Macro and Other Market Musings

Narayana Kocherlakota on Safe Assets and the Natural Interest Rate

noreply@blogger.com (David Beckworth) — Fri, 17 May 2013 23:17:00 +0000

Narayana Kocherlakota, President of the Minneapolis Fed, recently participated in a panel where he discussed the key challenges facing central banks. He viewed the safe asset shortage and the related inability of the Fed to push the actual market rate down to its natural interest rate level as problem number one. Readers of this blog know I completely agree with his assessment. I also agree with him that the reason this problem persists is that the zero lower bound is preventing the safe asset market from clearing.

Where we part ways is whether the Fed can solve this problem and its implications for financial stability. First, Kocherlakota does not seem to think there is much more the Fed can do where I believe the Fed through a "shock and awe" program could solve the safe asset shortage. The early results of Abenomics appear to support my view. The Fed, in conjunction with the U.S. Treasury Department, could also resolve this problem through a "helicopter drop". Though not my first choice, I would be fine with this approach as long as it were tied to a NGDP level target or some other nominal anchor. So the Fed is not helpless here, but has just failed to do all it can.

Second, he believes the Fed's attempt to push rates down to the neutral rate level may create financial instability. I disagree. The Fed is not causing financial instability because it is not the reasons interest rates are now low. The weak economy and resulting safe asset shortage is the reason interest rates are low. The Fed's share of marketable treasuries, for example, has been and is about 15%. That means most of the run up in public debt has been funded by you, me, and our financial intermediaries. If the low interest rates are causing an unnatural reach for yield, then blame us not the Fed. The Fed simply is playing catch up to the low interest rate environment we have created. Financial instability is more likely to emerge if the Fed were somehow able to temporarily lower the target federal funds rate below the natural interest rate as it did in 2002-2004. We are far from that situation now.

Okay, enough of my views. Here is Kocherlakota (my bold):

In my view, the biggest challenge for central banks—especially here in the United States—is changes in the nature of asset demand and asset supply since 2007. Those changes are shaping current monetary policy—and are likely to shape policy for some time to come.

Let me elaborate. The demand for safe financial assets has grown greatly since 2007. This increased demand stems from many sources, but I’ll mention what I see as the most obvious one. As of 2007, the United States had just gone through nearly 25 years of macroeconomic tranquility. As a consequence, relatively few people in the United States saw a severe macroeconomic shock as possible. However, in the wake of the Great Recession and the Not-So-Great Recovery, the story is different. Workers and businesses want to hold more safe assets as a way to self-insure against this enhanced macroeconomic risk.

At the same time, the supply of the assets perceived to be safe has shrunk over the past six years. Americans—and many others around the world—thought in 2007 that it was highly unlikely that American residential land, and assets backed by land, could ever fall in value by 30 percent. They no longer think that. Similarly, investors around the world viewed all forms of European sovereign debt as a safe investment. They no longer think that either.

The increase in asset demand, combined with the fall in asset supply, implies that households and firms spend less at any level of the real interest rate—that is, the interest rate net of anticipated inflation. It follows that the Federal Open Market Committee (FOMC) can only meet its congressionally mandated objectives for employment and prices by taking actions that lower the real interest rate relative to its 2007 level. The FOMC has responded to this challenge by providing a historically unprecedented amount of monetary accommodation. But the outlook for prices and employment is that they will remain too low over the next two to three years relative to the FOMC’s objectives. Despite its actions, the FOMC has still not lowered the real interest rate sufficiently in light of the changes in asset demand and asset supply that I’ve described.

Great points!

Abenomics and the Supply of Safe Assets

noreply@blogger.com (David Beckworth) — Fri, 17 May 2013 02:25:00 +0000

One of the big challenges facing the global economy is the shortage of safe assets. These are the highly liquid, information-insensitive assets that function as money. The financial crisis raised the demand for these safe assets just as many of them were disappearing. This cyclically-driven safe asset shortage (or excess money demand) that emerged continues to this day and is why aggregate demand in many countries remain depressed.¹

The figure below illustrates this problem for the United States. It shows the Gorton et. al.(2012) safe assets measure along with the amount of safe assets needed to hit the pre-crisis trend growth path for NGDP as well as the CBO's full-employment level of NGDP.² It shows an ongoing gap that is preventing a robust recovery from occurring.

The big question, then, is how to restore an adequate supply of safe assets. Given the Triffin Dilemma, I have argued the only sustainable way this can happen is if the public's perception about the safety of private debt improves and thus raises investors' demand for it. In other words, the relatively high risk premium on private debt relative to treasuries must come down so that private securities can be view as more safe and used as money. But how?

My answer, which assumes that the relatively high risk premium is result of excessive pessimism, is that we need a major slap to the market's face. Something that would "shock and awe" investors into more normal portofolio holdings and along the way spur aggregate demand. I claimed an aggressive NGDP level target that significantly raised expected nominal income growth would do just that. It would both reduce the excess demand for safe assets (because of greater nominal income certainty going forward) and at the same time catalyze financial firms into making private safe assets (because of the improved economic outlook and the related increased demand for financial intermediation).

The only problem with my story is that it seemed it would never get tested. But that was before Abenomics. Though it doesn't target NGDP, Abenomics does create a radical departure from past economic policy in Japan. Among other things, it has committed the Bank of Japan to open-ended asset purchases until inflation hits 2% and the monetary base doubles. This has provided a significant jolt to expectations, a big regime change that should catalyze the demand for and supply of privately-created safe assets if my story has merit.

So what has happened? Is there any evidence that Abenomics is catalyzing a major portfolio rebalancing that is leading to more privately-created safe assets? On the portfolio rebalancing front, circumstantial evidence suggests that answer is yes. The figure below shows the 10-year government yield in Japan is sharply rising. This indicates investors are, at a rapid pace, starting to move out of government debt and into other assets:

And it appears that those other assets investors are moving into include private debt. The figure below shows an average CDS spread equally weighted over 50 Japanese corporate bonds. This risk premium measure on corporate securities shows a rapid decline since the beginning of 2013, a sign that portfolios are rebalancing toward corporate debt.

But what about safe asset creation? Is there evidence that Abenomics has also catalyzed privately-produced safe assets? To answer this question we turn to the broadest measure of money, L, that is tracked by the Bank of Japan. The L money supply includes both retail and institutional money assets and is similar in scope to the U.S. M4 money supply tracked by the Center for Financial Stability. If privately-created safe assets were increasing in response to Abenomics we would expect to see it in this measure. And we do, as seen in the figure below:

This figure indicates that the right kind of QE can actually increase the supply of safe assets. Many observers think that QE simply swaps one safe assets for another with no effect. But the right kind of QE--one that leads investors to expect a permanent increase in the monetary base--can raise the supply of safe asses and help shore up a strong economic recovery for a depressed economy. It worked for FDR in 1933 and it appears to be working for Shinzo Abe in 2013.

With all that said, Abenomics is in its early stages and a lot could still go wrong. So this preliminary evidence may not be the last word.

¹There is also a structural safe asset problem that has been in play well before the crisis began. This safe asset shortage problem is the consequence of the world economy growing faster than the global capacity to produce safe assets.

²The amount of safe assets needed to hit the pre-crisis trend NGDP path and CBO full-employment NGDP is calculated as follow. I solve for the optimal amount of money in the equation of exchange given an optimal amount of Nominal GDP (the pre-crisis trend and CBO values) and actual trend money (safe asset) velocity as estimated by the Hodrick-Prescott filter. That is, I am solving for M* in M^*_t= NGDP^*_t/V^*_t .

The Data Have a Market Monetarist's Bias

noreply@blogger.com (David Beckworth) — Tue, 14 May 2013 19:01:00 +0000

It almost seems unfair, as if the evidence is biased toward Market Monetarist's views. First it was the better-than-expected employment report last week and now it is the forecast-beating retail sales report. These developments should not be happening, especially now with sequestration, if the fiscal multiplier were large. But they are happening and underscore the case that the monetary policy can offset the drag of fiscal austerity.

