Guest blog: The Integral Reviews: Paper 3 – Hall (2009)

Guest blog – The Integral Reviews: Paper 3 – Hall (2009)
by “Integral”

Reviewed: Robert Hall (2009), “By How Much Does GDP Rise If the Government Buys More Output?” NBER WP 15496

Executive summary

The average government purchases multiplier is about 0.5, taking into account empirical and structural evidence. The only way to get “large” multipliers of 1.6 is to assume a large degree of non-optimizing behavior, an inflexible wage rate, at the zero lower bound on nominal interest rates, and assuming monetary policy is completely ineffective at influencing aggregate demand but the fiscal authority retains that influence.

The key ingredients to generating a large output multiplier are sticky wages/prices, a highly countercyclical markup ratio, and “passive” monetary policy which does not counteract the fiscal expansion.

The assumptions that underlie “the effectiveness of monetary policy” (sticky prices and a countercyclical markup) also drive “the effectiveness of fiscal policy.” The two are similar in that respect.

Summary

Hall provides a convenient overview of the state of economic knowledge about the government purchases multiplier. He does this in four steps: simple regression evidence, VAR evidence, structural evidence from RBC models, and structural evidence from various sticky-price/sticky-wage models.

Empirical evidence begins with the simple OLS regression framework. Hall obtains the output multiplier by regressing the change in military expenditures (a proxy for the exogenous portion of government spending) on the change in output. He finds multipliers significantly larger than zero but less than unity, mostly in the neighborhood of one-half. This estimate of the “average multiplier” is confounded by two problems: (1) the implied multiplier be taken as a lower bound rather than an unbiased estimate due to omitted variable bias, and (2) the estimates are driven entirely by observations during WWII and the Korean War.

The VAR approach produces a range of estimates. Hall surveys five prior studies and finds that the government purchases multiplier is non-negative upon impact across all studies and consistently less than unity, but there is much variation in the exact point estimate. The VAR approach typically suffers the same omitted variable bias as OLS.

Hall then turns to a review of the structural evidence. He first shows the standard RBC result that if wages and prices are flexible, the output multiplier is essentially zero or even negative. While a useful benchmark this is not particularly useful for applied work.

Adding wage frictions forces laborers to operate off of the labor supply curve, so output could plausibly expand from an increase in government demand. Hall indeed finds that the multiplier is higher in small-scale NK models and depends on consumer behavior. With consumers pinned down by the permanent-income/life-cycle model, multipliers tend to range around 0.7. If consumers are rule-of-thumb or iiquidity constrained, one finally finds multipliers above unity, in the neighborhood of 1.7, in the presence of the zero lower bound on nominal interest rates.

Review

The empirical evidence is plagued by persistent endogeniety and omitted-variable bias, which Hall frankly acknowledges. Identification is extraordinarily difficult in macroeconomics; as a practical matter it is impossible to untangle all of the interrelated shocks the economy experiences each year.

On the theory side, Scott Sumner would consider this entire exercise a waste of time: the Fed steers the nominal economy and acts to offset nominal shocks; government shocks are a nominal shock, so the Fed will act so as to ensure that the government expenditures multiplier is zero, plus or minus some errors in the timing of fiscal and monetary policy.

Is this a good description of the world? On average over the postwar period, a $1 exogenous change in government spending has led to a $0.50 increase in output; excluding the WWII and Korean War data drive this number down significantly. As a first-order approximation the fiscal multiplier is likely zero on average. But we don’t care about the average, we care about the marginal multiplier, at the zero bound. In that scenario, multipliers are on average higher but still below unity. A crucial open question is to what degree the monetary authority “loses control” of nominal aggregates at the zero lower bound, and to what degree fiscal policy is impacted if the monetary authority is “helpless”. (If we are in a situation where the Fed cannot move nominal aggregates, why wouldn’t Congress be similarly constrained?)

Hall’s paper does not explicitly discuss monetary policy. However, adding a monetary authority to his models would only reduce the already-low multipliers that Hall uncovers. His point, that one cannot plausibly obtain multipliers in excess of unity in a modern macro model, is already well-established even without explicitly accounting for the central bank.

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Christensen’s “postmodernist mind fuck”

I have now been blogging since early October last year and I truly enjoy it. Most of my readers seem to be happy about what I write and I believe that most of my readers and commentators are quite Market Monetarist sympathies. However, there is one exception – lefty blogger Mike Sax. Yes, I called him lefty – I don’t think Mike would not disagree with this (if he called me a libertarian that would not make me angry either…). Mike is actually reading the Market Monetarist blogs and I think he pretty much understands what we are talking about. I will readily acknowledge that despite the fact that I probably disagree with 99% of what he has to say about economics and monetary theory.

Today I ran into a comment Mike wrote a couple a days ago about the debate about fiscal policy between on the one side the New Keynesian (Old Keynesians??) and on the other side the Market Monetarists  (and John Cochrane). Even though Mike is extremely critical of  my views I actually had quite a lot of fun reading it.

Here is Mike Sax (and yes, believe it or not the name of his blog is “Diary of a Republican Hater”…):

“If you want to get the endgame of this whole market monetarist phenomenon I say put down Scott Sumner and check out Lars Christensen. His post is called simply Market Monetarist, and indeed the very name of market monetarism is actually his coinage rather than Scott.

