Where Angels Fear To Tread

The ever so genteel Ramesh Ponnuru makes the mistake of replying to the Walking Rothbardian Dead.  

P.S. Here is my take on the Ponnuru piece that started all of this commotion.

Christina Romer: We Need A Regime Change at the Fed

Christina Romer does the Five Books interview and one of her recommended reads is a famous article by Peter Temin and Barry Wigmore titled "The End of One Big Deflation."  This is a great choice since it shows that even in a "balance sheet recession" facing a binding zero percent lower bound, monetary policy can still be very effective by managing expectations.  The key is to radically shift expectations.  Here is Romer discussing the implications of this article for today:

What we learned from the Temin and Wigmore paper is that one way out of a recession at the zero lower bound is by changing expectations. To do that, often what is needed is a very strong change in policy – something economists call a “regime shift”. The most effective way to shake an economy out of a terrible downturn when we’re at the zero lower bound is an aggressive change in policy that makes people wake up, say “this is a new day” and change their expectations. What the Fed has done since early 2009 is much more of an incremental change.

In other words, the Fed has failed to appropriately manage expectations and so we are stuck in a slump.  And I am not convinced that it is now doing any better with its new long-run forecasts of the federal funds rate.  So what in the current environment would rise to the level of a "regime shift"?  What would change expectations enough to catalyze a broad-based recovery in aggregate demand?  Here is Romer's answer: 

I think that what the Fed needs instead is a regime shift. A number of economists have suggested that the Fed adopt a new framework for monetary policy, like targeting a path for nominal GDP. If the Fed adopted such a nominal GDP target, they would start in some normal year before the crisis and say nominal GDP should have grown at a steady rate since then. Compared with that baseline, nominal GDP is dramatically lower today. Pledging to get back to the pre-crisis path for nominal GDP would commit the Fed to much more aggressive policy – perhaps more quantitative easing and deliberate actions to talk down the dollar. Such a strong change in the policy framework could have a dramatic effect on expectations, and hence on the behavior of consumers and businesses.

Such a regime shift would require Bernanke to man up and have his own Volker moment, as previously noted by Romer.  It would be a huge change and that is the point.  A big shock to public expectations, one that would meaningfully change the expected path of future aggregate nominal spending, could be created by a public commitment to a nominal GDP level target.  This is just the medicine the U.S. economy needs right now.  

P.S. No, a nominal GDP level target would not unmoor long-run inflation expectations and it would not depend on a bank lending to work.

P.P.S. Yes, there is evidence for nominal GDP expectations mattering for subsequent NGDP growth.  Here is how I think it would actually unfold. 

The New York Fed Acknowledges the Fed's Superpower Status

I have made the case many times that the Fed is a monetary superpower.  It controls the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Consequently, its monetary policy gets exported across much of the globe. The other two monetary powers, the ECB and the Bank of Japan, are therefore mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well.  This understanding implies the Fed helped fuel excessive global liquidity in the early-to-mid 2000s, but now it is doing the opposite with its passive tightening of monetary policy.

This understanding also weaves nicely into the shortage of safe assets story.  Back in the early-to-mid 2000s the Fed's loose monetary policy meant dollar-peggers had to buy up  more dollars to maintain their pegs.  These economies then used the dollars to buy up U.S. debt. This increased the demand for safe assets and further drove down yields.  Fast forward to late 2008. The Fed fails to prevent the collapse of NGDP and never attempts to fully restore it to some reasonable pre-crisis path.  This causes the destruction of many safe assets and thus further exacerbates the safe-asset problem.   Now these developments are only the cyclical part of the safe asset problem--there was also a structural shift in demand for safe assets coming the emerging world--but it is an important part of the story.

I bring this up because Andrea Ferrero of the New York Fed has a new paper that makes a similar argument.  He, however, uses more formal modeling than me and notes the implications for the current account deficits.  He is careful not to say the Fed's monetary superpower status was the only factor, yet finds that it was quantitatively important.  Here is an Ferrero:

[T]hese [pegging] countries import U.S. monetary policy so that low U.S. interest rates lead to low global interest rates. The quantitative analysis shows that foreign pegs, coupled with over-expansionary U.S. monetary policy, exert additional downward pressure on the real interest rate and impair a real depreciation of the dollar that would help rebalance the U.S. current account de cit.  Taken together, the relaxation of borrowing constraints and low interest rates in the U.S. coupled with foreign pegs account for about two-thirds of the increase in real house prices and almost one-half of the deterioration of the current account during the first half of the 2000s. These quantitative findings complement the role of other factors in accounting for the correlation between the house price boom and the deterioration of the current account in the U.S. during the early 2000s.

