This is the real root of our current economic malaise—the conceit of Congress and the White House that more government spending, taxing and rule-making can force-feed economic expansion. Now that this great government experiment is so obviously failing, the politicians and the Wall Street Keynesians who cheered the stimulus are asking the Federal Reserve to save the day. Mr. Bernanke should tell them politely but firmly that his job is to maintain a stable price level, not to turn bad policy into wine.

Here was my reaction:

So that’s what it’s really all about.  I agree that Obama’s economic policies are highly counterproductive.  But unlike some conservatives I am not willing to unemploy millions of workers to win a policy argument.  I guess that’s the difference between hard core conservatives and pragmatic classical liberals like Friedman and I.  We should do the right thing and then put our trust in the democratic system.

Was I being unfair?  Maybe the WSJ would have made the same argument if a Republican was president.  After all, they say they favor a stable price level, and prices are still rising at 1%, and are expected to continue rising at that rate.  Do I have any right to infer they were trying to prevent Obama’s policies from looking more effective than they really are?

Fortunately, there is a very good way of showing whether they are advocating tight money for idealistic reasons, and not merely to insure the US economy is performing poorly in November.  A few weeks back I asked commenters to supply a WSJ editorial on monetary policy from back when Reagan was president.  Benjamin Cole came up with a very revealing editorial called “Who’s Easy” from December 18, 1984.  Here’s the first paragraph:

As the Federal Reserve Open Market Committee meets to chart monetary policy, real growth is equivocal and prices are rising at most slowly.  The arguments are for an easier policy, but probably the Fed thinks it’d eased already.

Sounds reasonable.  Presumably in December 1984 prices and output were rising much more slowly than the recent rates, and hence there was a need for easier money.  Just to make sure, let’s check the data:

Most recent 12 month growth rates, 2009:2 to 2010:2:

NGDP — 3.85%      RGDP — 2.98%     GDP deflator – 0.85%

Most recent 12 months growth rates as of December 1984 (1983:3 to 1984:3):

NGDP — 10.84%     RGDP — 6.87%   GDP deflator – 3.73%

Interesting that when Reagan was president the WSJ saw 4% inflation as too low, as prices that were “rising at most slowly.”  Now anything higher than 0.85% constitutes an abandonment of the Fed’s duty to maintain price stability.  If price stability is truly the goal, then why advocate greater monetary ease when inflation is almost 4%?   And if 6.87% real growth is “equivocal” then what is 2.98% growth? 

I’m afraid the WSJ was wrong in 1984 (we didn’t need easier money) and they are wrong now (we do need easier money.)  I favor the same NGDP target whoever is president–a 5% growth trajectory, level targeting.  That means we need more than 5% NGDP growth for the next year or two.

Perhaps the WSJ got confused over interest rates; after all, they were much higher then than now.  Actually, in 1984 the WSJ had an almost Friedmanesque understanding that interest rates are highly misleading:

Interest rates, we should have learned these past few years, are not a reliable guide to monetary policy.

Unfortunately by 2010, when Obama was president, the WSJ seems to have forgotten what it once knew:

As for the current moment, the Fed has maintained its nearly zero interest rate target for 20 months, while expanding its balance sheet by some $2 trillion. By any definition this is historically easy monetary policy, and not without costs of its own.

The balance sheet numbers are not accurate, and even if they were they were, “historical” definitions of easy money would be meaningless once the Fed started paying interest on reserves.  I suppose they might argue that even though inflation is now low, easier money would lead to dangerous increases in inflation.  Here’s what the WSJ said in 1984:

For our part though, we have trouble understanding what’s wrong with economic growth.  What does the open market committee have against it?  In particular, growth is not inflationary; inflation is too many dollars chasing too few goods, and growth produces more goods.   When was it the committee came down from the mountain with stone tablets saying that 3% real growth is OK, but 4% will produce “bottlenecks and “overheating”?

Or “structural problems,” or “job mismatches,” I might add.  I can’t answer their question, you’ll have to ask the hawks at the Fed.

OK, so the WSJ has changed its mind on monetary policy.  Surely there is no reason to think that this reflects political bias.  It’s not like their earlier views were aimed at making Reagan’s policies look good.  Or were they?

Fed policymakers tend to discount any significant possibility of a 1985 recession, and on that assumption feel free to take another yank or two at the remnants of inflation.  But if they are wrong, the price will be high.  Indeed, a 1985 recession would probably mean not only the political failure of Reagan’s budget cuts, but an economic donnybrook with new international and banking-system problems.

Two terms jump out at me; ‘remnants’ of inflation, and the ’political’ failure of Reagan’s budget cuts.

So what do you guys think?  Does political bias lead the WSJ to call for monetary policies that are good for the economy when Republicans are in office and bad for the economy when Democrats are in office?

2.  Much of the property market is controlled by the government

3.  Government bought lots of shares of stock to boost economy during recession.  Still owns many shares.

4. Introduced deposit insurance in 2008.

5.  Stopped accepting foreign doctors in 1997 (unless locally-certified.)

6.  Established anti-trust laws.  As elsewhere, policymakers ignore government-connected monopolies and go after purely private firms.

7.  Government first regulated the 4 stock and derivative exchanges, then forced a merger, then became largest shareholder, then prevented new entrants.

8.  Unlike the Nordic countries, the government is taking over formerly private infrastructure such as tunnels.  Huge new projects are now built and run by the government.

9.  The government is increasingly involved in “industrial policies” despite the ineffectiveness and corruption of its initial forays into planning.

Obviously I’m describing what is almost universally viewed as the most laissez-faire country entity on Earth—Hong Kong.

