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I’ve been giving some thought to how my views of macro are different from those of other economists. Until this crisis hit, I assumed that I was doing “normal economics,” to use Thomas Kuhn’s terminology. NGDP targets are different from the Taylor Rule, but they aren’t all that different. Even Ben Bernanke has talked about targeting the forecast. You’ve seen me endlessly recite Mishkin’s 4 key concepts from his monetary textbook. They are a virtual blueprint for my current critique of monetary policy. So I’ve never thought of my views as being particularly heterodox.

And yet . . . . You could count on one hand the number of economists who think money was tight last fall. And you could count on one hand the number of right-wing economists who think that the economy currently needs much more stimulus. So although my views are not completely unique, there is apparently something rather unusual about my approach to macro.

Kuhn is famous for arguing that scientific revolutions were preceded by a buildup of “anomalies,” or things that were difficult to explain within the standard model. I’d like to discuss two possible anomalies, although in this case I don’t think that either are currently recognized as such. I hope to change that. The discussion will actually be more of a challenge to my fellow economists. Can you explain these anomalies in a way that is consistent with the standard model?

Anomaly 1: Economists talk about “monetary policy” without having a coherent idea of what they mean by the term.

Recall that a standard model should have an agreed upon set of terms, so that communication between scientists is possible. OK, what do we mean by the “stance of monetary policy?” What do we mean by “easy money?” How about “tight money?” Surely if we claim to be a science it’s not good enough to say “it depends” or “I know it when I see it.” We must have some metric in mind, something in the real world we can point to, beyond our gut instinct. So let me throw out this challenge: I say it is impossible to come up with any sort of coherent meaning for terms like ‘easy money’ and ‘tight money’ in the context of the standard model. Economists use these terms all the time, and yet are really just spouting nonsense. To make things simpler I’ll offer 6 options, which conform to all of the ways in which I have heard people try to give meaning to the term:

1. The Joan Robinson interpretation:

As you may recall, I like to mock Joan Robinson’s statement that the German hyperinflation could not possibly have been caused by easy money; after all, nominal interest rates were not low in Germany during the early 1920s. I think it is fair to say that Joan’s views are no longer part of the standard model. It is now widely believed that the German hyperinflation was caused by easy money, and hence nominal interest rates cannot be the right indicator for the stance of monetary policy. When economists say “easy money” they can’t possibly be referring to low nominal interest rates, otherwise they’d have to accept Joan’s rather eccentric views.

2. How about real interest rates?

When I make the preceding argument to economists, the quick retort is usually “of course what I really meant was that easy money means low real interest rates, and tight money means high real interest rates.” Fair enough. So let’s look at the record. Real interest rates on five year TIPS rose from 0.57% in mid-July 2008 to 4.24% in late November 2008. If real interest rates are the appropriate indicator of the stance of monetary policy, then this 4 month period was one of the most sudden and aggressive examples of monetary policy tightening in all of recorded history.

So maybe we do have a coherent view of the stance of monetary policy. It refers to the level of real interest rates. Except there is just one problem. When I tell other economists that money became ultra-tight in the second half of 2008, I am met with stares on incomprehension, as if I had just escaped from a lunatic asylum. So whether or not real interest rates are the “right” indicator (and for what it’s worth I don’t think they are) one thing is perfectly clear—this is not the standard model. If only a tiny handful of economists think money was tight last fall, most economists obviously are defining “tight” as in terms of much higher real interest rates.

3. The monetary base:

I used to like this one. It seems to conform best to what the Fed actually does. They print money. And the money they print isn’t M1 or M2, it’s base money. But again, whether or not this is the best indicator (and I no longer think it is) it’s clear that it hasn’t been the standard view for decades, if ever. As Friedman and Schwartz showed the base was extremely misleading in the Great Depression, as M1 and M2 fell sharply at the same time as the base was rising rapidly. Most of the profession now accepts their view that Fed policy was very tight in the early 1930s. During that period the sharply falling M1 and M2 seemed to be better indicators as we also experienced extreme deflation, not what you’d expect from easy money. Now of course there are other ways to look at this picture. Krugman has argued that one could think of money as being easy, but that because we were in a liquidity trap the easy money did no good. However, the fact that Krugman might make this argument doesn’t mean that he thinks the monetary base is the right indicator of the stance of monetary policy. I rarely see him (or other Keynesians) pay any attention to the base. I suppose one could still argue that the base is the right indicator of monetary policy, but that view is certainly not the standard view. I’ll bet 90% of the economists who claim Greenspan ran an easy money policy in 2003 have never once examined the base data from that year.

4. How about the broader aggregates?

In some ways M2 is better than the other three. It certainly gave a more useful indication of monetary policy than either the base or nominal interest rates during the Great Depression. (And my hunch is that even real rates were misleading, although there is some debate about whether the deflation was anticipated.) But once again, it is certainly not the standard view that M1 or M2 are the right indicator of the stance of monetary policy. Indeed, after the early 1980s most economists lost any interest in these variables. Mike Belongia argues that we can and should come up with much more informative aggregates. He may be right, but that’s not the issue I am examining here.

This week’s Economist mentioned how M2 has recently been flat, and then a few sentences later asked “whether all this fiscal and monetary stimulus will work.” Obviously they are assuming that nobody would view M2 as the right indicator of monetary policy.

