I got the QE blues

Ramesh Ponnuru tells us to stop worrying and love QE3. But Ramesh is not giving you the straight poop!

Ramesh: "Long-term interest rates rose after its announcement".

Me: sure for one day, then they started falling right back again.

Look for yourselves:

Ramesh:  "The (stock) market reaction is a sign that this time loosening was warranted".

Me: Yes, stock prices jumped up that day. But look at the trend in stock prices over the last four years

Since early 09, the stock market has been trending up. It's very close to pre-crash levels in nominal terms. QE announcement effects are a drop in the proverbial bucket and certainly don't prove anything about whether or not QE is going to help the real economy.

Ramesh: "Looser money is boosting stocks because it is raising expectations of economic growth and thus of future profits."

Me: Any evidence or proof to back up that assertion? I see no way for him to show this cause and effect.

Do read the whole article. It's really quite bad.

************UPDATE********************

The always relevant Soberlook has more information here.

Macroeconomic Surrealism

Wow. I am old and have already seen too much in my career, but this morning I was treated to a Dali-esque display of Macro.

Witness this blogpost, which graphs two completely unobservable and totally made up variables against each other and uses their correlation to castigate the Fed.

The first variable is "Aggregate demand uncertainty" and it is none other than the newly constructed index that has so riled up the progressive blogosphere.

The second is "Potential Nominal GDP" minus actual Nominal GDP.  I have been on record elsewhere criticizing measures of potential real GDP  but this is even stranger.

Wouldn't potential nominal GDP always be infinite? Can't the Fed always raise the price level a little bit more?

Isn't this a fake variable that doesn't even make sense in theory?

Anyway, it turns out that these two constructed versions of unobservable variables are negatively correlated. Check it out:

If two fake variables explain each other in a graph, does it make a sound?

People, the author of the post in question didn't make up these stinky variables; Potential Nominal GDP is on FRED for Pete's sake! He just used them to go all Luis Brunel on us.

Promises, Promises

Yesterday, Slate's Matt Yglesias tweeted,

"If Bernanke ended the recession tomorrow, it would be an admission that he could have ended it two years ago. So he won't."

Let's break it down, KPC style:

1. Matt, the recession is over. The NBER dates the business cycle and puts the end of the recession as June 2009!  Matt is not the only one doing this, but it is misleading and quite incorrect to do so.

2. For argument's sake, let's replace "ended the recession" with "accelerated growth". Then the conditional statement would be true. If BB could instantly accelerate growth tomorrow, he also could have done it two years ago.

3. Consider all the things BB has done to try and accelerate growth. Short term rates at zero. Promising to keep short term rates at zero for years (until late 2014). Pumping reserves into the system at an historically unprecedented rate. Two rounds of quantitative easing.

4. Matt doesn't say how BB could accelerate growth tomorrow (he only had 140 characters). I assume Matt means that BB could make a policy announcement that would instantly change everything. Something like a retroactive commitment to an nominal GDP path or a retroactive commitment to a price level path. If that's not what Matt means, then I apologize and withdraw what follows below.

5. The key for policies like that to work, even in theory, is that BB must, in Paul Krugman's words, "credibly promise to be irresponsible" and I see no way for the Fed to do so in general, let alone in this political environment. It's a lot harder than it might seem (to get an idea of how hard, check out Svensson's "foolproof way" paper).

6. I too am unhappy with the current state of the US economy. Growth is too slow and unemployment is too high. But it simply is not in the power of any single person in the world to change that in a day. Implying that BB is deliberately keeping the US economy down does not serve any constructive purpose.

The (Minsky) Empire Strikes Back!

Hyman Minsky is like the monster in a horror movie. You think it is gone... but no. It keeps coming back, over and over...

When Credit Bites Back: Leverage, Business Cycles, and Crises
Òscar Jordà, Moritz HP. Schularick, and Alan M. Taylor
NBER Working Paper No. 17621
November 2011
JEL No. C14,C52,E51,F32,F42,N10,N20

ABSTRACT This paper studies the role of leverage in the business cycle. Based on a study of nearly 200 recession episodes in 14 advanced countries between 1870 and 2008, we document a new stylized fact of the modern business cycle: more credit-intensive booms tend to be followed by deeper recessions and slower recoveries. We find a close relationship between the rate of credit growth relative to GDP in the expansion phase and the severity of the subsequent recession. We use local projection methods to study how leverage impacts the behavior of key macroeconomic variables such as investment, lending, interest rates, and inflation. The effects of leverage are particularly pronounced in recessions that coincide with financial crises, but are also distinctly present in normal cycles. The stylized facts we uncover lend support to the idea that financial factors play an important role in the modern business cycle.

(Nod to A-Denz, who knows things)

Every picture tells a story

Since the creation of the Federal Reserve, middle and working-class Americans have been victimized by a boom-and-bust monetary policy. In addition, most Americans have suffered a steadily eroding purchasing power because of the Federal Reserve's inflationary policies

~Ron Paul

I'll give him the boom and bust part (though I'm not sure why it only applies to "middle & working-class folks), but I have to call bull*&^* on the steadily eroding purchasing power part.

