Some Thoughts on Liquidity

The quantity theory relates not so much to money as to the whole array of financial assets exogenously supplied by the government. If the government debt is doubled in the absence of a government-determined monetary base the price level doubles just as well as in the case of a doubling of the monetary base in the absence of government debt. — Jurg Niehans, 1982

Seemingly lost in the discussion of monetary policies various QEs is a meaningful resolution of our understanding of the monetary transmission mechanism.  Sure, New Keynesians argue that forward guidance about the time path of the short term nominal interest rate is the mechanism, Bernanke argues that long term interest rates are the mechanism, and skeptics of the effectiveness of QE argue that it is the interest rate on excess reserves that is the mechanism.  I actually think that these are not the correct way to think about monetary policy.  For example, there are an infinite number of paths for the money supply consistent with a zero lower bound on interest rates.  Even in the New Keynesian model, which purportedly recuses money from monetary policy, the rate of inflation is pinned down by the rate of money growth (see Ed Nelson’s paper on this).  It follows that it is the path of the money supply that is more important to the central bank’s intermediate- and long-term goals.  In addition, it must be the case that the time path of the interest rate outlined by the central bank is consistent with expectations about the future time path of interest rates.  The mechanism advocated by Bernanke is also flawed because the empirical evidence suggests that long term interest rates just don’t matter all that much for investment.

The fact that I see the monetary transmission mechanism differently is because you could consider me an Old Monetarist dressed in New Monetarist clothes with Market Monetarist policy leanings (see why labels are hard in macro).  Given my Old Monetarist sympathies it shouldn’t be surprising that I think the aforementioned mechanisms are not very important.  Old Monetarists long favored quantity targets rather than price targets (i.e. the money supply rather than the interest rate).  I remain convinced that the quantity of money is a much better indicators of the stance of monetary policy.  The reason is not based on conjecture, but actual empirical work that I have done.  For example, in my forthcoming paper in Macroeconomic Dynamics, I show that many of the supposed problems with using money as an indicator of the stance of monetary policy are the result of researchers using simple sum aggregates.  I show that if one uses the Divisia monetary aggregates, monetary variables turn out to be a good indicator of policy.  In addition, changes in real money balances are a good predictor of the output gap (interestingly enough, when you use real balances as an indicator variable, the real interest rate — the favored mechanism of New Keynesians — is statistically insignificant).

Where my New Monetarist sympathies arise is from the explicit nature in which New Monetarism discusses and analyzes the role of money, collateral, bonds, and other assets.  This literature asks important macroeconomic questions using rich microfoundations (as an aside, many of the critics of the microfoundations of modern macro are either not reading the correct literature or aren’t reading the literature at all).  Why do people hold money?  Why do people hold money when other assets that are useful in transactions have a higher yield?  Using frameworks that explicitly provide answers to these questions, New Monetarists then ask bigger questions. What is the cost associated with inflation? What is the optimal monetary policy? How do open market operations work?  The importance of the strong microfoundations is that one is able to answer these latter questions by being explicit about the microeconomic assumptions.  Thus, it is possible to make predictions about policy with an explicit understanding of the underlying mechanisms.

An additional insight of the New Monetarist literature is that the way in which we define “money” has changed substantially over time.  A number of assets such as bonds, mortgage-backed securities, and agency securities are effectively money because of the shadow banking system and the corresponding prevalence of repurchase agreements.  As a result, if one cares about quantitative targets, then one must expand the definition of money.  David Beckworth and I have been working on this issue in various projects.  In our paper on transaction assets shortages, we suggest that the definition of transaction assets needs to be expanded to include Treasuries and privately produced assets that serve as collateral in repurchase agreements.  In addition, we show that the haircuts of private assets significantly reduced the supply of transaction assets and that this decline in transaction assets explains a significant portion of the decline in both nominal and real GDP observed over the most recent recession.