As noted above, the flip side of this argument is that Fed is now being too tight for the global economy, at least passively.

Ramesh Ponnuru, Ron Paul, and the Gold Standard

Ramesh Ponnuru has a new article on Ron Paul's monetary economics.  It is a great read throughout that highlights some of the problems with Ron Paul's views.  Among other things, Ponnuru explains many of the well-known problems of the gold standard and its role in making the Great Depression so great.  Here is an excerpt (my bold):

Representative Paul’s strategy for dealing with the theoretical and historical arguments against the gold standard in End the Fed is to ignore all of them. All he says is that problems arose in the 1930s because of the “misuse of the gold standard.” But note that the great advantage of the gold standard is supposed to be that governments cannot manipulate it. Concede that they can and the argument is half lost.

That is an important point.  If the interwar gold standard did not work because France and United States were not playing by the rules of the game, why do we think countries would be any better behaved today?  Would the U.S. political process really be able to tolerate the requirements of a gold standard?  I do not see it happening.  This is especially true if the gold standard covered an area that was not an optimal currency area.  Look no further than the current Eurozone crisis or the UK  leaving the European Monetary System in 1992.  Both demonstrate how difficult it is to maintain a fixed exchange rate monetary system when internal economic concerns conflict with external ones.  

P.S. Kurt Schuler probably will not be happy with this post of mine either.  

P.PS.  George Selgin proposes an innovative solution to some of the gold standard problems in his quasi-commodity standard.

Some Thoughts for St. Louis Fed's James Bullard

David Andolfatto recently discussed an interesting speech by St. Louis Fed president James Bullard:

I think that Bullard makes a persuasive case that the amount of household wealth evaporated along with the crash in house prices should likely be viewed as a "permanent" (highly persistent) negative wealth shock. Standard theory (and common sense) suggests a corresponding permanent decline in consumer spending (with consumption growing along its original growth path). The implication is that the so-called "output gap" (the difference between actual and "trend" GDP) may be greatly overstated by conventional measures.

To some extent the CBO agrees with Bullard.  They have adjusted their potential real GDP estimates below pre-crisis trend path values.  Still, there remains a large output gap, one that Bullard finds questionable given the negative wealth shock.  So how much is the output gap is overstated?  And how do  we know which measure of the output gap to trust?  These are hard questions and I am not sure they are even the right ones to be asking.  I believe a more constructive approach is to consider whether there still remains monetary problems that could be addressed by monetary policy.  

To begin thinking about whether monetary problems remain, and doing so in light of Bullard's concens about a negative wealth shock, consider the figure below.  It shows for the years 1952:Q1 - 2011:Q4 the percent change from a year ago of  households net worth plotted against the change from a year a ago of households liquid asset share (i.e. currency, checking accounts, saving and time deposits, retail money market funds, and treasuries as a percent of total household assets).  This liquid asset share can be interpreted as a measure of household money demand.

 Source

There is a strong negative relationship here that suggests positive household money demand shocks tend to pull down household net worth.  And currently households are maintaining unusually high shares of liquid assets in their portfolios, indicating there has been series of positive money demand shocks:

Source

In other words, some of the negative wealth shock mentioned by Bullard is probably tied to the elevated money demand by households.  Another way of viewing this issue is that household have adjusted their portfolios toward highly liquid, safe assets.  Is this a problem could the Fed could fix?  Yes.  Through proper expectations management the Fed could cause households to start rebalancing their portfolios toward more normal levels.  Josh Hendrickson and I have a paper that provides systematic evidence on the link between household portfolio rebalancing and aggregate nominal spending.  The Fed has influence here and armed with something like a nominal GDP level target it could do wonders in catalyzing massive portfolio rebalancing by households.  (And no, bank lending is not necessary for the rebalancing of household portfolios and no, long-term inflation expectations would not become unmoored since this is a level target.)