During the interminable tangent-a rather amusing three ring circus that Sumner led-Lars wrote a post called “There is no such thing as fiscal policy.” This is a pretty radical attack on fiscal policy. From Cochrane claiming that fiscal policy can’t work-till his bout face today-and Sumner saying it can never be as effective as monetary policy in reviving demand-we have Lars claiming it simply doesn’t exist.

Whoa! I guess if it doesn’t even exist we can’t use it. Ever. It’s another postmodernist mind fuck evidently. What are Cochrane and Christensen going to say to each other now? I will suggest that if you want to make any sense of market monetarism read Lars. You get it much more concisely and to the point if nothing else.

Now here is his point. In a barter economy, he tells us, there can be no fiscal stimulus. Why is this? Because, “As there is no money we can not talk about sticky prices and wages. In a barter economy you have to produce to consume. Hence, there is no such thing as recessions in a barter economy and hence no excess capacity and no unemployment. Therefore there is no need for Keynesian style fiscal policy to “boost” demand.”

Fiscal policy can redistribute income but not effect demand.

“in a barter economy fiscal policy is a purely redistributional exercise, but it will have no impact on “aggregate demand”

http://marketmonetarist.com/2012/01/18/there-is-no-such-thing-as-fiscal-policy/

Ok but maybe the title of this post is wrong. It shouldn’t say there is no such thing as fiscal policy just fiscal stimulus.

The reason we believe that fiscal policy can impact demand is because of money illusion.

“for fiscal policy to influence aggregate demand we need to introduce money and sticky prices and wages in our model. This in my view demonstrates the first problem with the Keynesian thinking about fiscal policy. Keynesians do often not realise that money is completely key to how they make fiscal policy have an impact on aggregate demand.”

What NGDP targeting is meant to do is to take away money illusion by taking away this misleading effect of the velocity of money.

“Under NGDP level targeting M*V will be fixed or grow at a fixed rate. That means that we is basically back in the Arrow-Debreu world and any increase in G must lead to a similar drop in D as M*V is fixed.”

The goal of NGDP targeting therefore as Sumner, Lars, David Glasner, et al, conceive it is a return to in effect a barter economy. Money is therefore for them kind of like the root of all evil or at least original sin. Like for old fashioned philosophers appearance was the veil that led us to misapprehend true existence, so for the market monetarists, money is the veil that makes us misapprehend the truth of the economy.

Yet Lars does admit that fiscal stimulus can work or seem to work due the the Circe of money.

“lets say that the central bank is just an agent for the government and that any increase in G is fully funded by an increase in the money supply (M). Then an increase in G will lead to a similar increase in nominal income M*V. With this monetary policy reaction function “fiscal policy” is highly efficient. There is, however, just one problem. This is not really fiscal policy as the increase in nominal GDP is caused by the increase in M. The impact on nominal income would have been exactly the same if M had been increased and G had been kept constant – then the entire adjustment on the right hand side of (3) would then just have increased D.”

Yeah let’s say that. Actually I think this accurately describes the actual historical record of the Fed between the time of Marriner Eccles and the 1970 when Milton Friedman started whispering sweet nothings in Nixon’s ear.

To be sure Christensen claims that this effect is still misleading as it’s the printed money-monetary policy-that does the real heavy lifting. It would have been exactly the same had the supply of money been increased and government spending been kept constant.

In a way these claims by Lars actually straddles the line with MMTers who do actually argue that it makes no difference whether the Fed or Treasury prints the money but where they go from here is obviously more or less diametrically opposed to what the MMers do with it. The Market Monetarists vs. The Modern Monetary Theorists… Talk about a battle royale.

Again though Lars should call this “There is no such thing as fiscal stimulus.” It seems to me though that even if you believe that fiscal stimulus is a fiction it may nevertheless have proved to be as the belief in God once was.

For what’s curious is during the time we believed fiscal stimulus we had the Keynesian era. Since we gave it up we have had an anti-Keynesian era. During this anti-K ear we have seen the wages of median Americans stagnate. Is this all coincidence? What do you think?

In any case Sumner’s oft repeated argument that the fiscal multiplier is roughly zero because any fiscal stimulus will be followed by monetary tightening according to Lars depends on the policy of the Fed. It wasn’t true during the Keynesian ear. However in this anti inflation era, post Volcker and of the Taylor Rule-the much lauded Great Moderation-it is true of how the Fed has in fact acted. This doesn’t prove that fiscal stimulus doesn’t work but rather the Fed is off the rails and probably could use the kind of reforms Barney Frank wanted for it. Namely not ending the Fed as Ron Paul says but rather ending its “independence.””

Frankly speaking, Mike of course have no clue about economics, but he is 100% right – I should of course have said that there is no such thing as fiscal stimulus (and not policy), but then he would have had nothing to write about. Mike don’t know this, but I hate everything “postmodernist” so he succeed with his low blow.

Anyway, let me say it again fiscal policy is not important. People like Paul Krugman (and Mike Sax) think that we need massive fiscal stimulus to take us out of the slump in Europe and the US and some think (for example European policy makers) think that the only solution is fiscal austerity. I think both parties are wrong – lets fix monetary policy and then we don’t have to worry (too much) about fiscal policy (other than balancing the government budgets in the medium to long run…). This is why I find it so utterly borrowing to discuss fiscal policy…

PS Mike mentions Battle Royal…he is unaware that that is my favourite Japanese movie.