The reason that I bring this up is because this framework allows us not only to suggest a mechanism through which transaction assets shortages emerge and to examine the role of these shortages in the context of the most recent recession, but also because the theoretical framework can provide some insight into how monetary policy works.  So briefly I’d like to explain how monetary policy would work in our model and then discuss how my view of this mechanism is beginning to evolve and what the implications are for policy.

A standard New Monetarist model employs the monetary search framework of Lagos and Wright (2005).  In this framework, economic agents interact in two different markets — a decentralized market and a centralized market.  The terms of trade negotiated in the decentralized market can illustrate the effect of monetary policy on the price level. (I am going to focus my analysis on nominal variables for the time being.  If you want to imagine these policy changes having real effects, just imagine that there is market segmentation between the decentralized market and centralized market such that there are real balance effects from changes in policy.)  In particular the equilibrium condition can be written quite generally as:

P = (M+B)/z(q)

where P is the price level, M is the money supply, B is the supply of bonds, and z is money demand as a function of consumption q.  I am abstracting from the existence of private assets, but the implications are similar to those of bonds.  There are a couple of important things to note here.  First, it is the interaction of the supply and demand for money that determines the price level.  Second, it is the total supply of transaction assets that determines the price level.  This is true regardless of how money is defined.  Third, note that as this equation is presented it is only the total supply of transaction assets that determine the price level and not the composition of those assets.  In other words, as presented above, an exchange of money for bonds does not change the price level.  Open market operations are irrelevant.  However, this point deserves further comment.  While I am not going to derive the conditions in a blog post, the equilibrium terms of trade in the decentralized market will only include the total stock of bonds in the event that all bonds are held for transaction purposes.  In other words, if someone is holding bonds, they are only doing so to finance a transaction.  In this case, money and bonds are perfect substitutes for liquidity.  This implication, however, implies that bonds cannot yield interest.  If bonds yield interest and are just as liquid as money, why would anyone hold money? New Monetarists have a variety of reasons why this might not be the case.  For example, it is possible that bonds are imperfectly recognizable (i.e. they could be counterfeit at a low cost). Alternatively, there might simply be legal restrictions that prevent bonds from being used in particular transactions or since bonds are book-entry items, they might not as easily circulate.  And there are many other explanations as well.  Any of these reasons will suffice for our purposes, so let’s assume that that is a fixed fraction v of bonds that can be used in transactions.  The equilibrium condition from the terms of trade can now be re-written:

P = (M + vB)/z(q)

It now remains true that the total stock of transaction assets (holding money demand constant) determines the price level.  It is now also true that open market operations are effective in influencing the price level.  To summarize, in order for money to circulate alongside interest-bearing government debt (or any other asset for that matter) that can be used in transactions, it must be the case that money yields more liquidity services than bonds.  The difference in the liquidity of the two assets, however, make them imperfect substitutes and imply that open market operations are effective.  It is similarly important to note that nothing has been said about the role of the interest rate.  Money and bonds are not necessarily perfect substitutes even when the nominal interest on bonds is close to zero. Thus, open market operations can be effective for the central bank even if the short term interest rate is arbitrarily close to zero.  In addition, this doesn’t require any assumption about expectations.

The ability of the central bank to hit its nominal target is an important point, but it is also important to examine the implications of alternative nominal targets.  Old Monetarists wanted to target the money supply.  While I’m not opposed to the central bank using money as an intermediate target, I think that there are much better policy targets.  Most central banks target the inflation rate.  Recently, some have advocated targeting the price level and, of course, advocacy for nominal income targeting has similarly been growing.  As I indicated above, my policy leanings are more in line with the Market Monetarist approach, which is to target nominal GDP (preferable the level rather than the growth rate).  The reason that I advocate nominal income targeting, however, differs from some of the traditional arguments.

