Questioning the Assumptions of Modern Monetary Economics

Amid the carnage in the financial markets and the related response by the Fed, Edmund Phelps steps back to question modern monetary economics:

In recent times, most economists have pretended that the economy is essentially predictable and understandable...Today we are seeing consequences of this conceit in... central banking. "[R]ule-based" monetary policy, by considering uncertain knowledge to be certain knowledge, [is] taking us in a hazardous direction.

[...]

In the 1970s... a new school of neo-neoclassical economists proposed that the market economy, though noisy, was basically predictable. All the risks in the economy, it was claimed, are driven by purely random shocks -- like coin throws -- subject to known probabilities, and not by innovations whose uncertain effects cannot be predicted.

This model took hold in American economics and soon practitioners sought to apply it... Policy rules based on this model were adopted at the Federal Reserve and other central banks.

The neo-neoclassicals claimed big benefits from these changes... They asserted a decline in "volatility" in the U.S. economy and credited it to the monetary policy rules at the Fed.

Current experience is putting these claims to the test.

[...]

The claim for rule-based monetary policy is weak on its face. In deciding on the short-term interest rate it controls (the Fed funds rate) the Federal Reserve thinks about the "natural" interest rate -- the rate needed if inflation is neither to rise nor fall. Then the Fed asks whether the expected inflation rate is above or below the target. The Fed also asks whether the unemployment rate is above or below the medium-run "natural" unemployment level -- the level to which sooner or later the actual rate will return.

But the medium-run natural unemployment rate and the natural interest rate are anything but certain...

The Fed's view seems to be that the medium-term natural unemployment rate is stable. Thus the rise of actual unemployment in the past year is wholly or largely temporary... Yet there are good reasons why the medium-term natural unemployment rate may be a lot higher now than before...The Fed's view [also] seems to be that the natural interest rate has decreased with the business downturn. But this too is uncertain...

Phelp's discussion boils down to a RBC vs. New Keynesian interpretation of current events. He is arguing that maybe the economy is not temporarily deviating from its long-run trend growth path, but rather there has been a permanent shift. If so, then assumptions about the natural rate of interest and full employment can be way off the mark leading to distortionary monetary policies by the Fed.

Phelp's concern about a falling natural rate of interest seems particularly compelling at this time. Robert Gordon (via Michael Mandel) believes the productivity boom of the 1995-2004 is over. Since productivity is a key determinant of the natural interest rate, it stands to reason that the natural interest rate has fallen. This development would imply recent Fed actions may have a distortionary effect down the road. Below is a graph of trend productivity from Robert Gordon:

Something to Think About as You Wait for Your Rebate Check

Commodity Bubble?

I previously asked whether the next bubble will be in commodities. Yves Smith has chimed in on this discussion over at Naked Capitalism in light of a recent article in the Telegraph titled "Fears of a Commodity Crash Grow." One excerpt from Smith:

[The author of the article,] Evans-Prichard [,] is not saying that commodities will go into a long-term decline. However, given a 20% runup in many indices in a mere two months after a 30+% increase last year, some observers deem the market to be overbought and due for a correction. Evans-Pritchard points out that if you believe that the US and Europe are going to enter a recession (insiders believe that European financial institutions will soon see the kind of stress their US peers have suffered), Chinese demand isn't strong enough to justify continued robust prices (ex agriculture).

As parting food for thought, I have posted below two graphs of the commodity-tracking CRB Index.

Forgot the 1970s Stagflation Comparisons, Think 1990s Japan

so says Stephen Roach, one of the more prescient economists from Wall Street.

Double Bubble Trouble

AMID increasingly turbulent credit markets and ever-weaker reports on the economy, the Federal Reserve has been unusually swift and determined in its lowering of the overnight lending rate...

The central question for the economy is this: Will this medicine work? The same question was asked repeatedly in Japan during its “lost decade” of the 1990s. Unfortunately, as was the case in Japan, the answer may be no.

If the American economy were entering a standard cyclical downturn, there would be good reason to believe that a timely countercyclical stimulus like that devised by Washington would be effective. But this is not a standard cyclical downturn. It is a post-bubble recession...