Evans-Pritchard on the Latin Bloc’s “monetarist avenger”

The resident market monetarist at Britain’s Daily Telegraph Ambrose Evans-Pritchard has a comment on European monetary policy under the leadership of the new ECB chief Mario Draghi.

Here is Ambrose:

“Those of a monetarist bent are less alarmed by fiscal contraction (than Keynesians). I have no doubt that monetary stimulus a l’outrance – the classic remedy of Britain’s Ralph Hawtrey, Sweden’s Gustav Cassel and America’s Irving Fisher in the 1930s – can counter the effects of fiscal tightening if conducted in the right way. The debt-to-GDP burden falls faster that way and deflation is averted, a lesson that Japan forgot.

The great question is whether Mario Draghi is embarking on just such a policy, covertly, through his Long-Term Repo Operations (LTRO), starting with €489bn in three-year loans to 523 banks December and to be followed by another blast in February.

The LTRO is not entirely a free lunch. It is replacing funding that has dried up, but to the extent that banks in Italy, Spain, France and Portugal use the cheap money to buy government bonds at rich yields – the Sarkozy “carry trade” – they are not lending to business, as newly bankrupt Spanair can attest…

…Yet, monetarists think Draghi is quietly pulling off a remarkable coup. “This is stealth QE: the impact is dulled because they are not making it clear what they are trying to do, but in the end it may ultimately be as powerful as QE in America and Britain,” said Lars Christensen from Danske Bank.

Tim Congdon from International Monetary Research said Mr Draghi had already boosted total credit to banks from €580bn to €832bn since early November, entirely reversing the Trichet tightening of late 2010.

This may rise to nearer €1.5 trillion this year. While it does not lead to a rise in broad money at first (just the monetary base), it is likely to feed through over coming months in complex secondary effects. “My conclusion is that the Draghi bazooka is such an aggressive example of monetary easing that Eurozone M3 growth will run at 5pc or more [annualized] in mid and late 2012.”

“I (Tim Congdon)remain sceptical about the viability of the European single currency in the long run, but the day of the execution has been postponed once again,” he said.

If Mr Draghi really is the Latin bloc’s monetarist avenger, the Germans will find out soon enough. It is Germany that will overheat, inflate, and suffer a “Latin” credit bubble as EMU’s wheel of fortune turns. Europe’s crisis will take on a whole new political turn. But that is a chapter for tomorrow.”

Needless to say I tend to agree with most things that Ambrose says (and I also find it hard to disagree with Tim). I particularly like that Ambrose mentions Hawtrey, Cassel and Fisher.

———-

Update: For those interested in my view on fiscal policy see here.

Guest blog: Why Price-Level Targeting Pareto Dominates Inflation Targeting (By David Eagle)

Guest blog: Why Price-Level Targeting Pareto Dominates Inflation Targeting

- And a Bizarre Tale of Blind Macroeconomists

By David Eagle

Some central banks throughout the world, including the Central bank of Canada and the Federal Reserve, have been considering Price-Level Targeting (PLT) as an alternative to Inflation Targeting (IT). In this guest blog, I present my argument why PLT Pareto dominates IT.  My argument is simple, and one that many readers will consider so obvious that they would expect most monetary economists to be already aware of this Pareto domination.

Please read the following quotation from Shukayev and Ueberfeldt (2010):

Various papers have suggested that Price-Level targeting is a welfare improving policy relative to Inflation targeting. … Research on Inflation targeting and Price-level Targeting monetary policy regimes shows that a credible Price-level Targeting (PT) regime dominates an Inflation targeting regime.

Reading the above quotation indicates that economists already know that PLT Pareto dominates IT.  However, there is a bizarre twist to this literature, which we will discuss later in this blog.  I ask you to continue patiently reading and trust that the ending to the blog will be well worth the journey, even to market monetarists who oppose both PLT and IT.

In my last guest blog for The Market Monetarist, I discussed what I called the Two Fundamental Welfare Principles of Monetary Economics.  The First Principle concerned the Pareto implications when nominal GDP (NGDP) changes, but real GDP (RGDP) does not.  The Second Principle concerned the Pareto implications when RGDP changes, but NGDP does not.  Since PLT and IT have the same Pareto implications when RGDP changes, but NGDP does not; let us focus on the First Principle.  To do so, assume an economy where RGDP is known with perfect foresight; then the First Principle always applies.

A Nominal-Loan Example – Initial Expectations

Let us again consider a long term nominal loan.  This time, I will explain my argument with an example.  For this example, assume a €200,000 nominal mortgage with a 7.2% p.a. interest rate, compounded monthly, and a term of 15-years, and fixed, fully amortizing nominal monthly payments.  The monthly payment would then be a nominal €1820.09.  Let us assume that individual B borrowed the €200,000 from individual A.   The €1820.09 is the nominal amount B must pay A each month.

Let us also assume that both A and B expect inflation to be 2.4% p.a., compounded monthly, during this period.  They therefore built that expected inflation rate into their 7.2% p.a. negotiated nominal interest rate.[1]   Please note that in Finance, we second-naturedly convert per annum rates to per month rates when the rate is compounded monthly.  Thus, the 7.2% p.a. is actually 0.6% per month, and the 2.4% p.a. inflation rate is 0.2% per month.  While this monthly compounding adds an extra step and a source of confusion, I believe the gain in the realism of the example is worth it.

If inflation is the 2.4% p.a. expected rate, then the real value of the monthly payment at time t will equal 1820.09/(1.002)t where t is the number of months from the loan’s origination.  Since both A and B expect the inflation rate to be 2.4% p.a., compounded monthly, their expected real value[2] of this monthly loan payment at time t will be 1820.09/(1.002)t

As I discussed in my second guest blog on the Market Monetarist, PLT and IT have the same effect on the economy as long as the central bank is successful at meeting its target, whether that target is a price-level target or an inflation target.  Let us assume that under IT, the central bank’s inflation target is 2.4% p.a., whereas under PLT, the central bank’s price-level target at time t is 100(1.002)t.  Hence, under both PLT and IT, the central bank’s initial price-level trajectory is 100(1.002)t.

Scenarios of Missing the Target

When PLT and IT differ is when the central bank misses its target.  Suppose inflation on average over the first year turns out to be 1.2% p.a. instead of the expected  2.4% p.a (both rates are compounded monthly).  To be more clear given the monthly compounding issue, the central bank’s initially trajectory of the price level at one year (or at time t=12 months) was 100(1.002)12 = 102.43; however, the actual price level at one year turned out to be 100(1.001)12 = 101.21.  Under PLT, the central bank will try to return the economy to its initial price-level target of 100(1.002)t.  However, under IT, the central bank would shift its price-level trajectory to 101.21(1.002)t-12, which is less than the initial price-level trajectory of 100(1.002)t.  This is the phenomenon we call price-level base drift, which is caused by the central bank under IT letting bygones be bygones and merely aiming for future inflation to be consistent with its inflation target; the central bank under IT does not try to make up for lost ground.

The real value of the nominal loan payment at time t=12 when the actual inflation rate turns out to be1.2% 1820.09/1.00112 = €1798.39, which is greater than the expected nominal loan payment of €1776.97.

On the other hand, assume that the inflation rate on average over the first year was 3.6% p.a. rather than the targeted 2.4% p.a. This means that the actual price level at one year turned out to be 100(1.003)12 = 103.66.  Under PLT, the central bank would have tried to return the economy to its initial price-level target of 100(1.002)t.  However, under IT, the central bank would shift its price-level trajectory to 103.66(1.002)t-12, which is greater than the initial price-level trajectory of 100(1.002)t.

The real value of the nominal loan payment at time t=12 when the actual inflation rate was 3.6% instead of 2.4% is 1820.09/1.00312 = €1755,83, which is less that the initially expected value of €1776.97.

Comparing Actual to Expectations Beyond 12 Months

Because we are talking about four different scenarios, let PLT- and IT- represent PLT and IT when the inflation rate on average for the first year turns out to be 1.2% rather than 2.4%.  Let PLT+ and IT+ represent PLT and IT when the inflation on average for the first year turns out to be 3.6% rather than the expected 2.4%.  Under all four scenarios, assume that starting in at time t=24, which is 2 years after the loan began, the central bank is able to perfectly meet is price-level trajectory whether under PLT or IT and it does so for the remaining of the 15 years.

Under these assumptions, the real value of the monthly payment under PLT starting at time t=24 will be the same as expected because the central bank will get the price level back to its preannounced price-level target.  However, when the actual inflation rate for the first year turned out being 1.2%, the real value of the nominal monthly payment under IT would be 1820.09/((1.001)12(1.002)t-12) for t≥24 under the assumption the central bank (CB) then meets its target.  On the other hand, when the actual inflation rate for the first year turned out being 3.6%, the real value of the nominal monthly payment under IT would be 1820.09/((1.003)12(1.002)t-12) for t≥24 assuming the CB then meets its target.

The table below shows how the actual real values of these nominal loan payments compare to A and B’s original expectation under all four scenarios.

Note: This table only reports the payment at the end of each year.

That PLT Pareto dominates IT should be obvious from the table.  Under PLT, the central bank (CB) tries to get the real value of nominal loan payments to be back to what borrowers and lenders initially expected.  In other words, under PLT, the CB tries to reverse its mistakes.  Under IT, the CB makes its mistakes permanent.  Note that in the table under PLT, the real value of the nominal loan payments are as expected from time t=24 months on.  However, under IT, the real value of the nominal loan payments are either 1.21% less than expected when the CB fell short of its target, or 1.19% higher than expected when the CB overshot its target.  Clearly, both risk-averse borrowers and risk-averse lenders will be better off with the temporary deviations from expectations under PLT than under the permanent deviations under IT.

Kicking Borrowers or Lenders When They are Down

John Taylor referred to the price-level basis drift as the CB “letting bygones be bygones.”  After writing this blog, I have another view:  I view IT as meaning that when the CB hurts either borrowers or lenders because it is unable to meet its target, then the CB turns around and kicks that down borrower or lender again and again to make them suffer for the duration of their loan.  I have long opposed IT, but writing this blog makes me oppose it even more.  Why cannot other economists see IT for the Pareto damaging regime it is?

The issue of why PLT Pareto dominates IT is simple.  The risk to borrowers and lenders is not inflation risk; it is price-level risk.  To minimize price-level risk, we should not minimize inflation, we should minimize the deviation of the price-level from its expected value.  As such, when a central banking missing its target, it should not keep kicking those suffering from the CB’s past mistakes; the central bank should not make that miss permanent as in IT, but rather the CB should try to reverse that damage as it will try to do under PLT.  Hence PLT Pareto dominates IT.

The Bizarre Tale of the Blind Economists

Thank you all for bearing with me through my argument.  However, from the quote by Shukayev and Ueberfeldt, you knew that the economic profession already knew this.  After all, this is obvious.  (Lars, drink something before you read on; we don’t want your blood to boil too much.)

However, the argument that I gave is not the argument that the literature that Shukayev and Ueverfeldt cited.  That literature did not use the Pareto criterion; it used a loss function that included inflation.  (Yes, Lars, that xxxx loss function again.)

What the literature starting with Svenson (1999) found is that paradoxically when the central bank is trying to minimize a loss function involving inflation, it may actually be better able to do that through PLT than with IT.  That is what Shukayev and Ueverfeld (2010) meant when they said that the literature had found PLT welfare dominates IT.  That literature was referring to “welfare” as defined by their ad hoc loss function, not by their applying the Pareto criterion to the well being of borrowers and lenders.

Economists have been blinded from the obvious by their ad hoc assumption of a loss function involving inflation.  This bizarre twist to this literature is an example of the dangers that economists’ prejudices can enter into their ad hoc loss functions, causing them to miss the obvious.  In this case they have missed the obvious impacts on individual borrowers and lenders of PLT vs. IT.

Of course, there are other targeting regimes than just PLT and IT, but this blog focused on those two.  In my future writing, I plan to explain why NGDP level targeting Pareto dominates NGDP growth rate targeting, although the logic of that is really the same as I have just discussed; we just allow RGDP to vary so that the Second Fundamental Principle of Monetary Economics also applies.

Also, think about how the “kick them while they are down” characteristic of IT is relevant to the aftermath of the Financial crisis concerning the sovereign debt issues in Europe and the debt burdens on mortgage borrowers in the U.S. and elsewhere.  I guess I have to be careful here as I might be accused of starting riots.

References

Eagle, David and Dale Domian (2011), “Quasi-Real-Indexed Mortgages to the Rescue,” working paper delivered at the Western Economic Associating Meetings in San Diego, CA, http://www.cbpa.ewu.edu/~deagle/WEAI2011/QRIMs.doc

Shukayev, Malik and Alexander Ueberfeldt (2010).  “Price Level Targeting: What Is the Right Price?” Bank of Canada Working Paper 2010-8

Svensson, Lars E O, 1999. “Price-level Targeting versus Inflation Targeting: A Free Lunch?,”

Journal of Money, Credit and Banking, Blackwell Publishing, vol. 31(3), pages 277-95, August.

© Copyright (2012) by David Eagle


[1] The traditional Fisher equation states that i @ r + E[π] where i is the nominal interest rate, r is the real interest rate, and π is the inflation rate.  A more exact relationship we use in Finance is (1+i)=(1+r)(1+E[π) where these rates are per compound period, in this case per month.  According to the approximate and traditional Fisher equation, the real interest rate would be 4.8%, which equals the 7.2% nominal rate less the 2.4% expected inflation (the more precise Fisher equation using the monthly rates concludes the real rate will be 4.79%).

[2] You may note that the real value of the monthly nominal payment is expected to decline over time.  In the mortgage literature, this is known as the “tilt effect” (See Eagle and Domian, 2011).


Prediction markets and government budget forecasts

Recently I have had a couple of posts (here and here) on biases in the forecasts of policy makers and why central banks and governments should use prediction markets to do forecasting instead of relying on in-house forecasts that might or might not be biased due to for example political pressures.

Anybody who have studied the forecasts of government agencies are well aware of the notorious biases of such forecasts.  Jeffrey Frankel in a recent paper “Over-Optimism in Official Budget Agencies’ Forecasts” documents strong biases in government growth and budget forecasts. Here is the abstract:

“The paper studies forecasts of real growth rates and budget balances made by official government agencies among 33 countries. In general, the forecasts are found: (i) to have a positive average bias, (ii) to be more biased in booms, (iii) to be even more biased at the 3-year horizon than at shorter horizons. This over-optimism in official forecasts can help explain excessive budget deficits, especially the failure to run surpluses during periods of high output: if a boom is forecasted to last indefinitely, retrenchment is treated as unnecessary. Many believe that better fiscal policy can be obtained by means of rules such as ceilings for the deficit or, better yet, the structural deficit. But we also find: (iv) countries subject to a budget rule, in the form of euroland’s Stability and Growth Path, make official forecasts of growth and budget deficits that are even more biased and more correlated with booms than do other countries. This effect may help explain frequent violations of the SGP. One country, Chile, has managed to overcome governments’ tendency to satisfy fiscal targets by wishful thinking rather than by action. As a result of budget institutions created in 2000, Chile’s official forecasts of growth and the budget have not been overly optimistic, even in booms. Unlike many countries in the North, Chile took advantage of the 2002-07 expansion to run budget surpluses, and so was able to ease in the 2008-09 recession.”

Hence, the conclusion from Frankel’s paper is clear: We can simply not trust government forecasts! His solution is to set-up independent budget institutions as in Chile. Sweden and Hungary as in recent years set-up similar Fiscal Policy Councils. Obviously this is much preferable to the politicised forecasts that we see in many countries (and from international institutions such as the EU and the IMF!), but I strongly believe that budget forecasts based on prediction markets would be much better. The easiest thing would be to let the central bank of the country set-up a prediction market for key macroeconomic numbers which are relevant for the conduct of monetary and fiscal policy and then all government institutions would use these numbers in the conduct of policy.

Robin Hanson reaches a similar conclusion.

Please fasten your seatbelt and try to beat the market

Scott Sumner and other Market Monetarists (including myself) favour the use of NGDP futures to guide monetary policy. Other than being forward-looking a policy based on market information ensures that the forecast of the future development is not biased – in the market place biases will cost you on the bottom-line. Similarly, I have earlier suggested that central banks should use prediction markets to do forecasting rather rely on in-house forecasts that potentially could be biased due to political pressures.

A common critique of using “market forecasts” in the conduct of monetary policy is that the market often is wrong and that “herd behaviour” dominates price action – just think of Keynes’ famous beauty contest. This is the view of proponents of what has been termed behavioural finance. I have worked in the financial sector for more than a decade and I have surely come across many “special” characters and I therefore have some understanding for the thinking of behaviour theorists. However, one thing is individual characters and their more or less sane predictions and market bets another thing is the collective wisdom of the market.

My experience is that the market is much more sane and better at predicting than the individual market participants. As Scott Sumner I have a strong believe in the power of markets and I generally think that the financial markets can be described as being (more or less) efficient. The individual is no superman, but the collective knowledge of billions of market participants surely has powers that are bigger than superman’s powers. In fact the market might even be more powerful than Chuck Norris!

Economists continue to debate the empirical evidence of market efficiency, but the so-called Efficient-Market Hypothesis (EMH) can be hard to test empirically. However, on Thursday I got the chance to test the EMH on a small sample of market participants.

I was doing a presentation for 8 Swedish market participants who were on a visit to Copenhagen. I knew that they had to fly back to Stockholm on a fight at 18:10. So I organized a small competition.

I asked the 8 clever Swedes to write down their individual “bets” on when they would hear the famous words “Please fasten your seatbelts” and the person who was closest to the actual time would win a bottle of champagne (markets only work if you provide the proper incentives).

“Fasten your seatbelts” was said at 18:09. The “consensus” forecast from the 8 Swedes was 18:14 – a miss of 5 minutes (the “average” forecast was 8 minutes wrong). Not too bad I think given the number of uncertainties in such a prediction – just imagine what Scandinavian winter can do to the take-off time.

What, however, is more impressive is that only one of the 8 Swedes were better than the consensus forecast. Carl Johan missed by only 1 minute with his forecast of 18:08. Hence, 7 out 8 had a worse forecast than the consensus forecast. Said in another way only one managed to beat the market.

This is of course a bit of fun and games, but to me it also is a pretty good illustration of the fact that the collective wisdom in market is quite efficient.

I showed the results to one of my colleagues who have been a trader in the financial markets for two decades – so you can say he has been making a living beating the market. The first thing he noted was that two of the forecasts was quite off the mark – 14 minutes to early (Erik) and 14 minutes to late (Michael). My colleague said “they would have been dead in the market”. And then he explained that Erik and Michael probably went for the long shot after having rationalized that they probably would not have any chance going for the consensus forecast – after all we were playing “the-winner-takes-it-all” game. Erik and Michael in other words used what Philip Tetlock (inspired by Isaiah Berlin) has called a Hedgehog strategy – contrary to a Fox strategy. “Foxes” tend to place their bets close to the consensus, while “hedgehogs” tend to be contrarians.

My colleague explained that this strategy might have worked with the “market design” I had set up, but in the real world there is a cost of participating in the game. It is not free to go for the long shot. This is of course completely correct and in the real market place you so to speak have to pay an entrance fee. This, however, just means that the incentive to move closer to the consensus is increased, which reinforces the case for the Efficient-Market Hypothesis. But even without these incentives my little experiment shows that it can be extremely hard to beat the market – and even if we played the game over and over again I would doubt that somebody would emerge as a consistent “consensus beater”.

From a monetary policy perspective the experiment also reinforces the case for the use of market based forecasting in the conduct and guidance of monetary policy through NGDP futures or more simple prediction markets. After all how many central bankers are as clever as Carl Johan?

PS Carl Johan works for a hedge fund!

PPS if you are interested in predictions markets you should have a look at Robin Hanson’s blog Overcoming Bias and Chris Masse’s blog Midas Oracle.

UPDATE: See this fantastic illustration of the Wisdom of the Crowd.

Update 2: Scott Sumner has yet another good post on EMH.

Let the Fed target a Quasi-Real PCE Price Index (QRPCE)

The Federal Reserve on Wednesday said it would target a long-run inflation target of 2%. Some of my blogging Market Monetarist friends are not too happy about this – See Scott Sumner and Marcus Nunes. But I have an idea that might bring the Fed very close to the Market Monetarist position without having to go back on the comments from Wednesday.

We know that the Fed’s favourite price index is the deflator for Private Consumption Expenditure (PCE) for and the Fed tends to adjust this for supply shocks by referring to “core PCE”. Market Monetarists of course would welcome that the Fed would actually targeting something it can influence directly and not react to positive and negative supply shocks. This is kind of the idea behind NGDP level targeting (as well as George Selgin’s Productivity Norm).

Instead of using the core PCE I think the Fed should decomposed the PCE deflator between demand inflation and supply by using a Quasi Real Price Index. I have spelled out how to do this in an earlier post.

In my earlier post I show that demand inflation (pd) can be calculated in the following way:

(1) Pd=n-yp

Where n is nominal GDP growth and yp is trend growth in real GDP.

Private Consumption Expenditure growth and NGDP growth is extremely highly correlated over time and the amplitude in PCE and NGDP growth is nearly exactly the same. Therefore, we can easily calculate Pd from PCE:

(2) Pd=pce-yp

Where pce is the growth rate in PCE. An advantage of using PCE rather than NGDP is that the PCE numbers are monthly rather than quarterly which is the case for NGDP.

Of course the Fed is taking about the “long-run”. To Market Monetarists that would mean that the Fed should target the level rather growth of the index. Hence, we really want to go back to a Price Index.

If we write (2) in levels rather than in growth rates we basically get the following:

(3) QRPCE=PCE/RGDP*

Where QRPCE is what we could term a Quasi-Real PCE Price Index, PCE is the nominal level of Private Consumption Expenditure and RGDP* is the long-term trend in real GDP. Below I show a graph for QRPCE assuming 3% RGDP in the long-run. The scale is natural logarithm.

I have compared the QRPCE with a 2% trend starting the 2000. The starting point is rather arbitrary, but nonetheless shows that Fed policy ensured that QRPCE grew around a 2% growth path in the half of the decade and then from 2004-5 monetary policy became too easy to ensure this target. However, from 2008 QRPCE dropped sharply below the 2% growth path and is presently around 9% below the “target”.

So if the Fed really wants to use a price index based on Private Consumption Expenditure it should use a Quasi-Real Price Index rather than a “core” measure and it should of course state that long-run inflation of 2% means that this target is symmetrical which means that it will be targeting the level for the price index rather the year-on-year growth rate of the index. This would effectively mean that the Fed would be targeting a NGDP growth path around 5% but it would be packaged as price level targeting that ensures 2% inflation in the long run. Maybe Fed chairman Bernanke could be convince that QRPCE is actually the index to look at rather than PCE core? Packaging actually do matter in politics – and maybe that is also the case for monetary policy.

Dinner with Bob Chitester

I don’t have a lot of time for blogging this week as I will be busy with a number of dinner arrangements – both fun and business.

Tonight I had dinner with Bob Chitester and other like-minded people. Bob was responsible as executive producer for Milton Friedman’s landmark PBS series “Free To Choose”. I am very happy to have met Bob today. Bob not only produced “Free to Choose” but he was also is the guy who convinced Friedman to do the series and as a consequence Bob truly changed the course of my life as the book that followed the TV series got me hooked on Friedman’s ideas at an age of 16 years or so back in the 1980s. People that know me would clearly acknowledge that I have not stopped talking about Friedman and monetary theory ever since then.

Bob had some wonderful anecdotes about “Uncle Milt”. Milton Friedman not only was a great economist and educator, but also a great sales man of his ideas – both economic and political.

Talking to Bob reminded me yet again of how important it is to “sell” the message in the right way. Milton Friedman of course was second to none in terms of that – what I have called a Pragmatic Revolutionary.

Milton Friedman of course would have turned 100 years this year. I look forward to celebrating him all through the year.

I want to thanks Bob for a great night and thanks to the Danish Free Market think tank CEPOS for arranging the event tonight.

It’s time to get rid of the ”representative agent” in monetary theory

“Tis vain to talk of adding quantities which after the addition will continue to be as distinct as they were before; one man’s happiness will never be another man’s happiness: a gain to one man is no gain to another: you might as well pretend to add 20 apples to 20 pears.”

- Jeremy Bentham, 1789

I have often felt that modern-day Austrian economists are fighting yesterday’s battles. They often seem to think that mainstream economists think as if they were the “market socialists” of the 1920s and that the “socialist-calculation-debate” is still on-going. I feel like screaming “wake up people! We won. No economist endorses central planning anymore!”

However, I am wrong. The Austrians are right. Many economists still knowingly or out of ignorance today endorse some of the worst failures of early-day welfare theory. Economists have known since the time of Jeremy Bentham that one man’s happiness can not be compared to another man’s happiness. Interpersonal utility comparison is a fundamental no-no in welfare theory. We cannot and shall not compare one person’s utility with another man’s utility. But this is exactly what “modern” monetary theorists do all the time.

Take any New Keynesian model of the style made famous by theorists like Michael Woodford. In these models the central banks is assumed to be independent (and benevolent). The central banker sets interest rates to minimize the “loss function” of a “representative agent”. Based on this kind of rationalisation economists like Woodford find theoretical justification for Taylor rule style monetary policy functions.

Nobody seems to find this problematic and it is often argued that Woodford even has provided the microeconomic foundation for these loss functions. Pardon my French, but that is bullsh*t. Woodford assumes that there is a representative agent. What is that? Imagine we introduced this character in other areas of economic research? Most economists would find that highly problematic.

There is no such thing as a representative agent. Let me illustrate it. The economy is hit by a negative shock to nominal GDP. With Woodford’s representative agent all agents in the economy is hit in the same way and the loss (or gain) is the same for all agents in the economy. No surprise – all agents are assumed to be the same. As a result there is no conflict between the objectives of different agents (there is basically only one agent).

