Monthly Archives: July 2009

Friedman’s Birthday

Today, July 31, was Milton Friedman’s birthday. Here is a clip of Milton Friedman, at his best, 30 years ago:

Quote of the Day

“Recently I read that the current low energy prices are actually a “bad thing,” because they will discourage consumers form conserving. I found this interesting, as I think the current low prices are a bad thing because they reflect consumers conserving energy. Why are they “conserving” energy? Because they are out of work.”

Scott Sumner

Krugman on Health Care

In a recent post, Paul Krugman makes the following argument as to why the free market cannot provide health care:

You could rely on a health maintenance organization to make the hard choices and do the cost management, and to some extent we do. But HMOs have been highly limited in their ability to achieve cost-effectiveness because people don’t trust them — they’re profit-making institutions, and your treatment is their cost.

Yes, as opposed to the government (whom everyone trusts), where your treatment is my cost.

Has Macroeconomics Failed? (UPDATED)

I thought about titling this post, “Macroeconomics as fortune-telling”, but ultimately decided against it. In any event, there has been much discussion recently about the purported failures of modern macroeconomics. A recent article in the Economist has only fueled the flames. Mario Rizzo provides this pithy summary of the story:

…the article argues that although the dominant macro model, dynamic stochastic general equilibrium theory [DSGE], appears to be in a state of near-total breakdown.

I think that this is a bit of wishful thinking from the folks at the Economist, Mario Rizzo, and those referenced and quoted in the article. The fact of the matter is that the DSGE model is NOT “in a state of near-total breakdown” and nor should it be. Rather the criticism (hatred?) of DSGE models fails to understand both the purpose and the scope of these models.

Since the start of the financial crisis, macroeconomics has undergone a great deal of criticism. This criticism has largely been directed at (1) the inability of macroeconomists to forecast such a severe downturn, (2) the lack of a consensus regarding fiscal policy, and (3) DSGE models. I have already written in great detail about (2) and I think that the evidence and the theory is much more clear-cut than the debate would have you believe. I think that many of the differences of opinion had more to do with ideology than economics. Regardless, the focus of this post will be on (1) and (3).

The failure of macroeconomists to forecast the financial crisis and the subsequent recession is perhaps the foremost criticism. I similarly find this criticism to be the most bizarre. It would be easiest to respond to this criticism and say that economists are not fortune-tellers (as I have done in the past). However, it seems that this is not even an accurate criticism. While macroeconomists as a whole did not predict the recession, there are many who did predict the housing collapse as well as those who predicted a severe recession. Of course, the most outspoken example is Nouriel Roubini. As our friend David Beckworth reminds us, the research staff at the Bank of International Settlements was also out in front of the current crisis:

What do you get when the key insights of Hyman Minsky–prolonged macroeconomic stability can actually be destabilizing if it causes observers to take for granted the “good times” and underestimate risk going forward–and Frederick Hayek–price stability is not a sufficient condition for macroeconomic stability–are accepted by a group of mainstream economists? You get economists who were able to foresee as early as 2003 the current economic crisis and issue a warning. And just who are these economists? They are the research staff at the Bank for International Settlements (BIS), formerly led by William White. Der Spiegel has a great article on William White and his colleagues that highlights how they repeatedly warned central bankers of the dangers lurking ahead but to no avail. What is amazing, is that the BIS is the bank for central banks and had the ear of Alan Greenspan and other central bankers. In other words, these were not a bunch of economic cranks, but serious research economists at a top economic institution who were given a hearing but ignored by top policymakers.

I’m sure that there are other examples, but the fundamental point is that there were prominent researchers out in front of the current crisis, but they were largely ignored until the downturn.

The more important criticism of macro, however, surrounds the dynamic stochastic general equilibrium (DSGE) models. The critics largely contend that these models failed both in their forecasting ability as well as the fact that they often ignore financial markets. The former is largely a criticism of forecasting and not DSGE models (after all, richly specified DSGE models produce better forecasts than other methods).

Much of the criticism seems to result from a failure to understand the use of the DSGE model. These models come in all different forms. There are rather simple models that seek to explain the response of the economy to a specific exogenous shocks. There are others that attempt to evaluate alternative monetary or fiscal policy regimes. Still more are aimed at explaining historical downturns. What’s more, there are models that include financial market frictions (although, admittedly, they are less appreciated than they should be). There are also larger models that are used for forecasting within central banks. Ultimately, there are a wide variety of DSGE models because they are used for a wide variety of purposes. Thus the criticisms of these models must take into account their explicit purpose (which they often do not).

What’s more, the criticisms of DSGE models is used to imply that modern macroeconomics as a whole has failed. This argument demonstrates are clear leap in logic and an ignorance of modern macroeconomics. There are other tools that a large number of economists use. For example, cointegrated VAR models emphasize taking the data to the theory rather than the other way around (as in the DSGE models). What’s more, there has been theoretical work and corresponding empirical evidence that is independent of the both the VAR and DSGE methodology. In fact, one of the most topical issues of the moment is in regards to the liquidity trap and the effectiveness of monetary policy. Many of the articles on this topic do not use DSGE models in their analysis.

I do not want the argument here to be misconstrued. I am not arguing that DSGE models are without flaws, nor am I arguing that they should be the only framework for macroeconomists to work within. I welcome those to follow Mario Rizzo’s advice and to be a “disruption” and think outside of the standard framework. I hope that I have the courage and insight to do so myself. Nonetheless, I don’t think that we need to kill the DSGE model to accomplish this goal.

UPDATE: Menzie Chinn joins the defense:

Reading the recent characterizations of Ph.D. education in our top departments, one would conclude that all one ever learned in a program is how to write out and calibrate dynamic stochastic general equilibrium (DSGE) models, or for the older among us, calibrate a real business cycle model. I have to say that this all seems a little like an all too convenient caricature (and, as I have said repeatedly in the past, these types of models have led to important insights for issues besides crises).


If my conjecture is correct, then the supposed failure of macroeconomics is more the failure of macroeconomics as described in the popular press, rather than of the discipline itself (after all, Joseph Stiglitz is as much of the economics discipline, if not more, than Eugene Fama.) My conclusion: Not quite time to jettison the apparatus of modern macroeconomics.

Graph of the Day

Isn’t it time for the Fed to consider eliminating interest payments on excess reserves?

What Super-neutrality Really Isn’t

Our friend Nick Rowe pays homage to Milton Friedman in one of his latest posts on what monetary policy cannot do. Indeed, Friedman’s speech to the AEA in 1967 should be required reading for any who wish to learn about monetary policy (it is indeed required reading for my Money and Banking students). The purpose of this homage is to absolve monetary policy of any wrong-doing in the current recession and preceding housing boom. Specifically, he argues:

It was in that paper that Friedman introduced the concept of the natural rate of unemployment. Prior to Friedman, most economists thought there was a downward-sloping Phillips curve, and that monetary policy could keep unemployment low provided we were willing to accept higher inflation. Friedman argued that this was true in the short run only, and that in the long run, when expected inflation equaled actual inflation, the Phillips curve was vertical. Monetary policy could target any rate of inflation, but the result would be the same long run equilibrium rate of unemployment.

Friedman needed a name for that long run equilibrium rate of unemployment, and he chose to call it the “natural rate of unemployment”. He chose that name to draw a parallel to Wicksell’s concept of the natural rate of interest.


There is nothing special about unemployment or interest rates in Friedman’s argument. Everything he says about them applies equally well to any real variable. Just as there is a natural rate of unemployment, and natural rate of interest, so there is a natural rate of output, employment, real wages, relative price of houses, or relative price of sardines. The underlying vision is one of the long-run super-neutrality of money.

Monetary policy has real effects in the short run, because it takes time for prices and expectations to adjust to a change in monetary policy. But if we compare alternative worlds where prices and expectations have adjusted to alternative monetary policies with different average money growth rates and average inflation rates, real variables should not be affected. They are pinned down at their natural rates by real, not monetary forces.

I am in agreement with Nick on nearly every point of this argument. Nevertheless, I am puzzled regarding his conclusion about relative prices. When discussing long-run superneutrality of money, he is referencing the idea that a change in money growth will only cause a change in the rate of inflation in the long run and thus have no effect on real variables. However, even accepting long run money neutrality, isn’t it possible (and in all likelihood probable) that relative prices have changed? In fact, this was Hayek’s main point in extending Wicksell’s idea of a natural rate of interest. In Prices and Production, for example, he writes:

. . . it seems obvious as soon as one once begins to think about it that almost any change in the amount of money, whether it does influence the price level or not, must always influence relative prices. And, as there can be no doubt that it is relative prices which determine the amount and the direction of production, almost any change in the amount of money must necessarily also influence production.

The appropriate question is thus whether superneutrality of money not only implies that the change in the rate of inflation is proportionate to the change in the rate of money growth, but also that individual price changes are equiproportional. Nick seems to believe that it is the case, whereas I find this conclusion wanting.

