The long run is now

I recently criticized the view that the Fed might want to consider raising interest rates because a long period of low rates could lead to financial imbalances, such as “reaching for yield.”  I actually have several problems with this view, but focused mostly on the implicit assumption that tighter money would lead to higher interest rates.  That’s not true over the sort of time frame that people are worried about.

Tyler Cowen linked to the post and offered a few comments:

Scott Sumner dissents on reach for yield.  I don’t think easier money will boost the American economy right now.  So I think you just get a loanable funds effect and then possibly a reach for yield.

A few reactions:

1.  I have a rather unconventional view on the question of policy lags, which Tyler is probably referring to in his “right now” remark.  I believe that monetary policy affects RGDP almost immediately, or at least within a few weeks.  This is based on three interrelated claims, which may or may not be true:

a.  Monetary policy immediately affects expected future NGDP growth.  That can be defended either as a definition (I define the stance of policy as expected NGDP growth) or if you prefer it can be defended on EMH/Ratex grounds.  If it affected growth expectations with a lag, then there would be lots of $100 bills on the sidewalk.  I don’t see many.

b.  Changes in expected future NGDP have an almost immediate impact on current NGDP growth.  I can’t prove this, and it’s the weakest link in the chain.  But I strongly believe it to be true.  Someone should do a study correlating changes in expected future NGDP (perhaps 4 quarters forward, consensus forecast) with changes in current NGDP.  I expect a strong correlation.  Thus during periods where the expected future NGDP falls sharply, such as the second half of 2008, current NGDP also falls sharply.

c.  Changes in current NGDP are highly correlated with changes in current RGDP. This is one of those “duh” observations, at least for anyone who pays attention to the data.

Most people believe in long and variable lags, because they associate “monetary policy” with changes in interest rates.  If the Fed created and subsidized trading in a NGDP prediction market, I believe we would quickly discover that my view of policy lags is correct, and the consensus view is wrong.  But even if I were wrong, wouldn’t it be useful to pin down this sort of stylized fact? You’d think so, but my profession seems surprisingly uninterested in these sorts of things.

2.  The loanable funds effect is exactly why I think I’m right.  Faster growth would lead to more demand for loanable funds, and thus higher interest rates.  I wonder if Tyler is referring to the “liquidity effect”, the tendency for monetary injections to lower interest rates in the short run.  If so, I don’t think this effect lasts long enough to justify distorting Fed policy with tight money in order to stop people from “reaching for yield.”

3.  I don’t like the term “reach for yield.”  When the interest rate falls, it’s rational for people to value any given future cash flow at a higher level.  So if rates fall for reasons unrelated to corporate profits or returns on apartments, then stock and real estate prices should rise.  That’s markets working the way they are supposed to.  I believe low interest rates are the new normal of the 21st century (partly but not entirely for Cowenesque “Great Stagnation” reasons), so I’m not at all concerned by higher asset prices.

4.  Tyler is on record predicting a very bad recession in China, and also for being open to arguments that the Fed might want to consider raising interest rates this year.  Each is an eminently reasonable and defensible view.  But surely they can’t both be true?  If China is going into a very bad recession, I can’t even imagine a scenario where the Fed raises rates and then a year later looks back and says, “Yup, we’re sure glad we raised rates.”  Stocks plunged earlier today on just a tiny, tiny piece of bad manufacturing news out of China.  How tiny? Notice that the same low PMI occurred three other times in the past 4 years, without RGDP growth ever falling below 7%.

Screen Shot 2015-09-01 at 2.03.54 PM

What would that index look like if Chinese RGDP growth was actually about to turn negative?  What would US stocks look like?

5.  I strongly agree with Lars Christensen’s post, which suggests that the Chinese are making a mistake by trying to prevent the yuan from falling.  I also agree with those who claim that recent events show the Chinese leadership to be less competent in economic affairs than many had imagined.  This is a consequence of development; the problems become trickier than when you are just cleaning up after the Maoist disaster.  They don’t seem to be any better at monetary policy than we are.