We live in a world of imperfect information and imperfect markets. As a result, some people face borrowing constraints.  Often these borrowing constraints mean that individuals have to have collateral.  In addition, lending is often constrained by expected income over the course of the loan.  The fact that we have imperfect information, imperfect markets, and subjective preferences means that these debt contracts are often in nominal terms and that the relevant measure of income used in screening for loans is nominal income.  A monetary policy that targets nominal income can potentially play an important role in two ways.  First, a significant decline in nominal income can be potentially harmful in the aggregate.  While there are often claims that households have “too much debt” a collapse in nominal income can actually cause a significant increase and defaults and household deleveraging that reduces output in the short run.  Second, because banks have a dual role in intermediation and money creation, default and deleveraging can reduce the stock of transaction assets.  This is especially problematic in the event of a financial crisis in which the demand for such assets is rising.  Targeting nominal income would therefore potentially prevent widespread default and develeraging (holding other factors constant) as well as allow for the corresponding stability in the stock of privately-produced transaction assets.

Postscript:  Overall, this represents my view on money and monetary policy.  However, recently I have begun to think about the role and the effectiveness of monetary policy more deeply, particularly with regards to the recent recession.  In the example given above, it is assumed that the people using money and bonds for transactions are the same people.  In reality, this isn’t strictly the case.  Bonds are predominantly used in transactions by banks and other firms whereas money is used to some extent by firms, but its use is more prevalent among households.  David Beckworth and I have shown in some of our work together that significant recessions associated with declines in nominal income can be largely explained through monetary factors.  However, in our most recent work, it seems that this particular recession is unique.  Previous monetary explanations can largely be thought of as currency shortages in which households seek to turn deposits into currency and banks seek to build reserves.  The most recent recession seems to be better characterized as a collateral shortage, in particular with respect to privately produced assets.  If that is the case, this calls into question the use of traditional open market operations.  While I don’t doubt the usefulness of these traditional measures, the effects of such operations might be reduced in the present environment since OMOs effectively remove collateral from the system.  It would seem to me that the policy implications are potentially different.  Regardless, I think this is an important point and one worth thinking about.

Observational Equivalence, Again

Suppose that prior to the recession, I told you that I had a theory of the business cycle. My theory suggested that shocks to net worth were a significant explanation of the business cycle. Following a shock to net worth, consumption, investment, and hours worked would decline. Suppose that I also told you that increases in the monetary base by the Federal Reserve would keep inflation close to the implicit objective, but have little effect on consumption, investment, and real GDP. Given the events of the last four years, this theory seems to fit pretty well with what we have actually observed. What might surprise you, however, is that the framework I am describing is a real business cycle model with financial market frictions. This view seems largely consistent with James Bullard’s interpretation of events.

Suppose instead that I told you that I had the following theory of the business cycle. My theory suggested that liquidity shocks were a significant explanation of the business cycle. Following a shock to liquidity, and without appropriate Federal Reserve policy, nominal and real GDP would decline and unemployment would rise. In addition, suppose that I told you that if the Federal Reserve increased the monetary base without an explicit target or goal that such an expansion would have little effect on real economic activity. Given the events of the last four years, this theory seems to fit pretty well with what we have actually observed. This view is largely consistent with Scott Sumner’s interpretation of events.

I have used these two examples to illustrate a couple of points. First, neither Bullard nor Sumner (or anybody else associated with similar views) are crazy. They have logically consistent ideas that are consistent with casual observation. Second, confirmation bias is dangerous. It is very tempting to have a theory, look at the world, observe events consistent with your theory, and conclude that your theory is correct. But that is just confirmation bias. What is necessary is to provide evidence to support your theory in light of other theories that have observationally equivalent observations. This is substantially harder to do — even for those who realize it is necessary. Third, and perhaps most importantly, the ability to distinguish between these and other competing theories is incredibly important given the vastly different monetary policy implications.

Economics and Politics

I repeatedly hear claims that solving the current global economic problems merely requires political will. If it wasn’t for the Republican obstructionists or the pigheaded Germans, the problems could (would?) be solved. What I find frustrating about this narrative is its simultaneous simplicity and certainty about the necessary policy prescriptions. Isn’t it possible that so-called Republican obstructionism is the result of a belief on the part of Republicans that the policies they are supposedly obstructing would be ineffective or deleterious? Isn’t it possible that the German leadership is opposed to many suggested policy prescriptions because they believe that many of these proposals simply kick the can down the road and leave them holding the bag? (Isn’t it possible to squeeze countless metaphors into one sentence?!)