There is no greater illustration of our opposing views than the idea of inflation targeting. Nick argues that monetary policy did not play a role in the Canadian housing boom:

Did a change in monetary policy cause the house price bubble? In Canada, absolutely not. There was no change in monetary policy in Canada. As I argued in my previous post, The Bank of Canada hit its inflation target almost exactly on average over the period when Canadian house prices were rising. With actual CPI inflation at the 2% target, and expected CPI inflation presumably at the same 2% target, there was no sign of the unexpected inflation that is the signature of the short run effects of a change in monetary policy.

The inflation target was 2% and actual inflation was 2%. Nick views as suggesting that monetary policy could not possibly be to blame for rising house prices. I do not find this evidence convincing in the least. What an inflation target does is establish transparency and accountability for the central bank. If the central bank hits its target, all this tells us is that they have hit their goal. It does not tell us about the desirability of the outcome.

It is entirely possible (if not probable) that monetary policy has an influence on relative prices and the allocation of resources without the aggregate level (growth) of money having an effect on the aggregate level (growth) of output. Indeed, the fact that housing prices rose 85% in Canada while the inflation rate was 2% poses interesting questions. Does the price index targeted by the Bank of Canada underweight housing? Is housing measured properly in the price indices? Doesn’t the rise in housing prices suggest that relative prices have changed (in real terms)?

I think that this is the fundamental point surrounding inflation targeting. If one focuses exclusively on the overall rate of inflation and monetary policy affects relative prices, then monetary policy directed in this manner has the potential to create asset price bubbles, resource misallocations (or simply reallocations), and boom-bust scenarios — even if super-neutrality holds.

Do We Need More Fiscal Stimulus? (UPDATED)

Last week, David Leonhardt wrote:

In the weeks just before President Obama took office, his economic advisers made a mistake. They got a little carried away with hope.


There are two possible explanations that the administration was so wrong. And sorting through them matters a great deal, because they point in opposite policy directions.

The first explanation is that the economy has deteriorated because the stimulus package failed. Some critics say that stimulus just doesn’t work, while others argue that this particular package was too small or too badly constructed to make a difference.

The second answer is that the economy has deteriorated in spite of the stimulus. In other words, the patient is not as sick as he would have been without the medicine he received. But he is a lot sicker than doctors realized when they prescribed it.

To me, the evidence is fairly compelling that the second answer is the right one.

I think that Leonhardt is conflating the two main points. First, there is a question as to whether the economy is worse than the current administration expected. If we believe their forecasts, one can have little doubt than it is worse than they expected (see this graph via Calculated Risk). This then begs the question as to whether the stimulus is insufficient to combat the downturn. Leonhardt seems to say that the economy is worse than expected and thus the stimulus has been insufficient:

In other words, the patient is not as sick as he would have been without the medicine he received. But he is a lot sicker than doctors realized when they prescribed it.

However, the fact that the economy is worse than expected does not necessarily mean that the stimulus is not big enough.

Frequent readers of the blog are aware of the fact that I am not a fan of fiscal stimulus. Nonetheless, the reason that I am so skeptical that the stimulus has not worked to date is not because of my aversion to fiscal stimulus, but rather because it has barely been tried! The government has spent something like $50 billion of the total of over $800 billion to date. In other words, only about 5% of the total money that was allocated for stimulus has been spent. How then are we to claim that the stimulus was not big enough?!

This is not to say that the stimulus package will eventually be a success. Nevertheless, it is too soon to say that it has failed.

UPDATE: Free Exchange raises much the same point:

GAO’s figures do suggest that it’s a little premature to be expecting much of the stimulus or passing judgment on it. Of the planned outlays in the stimulus, roughly $49 billion is targeted for spending in 2009, of which only about $29 billion has been spent. That $29 billion is only slightly larger than California’s state budget gap; it’s just not enough to make much of a dent in the broader downturn.

Of course, the spending isn’t the only part of the stimulus bill. The share of the fiscal boost already in the system increases to perhaps 15% if one includes the tax provisions. And Jan Hatzius is arguing that a far larger share of the actual impact of the bill has been felt than 10%. The net stimulative impact of the package isn’t an easy thing to measure, as it turns out.

Inflation is a Monetary Phenomenon, But This Isn’t Inflation

There has been much talk recently about the potential inflation on the horizon given the unprecedented movement of the Federal Reserve of increasing the monetary base through quantitative easing. The talk has predominantly surrounded the substantial increase in the monetary base. However, increases in the monetary base are not sufficient to cause inflation. Like discussion of other markets, we must consider both supply and demand conditions.