But what if there are two agents in the economy. One borrower and one saver. The borrower is borrowing from the other agent at a fixed nominal interest rate. If nominal GDP drops then that will effectively be a transfer of wealth from the borrower to the saver.

This might of course of course make the Calvinist ideologue happy, but what would the modern day welfare theorist say?

The modern welfare theorist would of course apply a Pareto criterion to the situation and argue that only a monetary policy rule that ensures Pareto efficiency is a good monetary policy rule: An allocation is Pareto efficient if there is no other feasible allocation that makes at least one party better off without making anyone worse off. Hence, if the nominal GDP drops and lead to a transfer of wealth from one agent to another then a monetary policy that allows this does not ensure Pareto efficiency and is hence not an optimal monetary policy.

David Eagle has shown in a number of papers that only one monetary policy rule can ensure Pareto efficiency and that is NGDP level targeting (See David’s guest posts here, here and here). All other policy rules, inflation targeting, Price level targeting and NGDP growth targeting are all Pareto inefficient. Price level targeting, however, also ensures Pareto efficiency if there are no supply shocks in the economy.

This result is significantly more important than any result of New Keynesian analysis of monetary policy rules with a representative agent. Analysis based on the assumption of the representative agent completely fails to tell us anything about the present economic situation and the appropriate response to the crisis. Just think whether a model with a “representative country” in the euro zone or one with Greece (borrower) and Germany (saver) make more sense.

It is time to finally acknowledge that Bentham’s words also apply to monetary policy rules and finally get rid of the representative agent.

——

For a much more insightful and clever discussion of this topic see David Eagle’s paper “Pareto Efficiency vs. the Ad Hoc Standard Monetary Objective – An Analysis of Inflation Targeting” from 2005.

Allan Meltzer’s great advice for the Federal Reserve

Here is Allan Meltzer’s great advice on US monetary policy:

“Repeatedly, the message has been to reduce tax rates permanently… A permanent tax cut was supposed to do what previous fiscal efforts had failed to do — generate sustained expansion of the American economy. 

No one should doubt that an expansion is desirable for US… and the rest of the world…The US government has watched the economy stagnate much too long. A policy change is long overdue. 

The problem with the advice (about fiscal easing) is that few would, and none should, believe that the US can reduce tax rates permanently. US has run big budget deficits for the past five years and accumulated a large debt that must be serviced at considerably higher interest rates in the future … And the US must soon start to finance large prospective deficits for old age pensions and health care. There is no way to finance these current and future liabilities that will not involve higher future tax rates… 

It is wrong when somebody tells the American to maintain the value of the dollar…The fluctuating rate system should work both ways. Strong economies appreciate; weak economies depreciate. 

What is the alternative? Deregulation is desirable, but it will do its work slowly. If temporary tax cuts are saved, not spent, and permanent tax cuts are impossible, the US choice is between devaluation and renewed deflation. The deflationary solution runs grave risks. Asset prices would continue to fall. Investors anticipating further asset price declines would have every reason to hold cash and wait for better prices. The fragile banking system would face larger losses as asset prices fell. 

Monetary expansion and devaluation is a much better solution. An announcement by the Federal Reserve and the government that the aim of policy is to prevent deflation and restore growth by providing enough money to raise asset prices would change beliefs and anticipations. Rising asset prices, including land and property prices, would revive markets for these assets once the public became convinced that the policy would be sustained. 

The volume of “bad loans” at US banks is not a fixed sum. Rising asset prices would change some loans from bad to good, thereby improving the position of the banking system. Faster money growth would add to the banks’ ability to make new loans, encouraging business expansion.

This program can work only if the exchange rate is allowed to depreciate. Five years of lowering interest rates has shown that there is no way to maintain the exchange rate and generate monetary expansion…

…Some will see devaluation as an attempt by the US to expand through exporting. This is a half-truth. Devaluation will initially increase US exports and reduce imports. As the economy recovers, incomes will rise. Rising incomes are the surest way of generating imports of raw materials and sub-assemblies from US trading partners.

Let money growth increase until asset prices start to rise.”

I think Allan Meltzer as a true monetarist presents a very strong case for US monetary easing and at the same time acknowledges that fiscal policy is irrelevant. Furthermore, Meltzer makes a forceful argument that if monetary policy is eased then that would significantly ease financial sector distress. The readers of my blog should not be surprised that Allan Meltzer always have been one of my favourite economists.

Meltzer indirectly hints that he wants the Federal Reserve to target asset prices. I am not sure how good an idea that is. After all what asset prices are we talking about? Stock prices? Bond prices? Or property prices? Much better to target the nominal GDP target level, but ok stock prices do indeed tend to forecast the future NGDP level pretty well.

OK, I admit it…I have been cheating! Allan Meltzer did indeed write this (or most of it), but he as not writing about the US. He was writing about Japan in 1999 (So I changed the text a little). It would be very interesting hearing why Dr. Meltzer thinks monetary easing is wrong for the US today, but right for Japan in 1999. Why would Allan Meltzer be against a NGDP target rule that would bring the US NGDP level back to the pre-crisis trend and then there after target a 3%, 4% or 5% growth path as suggested by US Market Monetarists such as Scott Sumner, Bill Woolsey and David Beckworth?

 

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