The point that I am making is not that the Republicans or the Germans are correct, but rather that it is not certain that they are incorrect. And in the case of Germany, it would seem that they have little to gain and much to lose by helping troubled Eurozone members. Many forget that from the German perspective the ECB’s monetary policy is close to optimal. As such, Germany is likely to be the most insulated from a European economic slowdown — at least according to New Keynesian-style logic. If it makes economic sense for the German leadership to take the position that it does, how can we fault them? Perhaps one could argue that they should care about their fellow Europeans, but that is philosophical and something that is beyond the scope of economics.

In the U.S., what types of policies have been prevented by political obstructionism that would have helped? What evidence is there that these policies would have helped? Is there a competing narrative that can explain the same outcome?

Frequent readers know that I think that monetary policy in the U.S. has been suboptimal. There are “political will” narratives here as well. Those who think that monetary policy has been tight think that the Fed lacks the political will to do what is correct right now. Many of those who think that monetary policy is going to create higher rates of inflation in the near future think that the Fed will lack the political will to bring down inflation when it starts to rise.

A much simpler story is that the Fed is an inflation targeter, with a not-so-implicit-anymore target of 2%. Under this narrative, the past rate of inflation is irrelevant. What matters is preventing the inflation rate from being consistently below target. When I look at the data and when I read speeches by folks like Jim Bullard, this seems entirely more plausible than the political will narrative.

In addition, if the political will narrative is correct, then aren’t these arguments really arguments against the Federal Reserve itself rather than merely policy? In other words, if there is an optimal policy that the Federal Reserve refuses to pursue because of political risks such as diminished credibility, then why have a monetary authority in the first place?

The political will narrative is easy to adopt and probably has some psychological appeal as well. If the POTUS isn’t signing into law policies that you believe would help or if the central bank isn’t following the policy that you believe would be optimal, it is perhaps easiest to think that they simply lack the political will to get things done. Whether policy has been optimal also depends on the objective. If the Fed’s objective is 2% inflation, then they have done a remarkable job. If the Fed’s objective is a trend path for the price level or nominal GDP, then they have done a substantially less than remarkable job. Perhaps it is political will that explains the policy path that has been chosen, but it is possible that there are alternative and entirely valid explanations of such a path.

Insiders Versus Outsiders

The Wall Street Journal reports:

So robust is the recovery in the U.S. auto industry that virtually all the union workers who were laid off by Detroit auto makers during the crisis years can have their jobs back, if they want them.

Even General Motors Co.’s Lordstown, Ohio, complex, long known for its money-losing small cars and its bad labor climate, is running 24 hours a day, with more than 4,000 workers churning out hot-selling Chevy Cruze compacts.

But here in Moraine, the GM assembly plant closed for good. Despite being one of GM’s most productive and cooperative factories, Moraine was closed following the company’s 2007 labor pact with the United Auto Workers union. Under a deal struck by the UAW during GM’s bankruptcy two years later, Moraine’s 2,500 laid-off workers were barred from transferring to other plants, locking them out of the industry’s rebound.

The trouble with Moraine: Its workers weren’t in the UAW.

[...]

Moraine’s workers got nothing in the bankruptcy deal. Their plant, which had closed months earlier, was ultimately sold to a developer. The workers were barred from transfers to UAW plants, as were thousands of others who had worked for Delphi Corp., GM’s former parts arm.

How Moraine’s interests diverged from the UAW’s is rooted in the plant’s history. A former appliance factory, it was converted to a pickup truck plant in 1981 after GM sold its Frigidaire brand. At the time, workers there elected to stick with their existing union, the International Union of Electrical Workers, rather than join the UAW. Over time, they generally accepted contracts negotiated by the UAW.

