The tools of ignorance

I'm pretty sure Mungo was trolling me this morning with his retweets, but it worked anyway.

So let's take a look at the wonder that is market monetarism and its incredible abuse of graphs and accounting identities.


Our data come from Italy and here are the graphs in question:

OK, so the first graph is the path of Nominal income (PY) relative to trend. The second is the path of real income (Y) and the third is the path of prices (P). Nothing objectionable about the graphs in themselves.

You can see NGDP has fallen a lot (relative to trend), mostly due to lower real GDP. Since we are dealing with accounting here, we really only need two of these graphs. the third one is implied by the other two.

But people, what just sets my teeth on edge and puts a bee in my bonnet is the idea that, and I quote:

The message from the graphs above is clear – the Italian economy is suffering from a massive demand short-fall due to overly tight monetary conditions (a collapse in nominal GDP).

Nominal GDP IS nothing more than the product of prices and output. To say that a fall in nominal GDP relative to trend "caused" the fall in the path of prices and output relative to trend is just gibberish.

Try it in the abstract without the sacred labels. "The fall in XY caused the fall in X and the fall in Y".

Ummm, maybe the fall in Y caused the fall in X and as a result XY also fell??  Or the fall in X? Or some third factor caused both X and Y to fall and as an unavoidable consequence of arithmetic, XY also fell?

Labeling PY as "Monetary conditions" and then saying Y fell because PY fell and blaming that on monetary conditions is not an economic theory. It's not even an un-economic theory.

Here's another example of the twisted logic of market monetarism:

One can obviously imagine that the Italian output gap can be closed without monetary easing from the ECB. That would, however, necessitate a sharp drop in the Italian price level (basically 14% relative to the pre-crisis trend – the difference between the NGDP gap and the price gap).

Thats a doozy.

Output is 14% too low so prices need to fall by 14%, doing this will leave NGDP unchanged and the output gap will be eliminated.

The basic problem comes from here:

It is no secret that I believe that we can understand most of what is going on in any economy by looking at the equation of exchange:

(1) M*V=P*Y

People, you can't explain anything about causation WITH AN ACCOUNTING IDENTITY!

Frequent Fed Failure Foolishness

If you start with the conviction that the Fed can perfectly control the real economy, then any protracted slump is, ipso facto, a Fed failure.

Hence we see blogposts like "This one figure shows why Fed policy failed".

Here's the figure in question:

The blogpost argues (awesomely I might add) that the graph shows failure in two ways. First because the increase in the Fed balance sheet was "temporary".

Now people, let me point out that it is April of 2014. So all the unshaded part of the graph is in the future! And as you can see, the latest projection of when the Fed's balance sheet returns to its pre-crisis trend is in 2021. And it's quite likely that future projections (if anyone is so nuts as to continue to make them) will push this date further into the future.

So the idea that a graph of things that have not happened can show the Fed failed is pretty weak sauce.

And, even if it does go down like that, we are still talking 14 years of super-sized balance sheets as too short a time to get people to "rebalance their portfolios"

The second reason the graph shows failure is because the asset purchases were so large! (I am not making this up).

The blogpost argues that in lieu of actual policy, the Fed should have just credibly committed to policy actions if needed and this would have raised velocity making the required purchases much smaller or even not needed at all:

"Had the Fed credibly committed from the start there never would have been the need for all the subsequent LSAPs."

But of course we know from econ 101 that the Fed cannot credibly commit! To anything, least of all to letting inflation run above its own desired level in order to top up nominal GDP from its recessionary shortfall.

People, repeat after me:

1. Not all recessions are prima facie evidence of Fed policy failures.

2. Not all Fed predictions / projections actually come to pass.

3. When you hear some one telling you all the Fed needs to do is "credibly commit", RUN!

Mother Superior Jumped the Gun (the case against the case against VARs)

Man, Arnold Kling is so cranky! While it's sometimes on point, and often entertaining, it's also sometimes just plain wrong.

Case is point is his recent anti-VAR rant.

Here's a snippet but do read the whole thing:

"The VAR crowd cheerfully ignores all the details in macro data. The economist with a computer program that will churn out VARs is like a 25-year-old with a new immersion blender. He does not want to spend time cooking carefully-selected ingredients. He just wants to throw whatever is in the pantry into the blender to make a smoothie or soup. (Note that I am being unfair to people with immersion blenders. I am not being unfair to people who use VARs.)"

