09 Nov 2009

Does Scott Sumner Need a Paradigm Shift?

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The days continue to expire, without my having written a rebuttal to Scott Sumner’s provocative blog post that is bouncing around the geeconosphere. The longer I let it fester, the more brilliant my riposte, but the less anyone cares. I break the logjam now and fire off my quick thoughts, realizing that another 24 hours would have increased my eloquence by epsilon. –RPM


Does Scott Sumner Need a Paradigm Shift?
By Robert P. Murphy

Scott Sumner has become famous in certain circles. It’s true, I don’t think there will be allusions to him in any hip hop videos released in the next six months. But among geeks who read econobloggers–in the medium that I have dubbed the geeconosphere–Scott Sumner is like the kid who plays Risk by hunkering down with all his forces in the corner. Sure he’s impregnable right now, but in the long run he’s dead.

Scott is a very interesting writer and he has a wonderful knack for noticing things that others miss, and then following through on his insights to reach counterintuitive conclusions. However, I fear that his one money issue–pun intended–is going to be his undoing. To put it succinctly, Scott thinks that the current worldwide financial catastrophe is the largely the result of the Fed adopting too tight of a monetary policy in the second half of 2008.

I think Scott is completely wrong. As I explain in my book, I believe that the housing and stock market booms were fueled by Greenspan’s artificially low interest rates, and that after the bubble popped, market prices needed to adjust in order to move resources to their best niches. Yet the federal government and Federal Reserve began systematically doing everything in their power to reflate the bubble.

Just as we now look back at Greenspan’s actions post-dot-com crash and think, “We should have just taken our lumps then,” so too will we experience an even worse crash within the next few years. At that point, many financial analysts will realize, “They should have just let the housing and financial corrections run their course. Bernanke made this much worse by running zero interest rates for three years.”

Now the interesting thing about Scott is that he would agree with me that Bernanke “shouldn’t run zero interest rates for three years.” Scott would say that by promising exceptionally low interest rates as far as the eye can see, the Fed is basically telling markets, “We are going to be mired in this rut for a long time, so don’t hire anyone and don’t expand your operations.” I don’t know that Scott has used the phrase, but my two-second distillation of his views is that the Fed has created a self-fulfilling prophecy in which the markets expect to have sluggish growth and deflationary pressures for years, just as in Japan.

Where Scott and I differ is in how the Fed should break out of this stupor. Scott thinks the Fed should get the banks lending again by charging them interest on the reserves they keep on deposit with the Fed, and/or by buying assets and directly infusing new money into the broader economy. Ironically, if the Fed basically started throwing dollar bills into the economy–engaging in “easy money”–this would cause the markets to expect future price inflation (and growth in GDP measured in actual dollars, not adjusted for rising prices) which would lead to higher interest rates. (After all, we can’t have lower interest rates!)

For my part, I would recommend instead that the Fed end all its extraordinary interventions in the financial markets. Let its short-term swaps and so forth with all the banks expire. Sell off the mortgage-backed securities and agency debt (issued by Fannie and Freddie) that it has accumulated. If I were actually setting policy, would I dump $1 trillion of Fed assets next Thursday? Probably not, but I would definitely begin to aggressively shrink the Fed’s balance sheet.

Mainstream commentators would be horrified at this proposal. Why, all the major banks would fail! Exactly right, as they should. We are supposed to be in a profit and loss system here. The banks aren’t making new loans, so they’re not performing the function that Paulson & Geithner cite when explaining why the “reluctantly” had to hand out hundreds of billions to bankers. It would be a good learning experience for everyone in the market: If you think there’s a bubble brewing, get out, because if you go down, you’re not getting bailed out.

Does Sumner Need a Paradigm Shift?

Now that I’ve given the context, let me go through one of Scott’s more brilliant posts. I don’t use that word lightly; I really do think the post qualifies as brilliant, but in the same way that Keynes’ General Theory was brilliant. There are many wonderful points in the post, and my own understanding of what’s going on has been sharpened by reading Scott’s blog faithfully. Even so, I want to point out what I perceive to be large failures in this post.

Scott’s first main point is that macroeconomists don’t have a scientific meaning for the terms “tight” or “easy” money. What’s worse, macroeconomists think they know what these terms mean, so they’re ignorant of their ignorance. Scott runs through 6 different possibilities for what these terms can mean, and argues that mainstream macro guys (and gals) either have rejected them or don’t use them consistently. Let’s look at Scott’s discussion of the first two:

1. The Joan Robinson interpretation

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

2. How about real interest rates?

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

Here’s the chart that Scott refers to, and I must confess at first it shocked me:

But after you recover from the initial shock, you need to ask yourself: Does Scott’s story make any sense? He is writing as if today’s conventional economists–who almost unanimously agree that Bernanke has engaged in “easy money,” especially during the 2nd half of 2008–are committing the opposite error of Joan Robinson.

But that’s not right. Joan Robinson looked at the German central bank raising interest rates and thought, “That means tight money.” She didn’t take into account the fact that relative to the rising expectations of price inflation interest rates weren’t being hiked fast enough, and so the “real interest rate” charged by the German central bank was ridiculously low.

In our situation then, the opposite mistake would be to look at the Fed cutting the target and thinking, “That means easy money,” even though inflation expectations were collapsing faster than the target. Now perhaps that is what happened, perhaps not. My point is that pointing to the TIPS yields has nothing to do with this.

I confess that I don’t have a particularly compelling explanation for what the heck was going on with that spike in TIPS yields, but what I am confident of is that it wasn’t a reflection of the fact that “real interest rates” suddenly zoomed way up because of tight money. Without having seen the data, the way I would have described the opposite of Joan Robinson’s mistake would be like this: You would see TIPS yields actually fall somewhat, as the economy became progressively worse and investors’ expectations of future (real) economic growth shrank. Thus investors would be willing to lend their inflation-adjusted money to the USG at even lower yields, because they just want to protect their principal as the recession deepens. However, the yield on nominal Treasurys would fall even more quickly, because (a) investors would not insist on the same real yield and (b) inflation expectations would be collapsing.

So in Scott’s scenario–where all macroeconomists except Scott Sumner were committing the opposite mistake of Joan Robinson–you would back out the “expected price inflation rate” from the difference between the TIPS and nominal Treasury yields. This number would be shrinking, because the TIPS yield would fall while the nominal yield would fall faster. Then you would look at the drop in the backed-out expected inflation rate and compare it to the Fed’s cutting of its own target. If the backed-out inflation rate was dropping faster than the Fed’s target, then Scott could justifiably say, “Aha! The Fed is cutting nominal rates but not enough to compensate for the collapse in expected price inflation. Hence, the Fed is unwittingly tightening, even though you morons are accusing Bernanke of easy money.”

Notice that two crucial ingredients of my story are (a) a slightly declining TIPS yield, as investors don’t insist on as high a real return from the government (since their alternate investments in the real economy are imploding) and (b) a comparison of the change in the Fed target with the change in inflation expectations as calculated by the spread between nominal and TIPS yields. It wouldn’t have occurred to me to directly check the “real interest rate” by looking at the TIPS yield, since you need to evaluate the Fed’s target against the market-determined variables.

If you’re getting lost, go back to the Joan Robinson example: We didn’t prove that the German central bank had really low real interest rates by looking at TIPS yields. It’s true, I imagine there wasn’t an analog for us to look at, even if we wanted to. But it just underscores my point that Scott is not actually checking for the opposite of Robinson’s mistake. He is doing something similar but it differs in the two crucial things I’ve outlined above.

In particular, I defy Scott to explain how Bernanke’s steps to destroy the economy could cause investors to all of a sudden insist on a 16-fold or so increase in the yield they wanted from the USG, precisely at the time that the world economy was collapsing. That doesn’t make any sense at all. As I said, for Scott’s story to work, I would like to have seen TIPS yields collapsing but the nominal yields collapsing even more quickly. (And then the Fed not cutting its target as quickly as the fall in this spread.)

Look at how the TIPS yield steadily increased from 2005 to mid-2007. I would explain this by saying investors demanded higher and higher real returns from handing their money over to the Treasury, because it seemed they could get higher and higher real returns from investing in real estate and stocks during the boom. Then that all collapsed from mid-2007 to early 2008.

So what happened in the next 9 months? Surely it wasn’t that investors became incredibly optimistic about the returns–adjusted for future inflation–they expected to get on real estate or the stock market or solar panels in China.

So what was going on? I think the following chart sheds some light:

For one thing, note that for a while the TIPS yields were significantly higher than the nominal Treasury yields. In a simple model where you just care about things like future NGDP growth, that should be impossible. Scott’s head should explode when he sees that. Remember that you don’t get dinged on your TIPS bonds’ principal if the CPI actually falls. So that means the nominal yields should never fall lower than the TIPS yields.

And yet they did. What gives? It must have been due to the general desire for liquidity and the flight into the safest assets available, namely nominal US Treasurys. In other words, you could have one bond where the US government said, “We will pay you $10,000 in 5 years,” and another where the US government said, “We will pay you at least $10,000 in 5 years, and more if CPI rises between now and then,” and investors were willing to pay more money right now for the former bond. (!) A large part of their motivation must have been their desire to hold something very marketable–in case they needed to sell it before the 5 years–and possibly also that they didn’t trust the US government to live up to its obligations to not reduce the $10,000 payment if CPI fell by 20% over the next 5 years.

I have also included the yield on AAA bonds to show that they spiked too, though not as much, as TIPS yields did, precisely at the time that the nominal Treasury yields collapsed. Again, I’m not saying that I know exactly what was going on for these critical months, but what I am saying is that the above chart is not what you’d expect from a straightforward collapse in the expectations of real GDP growth and CPI growth.

Moving On…

This post is already quite long, so I’ll make just two more points. Scott writes:

I suppose one could still argue that the base is the right indicator of monetary policy, but that view is certainly not the standard view. I’ll bet 90% of the economists who claim Greenspan ran an easy money policy in 2003 have never once examined the base data from that year.

I always knew I was in the elite.

Scott writes:

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

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

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

So who is right, those in the bond market or those economists forecasting much higher inflation? The answer is easy, those with money on the line.

I regret to say that here Scott is just playing to the crowd. Given the warm-up that I put in bold, the natural thing would have been for Scott to write, “So who is right, the bond market or the commodities markets?” The people in both markets have money on the line.

But instead of asking that tough question, Scott takes the path of Krugman by contrasting the smart bond traders with economists who disagree with Scott. Tsk tsk. I could just as well say, “Who is right? The central banks loading up on gold, or Paul Krugman and Scott Sumner firing off blog posts about how there’s no inflation threat?”

In any event, I am quite astonished by how decisive Scott and others think the judgment of “the market” is, when we’ve just seen two humongous bubbles in the last decade. I would argue that they were Fed-induced. If you buy that, then surely it’s possible that Bernanke’s literally unprecedented interventions might just have something to do with “the market’s” current configuration?

Robert P. Murphy holds a Ph.D. in economics from New York University. He is the author of The Politically Incorrect Guide to the Great Depression and the New Deal (Regnery, 2009), and is the editor of the blog Free Advice.

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