Here's Ron's go to graph:



Looks, pretty bad, right? The "purchasing power of the dollar" has been grotesquely eroded by inflation (the graph is an inverted graph of the price level). But what Dr. Paul fails to inform us is that we all have a HELLOVA LOT MORE dollars than we used to.

The average hourly wage in manufacturing in 1949 was $1.26!

Here is the graph Dr. Paul apparently is unaware of or at least hopes that you are unaware of:

People, inflation is a sustained rise in the general price level. That INCLUDES wages. Perhaps not month to month or quarter to quarter but over time, wages rise with the price level. In post world war two America, the standard of living of most Americans has steadily risen, not fallen.*

Now that I've worked up a full head of steam, let me go ahead and assert that there is little to no evidence that business cycles are more frequent or worst now than they were when then US was on the Gold Standard!

*Of course we can debate LeBron's Stagnation hypothesis over the most recent period, but that phenomenon is clearly unrelated to the modest inflation levels we have seen in the past decade.

Contra the NY Times, Vector Autoregressions are NOT magic

In an interesting human interest story on the newest Econ laureates, the NY Times tosses this into the mix:

Mr. Sims developed a statistical approach called vector autoregression, or V.A.R. It enables the testing of cause and effect — whether, for example, the money supply is affecting interest rates, or vice versa. That is a crucial determination if economic models are to have any accuracy, as the Nobel committee has noted.

So many things wrong here. Lets try to unpack it.

First of all, causality requires identification. VARs do not provide any automatic or free identification. To do policy analysis with a VAR (as opposed to agnostic forecasting) one has to make the same type of untestable identifying assumptions here as one does in the older, explicitly simultaneous equation, Cowles commission approach.

The most common way of identifying a VAR (ordering the variables and performing a Cholesky decomposition) is EXACTLY the same as using exclusion restrictions to identify a system of equations. Other structural VARS do NOT remove the need for identifying assumptions. VARS are not a free lunch.

Second, if the article is referring to Granger causality, then Granger's 1969 Econometrica article predates the VAR.

Third, is causality (i.e. identification) crucial for economic models to have any accuracy? Well that depends on what you mean by accuracy. If you mean on target forecasts of specific aggregates, then no, identification is not really needed (VARS are great for agnostic forecasting of specific variables). If you mean being able to perform convincing counterfactual policy simulations, then yes, identification is vital (but the VAR doesn't give a free lunch here).

Don't get me wrong, I think Sims is *awesome* and well deserving of the Prize (Sargent too!!!), but VARS are not magic.

My kingdom for a counter-factual

Popular Macro debates are getting so tiresome, strident and pointless. The standard of what counts as evidence has fallen to ludicrous levels, even for people who should know better.

For example, consider this common line of reasoning: Tax cuts don't work. After all, taxes were higher under Clinton than under Shrub and the economy performed better under Clinton.

Or this one: Stimulus doesn't work. After all, we spend $800 billion and unemployment just kept going up.

Both of these arguments are non-germane and virtually worthless because no reasonable counterfactual is being offered.

We are not told what would have happened under Clinton if taxes had been cut, or what would have happened under Shrub if taxes had not been lowered. The comparison offered holds no water because it is unreasonable to assume that the only factor that varied between the two time periods relevant for explaining economic outcome is the Federal Tax Schedule. We know that is not true.

The stimulus argument is even weaker. To evaluate its effect, we need to know what would have happened without its application. It is unreasonable to assume that the only factor that varied which was relevant for unemployment was the stimulus.

People, anytime you see a strong empirical claim being made and the supporting evidence is a graph or an anecdote or simple comparison of A vs. B, ask yourself: what is the counterfactual being offered? Is it reasonable?

To my mind, it is precisely because Macro is a non-experimental field (meaning convincing counterfactuals are difficult to find) that it has become so politicized. People can look at the same events and draw diametrically opposing conclusions.

Macro has all the interesting questions, but Lord is it hard to find good answers!

Do you believe in magic? Ryan Avent does!

Avent joins the crew attributing untapped magical powers to the Federal Reserve:

"Losing its credibility as an inflation-fighter, some of it anyway, is precisely what the Fed needs to accomplish. As Paul Krugman has put it, the Fed needs to promise to be irresponsible at some future point, thereby raising expectations of future inflation. That, in turn, will boost current inflation. Consumers will want to spend their money in the period before its value erodes, and through that mechanism future inflation becomes current inflation.

So the question then becomes: can the Fed convince markets that it will be irresponsible in the future? The answer, quite obviously, is yes. The Onion helpfully suggested one way in which this might be accomplished. At a recent dinner, colleagues of mine joked about other ways to solve the problem. One suggested that Ben Bernanke might ask to have his salary indexed to gold or the Swiss franc. Another said the chairman should take to the podium to tell Americans they'd better start spending their dough soon before it's worthless, lighting a cigar with a $100 bill all the while. More practically, Mr Bernanke could raise his desired inflation target or simply declare that the Fed won't touch rates for a certain period, no matter what happens in the broader economy."