This latest evidence for the Sumner Critique--the understanding that fiscal multiplier will be effectively zero when the central bank is stabilizing aggregate demand--should not be surprising since the Fed has been offsetting structural austerity since 2010, a fact lost on many Keynesian-minded folks. This post-2010 period is one of the great macroeconomic natural experiments now unfolding, pitting U.S. monetary policy against U.S. fiscal policy.¹

This multi-year natural experiment has not be lost on all observers. Jeff Spross of Think Progress takes note of it:

It hasn’t really made the front pages, but the United States recently began carrying out a massive and nearly unprecedented economic experiment, and 2013 looks to be the year when the results come in. The question is straightforward: When the economy is in a deep slump, and the government makes things worse by cutting spending, how much can monetary policy do to help? The answer could reshape the way we argue about economic policy, with profound implications for progressives’ economic priorities — and big opportunities, if they can seize them.

So far, progressives have tended to side with economists like Paul Krugman and bloggers like Mike Konczal. They argue that monetary policy is severely weakened at the zero lower bound...

But economists like David Beckworth and Scott Sumner countered that the economy’s 2.5 percent growth rate stuck around despite blows from multiple rounds of spending cuts, the European crisis, and worries about China. In fact, as Beckworth pointed out, government spending began shrinking by the start of 2010 — yet the economy just kept puttering along at 2.5 percent.

Other points in Beckworth and Sumner’s favor: Before sequestration, the latest round of across-the-board spending cuts, began, the group Macroeconomic Advisors projected growth for the first quarter below 2.5 percent if sequestration didn’t happen. Then the May 3 jobs report, which came out after Konczal’s piece, was so good it was almost shocking. Matt Yglesias and Ryan Avent, two other fans of monetary policy’s salutary effects, pointed to other data sources that suggest the Fed actually has been able to raise long-term inflation expectations. So this looks like at least a preliminary win for team monetary policy.

In my view, the most important insight from this "radical experiment" is not that monetary policy can effectively make the fiscal multiplier zero, but that it could be doing far more to shore up aggregate demand. The fact that the Fed has successfully offset structural fiscal austerity since 2010--as seen by the stable NGDP growth--suggest it could do far more. The Fed has made big strides with QE3, but has yet to unload both barrels of guns. It is time for a NGDP level target.

¹ The other, great macroeconomic experiment now unfolding is Abenomics in Japan.

Abenomics Confusion

noreply@blogger.com (David Beckworth) — Sun, 12 May 2013 21:28:00 +0000

Lars Christensen nails it on the confusion surrounding Abenomics:

There has been a lot of focus on the fact that USD/JPY has now broken above 100 and that the slide in the yen is going to have a positive impact on Japanese exports. In fact it seems like most commentators and economists think that the easing of monetary policy we have seen in Japan is about the exchange rate and the impact on Japanese “competitiveness”. I think this focus is completely wrong.

While I strongly believe that the policies being undertaken by the Bank of Japan at the moment is likely to significantly boost Japanese nominal GDP growth – and likely also real GDP in the near-term – I doubt that the main contribution to growth will come from exports. Instead I believe that we are likely to see is a boost to domestic demand and that will be the main driver of growth. Yes, we are likely to see an improvement in Japanese export growth, but it is not really the most important channel for how monetary easing works.

This story is not new. The abandonment of the interwar gold standard in the 1930s by many countries spurred domestic demand and was behind the subsequent sharp recoveries, not any export growth generated by the competitive devaluations. For if everyone is devaluing, there is no place to send additional exports. That was true in the 1930s and is true today.

With that said, the competitive devaluation arising from Abenomics may be the catalyst to kick start the ECB into more serious efforts if they care about the Eurozone's external competitiveness. The ECB may ease to keep the Euro from getting too expensive and in the process shore up European domestic demand. How ironic it would be if Abenomics were to accomplish in the Eurozone what intense human suffering could not: moving the ECB to forcefully act.

Balance Sheet Recessions Are Really Nominal Income Recessions

noreply@blogger.com (David Beckworth) — Fri, 10 May 2013 20:21:00 +0000

I recently lamented the Fed's ongoing dereliction of duty as seen in the sustained declined of households' expected nominal income growth:

In that post, I noted this observed decline was problematic for two reasons: (1) current nominal spending decisions are influenced by expected nominal income growth and (2) past nominal debt contracts were based on certain expectations of nominal income growth that did not happen. Here is what I specifically said on the latter point:

The figure also indicates that real debt burdens are higher than many households expected prior to the crisis. Look at the dashed line. It shows the average expected dollar income growth rate over the 'Great Moderation' period was 5.3%. Now imagine it is early-to-mid 2000s and you are taking out a 30-year mortgage and determining how much debt you handle. An important factor in this calculation is your expected income growth over the next 30 years. If you were average, then according to this data you would be forecasting about 5% growth rate. But that did not happened. Household dollar incomes declined and are expected to remain low. Nominal debt, however, has not adjusted as quickly leaving higher than expected real debt burdens for households.

An important implication of this development is that households' deleveraging over the past few years may not be so much about their weakened balance sheets as it is about the unexpected decline in their expected nominal income growth. Josh Hendrickson and I are working on a paper where we develop this point more fully and, among other things, report the figure below. It plots expected household nominal income growth against the percent change of nominal household debt:

This figure suggests that for households, expected dollar income growth matters a lot for deleveraging. It also implies "balance sheet recessions" are a byproduct of nominal income shortfalls. One policy implication, then, is that the Fed should have maintained aggregate nominal income growth at its expected path. It failed to do so in 2008 and has yet to fully make up for this shortfall.

I bring this up, because a new paper by Kevin D. Sheedy (hat tip Simon Wren-Lewis) shows that NGDP level targeting dominates inflation targeting for this very reason. It is much better at stabilizing the real debt burdens of households precisely because it is much better at stabilizing the growth path of nominal income. Here is his abstract:

Financial markets are incomplete, thus for many agents borrowing is possible only by accepting a financial contract that specifies a fixed repayment. However, the future income that will repay this debt is uncertain, so risk can be inefficiently distributed. This paper argues that a monetary policy of nominal GDP targeting can improve the functioning of incomplete financial markets when incomplete contracts are written in terms of money. By insulating agents' nominal incomes from aggregate real shocks, this policy effectively completes the market by stabilizing the ratio of debt to income. The paper argues that the objective of nominal GDP should receive substantial weight even in an environment with other frictions that have been used to justify a policy of strict inflation targeting.

Fed officials should take note. So should ECB officials since this finding is particularly poignant for the Eurozone. It is time to fully embrace NGDP level targeting.

The Seen and Unseen: Structural Budget Deficits Edition

noreply@blogger.com (David Beckworth) — Mon, 06 May 2013 03:00:00 +0000

On Friday I discussed the cyclically-adjusted U.S. budget deficit and asked any Keynesian to reconcile its decline with the steady growth of aggregate demand. Robert Waldman graciously replied, but he really didn't answer my question. His response focused on the pace of the recovery and changes in the overall budget balance. My question was about the structural budget balance. This distinction is an important one. So let me try this one more time.

The structural budget balance is the best way to gauge the stance of fiscal policy, as noted by Paul Krugman:

[M]easuring austerity is tricky. You can’t just use budget surpluses or deficits, because these are affected by the state of the economy. You can — and I often have — use “cyclically adjusted” budget balances, which are supposed to take account of this effect. This is better; however, these numbers depend on estimates of potential output, which themselves seem to be affected by business cycle developments. So the best measure, arguably, would look directly at policy changes. And it turns out that the IMF Fiscal Monitor provides us with those estimates, as a share of potential GDP...

Here is the IMF's cyclically-adjusted or structural budget balance for the United States:

So what does this figure tell us? It shows that fiscal policy, independent of business cycle influences, has been tightening since 2010. It has gone from a deficit of 8.5% in 2010 to an expected one of about 4.6% in 2013. In other words, the reduction in the federal budget deficit over the past three years is more than just the government adjusting its balance sheet in response to improvements in the private sector's balance sheet. It is also the result of explicit policy choices to impose fiscal austerity. And these explicit policy changes have been relatively sharp.

Many observers have overlooked the implications of this structural austerity experiment. Three years of explicit fiscal austerity in a depressed economy should, all else equal, lead to even more economic weakness. But it has not. Nominal GDP growth--a proxy for aggregate demand (AD) growth--has been remarkably steady. There is no evidence AD over the past three years has been adversely affected by this austerity. Friday's job report underscores this point.