For asset-dependent, bubble-prone economies, a cyclical recovery — even when assisted by aggressive monetary and fiscal accommodation — isn’t a given. Over the past six years, income-short consumers made up for the weak increases in their paychecks by extracting equity from the housing bubble through cut-rate borrowing that was subsidized by the credit bubble. That game is now over...

Japan’s experience demonstrates how difficult it may be for traditional policies to ignite recovery after a bubble. In the early 1990s, Japan’s property and stock market bubbles burst. That implosion was worsened by a banking crisis and excess corporate debt. Nearly 20 years later, Japan is still struggling.

There are eerie similarities between the United States now and Japan then. The Bank of Japan ran an excessively accommodative monetary policy for most of the 1980s. In the United States, the Federal Reserve did the same thing beginning in the late 1990s. In both cases, loose money fueled liquidity booms that led to major bubbles...

Like their counterparts in Japan in the 1990s, American authorities may be deluding themselves into believing they can forestall the endgame of post-bubble adjustments. Government aid is being aimed, mistakenly, at maintaining unsustainably high rates of personal consumption. Yet that’s precisely what got the United States into this mess in the first place — pushing down the savings rate, fostering a huge trade deficit and stretching consumers to take on an untenable amount of debt...

American authorities, especially Federal Reserve officials, harbor the mistaken belief that swift action can forestall a Japan-like collapse. The greater imperative is to avoid toxic asset bubbles in the first place. Steeped in denial and engulfed by election-year myopia, Washington remains oblivious of the dangers ahead

Predicting Recessions

Here is an interesting article given my own research interest.

Financial Market Perceptions of Recession Risk
Thomas B. King, Andrew T. Levin, and Roberto Perli

Abstract: Over the Great Moderation period in the United States, we find that corporate credit spreads embed crucial information about the one-year-ahead probability of recession, as evidenced by both in- and out-of-sample fit. Furthermore, the incidence of "false positive" predictions of recession is dramatically reduced by utilizing a bivariate model that includes a measure of credit spreads along with the slope of the yield curve; indeed, these bivariate models provide much better forecasting performance than any combination of univariate models. We also find that optimal (Bayesian) model combination strongly dominates simple averaging of model forecasts in predicting recessions.

Structural Unemployment Anyone?

From the NY Times comes this figure depicting the geographic distribution of net employment gains for the 2000-2007 period. The Rusbelt, particularly Michigan, continues to bleed jobs...hello structural unemployment.

Robert Reich on NAFTA and Trade

A thoughtful approach to trade by Democrat Robert Reich--take note Obama and Hillary!

Hillary and Barack, Afta Nafta

... It’s a shame the Democratic candidates for president feel they have to make trade – specifically NAFTA – the enemy of blue-collar workers and the putative cause of their difficulties. NAFTA is not to blame...

NAFTA has become a symbol for the mounting insecurities felt by blue-collar Americans. While the overall benefits from free trade far exceed the costs, and the winners from trade (including all of us consumers who get cheaper goods and services because of it) far exceed the losers, there’s a big problem: The costs fall disproportionately on the losers -- mostly blue-collar workers who get dumped because their jobs can be done more cheaply by someone abroad who’ll do it for a fraction of the American wage. The losers usually get new jobs eventually but the new jobs are typically in the local service economy and they pay far less than the ones lost

Even though the winners from free trade could theoretically compensate the losers and still come out ahead, they don’t. America doesn’t have a system for helping job losers find new jobs that pay about the same as the ones they’ve lost – regardless of whether the loss was because of trade or automation. There’s no national retraining system. Unemployment insurance reaches fewer than 40 percent of people who lose their jobs – a smaller percentage than when the unemployment system was designed seventy years ago. We have no national health care system to cover job losers and their families. There's no wage insurance. Nothing. And unless or until America finds a way to help the losers, the backlash against trade is only going to grow.

Get me? The Dems shouldn't be redebating NAFTA. They should be debating how to help Americans adapt to a new economy in which no job is safe...

Update
Lane Kenworthy makes a similar case in his call to "embrace economic change."