Through much of the 1990s, vehicles built at Moraine—models like the Chevy TrailBlazer and GMC Envoy—were big sellers and contributors to GM’s profits. In 2007, the plant won recognition as the nation’s most efficient midsize-SUV plant from the Harbour Report, a measure of manufacturing productivity.

“Moraine was always a good plant. The IUE was always a good union,” says Art Schwartz, former general director of labor for GM and now president of Michigan-based Labor & Economic Associates. “It’s a shame what happened to them.”

When GM began spiraling downward in 2007, as soaring fuel prices pummeled truck and SUV sales, IUE leaders decided to break ranks with the UAW and offer concessions to keep GM and Moraine afloat.

The IUE agreed to a two-tier wage system—long opposed by the UAW—in which new hires earn half as much as longtime workers. It also agreed to let the company unload its retiree health obligations into a union-run trust fund.

But as the crisis deepened, and GM and the UAW began negotiating a way out, Moraine’s workers had no seat at the table.

In the fall of 2007, GM promised work to dozens of UAW-represented plants in exchange for concessions on wages and health care, including some of the very changes offered by the IUE. By the time GM doled out enough work to satisfy the UAW, there was nothing left for Moraine.

The reference in the title is to this theory of the labor market.

The Strangest Thing I Read Today

Via Scott Sumner, I find Ezra Klein considering counterfactuals about policy and the recession. However, two sentences stuck out as particularly odd:

The stimulus was a bet that we could get out of this recession through the one path everyone can agree on: growth. The bet was pretty much all-in, and it failed.

The stimulus was about growth? Not the stimulus package that I saw.

The stimulus package was a “gap-closing” policy and the emphasis seemed to be more toward preventing the loss of public sector jobs like teachers, police, and fire service — as evident by the substantial chunk of the package that was devoted to transfers to states. Now we can debate the merits of such policies until we are blue in the fact, but there was very little in the way of growth-producing policies consistent with economic theory (and that remains true if you think that the transfer payments were good policy). What precisely was pro-growth about the stimulus package? Perhaps I missed something.

Quote of the Day

“Some articles point out one “bright spot” in this dismal day—the Fed succeeded in lowering long term yields. They also raised short term yields, making the yield curve flatter. You might want to get out your money textbook to find out what type of monetary policy causes a flatter yield curve.”

— Scott Sumner

Money, the Money Multiplier, and Monetary Theory

John Williams recently gave a speech on teaching about monetary theory and policy after the financial crisis. Here is the basic thesis:

When I was an undergraduate at Berkeley in the early 1980s, much of the monetary economics that I learned was based on theories from the 1950s or even earlier. These included the quantity theory of money, Keynes’s LM curve, Milton Friedman’s monetarism, and the Baumol-Tobin theory of money demand, to name a few examples. Now, there’s no question that Keynes, Friedman, and Tobin were among the greatest monetary theorists of all time. Their theories are elegant statements of fundamental economic principles. As such, they deserve to be taught for a long time to come. But viewing them as definitive in today’s world is like thinking that rock and roll stopped with Elvis Presley. The evolution of money and banking since the 1950s is at least as dramatic as what’s happened with popular music—not that I want to compare the Fed with Lady Gaga. The theories of that era need to be adapted to the brave new world in which we now live.

I am not sure what this means, however, given the remainder of the speech. Despite the fact that Williams claims that the work of Friedman, Tobin, and Keynes represent “elegant statements of fundamental economic principles”, he subsequently goes on in the speech to largely disparage this work; in particular, the quantity theory of money and the Baumol-Tobin inventory-theoretic model of money demand. While I share Williams view that we need to understand modern innovations in economic thinking, I also think that it is important to understand and appreciate contributions of the likes of Friedman, Tobin, Keynes, and others. There is much that we can learn from the history of economic thought and, in this respect, it is important to read primary sources of the literature and not second-hand accounts (note: this is a general statement, not a knock against Williams). Thus, while I share Williams’ view that we need to appreciate recent contributions, I think that it is important to give fair treatment to earlier important contributions as well. I will elucidate this point below.