So what explains this development? The answer is not that fiscal policy has no effect, but rather that all else is not being held equal for U.S. aggregate demand growth. Specifically, Fed policy has effectively responded to the fiscal austerity, Eurozone shocks, China slowdown shocks, and other shocks to AD. Though this is a great accomplishment, it is far from adequate and is ultimately frustrating to watch. For it speaks to both the power and shortcomings of current Fed policy.

It is not surprising to me that Keynesians and other observers fail to see this structural austerity. The Fed has offset it over the past three years and therefore kept it out of sight, out of mind. The ECB, on the other hand, has not and so it is more apparent to observers. But just because it is not seen, does not mean it is not there.

Pushback

noreply@blogger.com (David Beckworth) — Fri, 03 May 2013 23:42:00 +0000

Despite my enthusiasm about what today's employment report means, Josh Barro says it does not vindicate the Market Monetarist's view. Moreover, he believes we probably should not expect our view to ever be fully vindicated for political economy reasons:

Market monetarism, as advanced by [Ramesh] Ponnuru and the economist David Beckworth, among others, holds that aggressive monetary policy is a sufficient force to smooth out business cycles.And over the last year we’ve just had a mini-experiment along these lines. Congress and the president have imposed fiscal tightening by raising taxes and allowing sequestration’s haphazard spending cuts to come into effect. And the Federal Reserve has (with occasional tentativeness) gotten more aggressive in its easing, setting a specific target for unemployment and running an open-ended program of asset purchases since the fall.

The results so far are good but not great. Job growth is steady and economic growth is modest but positive. Sequestration’s human impacts are real, but a macroeconomic drag is not yet apparent. This looks a lot better than Europe, where the central bank hasn’t been so aggressive and many economies have slid back into recession. Yet we should worry about the limits of the market monetarist approach. Monetary and fiscal policy are both constrained by political forces, not just economic ones.

The political economy critique is a fair point. I remain optimistic, though, that QE3 will evolve to some kind of conditional monthly asset purchasing program where the Fed changes the size of the asset purchases to match economic developments. And once that happens we are well on the way to a nominal GDP level target.

Mike Konczal, meanwhile, pushes back on my response to his post that the Fed needs to adjust its pressure on the gas pedal:

We don’t often get a serious shift in expectations. That’s why I’m not sure how much the “gas pedal” from David Beckworth’s response is at play. Beckworth notes that the purchases in QE3 don’t automatically react to turbulence in the economy, and hopes that the Federal Reserve will buy more if the economy gets weaker. But if the expectations of where the Fed wants to end up are the real limiting factor for a robust recovery, why would a small change in purchases matter? This is partially why Greg Ip said the FOMC statement this week was “asymmetric,” even though the Fed said it might “increase or reduce” purchases: an increase is a small move, but a reduction is a genuine retrenchment.

If the public understood that the dollar size of the Fed's asset purchases were also conditional, then Fed policy should have a more meaningful effect on expectations. We may never know, however, if Josh Barro is correct about the political economy limits of monetary policy.

Is the Fed's Able to Offset Austerity? Insights from the Employment Report

noreply@blogger.com (David Beckworth) — Fri, 03 May 2013 19:54:00 +0000

The April employment report came out today and is better than expected. The number of new jobs exceeded the median forecast, the previous two months job numbers were revised upward, and the unemployment rate fell to 7.5%. This report is not what one would expect if fiscal austerity were overwhelming the Fed's efforts to shore up the economy. But the report also is not what one would expect if the Fed were unloading both barrels of the gun at the economy. The April employment rate, therefore, reveals both the strength and weakness of the Fed's efforts.

On the first point, Mike Konczal and Paul Krugman claimed earlier this week that the contraction of U.S. fiscal policy in 2013 was trumping the Fed's QE3 program and, in so doing, undermining the views of Market Monetarists like Scott Sumner and me. The employment report and its revisions to the previous months throw some cold water on their claim. But this should not surprise anyone, since fiscal austerity has been happening from 2010 and it has yet to stop the steady progression of nominal GDP (NGDP) growth.

This can be seen in the figures below. The first figure shows that the cyclically adjusted (i.e. structural) budget balance as a percent of potential GDP has been shrinking since 2010. This is the budget balance due to policy changes, not from changes to the economy. It shows fiscal tightening over the past three years:

And what has this fiscal tightening done to aggregate demand (i.e. NGDP) growth since that time? The figure below shows it has done nothing:

This broader 3-year experiment of fiscal policy versus money policy is the one Konczal and Krugman should be examining. Instead, they focus on the first quarter of 2013 and miss the forest for the trees.

With all that said, the stable employment and AD growth is far from what is needed for the economy to reach escape velocity. Therein lies the shortcoming of QE3 and the other, previous asset purchasing programs of the Fed. They have been enough to stabilize growth, but not enough to shore up a robust recovery. And that is frustrating to watch.

This frustration led me to propose earlier this week that the Fed make the size of its monthly asset purchases under QE3 conditional on how fast the economy was reaching the Fed's targets. Ryan Avent came up with a similar proposal. And then the Fed announced later in the week that it was prepared to do something just like this:

The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.

It is as if Fed officials were reading our blog posts! Okay, maybe not. More realistically, they too see the problems with QE3--it is applying the same pressure to the gas pedal irrespective of how the terrain on the road changes--and want to improve it. Unfortunately, the Fed did not get more specific than this statement so we don't know how or when this will happen. Josh Barro thinks it is unlikely it will ever happen. I hope he is wrong, otherwise we face a long journey to full employment.

Update: Robert Waldman replies to the post. Here is my response to Waldman.

There is No Debt Crisis In Europe

noreply@blogger.com (David Beckworth) — Tue, 30 Apr 2013 20:46:00 +0000

As much I criticize the Fed for its shortcomings, it pales in comparison to the failures of the ECB. Under its watch, aggregate nominal income and broad money growth has faltered in the Eurozone. This, in turn, has created an economic crisis. Note that causality runs from a weakened economy allowed by the ECB to a debt and financial crisis in the Eurozone, not the other way around. This is a point Ramesh Ponnuru and I have stressed before:

[Observers] tend to think of Europe’s current crisis as the result of overspending welfare states. And these states would indeed be better off with lower spending levels and less regulated labor markets. But many of the nations swept up in the euro-zone crisis, such as Spain and France, had spending and tax revenues well aligned before it hit. The true problem has again been monetary. Europe has for a decade had a monetary policy well suited to the circumstances of Germany but not to those of the rest of the euro zone and especially its periphery. Nominal income in Germany has stayed on a fairly steady trend line. In the periphery, however, it first went way up and then crashed. For the euro zone as a whole, nominal spending has fallen far below its previous trend—and has been continuing to fall farther away from it. Monetary policy therefore remains very tight in the euro zone overall. One effect of that drop-off, in Europe and in the U.S., has been to make debt burdens more onerous.

The graph below underscores this point. It shows that below-trend growth in Eurozone NGDP--the NGDP gap--has been matched by a rise in Eurozone government debt. The Eurozone crisis, then, is a nominal GDP crisis, not a debt crisis:

I bring this up because today we learn just how bad conditions are becoming in the Eurozone: unemployment hit 12.1% in March, 2013! Michael Darda of MKM Partners observes that this is the highest unemployment rate in the Eurozone over the past few decades. And on a country-by-country basis the unemployment numbers are even more harrowing, as shown by Ryan Avent. What more will it take for the ECB to act more aggressively? Apparently, intense human suffering is not enough. Maybe the advent of Abenomics in Japan in conjunction with the Fed's ongoing QE3 program will spur the ECB into action out of fear of losing external competitiveness. How ironic it would be if Europe's periphery became the main beneficiary of Abenomics.