Household's elevated demand for retail money assets, however, is only part of the current monetary problem.  There is also an elevated demand by large institutional investors for transaction assets that facilitate exchange (commercial paper, treasuries, repos, large-time deposits, institutional money market funds, etc.).  Unlike retail money assets, though, which have grown in response to the spike in retail money demand, the problem here is that the elevated demand for institutional money assets has occurred as their supply has fallen.  This can be seen in the following figure that shows monetary divisia aggregates through M4. These measures include the retail money assets but also institutional money assests (i.e. M4 divisia = M2 assets plus commercial paper, treasuries, repos, large-time deposits, institutional money market funds weighted appropriately). 

Center for Financial Stability

Since M2 has risen, the reason for the M4 divisia decline in the reduction of institutional money assets.  As I have argued before, the failure of the Fed to restore nominal incomes to their pre-crisis expected path (even after accounting for the slightly higher levels during the housing boom) both reduced institutional money assets while increasing the demand for them.  The Fed could breach this gap by adopting a nominal GDP level target that restored aggregate nominal income to a reasonable pre-crisis path. This should be the focus of James Bullard's efforts.  Forget the output gap, start worrying about the aggregate nominal income gap.

P.S. Josh Hendrickson has a forthcoming paper where he shows that the Great Moderation can be traced to the Fed effectively targeting nominal income.  The failure of the of the Fed to keep doing so in late 2008, early 2009 explains many of our economic problems today.   

Can Raising Interest Rates Spark a Robust Recovery?

Could the Fed spark a robust recovery by raising its federal funds rate target?  For Bill Gross the answer is yes.  He believes a key reason holding back the recovery is that the Fed is engaged in a type of financial repression where financial intermediaries' net interest margins--the difference between their funding costs and lending interest rates--are being squeezed by the Fed's low interest rate policies.  He sees the Fed driving down interest rates across the yield curve and thus removing the incentive for lending.  If only it were that easy.

The Cyclical Dimension of the Safe Asset Problem

An important problem facing the global economy is the shortage of safe assets, assets that facilitate transactions at both the retail and institutional level.  There is both a long-term, structural dimension to this problem as well as a short-term, cyclical one.  The structural dimension is that global economic growth over the past few decades has outpaced the capacity of the world economy to produce truly safe assets, a point first noted by Ricardo Cabellero.  The cyclical dimension is that the shortage of safe assets was intensified by the Great Recession, a point stressed by Gary Gorton.  I previously made the case that both the Fed and the ECB were an important part of the cyclical story by failing to restore nominal incomes to their expected, pre-crisis paths.  In other words, since 2008 the Fed and the ECB passively tightened monetary policy which caused some of the safe assets to disappear while at the same time increasing the demand for them. 

I still hold this view, but after reading some papers on safe assets and talking with Josh Hendrickson I have come up with a more general view to the cyclical dimension of the safe asset problem. It goes as follows.

Gorton, Lewellen, and Metrick (2012) show that safe assets have constituted a relative stable share of all assets since the 1950s. They also show, as does Bansal, Coleman, and Lundblad (2011), that public and private safe assets tend to act as substitutes in providing liquidity services.  Given these findings, it stands to reason that when the central bank is doing its job and nominal GDP (NGDP) is growing at its appropriate trend, then there will be enough safe assets being privately provided.  If, however, the central bank slips and NGDP falls below its expected path, then some of the privately produced safe assets disappear, creating a shortage of safe assets. The government steps in and creates safe assets that, if produced sufficiently, would restore NGDP back to its expected path. In other words, if monetary policy does not do its job then fiscal policy could substitute for it, but in a way not normally imagined. It would do so not by increasing aggregate demand via higher government spending, but by making up for the shortage of safe assets that facilitate transactions.  All this requires is running a budget deficit which may or may not imply higher government spending (i.e. it could also come from tax cuts).  Debates about Ricardian equivalence, crowding out, and other fiscal policy concerns become moot.  What matters is if there are enough safe assets, and if not, whether fiscal policy can provide them in the absence of a NGDP-stabilizing monetary policy. 

This understanding may serve as the basis for a paper, so I look forward to any feedback you can provide.