It did take macro folks quite a while to come to the following realization, but pretty much everyone is on the same page now and agrees that,

In order to do policy analysis with a VAR you have to solve the same identification problem that a old fashioned structural model has to solve. It's not a free lunch.

Further more, pretty much everyone agrees (except for a few special cases) that 

achieving identification by making the system recursive is not a very smart strategy.

So "the VAR crowd" is working on improved identification strategies (long run restrictions, sign restrictions, identification via covariances) and has made a lot of progress. Look, identification issues are not unique to VARs. They plague virtually all non-experimental studies.

Another area that, contra Kling, the crowd has made huge progress on is structural change.

VARS with common factors whose loading are time variant. VARs with regime switching both in the means and in the conditional variances. VARs with time-varying coefficients.

One area where VARs have gone var beyond old fashioned structural models is modeling time varying conditional variances (and covariances) using either GARCH or stochastic volatility.

A lot of this work is being done using Bayesian computational tools, but it's very mainstream. Primiceri's 2005 RESTUD piece is a good place to start.

accounting identities are not causal (and your opinion is not evidence)

Today's sermon takes the following NY Times editorial, "Will Saving on Health Care Hurt the Economy" as its text for exegesis.

And what a text it is.

Let's begin with a classic case of confusing accounting identities for causal relationships:


LOST in all the debate last week about whether or not the Affordable Care Act will hurt the economy is the fact that health care is already imposing a drag on growth.

The health care sector has repeatedly helped to pull the economy from recession in recent decades, but this time around it is lagging behind the recovery.

Health care spending grew more slowly than the economy in 2011 and 2012 and will probably be found to have done so again in 2013.

People, health care spending growing slower than overall spending does NOT mean that the sector is "imposing a drag on growth". I know people say stuff like that all the time, but it's just not true.

Nor is it true that, "the health care sector has repeatedly help to pull the economy from recession in recent decades.

Look, we can always ex-post measure spending growth by sector and compare them. But the idea that if only health care spending could be made to grow more rapidly, nothing else would change and overall economic growth would rise is risible. Those numbers are simply ex-post accounting and they PROVIDE ZERO INSIGHT into the potential outcomes of various counterfactual scenarios.

The world would be a much better place if we could just stop from abusing accounting identities in this manner.

OK. Let's take a break to pass the collection plate and then proceed to the second theme of our homily, namely that your opinion does not constitute evidence.

Thank you for your generous contributions, Now let's return to our text:

But there is evidence that moderate inflation can help to stimulate economic activity. Rising prices spur people to borrow and spend more quickly. Rising prices also tend to raise nominal wages, making it easier for borrowers to pay fixed debts like mortgage loans.

And sluggish inflation can be self-perpetuating. Inflation is rising slowly because the economy is weak, and slow inflation is restraining faster growth.

People if you click on the link purporting to give this "evidence", it's another opinion piece by the same author! And here's an example of the level of evidence being provided:

“I’ve always said that a little inflation is good,” Richard A. Galanti, Costco’s chief financial officer, said in December 2008. And then there's this gem. "Executives at Walmart, Rent-A-Center and Spartan Stores, a Michigan grocery chain, have similarly bemoaned the lack of inflation in recent months."

People, your opinion is not evidence. Empirical models with a convincing identification strategy produce evidence. Richard A. Galanti's mouth produces hot air, and, at least on this topic, Mr. Appelbaum's word processor produces gibberish.

There is a theoretical case out there that a credible promise of seemingly inappropriately high levels of future inflation can help lift an economy out of a liquidity trap. This is Krugman's "credible commitment to be irresponsible" argument. There is another theoretical case that a higher inflation target may reduce the frequency at which the economy may hit the zero lower bound on nominal interest rates.

But neither of these cases have empirical support, and even if they did, they are a far cry from the simple minded notion that, "moderate inflation can help to stimulate economic activity".

Two Cheers for The Bernank

Bernanke's days are numbered and Janet Yellen is primed and ready to take over the Fed.

People, she has big shoes to fill.

Bernanke did exactly what he told Milton Friedman the Fed would do in the next crisis. He remembered the lessons from the Great Depression and made sure the Fed would not make the same mistakes.

Bernanke threw the kitchen sink at the problem in 2008 and it worked. The money supply did not fall, the banking system did not fail, we made it through.