A few comments:

That’s why I wasn’t impressed a few months back by arguments that Adam Smith did not favor laissez-faire, merely because he favored a few government interventions.  It’s all relative. 

Commenters frequently question my assertion that Singapore is the second most neoliberal economy—pointing to all sorts of government intervention.  If Hong Kong is number one despite all the intervention listed above, you can imagine how little laissez-faire is required to come in second.   

I’m actually not too concerned about these actions, although I agree with The Economist, which is mostly skeptical of how well the new interventions will work.  Indeed they are even critical of a new food labeling law that I didn’t mention.  But this reflects the increasingly democratic nature of Hong Kong.  In my research on neoliberalism and culture, Hong Kong was somewhat of an outlier—much more free market-oriented than you’d expect given it’s not particularly civic-minded culture.  So it’s merely reverting to its natural position.  And there is a lot of ruin in a nation.  Hong Kong will probably continue to come in number one in the various free market rankings for quite some time.  But I expect it to eventually be overtaken by Denmark.

In the long run the challenge is to change culture so that governments respond to the general interest, not special interest.  And the other challenge is to change economic worldviews so that well-meaning government officials (no, not always an oxymoron) understand that free markets are more effective at promoting the general welfare than most people currently believe.  I’m not going to change cultures, but I’m trying to change worldviews.

Milton Friedman, Nobel Laureate in Economics, died in 2006. Monetarism, the school of thought he founded, seems to have died with him, judging from recent comments.

Academics, such as Princeton’s Alan Blinder and Harvard’s Martin Feldstein, are claiming there’s very little the Federal Reserve can do to stimulate the U.S. economy. Newspaper headlines deliver the same message: the Fed is “Low on Ammo.” The public is feted with explanations — couched in technical terms, such as the “zero-bound” and a “liquidity trap” — as to why the Fed’s hands are tied.

What planet are these people on?

They’re clearly not on planet monetarism.  On the other hand John Taylor thinks Friedman’s message still resonates, but that he would have been opposed to additional monetary stimulus:

I see neither those ideas nor their adherents going to the grave. Indeed, the experience of this crisis is proving that Milton Friedman’s ideas were right all along, and I can see them gaining favor.

Two of Friedman’s most famous ideas in the macroeconomic sphere were (1) that monetary policy should follow a simple policy rule and (2) that discretionary fiscal policy is not useful for combating recessions, and indeed could make things worse. Both ideas have been reinforced by the facts during the recent crisis.

The first idea is reinforced by the evidence that the crisis was brought on by the failure of the Fed to keep following the rules-based monetary policy that had worked well for 20 years before the crisis. Instead, it deviated from such a policy by keeping interest rates too low for too long in 2002-2005. But Caroline Baum wonders whether the Fed should now just print a lot more money and buy more mortgages or other securities. That might sound like a monetarist solution, but Friedman did not believe in big discretionary changes the money supply. Rather, he advocated a constant growth rate rule for the money supply. I doubt that he would have approved of the rapid increase in the money supply last year, in part because he would have known that it would be followed by a decline in money growth this year. He always worried about monetary policy going from one extreme to the other and thereby harming the economy. That is why the Fed should be clear and careful as it brings back down the size of its balance sheet, which exploded during the crisis.

While Taylor’s argument is defensible (and I agree with him on fiscal policy), I believe the weight of evidence supports Baum’s interpretation.  Let’s look at what Milton Friedman had to say about Japan in December 1997.  The subtitle is as follows:

Nobel laureate and Hoover fellow Milton Friedman gives the Bank of Japan step-by-step instructions for resuscitating the Japanese economy. A monetary kiss of life.

And here’s Friedman’s argument:

The surest road to a healthy economic recovery is to increase the rate of monetary growth, to shift from tight money to easier money, to a rate of monetary growth closer to that which prevailed in the golden 1980s but without again overdoing it. That would make much-needed financial and economic reforms far easier to achieve.

Defenders of the Bank of Japan will say, “How? The bank has already cut its discount rate to 0.5 percent. What more can it do to increase the quantity of money?”

The answer is straightforward: The Bank of Japan can buy government bonds on the open market, paying for them with either currency or deposits at the Bank of Japan, what economists call high-powered money. Most of the proceeds will end up in commercial banks, adding to their reserves and enabling them to expand their liabilities by loans and open market purchases. But whether they do so or not, the money supply will increase.

There is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so. Higher monetary growth will have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately. A return to the conditions of the late 1980s would rejuvenate Japan and help shore up the rest of Asia.

The Interest Rate Fallacy

Initially, higher monetary growth would reduce short-term interest rates even further. As the economy revives, however, interest rates would start to rise. That is the standard pattern and explains why it is so misleading to judge monetary policy by interest rates. Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

In the article, Friedman presents data showing Japanese monetary growth slowing sharply in the 1990s.  He also notes that RGDP growth slowed from 3.3% during what he calls the “Golden Age” of 1982-87 to only 1.0% during 1992-97.  Inflation slowed from 1.7% to 0.2%.  From this we can infer:

1.  Friedman does not seem to agree with Fed hawks who think price stability is a good thing.  After all, Japanese prices were very stable during the 5 year period when he thinks money was far too tight.  Admittedly, some at the Fed define price stability as 2% inflation, but the hawks clearly don’t agree, as inflation is 1% and falling, yet the hawks still oppose stimulus. 

2.  Friedman thinks near-zero interest rates are a sign that money has been too tight.  And he suggest that QE is the proper response.

3.  Friedman cites data showing that Japanese NGDP growth has slowed from 5% during the golden age to 1.3% in 1992-97.  Of course 5% NGDP growth is quite close to the US experience from 1992-2008, another “golden age.”  But then US NGDP fell 3% between mid-2008 and mid-2009, nearly 8% below trend.  And it continues to grow at well under trend during the “recovery.”  Friedman would have seen that as a warning sign.