People, if the Fed has credibility as an inflation fighter it is for the Rogoffian reason that we have appointed inflation adverse central bankers. That is, people whose preference is for low inflation.

Please repeat after me:

THE FED HAS NO MECHANISM TO BIND ITSELF TO LIVE UP TO ANY ARBITRARY PROMISES IT MAY MAKE TODAY ABOUT THE FUTURE!!!

Promises to act against one's preferences in the future that are made without any commitment mechanism are simply cheap talk and are extremely unlikely to shape agent's expectations or actions.

We could appoint a central banker whose preference was for high inflation. In that case any promises to create low inflation or deflation in the future would be incredible and ineffective for exactly the same reason today's conservative central bankers' promises to create future inflation would be incredible and ineffective.

This is not a Tinkerbell situation folks; believing in magic is not going to get us through the crisis.

Do you believe in magic?

In a recent post, Scott Sumner claims that the Fed can easily credibly commit to a nominal GDP target. He further claims that the act of choosing the target in itself would allow the Fed to hit the target without any great amount of monetary expansion:

"The Fed has plenty of credibility, that’s not the problem. The problem is that they are using the credibility to assure investors that low inflation is here to stay. With the right target, there would probably be no need for massive quantitative easing, or other extraordinary policies.

The punch line is that the problem isn’t the Fed’s unwillingness to do enough QE, twists, or cuts in IOR, the problem is the Fed’s inadequate target, just like in Japan."

In other words, the Fed can credibly commit to arbitrary future policies so well that a simple announcement of a new policy path will put the economy on that path without any heavy lifting required.

In other other words, magic!

People, the Fed has no ability to make credible commitment to future policies that might conflict with their period by period preferences! Read Kydland & Prescott. Read Barro & Gordon. Repeat after me: time inconsistency, time inconsistency, time inconsistency.

All the Fed can do is act each period according to its own preferences (yes it's weird to treat the Fed as a unitary actor given all the dissents we've seen recently, sorry).

Many societies have responded to this dilemma by invoking the Rogoff gambit; we appoint conservative central bankers. They deliver low inflation not because they are following some policy rule or pre-determined path, but because their preference is for low inflation!

The idea that there's a magic bullet out there that solves our economic problems, that the Fed could fix things by putting out a press release with a couple sentences about their plans for future NGDP growth, is wrong and somewhat dangerous.

7 million new jobs in 7 paragraphs

Man Robert Frank is ON FIRE in his Economic View column. The whole thing is 16 paragraphs, but in grafs 6-12 Bob lays out how we can get "more than 7 million" new jobs by the end of 2012.

I can boil his 7 grafs into 3 words:

payroll tax holiday

Yessirree Bob; it's just that easy. Cut the employee rate to zero and cut the employer's rate to zero for all new hires from now to the end of 2012.

I am in favor of cutting the payroll tax permanently, not just for 18 months, or so regardless of how many jobs it creates, but I am amazed that (a) Bob Frank is advocating this policy, and (b) that he is so sure that the resulting employment gains would be so strong.

The mystery of Yglesias

Matty Y has put up a mysterious blog post called "The non-mystery of the recession".

He shows this graph:

And then says "As for the current recession, this just goes to emphasize how non-mysterious everything is"

And that to me is mysterious!

Is he saying the fall in consumption explains the fall in GDP (rather than vice versa or both being caused by a third factor)?

Or is he saying that the current recession is typical of US recessions?

People, the recession we have endured and its aftereffects are anything but non-mysterious.

GDP and consumption usually snap back to trend relatively quickly after a recession in the USA. The current case, where GDP and consumption are moving along a path parallel to but below the original trend is rare and, dare I say it, mysterious.

Either Matty is too deep for me, or Matty doesn't know what the word "mystery" means (or both I guess could be true).

Can the Fed do more?

Bernanke unprecedentedly goes public today with a post FOMC meeting news conference!

The progressive pack wants to hold him accountable for not "doing more" to fight unemployment (here's David Leonhardt for example).

But, can Chairman Ben do more?

Well in one sense, yes, he could always announce another policy initiative. QE III anyone?

But the important question is can the Fed do anything right now to reduce unemployment faster?

I don't think so.

All the policies Leonhardt mentions require the Fed to make a credible current commitment to an unusual set of future actions (set interest rates at near zero for several more years, create higher than "normal" future inflation).

In other words, for these types of polices to work, the Fed has to change expectations about future Fed behavior.

People, there is a huge literature exactly about the fact that the Fed cannot credibly commit to some future optimal policy (the so called "time-inconsistency" literature).

Fed promises to do strange things in the future simply are not believable and are thus extremely unlikely to produce the desired private sector reaction.

To my knowledge, none of the proposals being floated for the Fed to do more avoids this basic issue, and thus, I do not believe the Fed can do anything at this point to make unemployment fall appreciably faster.

How not to do economics; another edition

People, if you are going to write a paper called "Global Liquidity Trap", the first line of your abstract probably should NOT read as follows:

"In this paper we consider a two-country New Open Economy Macroeconomics model, and analyze the optimal monetary policy when countries cooperate..."

Ah yes, future economists, count off after me; 1, infinity and we're done!