Is Monetary Policy Capable of Offsetting Fiscal Austerity?

noreply@blogger.com (David Beckworth) — Mon, 29 Apr 2013 06:58:00 +0000

Mike Konczal has a new article where he claims there is a great natural experiment unfolding in the U.S. economy, one that Ramesh Ponnuru and I proposed back in 2011:

We rarely get to see a major, nationwide economic experiment at work, but so far 2013 has been one of those experiments — specifically, an experiment to try and do exactly what Beckworth and Ponnuru proposed. If you look at macroeconomic policy since last fall, there have been two big moves. The Federal Reserve has committed to much bolder action in adopting the Evans Rule and QE3. At the same time, the country has entered a period of fiscal austerity. Was the Fed action enough to offset the contraction? It’s still very early, and economists will probably debate this for a generation, but, especially after the stagnating GDP report yesterday, it looks as though fiscal policy is the winner.

So Mike Konczal's assessment of this experiment is that monetary policy has not been able to offset fiscal austerity. Paul Krugman agrees as do other observers who question the effectiveness of monetary policy in a liquidity trap. I agree that there is an interesting experiment going on, but Konczal and Krugman (K&K) oversell what it means and ignore other recent developments that shed light on the efficacy of monetary policy.

For starters, this experiment is only measuring whether QE3 is powerful enough to offset fiscal austerity. It is not measuring whether the actual proposal Ramesh and I laid out in 2011, a nominal GDP level target (NGDPLT), is capable of offsetting fiscal austerity. QE3 is a big change in Fed policy, but it is still far from a NGDPLT in terms of efficacy. One way to see this is to note that QE3 constrains asset purchases to a fixed dollar amount of $85 billion per month no matter how fast or slow the economy is converging to the Fed's inflation and unemployment targets. Consequently, if a spate of bad economic shocks--more Eurozone uncertainty, sequestration, China slowdown concerns, etc.--suddenly increased money demand the $85 billion injection may not be enough to offset it. In this case, aggregate demand would slow down and stall the convergence to the Fed's target.

QE3, then, is like taking a road trip and applying the same pressure to the gas pedal regardless of whether one is driving up a hill, down a hill, or on a flat terrain. The trip's length would depend on the changing terrain of the road (the shocks) and would be hard to know ahead of time even though you know your trip's destination (the target). This is better than taking a QE2 road trip, where you don't know your destination, but there is still much uncertainty about how long the QE3 trip will take. Now imagine you turn on cruise control at 70 MPH so that your car automatically adjusts the amount of gas based on the terrain. There would be much more certainty about the trip and much better expectations management. This would be much closer to a NGDPLT and provide the real test of whether monetary policy can offset fiscal austerity. It could be operationalized by conditionalizing the size of the QE3 asset purchases each month so that constant progress to the Fed's targets were being maintained. QE3, therefore, is farm from ideal and, as Matt O'Brien observes, it is not even clear the Fed is fully on board with it.

With that said, one can still learn a lot about the potential of monetary policy to offset fiscal austerity by looking at the fiscal consolidation in the United States over the past few years. As I have noted before, fiscal austerity has been happening in the U.S. economy since about mid-2010. And yet, the Fed has kept NGDP growing on a remarkably steady growth path (albeit, below its pre-crisis trend path). This performance is even more remarkable when you consider that there have been other negative AD shocks buffeting the U.S. economy. K&K ignore this achievement and its implications for monetary policy offsetting fiscal austerity.

Evan Soltas notes that further insights about monetary policy's ability to offset fiscal austerity can be gleaned by comparing the U.S. economy to the Eurozone economy over the past few years. Below are some figures that make this comparison. The first one compares government spending in both regions in absolute dollar and euro amounts. The figure shows that both regions experienced a similar flattening of government spending beginning around 2010. (Total federal expenditures actually decline in the United States. I couldn't find a similar measure for the Eurozone.)

If we now look at government spending as a percent of NGDP, we see that government spending's share has been falling in both regions. The U.S. decline has been the sharpest.

So we have two large economies experiencing fiscal austerity as seen above. Both are receiving the fiscal austerity 'treatment'. What effect is that treatment having on their NGDPs? The figure below shows the respective NGDP growth rates in both regions:

The U.S. series shows a stable NGDP growth rate of about 4%, consistent with the NGDP level figure linked to above. The Eurozone NGDP, however, shows a pronounced decline starting in 2010. So both regions have fiscal austerity, but only the United States has stable aggregate demand growth. The easiest explanation for the difference is monetary policies: the Fed has been far more aggressive than the ECB in responding to the slump. Yes, this is not definitive evidence, but it certainly is suggestive that monetary policy makes a big difference in offsetting fiscal austerity.

P.S. Scott Sumner, Ryan Avent, Marcus Nunes, and Matt Yglesias reply as well.

Update: A commentator correctly notes my first few graphs ignore the fiscal drag created by tax changes. So I grabbed the IMF's estimate of structural budget balances as a % of potential GDP and made the following figure:

While it does show a higher level of fiscal austerity for the Eurozone, it also indicates the rate of fiscal tightening is very similar in both regions. In other words, fiscal consolidation is happening at a similar pace across the two regions though they start from different points. Given this similarity, one would expect to see some similarity in the NGDP growth rate graph since the tightening began in 2010. But there is none. The gap, then, can still be explained by the differences in monetary policy.

The Ongoing Dereliction of Duty

noreply@blogger.com (David Beckworth) — Tue, 23 Apr 2013 20:05:00 +0000

Last year I made the case that the Fed's failure to keep nominal income growth expectations stable was a dereliction of duty:

[We] have long made the case that a nominal GDP (NGDP) level target would firmly anchor the expected growth path of nominal income. Doing so, in turn, would stabilize current nominal spending since households and firms are forward looking in their decision making. For example, holding wealth constant, households generally will put off purchasing a new car or renovating their homes if they expect their nominal incomes to fall and vice versa. This is why Scott Sumner likes to say monetary policy works with long and variable leads. This understanding implies, therefore, that the reason for nominal spending remaining below is its pre-crisis trend is that the Fed has failed to restore expected nominal income to its pre-crisis path. This failure amounts to a passive tightening of monetary policy.

Since then, the Fed has improved its management of expectations by introducing the conditional asset purchasing program of QE3. While this program is progress, it is still far from adequate. This can be easily seen by looking at data from a question on the University of Michigan/Thompson Reuters Survey of Consumers where households are asked how much their dollar (i.e. nominal) family incomes are expected to change over the next 12 months. The figure below shows the average response for this question up through March, 2013:

The fall of household dollar income expectations and its failure to fully recover is stunning. It suggests that the now lower expected future income growth is depressing current household spending, a point forcefully made by Mariacristina De Nardi, Eric French, and David Benson of the Chicago Fed. Digging into the data, they find that expected nominal income growth deteriorates across all age groups, educational levels, and income levels over the past few years. This is not some sectoral-specific development, it is a systemic nominal problem. They also find that the collapse in expected dollar income growth explains much of the decline in aggregate consumption since the crisis erupted.

But there is more. The figure also indicates that real debt burdens are higher than many households expected prior to the crisis. Look at the dashed line. It shows the average expected dollar income growth rate over the 'Great Moderation' period was 5.3%. Now imagine it is early-to-mid 2000s and you are taking out a 30-year mortgage and determining how much debt you handle. An important factor in this calculation is your expected income growth over the next 30 years. If you were average, then according to this data you would be forecasting about 5% growth rate. But that did not happened. Household dollar incomes declined and are expected to remain low. Nominal debt, however, has not adjusted as quickly leaving higher than expected real debt burdens for households.

This is something that the Fed could correct. QE3 is a step in the right direction, but more needs to be done with this program to raise expected nominal income growth. One way to do this is to make the size of the asset purchases conditional. That is, instead of conducting fixed $85 billion purchases every month until the economic targets are hit, vary the size of the purchases depending on the progress of the recovery. For example, if inflation and unemployment are not moving fast enough to their target, then increase the dollar size of the of asset purchase and vice versa. For if $85 billion is not enough for the nominal economy to gain traction, then it must be the case that money demand is rising enough to offset the benefits of the $85 billion injection. If this conditionality were added and widely understood, QE3 would better manage expectations and pack a larger punch. No more dereliction of duty.

Update I: Per Nick Rowe's request I have added the following two figures. The first one shows expected household dollar income growth plotted along side NGDP growth over the past year. The former does seem lead the latter.

The second figure shows the mean and the median expected household dollar income growth. Interestingly, the gap between the two series is relatively stable until the crisis, after which it narrows.

Update II: The first two figures above use a three quarter center moving average to smooth the series. The last figure--the one directly above showing the mean and median--shows the raw, unsmoothed series.

Fed Panel Discussion at the AEI

noreply@blogger.com (David Beckworth) — Fri, 22 Mar 2013 04:06:00 +0000

Friday, I will be participating in a panel discussion on Fed policy at the American Enterprise Institute. Along with me will be Scott Sumner, Ryan Avent, and Jim Pethokoukis. If you are in DC and can make it, I hope to see you there.

Update: Here is the video of the panel discussion and here is a link to my PowerPoint file.

Missing the Forest For the Trees: Cyprus Edition

noreply@blogger.com (David Beckworth) — Tue, 19 Mar 2013 01:27:00 +0000

The Cyprus bank heist has received a lot of coverage, but in most cases the analysis is missing the forest for the trees. The real problem facing Cyprus and the rest of the Eurozone periphery is more fundamental than who will be bailed out, who will be bailed in, and how it will happen. For these concerns are the result of a flawed monetary union--a currency area that does not meet the optimum currency area criteria--that if not fixed will continue to haunt the Eurozone. Figuring out how to deal with Cyprus without addressing the flawed nature of the Eurozone is just kicking the can the down road. More radical reforms are needed.

One reform is to alter ECB policy so that it actually tries to stabilize nominal spending for the entire Eurozone, not just Germany. Since it inception, ECB monetary policy has been biased toward Germany at the cost of destabilizing the Eurozone periphery. This could be fixed by having the ECB abandoned its flexible inflation target and adopt a NGDP level target. Another complementary reform, would be to create meaningful fiscal transfers in the Eurozone similar in scale and scope to the United States. Both of these options, however, would face stiff opposition from Germany. For the former would require temporarily higher inflation than Germany desires and the former would require large fiscal commitments for the Eurozone from Germany. Neither is likely to happen.

That leaves the final reform option: break up the Eurozone into austere and non-austere currency unions. This ideas has been suggested before by Ramesh Ponnuru and Ambrose Evans-Pritchard. Here is Pritchard:

My solution - like that of Hans-Olaf Henkel, the ex-head of Germany's industry federation (BDI) - is to split EMU into two blocs, with France leading a Latin Union that keeps the euro. This bloc would devalue but not by 60pc, yet uphold its euro debts intact. The risk of default and banking crises would decrease, not increase.

The German bloc could launch their Thaler, recapitalizing banks to cover losses from rump euro debt. Disruptions could be contained by capital controls at first. None of this is beyond the wit of man. My bet is that aggregate losses would be lower than the status quo, and the long term outcome much healthier. The EU might even carry on, unruffled.

This reform is very radical, but there really is no other viable alternative. The German response over this crisis has given us no reason to believe the other options of improving the existing Eurozone monetary and fiscal structures will ever happen. So why keep pretending otherwise? The current Eurozone approach is the equivalent of an economic whack-a-mole game that never truly solves the problem. The Cyprus crisis is just the latest mole to stick up its head.

Fortunately, Matthew C. Klein reports that there already is some movement in Germany to create two new currency blocks. This is a start. But there is a long way to go and there needs to be a greater sense of urgency. Who knows how long the whack-a-mole game can continue before it turns ugly. Martin Feldstein warned in 1997 that the EMU could lead to conflict. I hope he is wrong.

P.S. Matthew Yglesias is one observer that does consider the larger Eurozone context behind the Cyprus crisis.

P.P.S. Just how big are fiscal transfers in the United States? Here is one data point from Paul Krugman:

[I]f Florida suffers an asymmetric adverse shock, it will receive an automatic compensating transfer from the rest of the country: it pays less into the national budget, but this has no impact on the benefits it receives, and may even increase its benefits if they come from programs like unemployment benefits, food stamps, and Medicaid that expand in the face of economic distress.

How big is this automatic transfer? Table 2 shows some indicative numbers about Florida’s financial relations with Washington in 2007, the year before the crisis, and 2010, in the depths of crisis. Florida’s tax payments to DC fell some $33 billion; meanwhile, special federally funded unemployment insurance programs contributed some $3 billion, food stamp payments rose almost $4 billion. That’s about $40 billion in de facto transfers, some 5 percent of Florida’s GDP – and that’s surely an understatement, since there were also crisis-related increases in Medicaid and even Social Security, as more people took early retirement or applied for disability payments.

Echoes of 1933: the Cyprus Heist

noreply@blogger.com (David Beckworth) — Sun, 17 Mar 2013 06:21:00 +0000

Bank depositors in Cyprus learned today of a planned heist on their funds. It was a well organized one that will take 6.75% of all small deposit accounts and 9.90% of all large depositor accounts. What is truly shocking about this heist is that it was planned by the EU and IMF and applied to funds, at least for the small depositors, that were supposedly government insured (i.e. risk free). This is what we call a major shock to expectations.

Now the depositors do get bank equity in exchange and some observers note this heist is not as bad it could be--the alternative could have been a complete financial collapse--but from a broader perspective these excuses miss the mark. The very reason the crisis has got to the point that bailouts or "bail-ins" are needed is because the Eurozone was a flawed monetary union from the start. It never met the criteria of an optimum currency area and its monetary policy has effectively been geared toward Germany. Thus, at the advent of the Euro, the ECB policy interest rate was close to what a Taylor rule would predict for Germany, but far too low for the periphery. Likewise, since the crisis the policy rate has been close to what a Taylor rule would predict for Germany, but too high for the periphery. In both cases, ECB policy has been destabilizing to the periphery. That is why, despite being in the midst of a crisis, the ECB explicitly tightened monetary policy in 2011 by twice raising its policy rate. It is also why the ECB has implicitly (or passively) tightened policy over the past few years as evidenced by the flatlining of the broad money supply and nominal GDP. In short, the boom-bust cycle of the Eurozone periphery that helped make the Cyprus financial crisis is largely the result of a flawed monetary system biased toward Germany.

But that part is not new. What is new is the unexpected seizing of depositors funds. As Lars Seier Christensen, Ed Conway, Felix Salmon, and Frances Coppola note, this sets a dangerous precedent for all Eurozone bank deposits. Here is Coppola:

[T]he fact is that deposit insurance everywhere in the EU has now been undermined. The precedent has been set for insured depositors to suffer losses in order to protect Russian oligarchs and reckless banks. If the Eurogroup can impose this on Cyprus, it can do so elsewhere too.

Yes, EU leadership promised this action was a one-off event, but the fact that they had to make this promise is a sign that they no longer can be trusted. Just imagine what you would be thinking now if you were a resident of troubled periphery economy and had funds in your bank account. I suspect it would be whether my bank was next and whether I needed to get my funds out ASAP. It is almost as if the EU and IMF were trying to create a banking panic in Europe.

What the EU and IMF did to Cyprus today is poised to be a repeat of what happened to U.S. banking in 1933. In February of that year, the governor of Michigan declared a statewide banking holiday as a means to resolve an impasse on how to wind down an important bank in Detroit. Like the Cyprus action today, the governor's actions back then sent chill waves across a continent, as depositors in other states began to wonder if their governors would also call bank holidays to prevent withdrawal of funds. The fear was so poignant, that the Ohio governor made it a point to declare the bank holiday would not happen in Ohio. But it was too late, the die had been cast. By March 1933, 48 states had declared some form of bank withdrawal restrictions as the bank panic spread and fed upon itself. Only with FDR's national bank holiday and the advent of national deposit insurance in March, 1933 was the bank panic stopped.

What is crazy about the Cyprus heist today is that it has the potential to create the same self-fulfilling bank panics across Europe, but without the benefits of a unified treasury to credibly commit to Eurozone deposit insurance. I can't help but hear the echoes of 1933 now unfolding in Europe.