Williams seems to disparage the quantity theory of money by pointing to a fairly standard objection:

There have been a number of attempts to find a broader measure of “money” that has a stable relationship with nominal spending — that is, a constant velocity.

He then proceeds to detail differences in different monetary aggregates and their growth rates during the crisis. Differing growth rates and changes in velocity over the past few decades are then cited as evidence that using using the money supply to forecast nominal spending or inflation is a fool’s errand. This reasoning is flawed for two reasons. First, constant velocity is a straw man as Thomas Sowell details in On Classical Economics:

The idea that the price level is rigidly linked to the quantity of money by a velocity of circulation which remains constant through all transitional adjustment processes cannot be found in any classical, neoclassical, or modern proponent of the quantity theory of money. Changes in the velocity of circulation — short run and/or long run — were analyzed by David Hume, Adam Smith, Henry Thornton, T.R. Malthus, David Ricardo, Nassau Senior, John Stuart Mill, Alfred Marshall, Knut Wicksell, Irving Fisher, and Milton Friedman.

As I have illustrated before, velocity is not constant, but appears to be a stable function of the interest rate. (See Allan Meltzer’s graph.)

The second flaw in the analysis is that Williams is relying on simple sum aggregates, which are theoretically flawed and often produce puzzling empirical results. The question surrounding the quantity theory of money is essentially whether or not money can forecast inflation and nominal income growth and the answer is yes especially using longer time horizons and low frequency data.

Williams similarly caricatures analysis of the money multiplier:

The breakdown of the standard money multiplier has been especially pronounced during the crisis and recession. Banks typically have a very large incentive to put excess reserves to work by lending them out.

I assume that what Williams means by “the standard money multiplier” is the framework put forward in Phillips’ (1920) Bank Credit in which the money multiplier is a parameter. This view of the multiplier might be taught in principles, but I don’t think that it is used beyond that point. Even in Mishkin’s Money and Banking text, which does include analysis of the multiplier, there are explicit references to changes in the underlying factors that determine such a multiplier. Indeed, the literature on monetary theory has long recognized that the money multiplier could not be viewed as fixed coefficient. In the post-war era, this view was recognized by Gurley and Shaw (1960) and Tobin (1963). In addition, Brunner and Meltzer (e.g. JPE, 1968; JPE, 1972) explicitly modeled the money multiplier as a function of interest rates.

Jurg Niehans (1978: 274) elaborates on the points above:

While this fixed-coefficient approach, though perhaps pedestrian, is often useful and , for certain purposed, illuminating, it is also subject to serious limitations. Taken at face value it seems to say that money is very different from other things, inasmuch as demand has no influence on the quantity available; the quantity seems to be purely supply-determined. However, this is a superficial impression. It is well recognized that the coefficients appearing in the multiplier are not, in fact, technological constants, but depend, in turn, on interest rates (Brunner and Meltzer, 1968).

In addition, as Niehans (1978: 274) details, the general equilibrium approach in which interest rates are jointly determined with the money supply was developed by Tobin (1963), but actually has “its long ancestry in the pre-Phillips tradition of money supply theory.” Those who have used the money multiplier in discussions of the crisis have, by and large, recognized these points as well.

Like Williams, I agree that the financial crisis and the broader recession pose important questions for monetary theorists and teachers. However, I believe that there is much to be learned in both the present literature and the past literature on issues of monetary analysis and central banking (see Perry Mehrling’s The New Lombard Street, for example). And I wish that Tobin and Friedman would have received fairer treatment from Williams.

Thoughts on Fiscal Stimulus

I finally got around to listening to Russ Roberts’s podcast with Steve Fazzari about the stimulus package. While it was encouraging to hear a civilized conversation on the matter, I have come away with a pessimistic view about any likelihood of forging a consensus on the role of fiscal stimulus.

This pessimism is further enhanced by examining the evidence presented in the blogosphere. For example, Paul Krugman recently argued that fiscal stimulus wasn’t even tried:

What’s extraordinary about all this is that stimulus can’t have failed, because it never happened. Once you take state and local cutbacks into account, there was no surge of government spending.

Meanwhile, John Taylor presents a graph that shows:

…that state and local governments did not increase their purchases of goods and services—including infrastructure—even though they received large grants in aid from the federal government. Instead they used the grants largely to reduce the amount of their borrowing as the following graph dramatically shows.

Each of them are looking at similar data and coming to vastly different conclusions. The reason for the differing conclusions is the result of the identification problem. For example, it is possible that borrowing by states declined as a result of the fact that the federal government increased grants to states. However, it is also possible that the grants to the states offset planned reductions in borrowing. In the former case, the stimulus was ineffective. In the latter case, the grants possibly prevented a worse outcome. An abstract look at the data, however, is not sufficient to draw a conclusion.

It would be a mistake, however, to equate my pessimism about a consensus with pessimism about the process of evaluating the stimulus. I predicted in February of 2009 that the stimulus would fail and I believe that I have been proven correct.

Given the identification problems involved, how can I possibly think that I am correct? First, it is important (and necessary) to judge the stimulus by a particular criteria. I, for example, choose to judge the stimulus by the criteria outlined by Christina Romer and Jared Bernstein. The reason that I think the stimulus should be judged based on this criteria is because it is based on an explicit model, it produces specific predictions about the effects of the stimulus, and it represents the views of the policymakers who passed it. With the criteria chosen, it is then possible to evaluate the effects of the stimulus.

I don’t think that I need to go into much detail to suggest that the stimulus failed with the chosen criteria. Romer and Bernstein predicted that without the stimulus the unemployment rate would peak around 9% in 2010. However, with the stimulus the unemployment rate was projected to peak around 8% in the third quarter of 2009. Casual observation demonstrates that this projection was false. Based on this criteria, the stimulus failed.

Critics of this type of evaluation make two charges: (1) they argue that the economy was worse than expected and thus the effectiveness of the stimulus was less than expected as well; and (2) that things would have been worse without the stimulus.

Was the economy worse than realized? After the fact we might say so, but what is our evidence that the economy was actually worse than we thought at the time? It is true that Bernstein-Romer’s forecast of the peak unemployment rate with the stimulus was lower than the actual unemployment rate, but is that prima facie evidence that they under-forecast what unemployment would have been in the absence of the stimulus? No. The identification problem rears its ugly head again. It might be true that the model simply under-forecast unemployment. However, it also might be true that the stimulus was ineffective and the model’s predictions about the effectiveness of the stimulus were wrong. What’s worse is that in either case the model is significantly flawed and therefore not particularly useful for policy analysis.

Others claim that things would have been worse without the stimulus. Whether true or not, this point is irrelevant. There is no predictable content in that statement. In addition, the fact that things could have been worse is not in and of itself a strong justification for stimulus. It is important to understand how much worse it could have been. For example, would it have been worth it to spend $800 billion to reduce unemployment by 0.1%? By 0.5%? In other words, it is important to consider the fact that while there are potential benefits to stimulus, there are also costs — both monetary and non-monetary. The idea that it could have been worse says nothing about whether the benefits exceed the costs.

Prior to the recession, I thought that there was an emerging consensus on the role of fiscal stimulus (one fellow blogger even referred to my original post on the stimulus as a short lesson in Ph.D. macro). Perhaps there is largely a consensus within academia that seems smaller due to the voices that propagate the blogosphere and policy circles. Or perhaps that consensus is only imagined. Regardless, it is clear that influential minds still believe in the power of fiscal stimulus and are not persuaded by the evidence presented above. Nonetheless, the evaluation of fiscal stimulus cannot be made in the abstract. The only reasonable means to evaluate stimulus is to do so in light of ex ante predictions about the effects of stimulus derived from an explicit framework. Based on this criteria, the stimulus has failed.