4.  Friedman advocates raising money growth rates in Japan (M2) up much closer to the 8.2% of Japan’s Golden age.

5.  In the US monetarists tend to look at broader aggregates like M2 and MZM (although unfortunately we lack the ideal divisia index that monetarists like Mike Belongia say is needed.)  For what it’s worth, here are the growth rates of M2 and MZM from mid-2008 to mid-2009, and then from mid-2009 to mid-2010:

2008-09:   M2 grew 8.8%,  MZM grew 10.2%

2009-10:  M2 grew 2.1%, MZM fell 1.8%

So on average the aggregates grew around 9-10% during the financial turmoil, and then barely changed over the following 12 months.  It is difficult to know what Friedman would say about the increase in the money supply between 2008 and 2009.  Obviously the facts don’t exactly fit either my interpretation or Taylor’s.  But if we take a more expansive view of Friedman’s approach to macroeconomics, then I believe there is even more reason to believe that he would now favor monetary stimulus, just as in Japan:

1.  In the Monetary History, Friedman and Schwartz decided not to use the monetary base as their indicator of the stance of monetary policy.  In my view, this was partly because the base increased sharply between 1929 and 1933.  Friedman understood that NGDP had fallen in half during those four years, and thus monetary policy had obviously been too contractionary for the needs of the economy.  He also understood that the increase in the base reflected hoarding of cash and reserves during the banking panics.  Thus the most natural monetary indicator for a libertarian, the one directly controlled by the government, was not going to work.  Instead he and Anna Schwartz focused on broader aggregates, which declined sharply between 1929 and 1933.

2.  Now consider the 2008-09 increase in the broader aggregates.  Because we now have FDIC, people no longer hoard cash during a liquidity crisis; instead they hoard the very liquid and safe assets that make up MZM.  Friedman would have understood that the financial crisis was a special situation, and hence required economists to look past the temporary blip in MZM, just as he had overlooked the rise in the base during 1929-33.  He understood that money was actually tight during 1929-33, despite the increase in the base and the low interest rates.  (And he’d understand that the bloated base since 2008 largely reflects interest-bearing excess reserves, where yields exceed the rate on T-bills.)

3.  Friedman also understood that in uncertain times markets can provide an indication of whether money is too tight.  Recall his defense of speculators, and also floating exchange rates.  He clearly thought market signals were meaningful.  In 1992 [Money Mischief] he endorsed Robert Hetzel’s idea of having the Fed directly target expected inflation, by trying to peg the spread between nominal and indexed bonds.  Now recall that the TIPS spread briefly went negative in late 2008, and even today is only about 1% for one and two year T-bonds.  So if Friedman thought Hetzel’s proposal was a good idea, I think it unlikely he would brush off the message in the TIPS markets, as many conservatives seem to do.  The markets are clearly indicating both inflation and output will remain below the Fed’s implicit target for quite some time.  Friedman would have seen the importance of those market signals.

4.  There are some modern monetarists, such as Tim Congdon  (and this), who have made many of the same arguments that I’ve used in this post.  

To summarize:

1.  In 2009 NGDP fell at the sharpest rate since 1938.  And NGDP growth is expected to remain very weak.   If M*V is that weak, something must be wrong.

2.  Friedman argued the low rates in Japan were actually evidence of tight money.

3.  Friedman would have been concerned by the abrupt slowdown in the growth rates of the monetary aggregates since mid-2009.

4.  Some modern monetarists like Tim Congdon think money is way too tight.

The burst of M2 and MZM in 2008-09 does point slightly in John Taylor’s favor, but overall I believe the evidence supports Baum’s view.

Of course neither John Taylor nor I hold identical views to Friedman.  He supports the Taylor Rule (why not, he invented it!)  I give him a lot of credit, as the Taylor principle is the primary factor behind the Great Moderation.  However I believe a Svenssonian “targeting the forecast” approach is even better.  In September 2008 the Fed failed to cut rates below 2%, looking backward at the high rates of headline inflation during the summer of 2008.  But forward-looking real growth and inflation indicators were already slowing rapidly, indeed the TIPS spread on 5 year bonds fell to 1.23% just before the post-Lehman Fed meeting.  I think almost everyone would now agree the Fed should have moved much more aggressively in September 2008, before rates had fallen to zero.  A forward-looking approach would have allowed them to do so, but instead they relied on historical data that seemed to suggest the risks of inflation and recession were equally balanced.  They did nothing.

I suppose the fight over Friedman’s legacy is related to the fact that he is the one right-wing macroeconomist who is almost universally respected by conservative/libertarian economists.  Even though I’m not a strict monetarist, I’d like to think he would support my view of the current crisis.  I’m guessing Taylor feels the same way.

HT:  DanC, Benjamin Cole, David Pearson, Richard W.

PS:  After 16 months of leisure frantic blogging activity, school starts tomorrow.  Unfortunately, posting and comment replies will have to slow down.

Let’s suppose neoliberalism works.  What should have happened as a result of all those Chinese reforms.  Here are three choices:

1.  China stays as poor (in relative terms) as in 1976.  Comparable to central Africa, or Bangladesh.

2.  China grows rapidly, but even in 2010 remains much poorer than Mexico.

3.  China grows at explosive rates, and became a fully-developed country by 2010.

Which would be the outcome that would vindicate neoliberalism?  And which would refute it?  I could imagine reasonable people saying #2 would vindicate the neoliberal reforms.  That’s what I’d say, and that’s what happened.  I could imagine someone hostile to capitalism insisting that only #3 would count as success.  But I must admit that until I read this book review from John Gray, I could never have imagined someone arguing that only outcome #1 would vindicate neoliberalism.  At least that’s what I think he is saying.  See what you think:

Disdainful or ignorant of the past, Ridley is uninterested in the forces that shape events. He writes hundreds of pages about the wealth-increasing virtues of free markets, but allots post-Mao China only a few lines. This brevity is symptomatic, as China falsifies Ridley’s central thesis; the largest burst of continuous economic growth in history has occurred without the benefit of free markets. Wealth has been created as never before, not as a result of evolutionary change, but as a product of revolution and dictatorship.