Update I: Our friend Lars Christiensen, the Market Monetarist one, also weighs in with good thoughts.
Update II: A fitting picture on the Cyprus heist:

Why Inflation with a Large Output Gap?

noreply@blogger.com (David Beckworth) — Wed, 06 Mar 2013 19:50:00 +0000

This is a question that observers, particularly those who are skeptical of the aggregate demand-shortfall view, often raise. Ryan Avent and Paul Krugman both answer this question in recent posts. Here is Avent:

The answer to the question of why deflation in, say, America hasn't been sustained despite little progress closing the output gap is extremely simple: the Fed has been determined not to allow that to happen...What the record shows is that disinflation below 2% inflation prompts aggressive Fed reactions, which are generally successful at reversing inflation expectations. The critical difference between the Depression and the Great Recession was that Great-Recession-era central banks were determined to avert deflation and where willing to prop up the financial system, drop rates to zero, and engage in unconventional policy in order to keep inflation positive.

I think that assessment is largely correct. The only part I would add is that once FDR took the reins of monetary policy in 1933 (by breaking the link between the dollar and gold and not sterilizing gold inflows) inflation emerged and coincided with a large output. Though the Fed didn't cause this inflation, the Fed tolerated it until 1937 as seen in the figure below:

As Paul Krugman notes, this bout of inflation between 1933 and 1937 was not that different from what we have today as seen in the chart below.

Below is a table that compares the output gaps and inflation rates that occurred after the troughs of 1933 and 2009. Again, we see that inflation rates were not that different.

The only big difference between the periods is the output gaps. The mid-1930s output gap was far larger than the current one and yet that period had a similarly-sized rate of inflation. For me, then, the interesting question is why has inflation during the last two largest U.S. economic crisis been similar? Why were they both gravitating around 2%? Ryan Avent has an answer that I suspect is true to some extent for both periods:

[T]he Fed's observed success in averting deflation should lead one to ask whether its control over inflation expectations suddenly evaporates once those expectations hit 2%. My view is that it does not—why should it, after all?—and that the main constraint on a faster economic recovery is the Fed's reluctance to push inflation over 2%.

This makes a lot of sense for the 1930s too since it is well documented the Fed was concerned about inflation getting too high during this time. There were a few years of higher-than-normal inflation, but the average inflation rate was kept in line by the Fed. Even at the expense of creating a recession in 1937-1938. History repeats itself.

P.S. Yes, I said in my last post the next one will be Bernanke's Friday Night Special II, but it had to wait. I hope to get it up later this week.

Bernanke's Friday Night Special: Part I

noreply@blogger.com (David Beckworth) — Mon, 04 Mar 2013 19:52:00 +0000

Fed Chairman Ben Bernanke gave one of his better speeches last Friday night. In it, he explained why long-term interest rates have declined over the past four years and, in so doing, provided an important rebuttal to the popular view of the Fed as the great enabler of the large government deficits. The evidence Bernanke presented in his speech should give any honest proponent of the Fed as the great enabler (FGE) view pause. Unfortunately, this speech has not received the attention it deserves and many of the FGE proponents probably missed it.¹ Therefore, it is worth reviewing and elaborating on this important speech.

Chairman Bernanke began by his speech by observing that both nominal and real long-term interest rates on safe sovereign debt have been declining across the world, not just in the United States. Here, for example, is his chart showing the global decline in real interest rates on government bonds:

What is striking about this figure is that there is both a sudden, downward shift in trend beginning in 2008 and a narrowing of spreads among these interest rates. This pattern is also evident in long-term nominal yields, as I noted last year. These figures alone undermine FGE claims since they indicate something global in nature is affecting all these yields in a similar manner. Blaming the Fed for the low, long-term interest rates ignores this global phenomenon.

Bernanke then turned to the movements in long-term U.S. yields. He did so by invoking the expectation hypothesis--the theory that long-term interest rates equal the average of expected short-term interest rates over the same period plus a term premium--to explain the decline in long-term treasury yields. He also decomposes the expected average short-term nominal interest rate into an expected real interest rate and expected inflation component. Here is how this break down comes out for for the 10-year treasury:

With this decomposition, Bernanke notes that most of the the 10-year treasury decline over the past four years comes from a decline in the expected average real interest rate and the term premium.

On the former, Bernanke correctly observes that though the Fed can directly influence the expected path of short-term real interest rate over the short-to-medium term, its influence beyond that is muted by real factors. In other words, the expected average real short-term yield over the next 10 years is shaped more by the economic outlook than by the Fed².

On the later, Bernanke attributes the term premium's decline to three things: increased interest rate certainty because of the zero lower bound (makes it easier to forecast), the safe asset shortage problem, and the Fed's large scale asset purchases (LSAPs). The first two of these developments are result of the crisis. Only the LSAPs are the Fed's doing. So most of the factors driving down the 10-year treasury yields have been developments outside the Fed. This is consistent with the pattern of safe asset yields falling across the world. It is hard to find support for the FGE view here.

There is more Bernanke could have said about the LSAPs. First, contrary to the claims of many FGE proponents, the LSAPs have not been terribly large in relative terms. The stock of marketable treasuries went from about $5.13 trillion at the end of 2007 to $11.27 trillion at the end of 2012. Over this same time, the Fed’s holding started near $0.74 trillion and reached $1.65 trillion. The Fed’s net gains, then, are approximately $0.94 trillion over this time compared to $6.14 trillion change in marketable debt. (The Fed actually has purchased a little more, but it also sold some securities in 2007.) The figure below shows the Fed's holding of marketable securities at the end of 2012:

Relative, then, to the rise of total marketable debt the Fed’s holdings have not risen rapidly. In fact, the Fed now holds about 15% of marketable treasuries, roughly the same share it has held over the past few decades. Some FGE observers like to point out the Fed purchased 77% of marketable treasuries in 2011.³ What they ignore is that the Fed also sold off a sizable portion in 2007, leaving the Fed's overall share of treasuries about the same. Therefore, the large run up in in U.S. public debt has funded largely by individuals, their financial intermediaries, and foreigners. Blame them, not the Fed, for enabling the large budget deficits.

Second, the LSAP actually stopped with the end of QE2 in mid-2011 and did not resume until late 2012 with QE3. During that time, when the Fed's treasury holdings were relatively stable, real interest rates on 10-year treasuries continued to fall. How do FGE proponents explain this development? It is easy to explain if one looks to the other factors Bernanke listed as being important determinants of the long-term interest rates.

Third, even with the advent of QE3 and its $85 billion treasury purchases per month, it is unlikely the Fed will see its share of treasuries grow to the point where one can say the Fed is truly engaged in financial repression. Here is why. The Fed's QE3 purchases can be viewed as the Fed simply increasing the supply of the monetary base to match the demand for it. To the extent the Fed overshoots--and the FGE proponents are correct--then inflation will rise and force the Fed to reverse itself since QE3 is conditional on explicit inflation thresholds being hit. If the Fed does not hit these thresholds (and assuming no positive supply shocks that create downward pressure on inflation), then the Fed's treasury purchases will simply be accommodating growing monetary base demand. And if that is the case, the economy will still be weak leading to more budget deficits and a relatively stable share of treasury holdings for the Fed.

So far from being the great deficit enabler, the Fed's policies are actually playing catch up with soaring liquidity demand. And on that point the Fed can be held accountable for not doing enough, but that is subject of my next post.

¹Noteable exceptions include Joe Weisenthal, Jim Hamilton, and Ryan Avent.
²In other words, the natural real interest is low and the actual real interest rate is reflecting that.
³According to this data, the number is actually 61%, not 77%.

Update: Below is total marketable treasuries and the Fed's share in dollars.

Everything You Wanted to Know About the Safe Asset Debate

noreply@blogger.com (David Beckworth) — Fri, 22 Feb 2013 22:28:00 +0000

Can be found here.

Update: one overlooked contributor in the above link is Steve H. Hanke. He has noted several times how Basel III is adversely affecting the supply of safe assets.

From Government Fiat Money to Private Commodity Money: the Case of Somalia

noreply@blogger.com (David Beckworth) — Tue, 12 Feb 2013 23:36:00 +0000

Lawrence H. White and William Luther have several papers on the fascinating case of Somalia money after the state collapsed in 1991. Here is an excerpt:

Over the last few decades, much work has focused on potential mechanisms to govern the supply of money in a desirable manner. Interestingly, a rough mechanism seems to have emerged naturally following the collapse of the Somali state in 1991. Without a functioning government to restrict the supply of notes in circulation, Somalis found it profitable to contract with foreign printers and import forged notes. Forgers were constrained since Somalis would only accept denominations issued prior to 1991; larger denomination notes could not be issued profitably. Although the exchange value of the 1000 Somali shillings note fell from $US 0.30 in 1991 to US$ 0.03 in 2008, the purchasing power eventually stabilized, as the exchange value equaled the cost of producing additional notes.

So even money forgers equate the margins: they continued to create counterfeit notes until the marginal cost of production equaled the marginal benefit. That is, the Somalia notes fell in value until they were worth no more than the paper, ink, printer, electric, shipping, and other costs required to make them. That sounds a lot like commodity money to me. And this led to a stable monetary environment for Somalia despite the failed state. This fascinating monetary experiment runs contrary to the common monetary history of commodity (or commodity-backed) money turning into fiat money. In Somalia, the government fiat money turned into private commodity money. I look forward to seeing what lessons JP Koning, the monetary historian of the blogosphere, draws from this experience.

Fiscal Austerity is Happening Now

noreply@blogger.com (David Beckworth) — Sun, 10 Feb 2013 21:30:00 +0000

Ryan Avent notes that fiscal austerity is happening now:

[T]he record shows that total federal government outlays were 25.2% of GDP in 2009, 24.1% of GDP in 2011, and 22.8% in 2012...Both outlays and receipts are, as a share of GDP, below pre-crisis level... the "austerity" of 2011-2012 wasn't "austerity" but austerity. Federal government spending fell by a meaningful share of GDP over that period. So did federal government employment, which dropped by 31,000 jobs in 2011 and 45,000 jobs in 2012. What's more, we have good reason to believe that these cuts entailed positive multipliers above those we'd observe in normal times. You don't have to take the IMF's word for it; even stimulus sceptics like Valerie Ramey find that multipliers may sometimes be above normal, and above one, during periods of economic slack.

This is exactly the case that I have been making. And apparently so has Goldman Sachs. The only additional point I have stressed is that despite this austerity happening at a time of high unemployment and a large output gap, a slowdown in aggregate demand growth has failed to materialize. This does not mean fiscal policy multipliers are small--they may be large--but only that the Fed has been offsetting the drag created by the fiscal austerity. And to boot, it has done so in an environment where the short-term interest rate is up against the zero-lower bound (ZLB). Monetary policy, therefore, is not out of ammunition at the ZLB, as I noted in my last post on this issue.

Just to be thorough, below are some figures that demonstrate the fiscal austerity observed by Ryan Avent. First, here is total federal government expenditures in current dollars. It has stalled and gradually started to fall:

As a percent of NGDP, total federal government expenditures is steeply falling. Not exactly a Keynesian prescription for stable aggregate demand when the economy is far from full employment:

If we look at the federal government deficit, whether in dollars or as a percent of GDP, it too indicates increasing fiscal austerity given the ongoing slack in the economy. Recall that running a deficit is how the government takes "idle" private-sector savings and puts it to "productive" work. Less and less of this transformation is being done:

Finally, if we look at those components that make up the "G" in GDP (i.e. Y=C+I+G+NX) in inflation-adjusted terms we see that G has been unequivocally falling:

Now this fiscal austerity is mild compared to what is proposed to happen going forward. But it is still fiscal consolidation and given large fiscal multipliers--which are more plausible in periods of significant economic slack like today--we should at least see aggregate demand faltering over the past few years while this unfolded. But in fact, we see relatively stable aggregate demand growth, as measured by NGDP:

This remarkably stable NGDP growth path since 2009 has occurred despite the fiscal austerity (and a host of other negative economic shocks like the Eurozone crisis, China slowing, debt ceiling talks, and fiscal cliff) and only makes sense if the Fed has been offsetting the fiscal drag. And again, it has been doing so in a ZLB environment. While the Fed's success here should be recognized, it is also apparent that the Fed has failed to restore NGDP to its pre-crisis trend. This failure to provide "catch-up" nominal spending growth is big black eye for the Fed and is why a NGDP level target is way overdue for the Fed.

P.S. Ramesh Ponnuru and I made a similar argument during the fiscal cliff debacle.

NGDP Targeting for Kentucky!

noreply@blogger.com (David Beckworth) — Fri, 08 Feb 2013 19:57:00 +0000

In case you couldn't get enough of NGDP targeting, here is a piece I wrote for the Lane Report, a Kentucky business publication, on what it is and what it means for the state of Kentucky.

If You Think the Fed is Behind the Low Interest Rates

noreply@blogger.com (David Beckworth) — Fri, 08 Feb 2013 19:45:00 +0000

Think again...

Long-term government yields on safe assets across the globe have been declining since the crisis broke out. Something more than the Fed is at work (hint: think global economy buffeted by series of bad economic shocks). For more, see here and here.

The Train Has Already Left the Station: A Reply to Paul Krugman

noreply@blogger.com (David Beckworth) — Fri, 08 Feb 2013 16:47:00 +0000

Paul Krugman says now is not the time to cut government spending. Why? Because the Fed is out of ammunition and cannot possibly provide any offset to the fiscal drag such spending cuts would make:

Today, by contrast, we’re still living in the aftermath of the worst financial crisis since the Great Depression, and the Fed, in its effort to fight the slump, has already cut interest rates as far as it can — basically to zero. So the Fed can’t blunt the job-destroying effects of spending cuts, which would hit with full force.

The point, again, is that now is very much not the time to act; fiscal austerity should wait until the economy has recovered, and the Fed can once again cushion the impact.

There are two big problems with this analysis. First, fiscal retrenchment has already started and has been happening since mid-2010. The fiscal austerity train has already left the station and shocker of shockers, it has not caused the cataclysmic collapse in aggregate demand that Paul Krugman fears. Here is a figure from a earlier post that shows NGDP growth has been relatively stable despite the reduction in total government expenditures:

The same story emerges if one looks at the shrinking budget deficit. Note also that short-term interest rates have been near 0% since early 2009. So somehow the Fed has been able to keep NGDP growth stable despite (1) a fiscal contraction and (2) the zero lower bound on short-term interest rates. According to Paul Krugman this is not possible.

The second problem, then, with Krugman's analysis is his claim that the Fed is out of ammunition at the zero lower bound. He, of all people, should know this is not the case given his seminal work on Japan. He should also know this given all the exchanges he has had with Scott Sumner and me over the past few years. But just to be thorough, let me spell it out once again why the Fed is far from powerless.

To begin, consider how the public would respond if the Fed suddenly announced it was raising its asset purchase by 20% per month until some NGDP level target was hit. That would be the monetary policy equivalent of shock and awe and should catalyze the mother of all portfolio rebalancings. Households and firms would start spending their built up stock of money assets on other riskier assets (like stocks and physical capital) as well as goods and services in expectation of higher nominal income and temporarily higher inflation. Asset prices would increase, household balance sheets would be repaired, and real debt burdens reduced. This would reinforce the recovery in NGDP growth.

The key to this working is permanently raising the expected size of the monetary base. When this happens, expected nominal incomes will go up and lead to the responses outlined above. Thus, even though open market operations at the zero lower bound might be trading near substitutes now--monetary base for treasuries earning 0%--the belief that they won't stay near substitutes in the future (because of the permanent increase of the monetary base) will trigger the portfolio rebalancing that will lead to higher nominal spending.

Under QE1 and QE2 this did not happen precisely because the public did not expect the increase in the monetary base to be permanent, a point noted by Michael Woodford. But it has happened before. Back in 1933 FDR effectively took the reigns of monetary policy from the Fed and credibly committed to a higher monetary base level by devaluing the dollar. As consequence, the U.S. saw one of its sharpest recoveries that year. The same can happen now by adopting an aggressive, but well anchored nominal GDP level target.

Is "Precautionary Saving" Still a Problem?

noreply@blogger.com (David Beckworth) — Mon, 04 Feb 2013 15:18:00 +0000

John Cochrane has an interesting post where he considers the various reasons why consumption has failed to return to its trend path. One area where I disagreed with him was this statement:

"[A] more precise version of my first equation adds a "precautionary saving" term. When people are very uncertain about the future, they save more...This story seems possible for 2008 and 2009, in the depths of the financial crisis and recession. But I'm less convinced that it describes our current moment."

As I noted in his comments, it does seem strange to think that almost five years later precautionary savings would still be an important part of the story. But the data clearly shows that this is the case, as seen in the figure below. The blue line in the figure shows liquid assets (checking and cash, saving and time deposits, money market accounts, and treasuries) of households as a percent of total household assets. Now this indicator is really a measure of liquidity demand, but it gets at the same notion as precautionary savings. The red line shows the unemployment rate.

Source

The figure indicates that liquidity demand rises before recessions and leads changes in unemployment. (Josh Hendrickson and I show in a paper that this indicator is systematically related to swings in aggregate nominal expenditures.) More importantly, this measure of liquidity demand still remains elevated to this day. So yes, precautionary savings (or precautionary demand for liquidity) still appears to be an important part of the ongoing slump.

P.S. This elevated demand for liquidity is just another way of seeing the inordinately high risk premium problem.

Note to Charles Goodhart: Europe is Flatlining Under Inflation Targeting

noreply@blogger.com (David Beckworth) — Fri, 01 Feb 2013 15:23:00 +0000

Charles Goodhart has an Op-Ed in the Financial Times and a piece at VoxEu where he comes out swinging against nominal GDP level targeting (NGDPLT). He mistakenly thinks NGDPLT implies targeting real variables and having no long-run nominal anchor. He also thinks flexible inflation targeting (FIT) has been a smashing success so why abandon it now? Like you, I too am puzzled after reading these pieces. Surely Goodhart recognizes that NGDPLT is a money-denominated (i.e. nominal) target and that by definition it is bounded because it is a level target. If anything, it creates a firmer long-run nominal anchor than a "memory-less" FIT. And surely Goodhart is aware that the Great Recession in the United States and the Eurozone crisis occurred under the watch of FIT-type regimes. If FIT is so amazing then why has there been sustained drops in aggregate nominal expenditures in these two large economies?

It is especially surprising that Charles Goodhart can still be singing the praises of FIT after seeing what it has failed to do in the Eurozone. The figures below, which show the Eurozone less Germany, illustrate this point very clearly. The first one shows that the broad money supply (M3) has flatlined in this region.

Unsurprisingly, the flatlining of the broad money supply in the Eurozone less Germany region has led to NGDP that has flatlined too (after an initial drop).

If this is the best the Eurozone can do with FIT then maybe one should reconsider its viability, no? As alluded to above, it is not just that FIT is flawed, it is that NGDPLT is so much more than Charles Goodhart understands. Here is but one of his confusion over NGDPLT:

Adopting a nominal income (NGDP) target is viewed as innovative only by those unfamiliar with the debate on the design of monetary policy of the past few decades. No one has yet designed a way to make it workable given the lags in the transmission of monetary policy and the publication of national income and product.

Actually, only someone unfamiliar with the literature on "targeting the forecast" (see Lars Svenson and Michael Woodford) would make this outdated claim about lags. By targeting the forecast, a central bank manages expectations and operates with a lead. Big difference there. Needless to say, there is much more wrong about Charles Goodhart's NGDPLT critique and the untiring Scott Sumner lays out it here and here. [Update: See also the responses of David Glasner, Lars Christensen, Marcus Nunes, and Britmouse.] See here for why NGDPLT provides a strong nominal anchor.

P.S. Maybe Goodhart is simply confused about FIT's performance in the Eurozone. Maybe he has been talking to his German friends and generalizing from their experience. FIT seems to be working rather well for the German-portion of the Eurozone:

Update 1: Saturos nails it on the confusion of NGDP as a nominal variable.
Update 2: The Economist swings back at Charles Goodhart and endorses NGDPLT for the UK.

Why is There Still a Shortage of Safe Assets?

noreply@blogger.com (David Beckworth) — Tue, 29 Jan 2013 13:44:00 +0000

JP Koning wants to know why many of us continue to talk about a safe asset shortage five years after the financial crisis started. Shouldn't this problem corrected itself many years ago? He has asked this questions many times and most recently framed it this way:

Why do we *need* more safe assets? Why don't we just let the existing ones rise in value, thereby providing safety? If we wanted to express our desire for safety by buying fire extinguishers, then I'd agree that we need to produce more safe assets. After all, only some sort of increase in the supply of extinguishers will be able to meet that demand.

But things are different if we express our demand for safety by turning to financial markets. The great thing about t-bonds is that unlike fire extinguishers, we don't need to fabricate more of them to meet our demands for safety... we just need a higher real value on the stock of existing t-bonds. This can be entirely met by shifts in prices. Where is the problem that needs to be rectified?

This is a great question. Why haven't financial markets--the nimblest, most flexible markets of all--pushed treasury values to levels that would cause the market for safe assets to clear? Shouldn't arbitrage in these markets fixed this problem long ago?

Let me begin my answer by recalling why the ongoing shortage of safe assets is such a big deal. Safe assets facilitate transactions for institutional investors and therefore effectively acts as their money. During the crisis, many of these transaction assets disappeared just as the demand for them was picking up. Since these institutional money assets often backstop retail financial intermediation, the sudden shortage of them also meant a shortage of retail money assets. In other words, the shortage of safe assets matters because it means there is an excess demand for both institutional and retail money assets. This excess money demand, in turn, is keeping aggregate nominal expenditure growth below where it should be.

It is also important to note that although the crisis began in 2007 there has been a series of subsequent shocks that have kept the demand for safe assets elevated: the Euro crisis of 2010-2012, the debt-ceiling talks of 2011, the fiscal cliff of 2012, and concerns about a China slowdown. So there hasn't been for sometime a period of prolonged calm to ease the heightened demand for safe assets. Still, Koning's argument should still hold despite this spate of bad economic news. Safe asset prices should be able to adjust to reflect these developments.

The problem is that safe assets, treasury securities in particular, cannot make this adjustment when they are up against the zero lower bound (ZLB) on nominal interest rates. Given the large shortfall of safe assets, interest rates need to go below 0% for treasury prices to rise enough to satiate the excess demand for them. Investors, however, can earn 0% holding money at the ZLB. Consequently, investors will not purchase enough treasury securities to sufficiently raise treasury prices (i.e. lower interest rates) and clear the market.¹

In addition, the heightened economic uncertainty and the ZLB means the demand for these transaction assets (i.e. money and treasuries) becomes almost insatiable. Investors, therefore, shy away from other higher yielding, riskier assets that normally would lure them. Portfolios get overly weighted toward liquid assets.

Note what is happening here: treasuries and money become increasingly close substitutes as they approach the ZLB, while the overall transaction asset market becomes increasingly segmented from other asset markets. In other words, as arbitrage becomes more powerful among transaction assets like money and treasuries, it becomes less powerful between the market for transaction assets and other asset markets. The short answer to Koning's question, then, is that the ZLB has segmented the transaction asset market and this is preventing the safe asset market from clearing.

Below is my initial attempt to show this graphically. It shows that while treasury and money assets substitutability is always responsive to interest rate changes, market segmentation is not and only kicks in after some threshold close to the zero bound is reached. In other words, at some point when treasuries and money become close enough substitutes, the market for transaction assets begins to segment from other markets. Where this actually occurs is unknown and the way I have drawn it is arbitrary. But hopefully you see the point.

Now market segmentation is a controversial idea. Many observers don't accept it. But it seems like a compelling story for the transaction asset market at the ZLB. Empirically, it provides an easy explanation for why BAA-AAA corporate yield spread, junk bond spread, and other non-transaction asset spreads are getting closer to historical norms, while the BAA yields-10 treasury yield spread and the S&P500 earnings yield-20 year treasury yield spread remain inordinately high.Welcome to the strange new world of transaction asset market segmentation.

P.S. Market Monetarists, including myself, typically downplay the importance of the ZLB for monetary policy. We argue the ZLB is really just an artifact of doing monetary policy with an interest rate; it should have no actual bearing on the efficacy of monetary policy. Here, in the case of the safe asset shortage, it does seem to be a non-trivial phenomenon that needs to be taking seriously.

¹Given a sticky price level, the increased holdings of money at the ZLB will also continue since the price level does not adjust quickly either.