6.  Off topic, I probably erred in saying Trump has no chance.  That’s my personal view, but maybe I’m just an old timer who is out of touch with changes in America. After all, Berlusconi was elected three times in Italy.  I saw Trump as just another example of a rabble-rouser like George Wallace or Patrick Buchanan, who rose up and then faded.  That’s still my gut level view, but commenter “John” points out that Trump does have a non-zero chance in prediction markets, and I do claim to be an EMH guy.  More importantly, even though Trump and Sanders are unlikely to even be nominated, I see their rise as bad news for American politics.  I could even see their limited success hurting the stock market slightly, as the prospect for sensible economic and immigration reforms seems ever more distant.  Historically, markets do worse in times when the political situation is adrift.  And at the moment China, the US and Europe all seem to be a long way from the almost effortless competence of the Reagan/Clinton era.

PS.  Japan 2014, Canada 2015.  Another fake “recession” call.  Read about it at Econlog.

Skeptical of the China data skeptics

The problem with answering comments is that one has to swat down one conspiracy theory after.  One recurring theme is that the China GDP data is fake. People breathlessly report obscure data on electricity production or rail shipments. I don’t doubt that the Chinese data is flawed, but there’s no reason to assume it’s not broadly correct.  You need to look at the big picture, and with China I mean really big.

1.  The quarter-to-quarter data is strangely smooth (although that’s partly an artifact of their use of year over year, rather than quarterly data.)  But over the business cycle RGDP growth varies as much as in the US, indeed even more.

2.  People forget that until recently China had 10% trend growth, so when it goes from 14% to 7%, that’s a big slowdown.  People also forget that some sectors of the Chinese economy are probably growing smoothly.  Health care, college education, subways rides (which are constrained by capacity), etc.  So if the overall RGDP growth rate slows from 14% to 7%, and some sectors are growing smoothly at 10%, then the cyclical sectors are slowing extremely rapidly.  And the cyclical sectors are also the commodity intensive sectors.  You could easily see lots of industry data that seems inconsistent with a 7% RGDP growth rate, during a cyclical slowdown.

3.  People sometimes argue that the trend rate has not been 10% in recent decades, but more like 7% or 8%.  The problem with these conspiracy theories is that China’s just too big and open to world trade to cook the books in that way. That’s because over the period since 1980, that kind of cheating would lead to China’s RGDP being overstated by a factor of 2 or 3.  China would now be far poorer than claimed.  (Having said that, trend growth is slowing, and will probably be 5% to 6% over the next decade.)

4.  The World Bank has China’s RGDP/person in PPP terms at 72.7% of Mexico, which seems about right to me (I’ve visited many areas of both countries.) By comparison, India’s at 33% of Mexico.  Does anyone think China’s even close to India?  Yes, China has poor rural areas, probably more than Mexico.  But some rural areas (like the highly populated Yangtze delta) are much richer than you’d think.

5.  These theories would also require cheating on all the sectoral data.  But trade data is two sided, and other countries also report soaring Chinese exports since 1980.  Chinese consumers buy 20 million cars per year, vs. 1 million in Mexico. And yet the poorer China has only 11 or 12 times Mexico’s population. India, with almost as many people as China, has a market of less than 3 million cars/year. That’s just cars, but take any appliance you wish and China looks at least as rich as the data shows, at least in terms of purchasing power.

6.  Maybe the auto figures are also faked.  Maybe VW and GM and all the other western car companies making cars in China are in on the conspiracy.  Maybe the Australian mining firms that claim to sell a God-awful amount of iron ore to China are also faking the data, as are the auto parts suppliers.  Maybe China’s not the world’s biggest exporter, not the world’s biggest carbon emitter.

Screen Shot 2015-08-30 at 10.01.26 AM

7.  Or maybe China really is 72.7% as rich as Mexico. Look at Chinese wages.  They only passed the Philippines in 2000, and are now more than 4 times higher.  They passed Indonesia in 2003, and are now twice as high.  And those two countries have been growing at about 5%/year.  Indeed I find that graph hard to believe, given how much richer Malaysia is than China:

Screen Shot 2015-08-30 at 3.25.41 PM

(OK, the previous picture is Beijing, so here’s a pic from Guangxi, one of China’s poorest regions):

Screen Shot 2015-08-30 at 10.17.38 AMAnd the next picture is from China’s absolutely poorest province, Guizhou.

(The article I found this picture in says this province is becoming a center of “big data.”  Would that happen in Chiapas?):Screen Shot 2015-08-30 at 10.38.04 AM

Pop Monetary Economics

Paul Krugman has an excellent post demolishing the following claim by William Cohan, in the NYT:

The case for raising rates is straightforward: Like any commodity, the price of borrowing money — interest rates — should be determined by supply and demand, not by manipulation by a market behemoth. Essentially, the clever Q.E. program caused a widespread mispricing of risk, deluding investors into underestimating the risk of various financial assets they were buying.

BTW, Krugman’s post is the one to read (not mine) if you only look at one post on this topic.  He carefully walks through an explanation of what’s wrong with this paragraph, in a way that would be recognizable to any competent monetary economist. But in some ways it’s even worse than Krugman assumes.  Here’s Krugman:

The Fed sets interest rates, whether it wants to or not — even a supposed hands-off policy has to involve choosing the level of the monetary base somehow, which means that it’s a monetary policy choice.

That’s also my view, but I suppose one could argue that from a different perspective if you set the money supply you are letting markets determine interest rates, whereas if you actually target interest rates, then you are “interfering” in the market.  Not exactly my view, but let’s go with it.  Let’s put the best spin on Mr. Cohan’s essay.

Now here’s the big irony.  For the past seven years the Fed hasn’t been targeting interest rates, they’ve been using base control to influence the economy, increasing the monetary base through QE programs.  They switched from interest rate control before 2008 to monetary base control after.  And now Cohan is calling for the Fed to raise interest rates.  That means he wants the Fed to go back to manipulating interest rates.

So the great irony here is that in the paragraph I quoted from above Cohan says:

Like any commodity, the price of borrowing money — interest rates — should be determined by supply and demand, not by manipulation by a market behemoth.

And yet in the essay he’s actually calling for the exact opposite; he wants the market behemoth (the Fed) to start manipulating interest rates, something it hasn’t been doing for the past 7 years.

Unlike quantum mechanics, monetary economics doesn’t seem too hard.  As a result the media produces a non-stop stream of stories on monetary policy that are utter nonsense.  And by “utter nonsense” I don’t mean stories that disagree with my particular market monetarist views (Cohan might be correct that the Fed should raise rates), but rather stories that are simply incoherent, that are completely detached from the field of monetary economics.

We don’t hire plumbers to teach quantum mechanics at MIT.  We don’t put plumbers on the Supreme Court.  But we do put Hawaiian community bankers on the Board of Governors.  It’s not just that our media and Congress and President don’t understand monetary economics, they don’t understand quantum mechanics either.  The real problem is that they don’t even understand that they don’t understand it.  So they have unqualified people write op eds, and sit on the Board of Governors.  People ask me what Trump or Sanders think about monetary policy.  They don’t even know what it is!  What they think doesn’t matter, even if they were to get elected.  Just as it doesn’t matter what their view is on the best trajectory for NASA’s next Saturn bypass.

BWT, I have no problem with Hawaiian community bankers having important policymaker roles at the Fed, but put them on the committee for banking regulation, not monetary policy.

The title of the NYT piece said the Fed needed to “Show Some Spine”.  Over at the Financial Times they want the Fed to “Show Steel.”  (I guess that makes Paul and me wimps.)  Here’s the argument at the FT:

Yet monetary policy cannot confine itself to reacting to the latest inflation data if it is to promote the wider goals of financial stability and sustainable economic growth. An over-reliance on extremely accommodative monetary policy may be one of the reasons why the world has not escaped from the clutches of a financial crisis that began more than eight years ago.

I suppose that’s why the eurozone economy took off after 2011, while the US failed to grow.  The ECB avoided our foolish QE policies, and “showed steel” by raising interest rates twice in the spring of 2011.  If only we had done the same.

Of course I’m being sarcastic, but that points to another problem with the Cohan piece. Rates are not low because of QE (as Cohan implied), indeed Europe didn’t do QE during 2009-13, and that’s why its rates are now lower than in the US, and will probably remain lower.

If this stuff is published in the NYT and FT, just imagine what money analysis is like in the average media outlet, say USA Today or Fox News.

HT:  Tom Brown, Stephen Kirchner

Nationalist–Socialist America

The German tight money policy of the early 1930s led to a surge in vote support for two groups, the nationalists and the socialists.  Today in America the nationalists and the socialists have all the momentum.  Consider:

1.  Dick Cheney might have been the worst Vice President in American history (at least Agnew didn’t do anything.)  Now add to the list his choice to be one heartbeat away from the presidency—Sarah Palin.  Palin is now gushing praise over Donald Trump, who campaigns on the same mix of statism and xenophobia that you see among the neo-fascist parties in Europe, with militarism thrown in.  For years I could take pride in the fact that America largely avoided that particular policy mix.  I don’t think even Pat Buchanan was a militarist.

Update:  Well that must be one of the most epic brain freezes in my 6 1/2 years of blogging, it was obviously McCain who chose Palin.  Cheney didn’t chose anyone, unless perhaps himself, when he headed Bush’s VP search committee.

2.  The heart of the Democratic Party is now with Bernie Sanders, whatever the polls show.  And let’s not have anyone accuse me of McCarthyism, he calls himself a “socialist.”  When asked, the head of the Democratic Party couldn’t think of a single difference between socialists and Democrats. And please don’t insult my intelligence by talking about Sweden.  Sweden is not a socialist country.  Venezuela is socialist.  When Sanders starts advocating free trade and investment, liberal immigration rules, privatization, zero inheritance tax, 100% nationwide school vouchers, a $0/hour minimum wage rate, then come back to me with your Sweden talk.  For now, he just wants the bad parts of Sweden.

The official Democratic platform now advocates a nationwide $15 minimum wage. Whatever you think of extreme Reagan era supply-side economics, the GOP never went that far off the rails on economic policy.  The GOP platform said consider the gold standard, not adopt the gold standard.  I suppose the Seattle case is debatable, but a nationwide $15 minimum wage law would literally destroy the economy in many low wage/low productivity parts of the country, such as Puerto Rico.  It would also create even more crime, a massive underground economy.

PS.  I hope it goes without saying that neither of these guys will win, but remember what happened to the policy platform of Eugene Debs

The first step is admitting you have a problem

That is, the first step toward NGDP targeting.  Marcus Nunes has a new post that quotes a Jon Hilsenrath story in the WSJ:

JACKSON HOLE, Wyo.—Central bankers aren’t sure they understand how inflation works anymore.

Inflation didn’t fall as much as many expected during the financial crisis, when the economy faltered and unemployment soared. It hasn’t bounced back as they predicted when the economy recovered and unemployment fell.

The conundrum challenges much of what central bankers thought they understood about the world, as well as their ability to do their job. How will they know when to raise or lower interest rates if they’re unsure what causes consumer prices to rise and fall?

“There is definitely less confidence, a lot less confidence” about how inflation works,James Bullard, President of the Federal Reserve Bank of St. Louis, said in an interview here Friday.

The mysterious path of inflation during the crisis and post-crisis era is the main topic at the Federal Reserve Bank of Kansas City’s annual economic symposium here, where Fed officials, academics and global central bankers gather every August to discuss economic issues.

Inflation dynamics are more than an academic issue. Fed officials are considering whether to raise short-term interest rates from near zero, where they have been since December 2008. The Fed’s main sticking point is that inflation has run below its 2% target for 39 straight months. Inflation is lower than central bank objectives throughout the developed world, despite exceptionally low interest rates and other extraordinary measures aimed at driving it higher.

Before raising rates, Fed officials want to be confident inflation will rise to 2%. They have a theory it will. Unemployment is falling—reaching 5.3% in July—and slack in the economy appears to be diminishing. As supplies of labor and productive capacity become more constrained, officials believe wages and prices will rise.

So far, however, there are few indications that’s happening. The Commerce Department reported Friday that U.S. consumer prices rose 0.3% in July from a year earlier, well below the Fed’s goal. Stripping out volatile food and energy categories, officially measured inflation also runs below 2%.

The economy’s performance has “really challenged” the notion of a strong link between unemployment and inflation, Mr. Bullard said on the sidelines of the conference. The existence of such a link was also challenged in the 1970s, an era of high inflation and high unemployment.

Fortunately, there another nominal variable that still does track the business cycle very closely:

Screen Shot 2015-08-29 at 10.42.05 AMMarcus’s post also has some interesting graphs.

PS.  I have a new article on Milton Friedman and the euro, published in Reason magazine.  (Subscribers only, but why wouldn’t you already be a subscriber?)