Am I misreading Gray, or is he actually saying that all that growth that followed Mao’s death is evidence that market reforms don’t work?  If I met him I’d love to ask him what sort of outcome for China would count as success for their neoliberal reforms.  I’ve noticed that when people have a strong aversion to a particular ideology, the answer is often a null set.  Is it just me, or do you guys think that if China was still as poor as sub-Saharan Africa, Gray would be using that fact as evidence neoliberal reforms don’t work?

At the opposite extreme, this is from an excellent book review written by Ronald McKinnon:

John Williamson (1990) did all a great favor by writing down the rules for what he called “The Washington Consensus” for developing countries to follow to absorb aid efficiently:

1. Fiscal policy discipline.
2. Redirection of public spending from subsidies (“especially in discriminate subsidies”)
toward broad-based provision of key pro-growth, pro-poor services like primary
education, primary health care, and infrastructure;
3. Tax Reform—broadening the tax base and adopting moderate marginal tax rates:
4. Interest rates that are market determined and positive (but moderate) in real terms;
5. Competitive exchange rates;
6. Trade liberalization—with particular emphasis on the elimination of quantitative
restrictions; any trade protection to be provided by low and relatively uniform tariffs;

7. Liberalization of inward foreign direct investment;
8. Privatization of state enterprises;
9. Deregulation—abolish regulations that impede market entry or restrict competition, except for those justified on safety, environmental and consumer protection grounds, and prudent oversight of financial institutions.
10. Legal security for property rights.

To provide perspective on these ten rules, the year 1990, when Williamson wrote, is important. It was just after the fall of the Berlin Wall and the complete collapse of confidence in Soviet-style socialism. The rules reflect the hegemonic confidence that most people then had in liberal market-oriented capitalism—think Ronald Reagan and Margaret Thatcher. But, 20 years later, should the meteoric rise of socialist China—both in its own remarkable growth in living standards, and in the effectiveness of its foreign “aid” to developing countries, undermine our confidence in Williamson’s Washington Consensus?

Surprisingly, no. The Chinese economy itself has evolved step-by-step (feeling the stones) into one that can be reasonably described by Williamson’s 10 rules!

At first glance McKinnon can seem just as out of touch as Gray, albeit in the opposite direction.  After all, we all know that China is following its own “Beijing consensus” which is much more state-led that the US system.  That’s partly true, but McKinnon makes a good case that China is gradually moving in the direction of the Washington consensus, even as we move in the opposite direction.  The book review (which is quite long) also has some very interesting information about China’s involvement in Africa.

McKinnon may be a bit over-optimistic, but he’s much closer to the truth than Gray.  And Gray isn’t just wrong about the China’s economy, he also misses important changes in China’s political system, which is much less based on the whims of a single dictator than Gray suggests.  This book review from The Guardian does a nice job of showing what happens when you really do give absolute power to a single man:

The book’s title is somewhat misleading. Horrific as it was, with its cannibalism and people eating mud in search of sustenance, the famine generated by the Great Leap’s failure and the diversion of labour from farming was only part of a saga of oppression, cruelty and lies on a gargantuan scale. Initially launched to enable China to overtake Britain in steel production, Mao’s programme took on a deadly life of its own. At the apex of the system, the chairman refused to recognise reality, spoke of people eating five meals a day, insisted on maintaining food exports when his country was starving and indulged in macabre throwaway remarks such as: “When there is not enough to eat, people starve to death. It is better to let half of the people die so that the other half can eat their fill.”

.   .   .

Finally, somebody had to confront the leader. As China descended into catastrophe, the second-ranking member of the regime, Liu Shaoqi, who had been shocked at the conditions he found when he visited his home village, forced the chairman to retreat. An effort at national reconstruction began. But Mao was not finished. Four years later, he launched the Cultural Revolution whose most prominent victim was Liu, hounded by Red Guards until he died in 1969, deprived of medicines and cremated under a false name.

The Cultural Revolution is widely remembered, the Great Leap much less so. Having gone through those two experiences, not to mention the mass purges that preceded them and the Beijing massacre of 4 June 1989, it is little wonder if the Chinese of today are set on a very different course that rejects ideology in the interests of material self-advancement.

In my view the most important engine of human progress is not science, but rather the growing acknowledgement that governments should be at least somewhat utilitarian.  Not chasing grand dreams of one sort or another, but rather focused mostly on the well-being of the average person.  China’s hardly a model in that regard, but despite all its problems it is definitely moving in that direction.  It’s a pity that Gray doesn’t understand that the dramatic progress he describes has occurred precisely because China is far less dictatorial and far more market-oriented than in the 1970s. 

Another person who doesn’t seem to get it is Adam Phillips, who seems positively disdainful of the “pursuit of happiness.”  Oddly, he seems to think the monsters of the 20th century were not out fanatically pursuing glorious crusades, but rather merely engaged in the mundane task of making the German, Russian, Chinese and Cambodian people more comfy:

What exactly might it mean to have an “unalienable right” to “the pursuit of happiness”, given that it is fairly obvious that the pursuit of happiness is so morally equivocal – could be, among other things, a threat to the society that promoted it? At first sight it seems to be a pretty good idea; if we are convinced of anything now we are convinced that we are pleasure-seeking creatures, who want to minimise the pain and frustration of our lives. Or at least a “we” could be consolidated around these beliefs. We are the creatures who, possibly unlike any other animal, pursue happiness. But the pursuit of happiness, like the pursuit of liberty – the utopian political projects of the 20th century – has legitimated some of the worst crimes of contemporary history across the political spectrum.

Think about it.  Do you really think Hitler, Stalin and Pol Pot were trying to make people happier?   Does the description of Mao’s reaction to the famine sound like he’s a utilitarian?

One guy who does get it is V.S. Naipaul:

Familiar words, easy to take for granted; easy to misconstrue . . . This idea of the pursuit of happiness is at the heart of the civilization to so many outside it or on the periphery.  I find it marvelous to contemplate to what an extent, after two centuries, and after the terrible history of the earlier part of this century, the idea has come to a kind of fruition.  It is an elastic idea; it fits all men.  It implies a certain kind of society, a certain kind of awakened spirit.  So much is contained in it: the idea of the individual, responsibility, choice, the life of the intellect, the idea of vocation and perfectibility and achievement.  It is an immense human idea.  It cannot be reduced to a fixed system.  It cannot generate fanaticism.  But it is known to exist; and because of that, other more rigid systems in the end blow away.  (Talk given in 1991)

That’s right, the key word isn’t happiness, it’s ‘pursuit.’  Life should be a sort of adventure.  The philosopher kings that are disdainful of markets and democracy want society to embody their ideas.  The utilitarian says “let 6.7 billion adventures bloom.”

HT:  John Taylor, Tyler Cowen, Robin Hanson

Dangerous Defeatism is taking hold among America’s economic elites

Goldilocks has played a trick on America. Growth is not warm enough to prevent hard-core unemployment climbing to post-war highs and sticking at levels that corrode the body politic, but not yet cold enough to overcome the fierce resistance of the Fed’s regional hawks for a fresh blast of stimulus.

Read the entire article, it’s great.  He has the same views as I do, but writes far better.

In this recent post I talked about how the British seemed to understand our monetary dilemma better they we do.  (I might have added that I once thought we understood the Japanese problem better than they did.  Now I wonder.)  In that earlier post I discussed some recent articles at The Economist Free Exchange and the Financial Times.  Do you ever see any articles in the NYT or WSJ that seem to understand monetary policy?  I suppose I am sounding like Brad DeLong, but on monetary economics the difference between the two countries’ press corps is so striking that it calls out for an explanation.  Does anyone have one?

Remember the phrase “overpaid, over-sexed and over here?”  If even the Brits are telling us Americans to get some (monetary) testosterone and snap out of our malaise, what does that tell you?

HT:  David Stinson

Just so I am not misunderstood, this post is not a criticism of Dean Baker.  Commenters sent me links to bubble predictions Baker made in 2002 and also 2005.  I am going to argue that the 2002 prediction was neutral, neither particularly good nor bad, and the 2005 prediction was a good one.  All in all a decent record, nothing that deserves criticism.  Rather I’d like to focus on a narrow technical point, and argue his 2005 prediction was actually far superior, even though it came later. 

Precisely what does it mean to predict a housing bubble?  Are people predicting that one will occur in the future?  That prices will rise very rapidly?  Or are they predicting that one is already here, that prices are too high relative to market fundamentals?  I think it is usually the latter.  If the term ‘bubble’ is to have any meaning at all (other than the trite observation that prices have recently risen) there must be an implied prediction that in the not too distant future (i.e. not 100 years out) prices will fall back closer to their fundamental value.  I’ve argued this point ad nauseum, and won’t repeat it here.  My hunch is that people confuse these two issues, which is why many people assume it is easier to spot bubbles than it really is.

Here is what Dean Baker said in 2002:

This paper examines whether the increase in home prices can be grounded in fundamental economic factors or whether it is simply a bubble, similar to the stock market bubble. It concludes that there is a housing bubble. While this process can sustain rising prices for a period of time, it must eventually come to an end.

He does acknowledge prices might rise before dropping, which is of course what happened.  But that comment is so vague that I take it as one of those things you almost have to say.  After all, if prices have been rising fast, only a fool would predict an immediate and sharp decline, especially given that housing prices have a bit more momentum that stock prices.  In a nutshell, I infer that he is mostly saying that housing prices have risen above their fundamental value and that at some point the real price of housing should drop to more reasonable levels. 

In this paper from late 2005, he and David Rosnick again make a bubble prediction.  This time much more accurately, in my view.

In my Krugman post, I used this graph to think about the accuracy of bubble predictions.  I argued that those seeing a bubble in the US in 2005 were right, but in Britain, New Zealand and especially Australia they were wrong (thus far.) 

If you just eyeball the data, to me it looks like these prices occurred in the US:

2002:  200

2005:  300

2006:   350

2010:   250

So it’s fair to say that 2005 bubble predictions turned out to be accurate.  But what about 2002?  Well the actual price seems to have risen about 25% in 8 years.  That’s not too different from the overall inflation rate, and hence I’d say there hasn’t been much change in real housing prices.  So I’d call that a neutral, where lower real prices in 2010 would be a win for Baker, and higher real prices would have been a loss.

I’d like to use an analogy, to suggest why it’s better to be late than early, why Krugman actually deserves credit for being late to the bubble party.  I recall after the 1987 stock market crash that someone praised John K. Galbraith for having predicted a stock crash.  He made the prediction in January 1987, when the Dow was around 1700.  It then rose to 2700 in August, before crashing to 1700 in late October.  So was Galbraith right?   As this post shows, people seem to assume he was.  But I’d say no, as his prediction really didn’t convey useful information:

1.  If you sold stocks on his prediction, you would not have made money—even in the long run.

2.  It was an implied prediction that stocks were overvalued relative to fundamentals.  But today very few people would say the Dow was overvalued in 1987 at 1700, indeed if anything it might have been a bit undervalued.  This shows how hard it is for even a very smart person to know whether something was overvalued in real time.  I could say the same about Boston house prices in 1987, and I’m sure people living in Manhattan, London, Vancouver or San Francisco could provide similar examples of prices that once seemed insane, but now (even in this recession) actually look (in retrospect) like equilibrium prices.

I think a good prediction, a useful prediction, would be someone that predicted a stock market crash in August 1987, not January 1987.  Those are the people who deserve credit if you (unlike me) believe market predictions aren’t just dumb luck.

I can think on one counterargument.  One could argue that an early prediction might have resulted in public policy changes that prevented the worst of the housing bubble.   But I favored those public policy changes even without being able to predict the bubble.  And I’m claiming it’s not obvious there was a bubble in 2002.  I’d hate to have public policy decisions based on inaccurate bubble predictions.

So from now on when someone tells you that Dean Baker predicted the housing bubble back in 2002, the correct response is “You think that’s impressive, well Krugman predicted it in 2005!”  Enjoy the puzzled look in their eyes, and savor the thought that you are soon about to show your superiority by setting them straight.  At least if you’re as big a jerk as I am.

PS.  Take a look at the link discussing Galbraith.  It was from 1994, and they assumed we were in the midst of another speculative bubble—when the Dow was trading in the 3500 to 4000 range.  What do you want to bet that they said “I told you so” in 2003, after the crash brought prices down to 8000?

1.  In the 1970s I thought we were on the road to serfdom.  I bought the whole Mancur Olson argument that modern democracies gradually became more statist, as they get captured by special interest groups.  (I haven’t read him in a while, so I am probably oversimplifying.)

2.  In the 1970s I thought communism was more of a threat than it turned out to be.  (Ditto for Iraq in 2003.)

3.  In the 1970s I thought monetary policy operated with long and variable lags, and thus fine-tuning would make things worse.

4.  In the 1970s I thought the Nordic economic model was much more seriously flawed than it really is.

5.  I used to think moral and aesthetic beliefs were ‘”mere opinion” and scientific beliefs were “objective facts.”

6.  I used to think I was smarter than other people who are just as intelligent as I am.  Actually I sort of still believe this, but at least now one half of my brain knows how silly the opinion held by the other half of my brain really is.

7.  In 2007 I thought it very unlikely that there would be a severe US banking crisis.

8.  In 2007 I thought the Fed would be able to avoid a Japanese-style zero rate trap.

9.  I predicted that aggressive QE would raise long term interest rates, a view which seemed to be refuted by the response on T-bond yields to the March 2009 Fed QE announcement. 

10.  I thought Brett Favre really was going to retire this year, after he said he was going to.  Arguably my most embarrassing error.

I’d like to talk about number 9 for a moment.  Any effective monetary stimulus would be expected to raise long term rates.  We have plenty of examples of that occurring.  My favorite is the surprise stimulus announcement of January 3, 2001, which caused long term (nominal) rates to soar.   Thus I was shocked to see long term rates fall sharply on the day of the March 2009 QE announcement. 

I don’t have a good theory for why that happened.  One could point to the fact that they quickly reversed, and soon rose far above the pre-announcement level.  So maybe markets made a mistake and I was right all along.  But that means the EMH is wrong, a theory I hold even more dearly.  So either way I’m screwed.

If I had to guess I’d say it might have something to do with the type of stimulus.  It didn’t so much raise the monetary base (indeed the Fed was correct in denying that it really was QE) rather it changed the composition of their balance sheet.  Even so, other markets (stocks, foreign exchange) reacted as if it was bona fide monetary stimulus.  So I am not really satisfied with that explanation either.

I am reluctant to form a firm opinion based on a single observation, so I will watch market reactions to other QE-type actions, to see if a pattern develops.  If I was forced to critique my own blog, the market response to the Fed’s March 2009 “QE” would be my number one weapon.

The study released Wednesday estimates that 11.1 million illegal immigrants lived in the U.S. in 2009. That represents a decrease of roughly 1 million, or 8 percent, from a peak of 12 million in 2007.

The study puts the number of illegal immigrants down to about where it was in 2005. They still make up roughly 4 percent of the U.S. population.

The Homeland Security Department’s own estimate of illegal immigrants is slightly lower, at 10.8 million. The government uses a different census survey that makes some year-to-year comparisons difficult.

Of course these are rough estimates, but let’s say a ballpark estimate is that since 2007 we have been losing about 300,000 illegals per year, instead of gaining 700,000 per year.   If so, then it appears population growth in the US might have slowed by about 1 million per year.  Births and deaths don’t change much year to year, and I was also unable to find any indication that legal immigration had changed much in the last three years.  It turns out the data is collected in a very confusing way, and I wasn’t able to find a reliable Census bureau estimate of the components of population growth.  The Census doesn’t show much change in US annual population growth rates, but given they were embarrassed to find 6 million more in the 2000 census than expected, I think it’s fair to say they don’t have a good handle on illegal immigration. 

So let’s suppose US population growth fell by one million after 2007, as a result of both the immigration crackdown and the recession.  Could this have caused the housing crash?  Just to get a rough idea of the magnitudes here, let’s assume a very simple model:

1.  Three people per family.

2.  Normal population growth 3 million per year.

3.  300,000,000 US residents

4.  100,000,000 US housing units

5.  Houses depreciate at 1% per year.

In this model we need a million new houses a year for new population, and another million replacement houses for depreciation.  Total construction should be 2,000,000/year, which was roughly the level of the mid-2000s.  Now assume population growth falls by 1,000,000.  This should reduce steady-state housing construction by 1/6th.  Not enough for a housing crash. 