And the extraordinary/unconventional policy actions of the Fed did not unleash the inflationary genies we were warned would follow.

As the recovery "progressed" in its halting and unsatisfactory manner, Bernanke undertook additional unconventional policy actions. Three round of quantitative easing. Time based forward guidance. Outcome based forward guidance. And while these policies produced no great stimulative effects for GDP or employment, neither did they create inflation.

The worst we can say is that maybe all the QE has helped to spark bubbles in asset markets here and abroad, but really is anyone unhappy that the Dow is over 16,000? I for one am not. And if we were seriously worried about the developing world, our immigration, trade and farm policies would be diametrically different than they currently are.

I know that it is hard to think of Bernanke as even mediocre, let alone exceptional, because of the massive strident criticism he's faced from an array of monetary cranks all convinced that they have the magic bullet to achieve prosperity and only Bernanke's stupidity or cowardice kept him from firing it.

If only he'd target nominal GDP! If only he'd raise the inflation target to 4%, If only he'd promise to keep inflation above its 2% target for years after the economy has fully recovered.

It is true ladies and gentlemen that if the Bernank had wheels, he'd be a bicycle. But he's not a bike, he's an economist and the Fed is not so powerful as to be able to fix our economy with a new nominal target or a new promise.

People take as given that monetary policy can hit any output target it wants to and use the failure of the economy to perform satisfactorily as prima facie evidence of Fed incompetence.

But it's just not true. It's a bureaucracy, not a bicycle! The illusion that the Fed can finely control the economy was borne from the "great moderation" a tiny blip on the time scale that managed to validate the Fed's awesome powers at the expense of all the rest of its history.

The Fed can avoid screw ups. It can prevent rampant inflation and it can stand as a supplier of liquidity and a lender of last resort in a crisis. But the notion that monetary policy can hit any desired output target in normal times or abnormal times is a foolish and dangerous notion, sadly often promulgated by macroeconomists in the Fed's employ.

So as you leave Great Bernank, I salute you for a job well done. Your biggest mistake was allowing your minions to over-promise what the Fed can actually do.

It's An EconTalk Extravaganza!

The Butler symposium, "Capitalism and the Good Society," is up at EconTalk.  Epstein, Munger, Sidelsky circus, with Russ Roberts as ringmaster.

It's really LOOONG, of course, but the individual parts are interesting, and different.  And the HD version of it is really quite beautiful filmed, as you would expect from genius-boy John Papola doing the production.

In which I tell:
1.  The Pig story
2.  The Shopping Cart story
3.  The Unicorn story
4.  The Bleeding story

So, story time!  (And ya gotta love Skidelsky's sox...)

Oh NGDP, is there anything you can't do?

In a long post over at Free Exchange, Ryan Avent passionately defends the honor of NGDPism against any and all heretics. This time it's GMU wonder boy Eli Dourado in the cross-hairs.

But Mr. Avent's analysis, to speak plainly, makes no sense at all. Let's break it down.

Mr. Avent starts with this chart, which he argues shows how NGDP growth is strongly related to job growth and thus crucial to economic performance:

But people here's the thing. NGDP is PY, the price level times real income. And one of those components, real income, is indeed highly correlated with jobs. The other component, prices, is not.

Let's look at how inflation (growth in the price level) and real GDP growth each chart up with jobs growth over Mr. Avent's sample period, starting with inflation:

The linear correlation between inflation and jobs growth shown here is 0.22, which is INSIGNIFICANTLY DIFFERENT FROM ZERO (t-stat = 1.01). In other words, one component of NGDP, prices, is not significantly correlated with job growth over this period (not even at the 0.20 level). Another way to see the lack of correlation is to note that if we ran a regression of jobs growth on inflation here the r-square would be around 0.05.

Now let's look at the other component, Real GDP growth:

The linear correlation between real GDP growth and jobs growth shown here is 0.64 which is SIGNIFICANTLY DIFFERENT FROM ZERO (t-stat = 8.2) at the 0.01 level. The r-square of this regression would be around 0.41.

In other words, Mr. Avent is using fluctuations in the real economy to explain fluctuations in the real economy. When real output tanks, jobs tank. It does appear from the graph that GDP growth might lead job growth, but we are really just graphing the same thing twice here.

People there's plenty more to come after the jump: