Bernanke, Obama and the political business cycle – and some research ideas

This week I attended a presentation by my good friend and professor of political science at the University Copenhagen Peter Kurrild-Klitgaard about the upcoming US presidential elections. In his presentation Peter presented some of his models for predicting the outcome of US presidential elections.

Peter’s thesis is that what determines the US presidential election primarily is the economic situation in the US in the 8 quarters prior to the election. Peter’s models are inspired by Douglas Hibbs’ so-called “bread and peace” models.

If Peter is right – and I think he is – then the US president and his party will have an incentive to manipulate the business cycle to peak just prior to the elections. This is of course also is what inspired a large theoretical and empirical literature on the so-called political business cycles (PBC).

Most PBC models focus on fiscal policy. In William Nordhaus’ traditional PBC model the government would increase public spending and/or cut taxes prior to the elections and as Nordhaus assumed a traditional keynesian model of the world the government would hence be able to manipulate the business cycle.

The fact that Nordhaus assumed a rather naive keynesian model of the world obviously is also a big problem with the model and with the integration of rational expectations in macroeconomic models in 1980s and 1990s it also became increasingly clear that even though Nordhaus’ traditional PBC model is intuitively appealing it did not stand the test of time.

The biggest problem with the traditional PBC models, however, is they disregarded the importance of monetary policy. Hence, it might be that a government or a president can increase public spending prior to an election to try to get reelected, but how will the central bank react to that? Obviously if the central bank is under political control the government can just dictate to the central bank to play along and to ease monetary policy prior to the elections.

However, it is not given that the central bank is under the control of the government. In fact the central bank might even be hostile to the government and favour the opposition and in that case the central bank might actually itself be involved in manipulating the business cycle to achieve a certain political outcome which would be in contrast to what the government would like to see. In an earlier post I have described how the Bundesbank in the early 1990s punished the Helmut Kohl’s government for overly easy fiscal policy following the German reunification. This hardly helped Kohl’s government, but the Bundesbank was nonetheless unsuccessful in its indirect attempt to oust Kohl.

Did Bernanke just ensure Obama’s reelection?

During Peter’s presentation he highlighted that political prediction markets such – as the Iowa Electronic Markets – are better at predicting the outcome of US presidential elections than opinion polls. I certainly agree with Peter on this issue and therefore one of my first thoughts just after the FOMC announced it new policy action on September 13 was to think about how this influences Obama’s reelection chances.

If Peters models are right that higher real GDP growth increases the likelihood that Obama will be reelected and if I am right that I think Bernanke’s actions will likely spur real GDP growth in the short-run then the answer must be that Bernanke just helped Obama get reelected.

So what are the prediction markets saying? Well, there is no question that Obama’s election chances have increased significantly in recently. Political pundits talk about Michelle Obama’s speech at the Democrats’ convention or Romney’s not too elegant comments about Democrat voters. However, both Peter and I know that that is not really what is important. To us it is as James Carville used to say “It’s the economy, stupid”

Just have a look at the market pricing of Obama’s reelection chances – this is data from intrade.com:

I think it is pretty clear – the Federal Reserve’s actions on September 13 have helped increase the likelihood of Obama getting reelected. Whether this is good or bad is a separate matter, but it certainly illustrates that if you want to be elected president in the US you want to have fed on your side.

This is not major news – for example former Fed chairman Arthur Burn’s rather scary account  “Inside the Nixon Administration” – of his meetings with President Nixon shows that Nixon certainly was well-aware that the fed’s actions could do a lot to increase his reelection chances and that he put a lot of pressure on Burns to ease monetary policy prior to 1972 presidential elections (See my earlier post on Nixon and Burns here and Burton Abrams’ excellent discussion of the same topic here.)

This is of course also why you want to depoliticize monetary policy and get it as far away from political influence as possible – if politicians gets to control monetary policy the likelihood that they will misuse that power certainly is very high. Here the keyword is depoliticize – you in general don’t want central banks to interfere in politics for good or for bad. The central bank should just take fiscal policy as a given and respond to it only to the extent that it has an impact of it’s monetary policy target. That also includes that the central bank should not punish governments for bad policies either – as the ECB seem to be doing.

In the case of the present situation in the US it is therefore paradoxical that the Obama administration apparently has done so little to influence the decisions at the fed. So even though the Obama administration has appointed numerous Fed policy makers it does not look as if any attempt has been made to appoint Fed officials that would press for monetary easing – which obviously would have been in Obama’s interest (note this is an uneducated outsider’s guess…). This might be because the president’s main economic advisors are staunch keynesians who have little time for monetary policy matters. So if Obama is not reelected he might want to blame Larry Summers for past sins. It is equally a paradox that the fact that the Fed now seems to be moving in the direction of a more ruled based policy is what likely will help Obama get reelected.

Ideas for future research 

When I started thinking about writing this blog post I actually started out with a research idea and I want to get back to that. One of the reasons that the literature on political business cycles has not produced any general conclusions or strong empirical results is in my view that models predictions are so dependent on what assumptions are made about the institutional set-up. Is the central bank for example independent or not? Will monetary policy counteract or accommodate pre-election spending?

I therefore think that there is scope for new research on particularly central bank’s institutional structures and how that might influence the political business cycle.

In the case of the US and the Federal Reserve I think it would be very interesting to study how different FOMC member’s partisan affiliations influence their voting during the election cycle. Would for example FOMC member appointed by the president vote for easier monetary policies prior to presidential elections? And will FOMC members from certain Fed districts vote in a way favorable to the dominant political affiliation of the given fed district?

I don’t know the answers to these questions, but I think it could be a rather interesting research project…

PS Peter’s model predicts that it will be 50/50 on who wins that presidential elections. If he is right then the present market pricing which clear favours Obama is wrong. Do you trust the models of a political scientist more than the market? I am sure that Peter would be on the side of the market…

PPS I should stress that I think that Bernanke and his colleagues with its latest actions have moved closer to a rule based monetary policy, which in itself should reduce the risk of political motivated monetary policy and I in general think that it is positive. That, however, does not change the fact that that might also have helped Obama. Whether that is a positive or negative side-effect dependents on your (party) political views and I luckily don’t have to have a view on who should win the US presidential elections…

PPPS Obviously the best way to avoid political business cycles is a strongly rule based monetary policy – such as NGDP level targeting, fixed exchange rates, a gold standard or free banking…some of these options I like better than others.

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Related post – Se how the ECB also has had significant impact on Obama’s reelection changes:“Will Draghi’s LTRO get Obama reelected?”

The fiscal cliff and the Bernanke-Evans rule in a simple static IS/LM model

Sometimes simple macroeconomic models can help us understand the world better and even though I am not uncritical about the IS/LM model it nonetheless has some interesting features which from time to time makes it useful for policy analysis (if you are careful).

However, a key problem with the IS/LM model is that the model does not take into account – in its basic textbook form – the central bank’s policy rule. However, it is easy to expand the model to include a monetary policy rule.

I will do exactly that in this post and I will use the Federal Reserve’s new policy rulethe Bernanke-Evans rule – to analysis the impact of the so-called fiscal cliff on a (very!) stylised version of the US economy.

We start out with the two standard equations in the IS/LM model.

The money demand function:

(1) m=p+y-α×r

Where m is the money supply/demand, p is prices and y is real GDP. r is the interest rate and α is a coefficient.

Aggregate demand is defined as follows:

(2) y=g-β×r

Aggregate demand y equals public spending and private sector demand (β×r), which is a function of the interest rate r. β is a coefficient. It is assumed that private demand drops when the interest rate increases.

This is basically all you need in the textbook IS/LM model. However, we also need to define a monetary policy rule to be able to say something about the real world.

I will use a stylised version of the Bernanke-Evans rule based on the latest policy announcement from the Fed’s FOMC. The FOMC at it latest meeting argued that it basically would continue to expand the money base (in the IS/LM the money base and the money supply is the same thing) to hit a certain target for the unemployment rate. That means that we can define a simple Bernanke-Evans rule as follows:

(3) m=λ×U

One can think of U as either the unemployment rate or the deviation of the unemployment rate from the Fed’s unemployment target. λ is a coefficient that tells you how aggressive the fed will increase the money supply (m) if U increases.

We now need to model how the labour market works. We simply assume Okun’s law holds (we could also have used a simple production function):

(4) U=-δ×y

This obviously is very simplified as we totally disregard supply side issues on the labour market. However, we are not interested in using this model for analysis of such factors.

It is easy to solve the model. We get the LM curve from (1), (3) and (4):

LM: r= y×(1+δ×λ)⁄α+(1/α)×p

And we get the IS curve by rearranging (2):

IS: r =(1/β)×g-(1/β)×y

Under normal assumptions about the coefficients in the model the LM curve is upward sloping and the IS curve is downward sloping. This is as in the textbook version.

Note, however, that the slope of the LM does not only depend on the money demand’s interest rate elasticity (α), but also on how aggressive  (λ) the fed will react to an increase in unemployment.

The Sumner Critique applies if λ=∞

The fact that the slope of the LM curve depends on λ is critical. Hence, if the fed is fully committed to its unemployment target and will do everything to fulfill (as the FOMC signaled when it said it would step up QE until it hit its target) then λ equals infinity (∞) .

Obviously, if λ=∞ then the LM curve is vertical – as in the “monetarist” case in the textbook version of the IS/LM model. However, contrary to the “normal” the LM curve we don’t need α to be zero to ensure a vertical LM curve.

Hence, under a strict Bernanke-Evans rule where the fed will not accept any diviation from its unemployment target (λ=∞) the (government) budget multiplier is zero and the so-called Sumner Critique therefore applies: Fiscal policy cannot increase or decrease output (y) or the unemployment (U) as any fiscal “shock” (higher or lower g) will be fully offset by the fed’s actions.

The Bernanke-Evans rule reduces risks from the fiscal cliff

It follows that if the fed actually follows through on it commitment to hit its (still fuzzy) unemployment target then in the simple model outlined above the risk from a negative shock to demand from the so-called fiscal cliff is reduced greatly.

This is good news, but it is also a natural experiment of the Sumner Critique. Imagine that we indeed get a 4% of GDP tightening of fiscal policy next year, but at the same time the fed is 100% committed to hitting it unemployment target (that unemployment should drop) then if unemployment then increases anyway then Scott Sumner (and myself) is wrong – or the fed didn’t do it job well enough. Both are obviously very likely…

I am arguing that I believe the model presented above is the correct model of the US economy. The purpose has rather been to demonstrate the critical importance of a the monetary policy rule even in a standard textbook keynesian model and to demonstrate that fiscal policy is much less important than normally assumed by keynesians if we take the monetary policy rule into account.

I think Ben just did it…

This is what I in a post earlier today asked the Federal Reserve to do:

Rather for example the Fed could just start at every regular FOMC meetings to state for example that “the expectations is now that without changes in our policy instrument we will undershoot our policy target and as a consequence we today have decided to use our policy instrument to increase the money base by X dollars to ensure that we will hit our policy target within the next 12 months. We will increase the money base further if contrary to our expectations policy target is not meet.”

I must admit Ben Bernanke nearly got it right! Here is from the FOMC’s statement:

“The Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions.  Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook.  The Committee also anticipates that inflation over the medium term likely would run at or below its 2 percent objective….

…To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. 

…The Committee will closely monitor incoming information on economic and financial developments in coming months.  If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability. “

So we nearly got what I asked for: 1) A clear target – not an NGDP level target, but a light Mankiw rule/Evans rule based on the Fed’s dual mandate. 2) A clear instrument to increase the money base: Mortgage backed securities. 3) A promise to do more if the target is not hit.

Now the markets should do a lot of the additional lifting.

I think it would be ungrateful to ask for more – yes, yes it is not NGDP level targeting and a lot of things can go wrong, but today I think we can take a little victory lap. This is excellent news for the US economy and for the global economy. Then we can hope that we in the coming months will get an even more clear defined “Bernanke rule” so we finally can back to a rule based rather than a discretionary monetary policy.

Related posts:

Scott Sumner has two comments (here and here) on the FOMC decision.

David Beckworth also has a comment and so has David Glanser.

While Scott and two times David share my general happiness about the Fed’s actions our friend Marcus Nunes is less euphoric. Marcus as always been the skeptic among the Market Monetarist bloggers, but he has also often been right so maybe we should be a little bit careful in not being carried away.

Update: Dajeeps and JPIrving are also happy.

Update 2: Our friend Mayor(!) Bill Woolsey also comments on the fed. Bill is as happy as the rest of us with the progress in the thinking of the FOMC, but he also correctly raises some points about the dangers of targeting real variables such as unemployment rather than focusing on nominal variables such as the NGDP level. Bill’s comment in many ways can be seen as the Market Monetarist reply to George Selgin’s friendly reminder to us (the Market Monetarists) that we should not become too friendly with the fed exactly because the fed is now so clearly targeting a real variable. Bill post was however (I think) written prior to George’s comment. Needless to say I agree with George and Bill. The FOMC’s actions is major step forward, BUT I am certainly also somewhat uncomfortable with the fact that the fed now so clearly targeting a real – rather than a nominal – variable.

Time to end discretionary monetary policy!

This week has been nearly 100% about monetary policy in the financial markets and in the international financial media. In fact since 2008 monetary policy has been the main driver of prices in basically all asset classes. In the markets the main job of investors is to guess what the ECB or the Federal Reserve will do next. However, the problem is that there is tremendous uncertainty about what the central banks will do and this uncertainty is multi-dimensional. Hence, the question is not only whether XYZ central bank will ease monetary policy or not, but also about how it will do it.

Just take Mario Draghi’s press conference last week – he had to read out numerous different communiqués and he had to introduce completely new monetary concepts – just take OMT. OMT means Outright Monetary Transactions – not exactly a term you will find in the monetary theory textbook. And he also had to come up with completely new quasi-monetary institutions – just take the ESM. The ESM is the European Stability Mechanism. This is not really necessary and it just introduce completely unnecessary uncertainty about European monetary policy.

In reality monetary policy is extremely simple. Central bankers can fundamentally do two things. First, the central bank can increase or decrease the money base and second it can guide expectations. It is really simple. There is no reason for ESM, OMT, QE3 etc. The problem, however, is that central banks used to control the money base and expectations with interest rates, but with interest rates close to zero central bankers around the world seem to have lost the ability to communicate about what they want to do. As a result monetary policy has become extremely discretionary in both Europe and the US.

That need to change as this discretion is at the core the uncertainty about monetary policy. Central bankers therefore have to do two things to get back on track and to create some kind of normality. First, central banks should define very clear targets of what the want to achieve – preferably the ECB and the Fed should announce nominal GDP targets, but other target might do as well. Second, the central banks should give up communicating about monetary policy in terms of interest rates and rather communicate in terms of how much they want to change the money base.

In terms of changes in the money base the central banks should clarify how the money base is changed. The central bank can increase the money base, by buying different assets such as government bonds, foreign currencies, commodities or stocks. The important thing is that the central banks do not try to affect relative prices in the financial markets. When the Fed is conducting it “twist operations” it is trying to distort relative prices, which essentially is a form of central planning and has little to do with monetary policy. Therefore, the best the central banks could do is to define a clear basket of assets it will be buying or selling to increase or decrease the money base. This could be a fixed basket of bonds, currencies, commodities and stocks – or it could just be short-term government bonds. The important thing is that the central bank define a clear instrument.

This would remove the “instrument uncertainty” and the ECB or the Fed would not have to come up with new weird instruments every single month. Rather for example the Fed could just start at every regular FOMC meetings to state for example that “the expectations is now that without changes in our policy instrument we will undershoot our policy target and as a consequence we today have decided to use our policy instrument to increase the money base by X dollars to ensure that we will hit our policy target within the next 12 months. We will increase the money base further if contrary to our expectations policy target is not meet.” 

In this world there would be no discretion at all – the central bank would be strictly rule following. It would use its well-defined policy instrument to always hit the policy target and there would be no problems with zero bound interest rates. But most important it would allow the financial markets to do most of the lifting as such set-up would be tremendously more transparent than what they are doing today.

Today we will see whether Ben Bernanke want to continue distorting relative prices and maintaining policy uncertainty by keeping the Fed’s highly discretionary habits or whether he want to ensure a target and rules based monetary policy.

PS a possibility would of course also be to use NGDP futures to conduct monetary policy as Scott Sumner has suggested, but that nearly seems like science fiction given the extreme conservatism of the world’s major central banks.

“Meantime people wrangle about fiscal remedies”

The other day I wrote a piece about the risks of introducing politics (particularly fiscal policy) into the central bank’s reaction function. I used the example of the ECB, but now it seems like I should have given a bit more attention to the Federal Reserve as Fed chief Bernanke yesterday said the follow:

“Monetary policy is not a panacea, it would be much better to have a broad-based policy effort addressing a whole variety of issues…I’d be much more comfortable if, in fact, Congress would take some of this burden from us and address those issues.”

So what is Bernanke saying – well he sounds like a Keynesian who believes that we are in a liquidity trap and that monetary policy is inefficient. It is near-tragic that Bernanke uses the exact same wording as Bundesbank chief Jens Weidmann used recently (See here). While Bernanke is a keynesian Weidmann is a calvinist. Bernanke wants looser fiscal policy – Weidmann wants fiscal tightening. However, what they both have in common is that they are central bankers who apparently don’t think that nominal GDP is determined by monetary policy. Said, in another other way they say that nominal stability is not the responsibility of the central bank. You can then wonder what they then think central banks can do.

What both Weidmann and Bernanke effectively are saying is that they can not do anymore. They are out of ammunition. This is the good old  “pushing on a string” excuse for monetary in-action.  This is of course nonsense. The central bank can determine whatever level for nominal GDP it wants. Just ask Gedeon Gono. It is incredible that we four years into this mess still have central bankers from the biggest central banks in the world who are making the same mistakes as central bankers did during the Great Depression.

Yesterday Scott Sumner quoted Viscount d’Abernon who in 1931 said:

“This depression is the stupidest and most gratuitous in history!…The explanation of our anomalous situation…is that the machinery for handling and distributing the product of labor has proved inadequate. The means of payment provided by currency and credit have fallen so short of the amount required by increased production that a general fall in prices has ensued…This has not only caused a disturbance in the relations between buyer and seller, but has gravely aggravated the situation between debtor and creditor. The gold standard, which was adopted with a view to obtaining stability of price, has failed in its main function. In the meantime people wrangle about fiscal remedies and similar devices of secondary importance, neglecting the essential question of stability in standard of value…The situation could be remedied within a month by joint action of the principal gold-using countries through the taking of necessary steps by the central banks.”

It is tragic that the same day Scott quotes d’Abernon Ben Bernanke “wrangles about fiscal remedies”. Bernanke of course full well knows that the impact on nominal GDP and prices of fiscal policy depends 100% on actions of the Federal Reserve. Fiscal policy does not determine the level of NGDP – monetary policy determines NGDP (Remember MV=PY!).

The Great Depression was caused by monetary policy failure and so was the Great Recession (See here and here). In the 1930s the Lords of Finance Montagu, Norman, Meyer, Moret, Stringher, Hijikata and Schacht were all wrangling about fiscal remedies and defended their failed monetary policies. Today the New Lords of Finance Bernanke, Shirakawa, Draghi and Weidmann are doing the same thng. How little we – or rather central bankers – have learned in 80 years…

UPDATE: Maybe our New Lords of Finance should read this Easy Guide to Monetary Policy.

Who did most for the US stock market? FDR or Bernanke?

My post on US stock markets and monetary disorder led to some friendly but challenging comments from Diego Espinosa. Diego rightly notes that Market Monetarists including myself praises US president Roosevelt for taking the US off the gold standard and that similar decisive actions is needed today, but at the same time is critical of Ben Bernanke’s performance of Federal Reserve governor despite the fact that US share prices have performed fairly well over the last four years.

Diego’s point is basically that the Federal Reserve under the leadership of chairman Bernanke has indeed acted decisively and that that is visible if one look at the stock market performance. Diego is certainly right in the sense that the US stock market sometime ago broken through the pre-crisis peak levels and the stock market performance in 2009 by any measure was impressive. It might be worth noticing that the US stock market in general has done much better than the European markets.

However, it is a matter of fact that the stock market response to FDR’s decision to take the US off the gold standard was much more powerful than the Fed’s actions of 2008/9. I take a closer look at that below.

Monetary policy can have a powerful effect on share prices

To illustrate my point I have looked at the Dow Jones Industrial Average (DJIA) for the period from early 2008 and until today and compared that with the period from 1933 to 1937. Other stock market indices could also have been used, but I believe that it is not too important which of the major US market indices is used to the comparison.

The graph below compares the two episodes. “Month zero” is February 1933 and March 2009. These are the months where DJIA reaches the bottom during the crisis. Neither of the months are coincident as they coincide with monetary easing being implemented. In April 1933 FDR basically initiated the process that would take the US off the gold standard (in June 1933) and in March 2009 Bernanke expanded TAF and opened dollar swap lines with a number of central banks around the world.

As the graph below shows FDR’s actions had much more of a “shock-and-awe” impact on the US stock markets than Bernanke’s actions. In only four months from DJIW jumped by nearly 70% after FDR initiated the process of taking the US off the gold standard. This by the way is a powerful illustration of Scott Sumner’s point the monetary policy works with long and variable leads – you see the impact of the expected policy change even before it has actually been implemented. The announcement effects are very powerful. The 1933 episode illustrates that very clearly.

Over the first 12 months from DJIA reaches bottom in 1933 the index increases by more than 90%. That is nearly double of the increase of DJIA in 2009 as is clear from the graph.

Obviously this is an extremely crude comparison and no Market Monetarist would argue that monetary policy changes could account for everything that happened in the US stock market in 1993 or 2009. However, impact of monetary policy on stock market performance is very clear in both years.

NIRA was a disaster

A very strong illustration of the fact that monetary policy is not everything that is important for the US stock market is what happened from June 1933 to May 1935. In that nearly two year period the US stock market was basically flat. Looking that the graph it looks like the stock market rally paused to two years and then took off again in the second half of 1935.

The explanation for this “pause” is the draconian labour market policies implemented by the Roosevelt administration. In June 1933 the so-called National Industrial and Recovery Act was implemented by the Roosevelt administration (NIRA). NIRA massively strengthened the power of US labour unions and was effectively thought to lead to a cartelisation of the US labour market. Effectively NIRA was a massively negative supply shock to the US economy.

So while the decision to go off the gold standard had been a major positive demand shock that on it’s own had a massively positive impact on the US economy NIRA had the exact opposite impact. Any judgement of FDR’s economic policies obviously has to take both factors into account.

That is exactly what the US stock market did. The gold exit led to a sharp stock market rally, but that rally was soon killed by NIRA.

In May 1935 the US Supreme Court ruled that NIRA was unconstitutional. That ruling had a major positive impact positive impact as it “erased” the negative supply shock. As the graph shows very clearly the stock market took off once again after the ruling.

FDR was better for stocks than Bernanke, but…

Overall we have to conclude that FDR’s decision to take the US off the gold standard had an significantly more positive impact on the US stock markets than Ben Bernanke’s actions in 2008/9. However, contrary to the Great Depression the US has avoided the same kind of policy blunders on the supply side over the past four years. While the Obama administration certainly has not impressed with supply side reforms the damage done by his administration on the supply side has been much, much smaller than the disaster called NIRA.

Hence, the conclusion is clear – monetary easing is positive for the stock market, but any gains can be undermined by regulatory mistakes like NIRA. That is a lesson for today’s policy makers. Central banks should ensure stable growth in nominal GDP, while governments should implement supply side reforms to increase real GDP over the longer run. That would not undoubtedly be the best cocktail for the economy but also for stock markets.

Finally it should be noted that both FDR and Bernanke failed to provide a clear rule based framework for the conduct of monetary policy. That made the recovery much weaker in 1930s than it could have been and probably was a major cause why the US fell back into recession in 1937. Similarly the lack of a rule based framework has likely had a major negative impact on the effectiveness of monetary policy over the past four years.

PS this post an my two previous posts (see here and here) to a large degree is influenced by the kind of analysis Scott Sumner presents in his book on the Great Depression. Scott’s book is still unpublished. I look forward to the day it will be available to an wider audience.

David Beckworth on Bernanke’s inconsistencies

David Beckworth has an extremely insightful blog post on the inconsistencies of Ben Bernanke’s views as an academic and as a central bank chief.

Anybody who have read the academic Ben Bernanke’s analysis of the Great Depression and particularly of Japan’s 1990s deflation will be stroke by how different his views are from Fed chairman Bernanke’s views. Bernanke obviously claims that he is not inconsistent. Furthermore, Bernanke claims that the situation in the US is very different from Japan in the 1990s. David on the other very clearly shows that Bernanke is indeed inconsistent and that the academic Bernanke would have realized that there are significant similarities between Japan in the 1990s and the US today.

David’s graph on Japanese and US demand deficiency shows it all. Have a look here.

I really have not much to add other than I think David is 100% right. The Federal Reserve is risking repeating the failures of the Bank of Japan if the Fed chairman keeps forgetting about the excellent research on Japan by the academic Ben Bernanke.

Scott Sumner has two post on Bernanke – here and here. Marcus Nunes also has a comment on Bernanke’s inconsistencies.

PS This discussion reminded me of one of my own earlier posts: Needed: Rooseveltian Resolve. The story is the same – I miss Ben Bernanke the academic.

NGDP level targeting and the Fed’s mandate

Renee Haltom has an interesting article in the recent edition of Richmond’s Fed’s magazine Region Focus on “Would a LITTLE inflation produce a BIGGER recover?”.

Renee among other things discusses NGDP targeting – it is unclear from the article whether it is a reference to growth or level targeting and somewhat surprisingly Market Monetarists such as Scott Sumner is not mentioned in the discussion. Rather Renee Haltom has interviewed Bennett McCallum. Professor McCallum is of course the grandfather of Market Monetarism so Renee is forgiven for not mentioning Scott.

What I found most interesting in Renee’s discussion was actually the relationship between NGDP targeting and the Fed’s legal mandate:

“NGDP is everything that is produced times the current prices people pay for it. It is similar to “real” GDP, the measure of economic growth reported in the news, except NGDP isn’t adjusted for inflation. One appeal is that growth in NGDP is the sum of exactly two things: inflation and the growth rate of real GDP (the amount of actual goods and services produced). Thus, it captures both sides of the Fed’s mandate in a single variable.”

So what Renee is basically suggesting is a that NGDP targeting would be fully comparable with the Federal Reserve’s mandate – to ensure price stability as well as to maximize employment. Unlike Scott Sumner I don’t think the Fed’s mandate is meaningful. The Fed should not try to maximize employment. In the long run employment is determined by factors completely outside of the Fed’s control. In the long run unemployment is determined by supply factors. In my view the only task of the Fed should be to ensure nominal stability and monetary neutrality (not distort relative prices) and the best way to do that is through a NGDP level target. However, lets play along and say that the Fed’s mandate is meaningful.

In his 2001 paper “U.S. Monetary Policy During the 1990s” Greg Mankiw suggested that Fed’s policy reaction function (for interest rates) could be seen as a function of the rate of unemployment minus core inflation. Lets call this measure Mankiw’s constant. The clever reader will of course notice that we now capture Fed’s mandate in one variable.

The graph below shows Mankiw’s constant and the ‘NGDP gap’ defined as percentage deviation from the trend in nominal GDP from 1990 to 2007 (the Great Moderation period).

The graph is pretty clear – there is a very strong correlation between the Fed’s mandate and NGDP level targeting. If the Fed keeps NGDP on trend then it will also ensure that Mankiw constant in fact would be a constant and fulfill it’s mandate. The graph of course also shows very clearly that the Federal Reserve at the moment is very far from fulfilling its mandate.

Given the very strong correlation between Mankiw’s constant and the NGDP gap it should be pretty easy for the Fed to argue that NGDP level (!) targeting is fully comparable with the Fed’s target. So Ben why are you still waiting?

What can Niskanan teach us about central bank bureaucrats?

 Numerous studies have shown that prediction markets performs remarkably well. For example prediction markets consistently beats opinion polls in predicting the outcome of elections. In general the wisdom of crowds is an extremely powerful tool for forecasting and there no doubt the markets are the best aggregators of information known to man.

Market Monetarists advocate using the power of prediction markets to guide monetary policy. Scott Sumner of course is advocating using NGDP futures in the implementation of monetary policy (as do I). Furthermore, I have advocated that central banks replace their internal macroeconomic forecasts with prediction markets and also that central banks could use Robin Hanson-style prediction markets to choose between different policy instruments in the implementation of monetary policy.

The advantages of using prediction markets are in my view so obvious that one can only wonder why prediction markets are not used more by policy makers – not only in monetary policy, but just think about the endless discussions about “climate change”. Why have policy makers not set-up prediction markets for the outcome of different “climate initiatives”? I think the explanation have to be found in public choice theory.

William Niskanen argues forcefully in his classic book on “Bureaucracy and Representative Government” (1971) that bureaucrats are no different from the rest of us – their actions are determined by what is in their own self-interest. Niskanen claims – and I think he is more or less right (I used to be civil servant) – that that implies that bureaucrats are maximizing budgets.

So how do bureaucrats maximize their department budgets? Well, it’s really simply – they use asymmetrical information. Take what is now called the Department of Homeland Security in the US. The job of the Department of Homeland Security’s is to monitor the risk of terror attacks on the US and implement policies to reduce the threat against “homeland security” (whatever that is…). If the Department of Homeland Security can convince the US taxpayers that the US faces a massive terror threat then the department is more likely to get allocated more funds. So if the Department of Homeland Security bureaucrats want to maximize their budget then it just have to convince the American public that the US faces a very large terror threat.

The average US taxpayer does not really have a large incentive to go out and find out how big the terror threat really is and remember as Bryan Caplan tells us that voters tend to be rationally irrational (they don’t really have an incentive to be rational in terms of political issues) and as a consequence the average US taxpayer would happily accept any assessment made by the Department of Homeland Security about the level of the terror threat. Hence, if the Department of Homeland Security overestimates the terror threat it will be able to increase its budget and as the Department has superior knowledge of the real threat level it can easily to do so. This of course is just an example and I have no clue whether the authorities are overestimating the terror threat (I am sure my US readers will be happy to tell me if this is the case).

Hence, a bureaucrat can according to Niskanen’s theory maximize its budgets by using asymmetrical information. However, there is a way around this and reduce the power of bureaucrats. It is really simple – we just introduce prediction markets.

Lets say that we set up one prediction market asking the following question: “Will more people die in terror attacks than in will die in drowning accidents in the US in 2012?”  – Then this “terror/drowning”-prediction could be used to allocate funds to the Department of Homeland Security. My guess is that we would be looking at major budget cuts at the Department of Homeland Security. What do you think?

Anyway, my concern is not really the Department of Homeland Security, but rather monetary policy. If you think that the bureaucrats at the US Department of Homeland Security would use asymmetrical information to increase their budgets what do you think central banks around the world would do? Why would you expect central bank’s to pursue any given economic target in the conduct of monetary policy? And why would you trust the central banks to produce unbiased forecasts etc.?

Why is it for example that the Federal Reserve is so reluctant to formulate a clear nominal target? Could it be that it would not be in the bureaucratic interest of the institution? Could it be that central bank bureaucrats are afraid that they would be held accountable if they miss their target?

I don’t know if it is so, but if not then why not just formulate a clear and measurable nominal target? For example a target to increase nominal GDP by 10% by the end of 2013? And why not then use the opportunity to set up a NGDP futures markets? And why not let prediction markets take care of the Fed’s forecasts?

I am not saying that Ben Bernanke and his colleagues are Niskanen style bureaucrats, but if they want to prove that they are not then I am sure that Scott Sumner or Robin Hanson will be happy to advise them on setting up a NGDP futures market (or any other prediction market).

Of course the US Congress (or whoever is in charge) could also just regulate the FOMC member’s salaries based on their ability to hit a given target…

PS The so-called Policy Analysis Market (PAM) actually was meant to be used to among other thing assess the global terror threat. The project was shot down after political criticism of the project.

PPS our friend Scott Sumner is not all about monetary policy – he has also done research on how to use Prediction Markets to Guide Global Warming Policy.

PPS George Selgin would of course tell us that there is an even better solution to the “central-bankers-as-budget-maximizing-bureaucrats”-problem…

Josh Hendrickson shows that the Fed targeted NGDP growth

I have previously quoted Alan Greenspan for saying the following at a FOMC meeting in 1992:

“Let me put it to you this way. If you ask whether we are confirming our view to contain the success that we’ve had to date on inflation, the answer is “yes.” I think that policy is implicit among the members of this Committee, and the specific instruments that we may be using or not using are really a quite secondary question. As I read it, there is no debate within this Committee to abandon our view that a non-inflationary environment is best for this country over the longer term. Everything else, once we’ve said that, becomes technical questions. I would say in that context that on the basis of the studies, we have seen that to drive nominal GDP, let’s assume at 4-1/2 percent, in our old philosophy we would have said that [requires] a 4-1/2 percent growth in M2. In today’s analysis, we would say it’s significantly less than that. I’m basically arguing that we are really in a sense using [unintelligible] a nominal GDP goal of which the money supply relationships are technical mechanisms to achieve that. And I don’t see any change in our view…and we will know they are convinced (about “price stability”) when we see the 30-year Treasury at 5-1/2 percent.

Now Josh Hendrickson has a new paper out – “An Overhaul of Federal Reserve Doctrine: Nominal Income and the Great Moderation” – that basically confirms that the Fed actually did what Greenspan said it would do – at least during the Great Moderation. Here is the abstract:

“The Great Moderation is often characterized by the decline in the variability of output and inflation from earlier periods. While a multitude of explanations for the Great Moderation exist, notable research has focused on the role of monetary policy. Specifically, early evidence suggested that this increased stability is the result of monetary policy that responded much more strongly to realized inflation. Recent evidence casts doubt on this change in monetary policy. An alternative hypothesis is that the change in monetary policy was the result of a change in doctrine; specifically the rejection of the view that inflation was largely a cost-push phenomenon. As a result, this alternative hypothesis suggests that the change in monetary policy beginning in 1979 is reflected in the Federal Reserve’s response to expectations of nominal income growth rather than realized inflation as previously argued. I provide evidence for this hypothesis by estimating the parameters of a monetary policy rule in which policy adjusts to forecasts of nominal GDP for the pre- and post-Volcker eras. Finally, I embed the rule in two dynamic stochastic general equilibrium models with gradual price adjustment to determine whether the overhaul of doctrine can explain the reduction in the volatility of inflation and the output gap.”

Josh has written and excellent paper and I recommend everybody to have a look at Josh’s paper – maybe if we are lucky Ben Bernanke might also read the paper. After all the paper will be published in Journal of Macroeconomics. Bernanke is on the editorial board of JoM.

PS Josh also has a comment on this on his blog.

Update: Scott Sumner also has a comment on Josh’s paper.

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