5. The Taylor Rule

Lots of economists have argued that the Taylor Rule suggests rates should now be much lower. I know there is some debate about their interpretation, but I’d like to focus on something different. Even those economists who say rates need to be much lower according to the Taylor Rule, do not draw the implication that money is currently very tight. So it is very clear that even economists who use the Taylor Rule don’t generally think it is an indicator of the stance of monetary policy.

6. The “it depends” view:

Once they’re painted in a corner, and there no longer seems any single coherent definition of monetary policy, some economists will strike a more nuanced pose. They will argue that it depends on a variety of factors. You can’t just look at one metric. It depends on the condition of the economy. But again, this is not the view within the standard model. If this were the standard view, then communication on monetary policy issues would look much different. Suppose we had an English professor go through reams of economics discussions, debates, articles, etc, looking for how economists use terms like ‘easy’ and ‘tight’ money. I am quite certain that he or she would find the terms used in a fashion that indicated their meaning was clear, and that both the speaker and the listener had the same shared understanding of what these terms mean. In other words, economists uses these terms in the same way scientists use terms like force and mass. But there is just one problem; scientists can point to agreed upon metrics (such as kilograms) for measuring their concepts. So here is my big challenge to the economics profession:

Where is the metric for the stance of monetary policy?

I say we don’t have one. Even worse, I say we think we have one, we talk as if we have one, but we aren’t even close to having one. Given how monetary policy moved front and center in macro after the new Keynesian consensus of the 1980s, I’d say that’s a pretty big problem.

Anomaly 2: Economists who claim to believe in markets, ignore the fact that the markets decisively reject their policy views.

Here’s one Krugman and DeLong would like, in the off chance they read this post. Lots of economists on the right talk with a high degree of confidence about whether money is too easy, or too tight. Let’s put aside the problem of defining easy and tight, and pretend there was a consensus. My reading of history is that more often than not the markets don’t agree with right-wingers, and even worse, those right-wingers who claim to believe in efficient markets and rational expectations just brush off the markets’ rejection of their policy views.

Some examples: I found that in the Great Depression the Fed mistakes identified by Friedman and Schwartz rarely had any discernable effect on asset prices. But gold market shocks had a huge impact on asset prices. Or take the “real business cycle” view, the view that nominal stimulus can’t boost real output, as recessions are caused by real shocks. In the Great Depression the real value of assets like stocks often soared on news of easier money. In addition, default risk fell sharply (as the Aaa/Baa yield spread fell on news of easier money.)

And we have seen the same in recent months. For anyone who pays even the slightest attention to equity markets, it is obvious that during a recession stock prices react extremely positively to even a slightly greater than expected easing of monetary policy. (And one thing Krugman won’t like, that’s even true when rates are at the zero bound.)

Here’s my favorite example. I recently saw a graph showing inflation expectations over the next few years. As I recall the medium forecast was about 2%, which is somewhat above market forecasts. But here is what was interesting; the distribution of forecasts was much wider than usual. There were a lot of 1% forecasts, and a lot of 3% forecasts. The typical distribution is much tighter. Some of my more astute commenters made this argument to me, after I cited the TIPs markets as evidence that we didn’t need to worry about inflation. They argued that those buying gold might have a very high inflation forecast, but aren’t participating in the bond market.

So who is right, those in the bond market or those economists forecasting much higher inflation? The answer is easy, those with money on the line. Remember how during the Bush years liberals used to make those sarcastic comments about faith-based vs reality-based views? There is a bit of truth in what they were saying (although of course they have their own biases.) It seems to me that if you take a “realistic” look at the big picture, inflation is likely to stay low. But some economists have “faith” in models that say when we have big deficits and double the monetary base then inflation will be just around the corner. Unfortunately, those models were wrong in Japan and they will be proved wrong here as well.

So my explanation for the wide dispersion of inflation forecasts is quite simple, ideology is driving the forecasts to a much greater extent than during normal times. And in this particular case the Keynesian model just happens to yield predictions that are closer to “reality.” Of course that’s not always true, the view that economic “slack” prevents higher inflation didn’t work very well in the 1970s, and performed absolutely horribly in the year after the dollar was devalued, when prices rose rapidly despite 25% unemployment. Still, right now the right is wrong.

BTW, this example also addresses a question I am often asked: “If even economists can’t agree on the right model, how could average traders possibly have rational expectations, how could they form expectations consistent with the right model.” Well I don’t know how the wisdom of crowds comes about, be we are currently seeing a beautiful example of rational expectations in action. Traders are rationally blowing off simplistic quantity theories of money, which some academic economists continue to cling to. They are trading TIPS as if they understand that the Fed interest payments on excess reserves changes everything.

I’ve gone on way too long. I think it makes sense to first see if any economist can meet my challenge, can come up with a coherent metric for measuring the stance of monetary policy that is also consistent with the standard model. Heck, I’d be happy with any metric that is consistent with the views of any substantial fraction of respected economists, on either the right or the left. I say there isn’t any.

In my next post I’ll discuss where I think macro needs to go and explain why we might need new concepts, new metaphors, indeed a completely new paradigm (something I never would have imagined before October 2008.) It will be a macroeconomics without lags and without multipliers. A macroeconomics where all important concepts are embedded in parallel asset prices measurable in real times. Where shocks and have no important macro implications. A macro free of VARs.

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This entry was posted on November 03rd, 2009 and is filed under Heterodox macro, Monetary Policy, Monetary Theory. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.