If the slowdown was concentrated in illegal immigrant-rich areas with fast population growth (California’s Inland Empire, Arizona, Nevada, etc) it could have had a significant effect on local markets—perhaps two or three times as large as the nationwide effect.  That could have triggered a significant housing slump in the sub-prime markets.  On the other hand, some immigrants left for reasons other than the immigration crackdown and the resulting drop in housing construction jobs.  So there is the issue of disentangling the various shocks.  If the immigration crackdown contributed to the decline in housing construction, there would be some sort of multiplier effect, as other immigrants would leave because of the resulting drop in economic activity.  But I don’t want to oversell that multiplier, as most of the recession was in non-housing areas.

Let me also emphasize that I am not trying to explain away bubble-like behavior at the micro level.  None of this explains banks giving mortgages to low income farm workers so they could buy $500,000 homes, rather I am trying to better understand how at the macro level otherwise intelligent investors might have gotten caught off guard by the nationwide housing slump and fall in real estate prices.  One factor propping up prices (rapid immigration) was pulled away unexpectedly.   In other parts of the country, the early stages of the housing slump were much less severe.

Now let’s suppose that some combination of less immigration and ordinary post-bubble problems led to severe banking problems for institutions that held lots of MBSs.  The Fed mishandles this problem and lets NGDP fall 8% below trend.  Now falling NGDP causes housing prices in non-sub-prime areas to begin falling.  Ditto for commercial real estate.  We saw in an earlier post that it was commercial real estate, not subprime housing, which was the main cause of bank failures. 

I actually think immigration was much less than 50% of the initial problem.  But even if it was only 20%, because of the various ripple effects that I just described it is not inconceivable that the ultimate effect of the immigration crackdown could have been quite significant.  In 2008 there may have been a “knife edge” equilibrium, where if the economy had been a bit stronger we might have avoided the zero rate bound.  And if we had avoided that problem, monetary policy might have been able to prevent a steep fall in NGDP.  Maybe immigration is one reason Australia avoided the zero bound and steep recession.  Still, this is all speculation.  Even though I favor a high rate of immigration, the preceding story seems far too speculative to inform our immigration policy.  We are better off learning from other countries that do it better than us (yes, I mean Australia and Canada.)

PS:  There are lots of guesstimates in this post.  My hunch is that immigration slowed, but by less than 1,000,000 per year.  But births have also slowed by a few hundred thousand, which I excluded from the estimates.  Again, I am not looking for a monocausal explanation of the housing crash.  I think it likely that almost all giant economic disasters have multiple causes, whether it be the Great Depression, or the Great Recession.

Let’s use the archive list of months as a vertical line to estimate prices in 2005 when Krugman made the call, and compare them to today’s price:

US   2005 = 300,  2010 = 250

UK  2005 = 375,  2010 = 395

NZ  2005 = 330,  2010 = 430

Aus 2005 = 390,  2010 = 550

I don’t know about you, but to me only the US looks like a clear-cut bubble.  Yes there were some rises and falls in other countries, but it wasn’t obvious (ex ante) in 2005 whether prices in the other three countries were above or below their long run equilibrium.  Indeed it still isn’t, as Australian housing prices could crash at any time. 

I’ve consistently argued that the bubble theory is only useful if it leads to good predictions.  Krugman did make a good prediction, that housing prices would be lower in the not too distant future.   BTW, I’d say you at least need to provide some sort of time frame—say 5 years out.  It’s not enough to say “I predict prices will keep rising, and then eventually fall.”  That’s true of any market.  Although Krugman did not provide a specific number in the post I linked to, I am pretty sure that the actual drop in the US occurred over the sort of time frame he envisioned, if he had been forced to name a date.  So I give him complete credit for a correct prediction. 

But here’s my question.  Given that the other three markets did not decline over the same time period, is it really true that we could be confident, ex ante, that US houses were overpriced in 2005?  It certainly seems so given everything that has happened since, but might that be a cognitive illusion?  Confirmation bias?  I doubt Krugman thought NGDP would suddenly fall 8% below trend in the 12 months after mid-2008.  Where would housing prices be today if NGDP had kept growing at 5%.  I don’t know.

I’m inclined to believe there was some irrationality in the 2005 housing market, but I am less confident than Krugman that price bubbles are easy to spot.  In the next post I’ll provide one reason why, despite the undeniable excesses that swept the housing market, investors with rational expectations about NGDP growth and immigration might not have spotted the oncoming collapse in US housing prices.

BTW, look at housing prices in Australia; the one country on the list that did not experience a recession in 2008, and which has very rapid immigration.

PS.  This interactive graph in The Economist shows that among 20 countries, only the US and Ireland showed a clear bubble-like pattern after 2005.  In most countries prices are now higher than in 2005, and in the few other exceptions (Germany, Japan) there had been no run-up in prices prior to 2005.  So my results don’t come from cherry-picking these four anglophone nations, bubbles really are hard to spot.  (I’m puzzled by the Spanish price graph, but even if it is inaccurate and Spain was a bubble, that just makes three clear bubbles in The Economist group of 20.)

You can adjust the horizontal scale to get different starting dates.   Many countries saw steep price run-ups prior to 2005.  If you start at 2005:Q2, it’s easy to compare current prices to mid-2005 prices.

PPS:  Compare Krugman’s mea culpa post, with these Japan predictions dredged up by David Henderson.  The second paragraph shows Krugman at his best.  What happened to that guy?

There is a good reason why most bank failures in 2009 did not occur in the sub-prime states; sub-prime loans were not the main problem.  Indeed mortgages of all types were not the main problem.  What was?  According to McNewspaper USA Today it was construction loans, often for commercial real estate: 

The biggest bank killer around isn’t some exotic derivative investment concocted by Wall Street’s financial alchemists. It’s the plain old construction loan, Main Street banks’ bread and butter for decades.

Deutsche Bank has called them “without doubt, the riskiest commercial real estate loan product.” The Congressional Oversight Panel, a financial watchdog, has warned that construction loans have deteriorated faster and inflicted bigger losses on banks than any other real estate loans.

That’s right, everything we were told about the financial crisis in 2009 (and which I also believed for a while) is wrong.  It’s a commercial RE crisis, not a mortgage crisis.   You might argue that it was housing loans that triggered the liquidity crisis of late 2008.  Yes, but the crash of late 2008 was caused by the Fed’s failure to do level targeting once rates hit zero.  The main public policy issue with bank failures is the cost to taxpayers, not the impact on the business cycle. 

In earlier posts I argued that the commercial real estate market does not appear to have been a bubble.  It held up very well in late 2006 and 2007, even as residential housing was falling almost continuously.  Only when NGDP growth slowed in 2008, did commercial real estate begin a significant decline.  No big surprise there, commercial real estate is extremely sensitive to falls in NGDP produced by excessively tight money.  The same problem hit commercial RE in the 1930s, when NGDP fell in half.  There are stories of the Empire State Building being mostly empty after it opened in 1931.

Why were all those bad commercial real estate loans made?  After all, shouldn’t banks take into account the risk of recession?  Well nobody could have expected NGDP to suddenly fall 8% below trend.  But even so, there clearly is a problem here.  Indeed it appears that our current banking crisis, which was initially thought to be very different from the 1980s S&L fiasco, was almost an exact replay of that earlier crash.  Initially we were told that the big banks were the problem this time–it was all about “Too-Big-to-Fail.”   But they have been quietly repaying their TARP loans.  Even the worst banking fiasco in nearly 80 years will not result in taxpayer money being permanently transferred to big banks.  Even if you include the AIG bailout as an implicit bailout of the big banks, the small banks are still the main problem.  Our government insurance company let’s smaller banks run wild, just as in the 1980s (i.e. before the so-called “regulatory reforms” that were supposed to fix the S&L problem.)  The cost to FDIC of all these smaller bank failures in places like Georgia will be many times larger than the net cost of AIG plus the banking part of the TARP bailout.  And let’s not even talk about the cost of bailing out the GSEs.

It’s not about big banks and it’s not about derivatives:

It did not end well. Construction loans started blowing up when the real estate market collapsed and the economy tumbled into recession. The 10 biggest banks, facing problems of their own with subprime mortgages, were largely immune to the deterioration in construction loans, which accounted for just 2% of their assets in 2007, according to the Federal Reserve. By contrast, construction loans accounted for more than 10% of assets at banks that didn’t rank in the top 1,000. “What’s causing the problem is Main Street America, the construction loan made by the bank down the street,” says Bill Bartmann, who owns a debt advisory firm. “They built, and nobody came.”

Making matters worse: Community banks never sold the construction loans to investors the way banks unload auto loans and residential mortgages. “Most construction loans are so unique, so different, so non-homogenous, that you can’t securitize them,” Bartmann says. “They were kept on the books of the banks that originated them.” And there, many of them started to turn rotten.

Here’s an example of what banks did in Georgia:

Rollo Ingram witnessed one spectacular flameout up close. He was chief financial officer at Atlanta’s RockBridge Commercial Bank, which opened in 2006, backed by other members of the city’s business elite.

RockBridge told banking regulators it planned to specialize in business lending. It didn’t, plunging instead into real estate and construction loans. The bank told regulators in 2006 that construction loans would account for 5% of its portfolio. By the end of 2007, they accounted for 42%. Business loans, which were supposed to make up 50% of RockBridge’s lending, came to just 28%, according to an after-the-fact autopsy by Federal Deposit Insurance Corp.’s inspector general.

Nor did RockBridge recruit veteran loan officers with enough experience to safely assemble its risky portfolio, the inspector general concluded. “They hired younger, less-experienced ones, and didn’t hire enough of them,” Ingram says. He says he was forced out in 2008 when he complained about the risky direction the bank was taking.

Those on the left complained the banking crisis resulted from “laissez-faire,” forgetting that the federal government effectively nationalized most of the liabilities of the banking system in 1934.  That’s right; when you deposit $100 in your bank account you are actually lending the money to Uncle Sam, who re-lends it at the same rate to the bank.  FDIC is effectively a government institution, and the fees on banks are effectively taxes, which of course are passed onto the public.  The government didn’t seem to care that wildcat banks in Georgia colluded with property speculators and ran wild with government loans made at risk free rates.

But some on the right were arguably even worse, not paying enough attention to this problem and constantly harping on the need for “deregulation,” aka the doctrine of “business should be free of regulations that inhibit their ability to loot the Treasury.”

I’m amazed that after the S&L fiasco of the 1980s our government wasn’t able to figure out the problem.  Or maybe they do understand the problem, but are in the pocket of property developers. 

And of course now if someone proposed a crackdown, there’d be complaints about how it would “starve the economy of capital, and slow the recovery.”  Just one more side-effect that results when hawks at the Fed prevent an adequate recovery in NGDP.

Update:  I just saw an example of the “blame it all on laissez-faire” meme discussed in Arnold Kling’s blog.  And Barry Eichengreen isn’t even very left wing.