Milton Friedman famously quipped, “inflation is always and everywhere a monetary phenomenon.” Friedman was undoubtedly correct. However, recently a few seem to have taken this claim to mean something different entirely. Namely, that any increase in the money supply necessarily causes inflation. This is something that Friedman himself did not believe.

In his restatement of the quantity theory of money, Friedman pointed out that the quantity theory is primarily a theory of money demand. Specifically, quantity theorists view the level of real money balances as more important than the nominal quantity of money. Thus, if at any point in time people have chosen to hold some level of real money balances that they deem optimal, an increase in the nominal money supply will leave these individuals with a larger level of real money balances than they wish to hold. These individuals will then necessarily try to reduce their holdings of nominal money balances such that their real money balances fall back to their optimal level (perhaps by increasing spending). Unfortunately, as a group, they will not be able to do so because every person’s spending is another person’s receipt (or income). Initially output will increase and gradually prices will rise until the level of real balances falls back to the optimal level.

Given this discussion, it should not be difficult to understand why I prefer a monetary equilibrium framework. What’s more, it should be apparent that what causes inflation is not an increase in the money supply, but rather an excess supply of money.

Ultimately, the question at hand is whether the current increases in the monetary base imply that there is an excess supply for money. If so, inflation is on the horizon. If not, we need not fear inflation.

Personally, I do not believe that the recent increases in base money imply that there is an excess supply of money. There are a couple reasons for this belief. First, it has been well-known — at least among monetarists — since Clark Warburton’s influential work that the peaks in the time series variables important for quantity theorists follow this order: (1) money, (2) output, and (3) velocity. The implication here is that declines in velocity (increases in the demand for money) are an accentuating feature of the business cycle. In other words, after output begins to fall, the demand for money increases. As our previous discussion of monetary equilibrium implies, this creates an excess demand for money, which results in falling output and prices — thereby exacerbating the previous decline in output.

Second, the money multiplier has declined drastically. In fact, the money multiplier for M1 remains below 1. This means that for every increase of $1 in base money, the money supply (as measured by M1) increases by less than $1. In order to determine the cause of the decline in the M1 multiplier, we should first discuss its components. The money multiplier for M1 consists of the currency-to-deposit ratio, the required reserve-to-deposit ratio, and the excess reserve-to-deposit ratio. An increase in any of these ratios implies that the money multiplier will fall. The required reserve ratio is set by the Federal Reserve and has not changed. Thus, the decline in the M1 multiplier must be the result of changes in the currency-to-deposit ratio and the excess reserve ratio. As previously mentioned, the demand for money often increases during the downturn in the business cycle. What’s more, financial crises often induce a flight to quality in which individuals abandon risky investments for safe investments such as bonds or cash. The increase in cash balances increases the currency-to-deposit ratio.

The largest cause of the decline in the money multiplier, however, is the result of the increase in the level of excess reserves. What’s more, this increase in excess reserves can be directly attributed to the fact that the Federal Reserve started paying interest on excess reserves late last year. In doing so, the Fed essentially reduced the opportunity cost of holding excess reserves thereby giving banks the incentive to hold more reserves on their balance sheets. This is why our friend Scott Sumner not only supports eliminating the interest payments on excess reserves, but prefers that the Fed impose a penalty on those who hold reserves above the required level.

Ultimately, the money multiplier (M1) has fallen from around 1.6 prior to the recession to .93 as of June 17. At the beginning of January 2008, the monetary base was roughly $848 billion. Given that money multiplier, this would suggest that M1 was around $1.356 trillion. Thus, given the current money multiplier, this would suggest that the monetary base would have to be about $1.458 trillion today to maintain the same money supply — an increase of roughly 72%. Given that we are currently in a recession, this suggests that the Fed wants to increase the money supply rather than simply maintain the earlier level. Given that the monetary base is about 90% higher than it was at this time last year, this would suggest that the Fed is expansionary, but hardly over-expansionary given the circumstances surrounding money demand.

With that being said, the Fed must be careful and begin pulling money out of the economy when this demand for base money subsides and the money multiplier begins to rise again. A failure to do so would result in a substantial period of inflation. However, at the current time, the evidence suggests that the massive increase in the monetary base is justified by the increase in the demand for base money. Thus, the increase is in the monetary base doesn’t suggest that massive inflation is on the horizon … yet.

(In the future, I hope to post on how the Fed can prevent finding itself in such a precarious situation in the future, but this is clearly enough for now.)