why didn’t the Fed adopt a more expansionary policy stance in late 2008?

7. Markets are efficient, and thus asset prices incorporate the optimal forecast of economic variables.

Some economist will argue that the Fed dared not adopt a more aggressively expansionary policy stance (as if their current policy was actually expansionary) because of the fear of an “inflationary time bomb” due to “long and variable policy lags.” This aspect of monetarism was discredited long ago, as it is entirely inconsistent with efficient markets. Indeed the few modern monetarists who do still adhere to this view state quite explicitly that they don’t believe that the implied inflation forecast in the bond market is right. Even though the indexed bond market is now signaling low inflation, they insist that the real danger is high inflation. What puzzles me is the fact that so many non-monetarists have seemed to have at least implicitly accepted this discredited view, and are willing to give the Fed a pass for not targeting the forecast, not adopting a policy that they expected would succeed.

8. The economy will be more stable if the Fed engages in “level targeting” rather than a “memory-less” policy of targeting the rate of inflation.

Almost every time there is a major collapse in aggregate demand, it is associated with a sharp change in the expected trajectory of prices and nominal GDP going several years forward. This occurred in late 1920, late 1929, late 1937, late 1981, and late 2008. In 1920 and 1981 the contraction was at least partly intentional, an attempt to slow inflation. In 1929, 1937, and 2008, however, there was a major loss of monetary policy credibility. Investors suddenly lost trust in the Fed’s ability to maintain adequate nominal spending growth going forward. And in each case the markets were correct.

Modern macro theory (developed by Michael Woodford and others) emphasizes that the single most important factor influencing today’s aggregate demand is the expected future path of demand. Prices and/or nominal spending will not fall sharply if the Fed has a credible policy to target the future path of prices or nominal spending. Thus if the Fed targets a price level path that rises 2% per year, and the actual price level falls 1% (3% below target) then the following year they would target much higher than 2% inflation in order to start catching up to the trend. But if the market understands this then velocity will not fall sharply, as each decline in prices increases expected inflation and reduces real interest rates. Of course (as President Bush found out when he issued a warning to Iraq only after they had invaded Kuwait), this policy is only effective if credible and explicit. Current Fed policy is neither. The markets correctly understand that although prices and nominal spending have fallen far below the Fed’s implicit target over the past 12 months, the Fed is quite content to let them fall even further below over the next 12 months. Almost no one expects 2% inflation in the next few years. We will never resume the previous trend line for prices and NGDP; instead we will eventually get on a new and lower trend line. Adjustments of this sort are always extremely painful.

9. We cannot rely on Keynesian economics to provide reliable fiscal multipliers.

Many commentators have discussed problems such as crowding out and Ricardian equivalence. But few economists have mentioned the most troublesome issue at all–monetary policy counterfactuals. There is no scientific way of estimating a fiscal multiplier because there is no scientific way of establishing the monetary policy that would be adopted with and without fiscal stimulus. One reason why fiscal stimulus was almost completely eclipsed by monetary policy in the so-called new Keynesian period (1982-2007) was because if you are using monetary policy to target inflation, then the expected fiscal multiplier should always be precisely zero. For instance, suppose the Fed always adjusts policy to keep expected inflation at 2%. In that case if fiscal expansion were expected to boost AD and inflation, the Fed would neutralize its impact through tighter money.

Some Keynesians like Paul Krugman have dismissed this problem, arguing that it implausible that Bernanke would offset the expansionary impact of fiscal stimulus in the current environment. Krugman then argues that fiscal stimulus has saved us from another Depression. But is this view really as reasonable as Krugman makes it seem? Logically Krugman is correct if and only if at least one of the following two assertions is true:

1. Monetary policy is ineffective at the zero bound.

2. In the absence of fiscal stimulus Ben Bernanke would have preferred to allow another Great Depression, rather than aggressively pursue some of the unconventional monetary policies that he had earlier recommended to the Japanese.

I find both assumptions highly improbable. Because I believe fiscal stimulus is relatively ineffective, and because I am confident that Bernanke would have pursued a much more expansionary policy in the absence of fiscal stimulus, I think it likely that the fiscal stimulus actually retarded the recovery. However I’d be the first to admit that there is no way of knowing how all these policy counterfactuals would have played out. In any case, we have no reliable way of estimating fiscal multipliers

10. The real problem isn’t real, it’s nominal.

Above all else, the current crisis represents a failure of imagination of the economics profession. If there is one thing we have learned from studying other periods of history, and other countries, it is that up close a deflationary economic crisis never looks like it was caused by tight money. It always seems to be something else. And this is not surprising, after all, no sensible central banker would every intentionally create an economic crisis. In both the US in the 1930s, and Japan in the late 1990s, local observers saw the problem as financial, not monetary. Only with the perspective of time (Friedman and Schwartz) or distance (Bernanke looking at the situation in Japan) did it become obvious that if nominal GDP and prices were falling, then money must be too tight relative to the demand for money.

The biggest failure of modern macro in this crisis wasn’t the abstract models; they provided all the tools we needed. Indeed one could argue that even David Hume could have understood why the Fed’s reserve injections failed:

“If the coin be locked up in chests, it is the same thing with regard to prices, as if it were annihilated.” David Hume — Of Money

And let’s not forget that Irving Fisher warned us that if prices starting falling during a debt crisis we needed to reflate with an explicit price level target. Instead, it was a failure to look beyond the headlines, a failure to think about what our models were telling us about monetary policy. We should have known from Friedman and Schwartz not to confuse a problem (falling nominal spending) with the symptoms of that problem (stock market crash, failing banks, etc.)

Unfortunately, the current Fed chairman drew the wrong conclusions from his study of the Depression. Bernanke saw the credit channel as key, and thus assumed that recovery could not occur until the banks were rescued. In fact, this precisely reversed causality. Every policy Bernanke tried was also tried during the Herbert Hoover administration—sharp cuts in interest rates, a massive increase in the monetary base, and (in 1932) a bank rescue program. And all failed miserably. Only when FDR came in to office and promised a much higher price level and aggressively began devaluing the dollar, did we get a recovery. Indeed in his first 4 months in office wholesale prices rose 14% and industrial production rose 57%. And all of this occurred when much of the US banking system was shutdown. So much for the view that a financial crisis is a “real shock” that cannot be papered over with higher nominal spending.

In fact, our current recession is roughly what any elite macroeconomist would have expected if told that because of a tight money policy NGDP was going to suddenly start falling at nearly a 5% annual rate in an economy with no banking crisis at all. The banking crisis may have made things a bit worse, but there is no credible evidence for that assumption.

Modern macro theory provides lots of what Lars Svensson called “foolproof” escape strategies for a liquidity trap. We have always known how to boost nominal aggregates if we got desperate enough, but unfortunately we relied on the same policy tools that had proved ineffective in the early 1930s, and more recently in Japan. Despite all our arrogant claims that we knew much more than the Americans of the 1930s, or the Japanese of the 1990s, we made the same mistakes. We also assumed policy was expansionary when it was not. And what makes it especially inexcusable is that we really do know more that economists did in the 1930s. We don’t need better theoretical tools; we need economists with better judgment about how to apply those tools to real world problems. Economists who don’t blandly assume that money is easy when rates are low and the base is rising fast. Economists who aren’t so blinded by news stories about a collapsing financial system that they are unable to look beyond the headlines to the deeper policy failures.

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