Does Trichet Understand Inflation? UPDATED

The Wall Street Journal reports:

Inflation fears—fueled by spiraling food, oil and raw material prices—are mounting around the globe, prompting the head of the European Central Bank to signal that it could raise interest rates in the future even though some countries have been weakened by the Continent’s debt crisis.

In my previous post, I demonstrated that there is reason to believe that tight monetary policy by the ECB can potentially explain the downturn in the Eurozone and, potentially, the drastic declines on the periphery like Ireland. This performance is worse when coupled with the fact that the ECB strongly encouraged the Irish to prevent bank failures providing temporary liquidity and then laying the problem at the feet of the Irish taxpayer when it turned out that the problem was worse than previously imagined.

Nonetheless, putting past performance aside, the ECB is now fearful of inflation. Unfortunately for those in the Eurozone, it is not clear to me from the article that the ECB understands inflation. For example, consider the following excerpt:

In an interview with The Wall Street Journal ahead of this week’s annual meeting of the World Economic Forum in Davos, Switzerland, Jean-Claude Trichet warned that inflation pressures in the euro zone must be watched closely, and urged central bankers everywhere to ensure that higher energy and food prices don’t gain a foothold in the global economy.

So far, so good. Rising energy and food prices might be signs of inflationary pressures. However, this is the following paragraph:

Mr. Trichet’s warning comes at a time when inflation concerns are mounting among investors around the world. Fast-growing emerging markets such as China and Brazil are seeing rising inflation at home, and their demand for globally traded commodities is pushing prices higher elsewhere.

So which is it? Are prices rising because of increased demand in Brazil and China or because of inflation? It cannot be both. If prices of globally traded commodities are rising, it could be a sign of inflation, but it could simply be a relative price adjustment — even if it is a sustained relative price adjustment. In other words, rising commodity prices are a potential sign of inflation, not the cause of inflation. There is a difference between arithmetic and economics.

Nonetheless, it could be sloppy reporting by the WSJ, except that it is not. Here is Trichet:

“All central banks, in periods like this where you have inflationary threats that are coming from commodities, have to…be very careful that there are no second-round effects” on domestic prices, said Mr. Trichet in his office overlooking Frankfurt’s financial district.

And here are the WSJ reporters:

Changes in food and energy prices are largely determined on world markets, and thus aren’t directly influenced by interest rates in any one economy. For that reason, central banks in many major economies, including the U.S., put greater weight on core inflation than on headline measures. For now, Fed officials don’t see much evidence that commodity prices are feeding broader inflation in the U.S.

The WSJ reporters clearly recognize the difference between relative price adjustments and inflation. So what does Trichet really believe? Does he believe that by raising interest rates in the Eurozone that he can reduce the demand for globally traded commodities in Brazil and China? Or, is he simply just trying to anchor inflation expectations? For everybody’s sake, I hope it is the latter.

UPDATE: Kantoos uses German inflation indexed bonds to calculate a TIPS spread of expected inflation in the Eurozone. Using these calculations inflation is expected to remain below 2% over the next 5 years and even below 1.5% over the next 2 years.

The Eurozone and NGDP

Several quasi-monetarist bloggers like Scott Sumner, David Beckworth, Bill Woolsey, and myself have all been making the claim that the recession can be blamed — at least in part — on tight monetary policy as reflected in the collapse in nominal spending.

As further evidence that this might be the case beyond the United States, Kantoos, a blog reader and fellow blogger, sent me a link to a recent post on nominal GDP of the Eurozone-15 from 1996 to the most recent data release. The graph shows the trend of NGDP for the Eurozone-15, the actual trajectory, and the percentage deviation from trend. As can be seen from the graph, in late 2008 NGDP began to fall significantly below trend. While NGDP has started to grow, it is still well below the trend line — nearly 10%.

Looking at this graph, I was struck by the fact that this is remarkably similar to situation in the United States. In addition, it raises serious questions about the monetary policy of the ECB — especially considering the severity of the collapse for some of the countries in the Eurozone.