The curious behavior of M2

Found something interesting in the course of doing my day job. Check out M2 (since 1995) against its trend:

Could higher interest rates help the economy?

We live in an age when central bankers grace magazine covers like pop stars. But what if they don’t actually know what they are doing? In the United States, at least, quantitative easing and low short-term interest rates may have done as much harm as good.

 

Trying to get a sense of household risk preferences

According to one common view, monetary policy works by influencing household (and to a lesser extent business) preferences for investing, saving, borrowing, and spending. Bernanke’s stated justification for quantitative easing was that he could stimulate the economy by getting people to move money from their checking accounts into the stock market and from their money-market funds into car dealerships.

Risk preferences are not determined solely, or even primarily, by monetary policy. When times are good and you are confident in the future, you put more of your savings in long-duration, risky, illiquid assets like equities and housing. When times are bad, cash is king. Using data from the flow of funds, we can see how American households’ risk preferences have changed over time. The crisis has caused many people to retrench and solidify their balance sheets, yet it turns out that there could be a long way to go.

More fun with level-targeting

Yesterday I asked whether the fans of NGDP-targeting had thought through the full implications of their models. Today I will look at another sort of level-targeting recently proposed by a former Fed economist who now works at Citi.

What if the Fed had taken NGDP targeting seriously?

Targeting the level of nominal GDP (the total number of dollars spent/earned in a year) has become the fad of the year, partly because it is a strong argument in favor of further Fed stimulus. Paul Krugman, Goldman Sachs, and The Economist have all said nice things about it. A professor at Bentley University seems to have dedicated the past few years of his life to it.

Of course, the idea is not new. Far from it—nominal income targeting actually goes back to the 1970s. Over subsequent years it got attention from several big-name economists including Martin Feldstein, Greg Mankiw, Robert Gordon, John Taylor and Robert Hall. It was even championed by my favorite Fed governor of the 1990s: Larry Lindsey.

The point of this post is not to review the literature or consider why nominal income targeting was not adopted earlier. I also do not want to return to the question of whether monetary stimulus alone is capable of healing the economy. Rather, I want to see what the Fed would have done in the years before the big slump if it had carefully targeted nominal income. The answer might surprise you.

Observations from the 29th Annual Cato Monetary Conference

Thanks to my work, I was able to spend most of Wednesday attending the Cato Institute’s 29th Annual Monetary Conference. The speakers were a pretty diverse group ranging from Rep. Ron Paul to Richmond Fed President Jeff Lacker to Professor Allan Meltzer.

The attendees came from even further afield. There were representatives from establishment organizations including the Bank of Korea and the IMF, but there was also a convicted “domestic terrorist.” I sat next to the former general manager of the Wu-Tang Clan. He now makes a living as an adviser to investors interested in sub-Saharn Africa, although he claimed that his real passion is monetary policy. Who can blame him?

The conference was divided into four panel presentations, two speeches, and a lunchtime conversation. I did not stay until the end but I was there for most of it. Additionally, I got a packet of all the papers that were presented during the panels. Some of the topics that were discussed: the role of a central bank, historical and international monetary arrangements, and ways to reform the existing system.

Deflation is not worse than inflation

Just over nine years ago, Ben Bernanke gave a famous speech entitled “Deflation: Making Sure ‘It’ Doesn’t Happen Here.” He articulated a view that has since become completely mainstream, namely, that falling prices are far worse than rising prices. Why should this be?

Orthodox macro economists fear deflation (negative changes in the consumer price index) more than inflation (positive changes in the consumer price index) for three reasons. Professor Krugman provided a good summary of the standard argument.

First, falling prices supposedly create expectations of further price declines. This supposedly encourages households and businesses to postpone spending and hoard cash, which could induce a recession. Second, falling prices often—although not always—go hand-in-hand with declines in nominal wages, which means that deflation increases the burden of existing debts. Finally, it is supposedly harder to stop prices from falling than to stop them from rising because the central bank could push nominal interest rates up towards infinity but cannot push them below 0%—hence the so-called “zero bound.”

It turns out, however, that all three of these arguments are either flawed or incomplete. Broad declines in nominal wages and prices, while generally undesirable, are no worse than broad increases in nominal wages and prices.

The Fed is out of ideas

Today’s Wall Street Journal has an article by Jon Hilsenrath about what the Fed is likely to consider in its upcoming meeting on November 1 and 2 in response to the stubborn weakness of the U.S. economy. This is significant because Hilsenrath is the journalist that the Fed trusts the most for conveying its views to the public. A close reading of what he wrote can tell us a great deal about what the members of the FOMC are thinking. Worryingly, it appears that they are out of good ideas.

The lessons of the baby-sitting co-op reconsidered

During the depths of the Asian Financial Crisis, Professor Paul Krugman wrote an essay for Slate where he argued that central banks can prevent recessions by manipulating interest rates. To make his point, the professor used a real-life example of a baby-sitting cooperative from the 1970s. It is well worth reading, particularly the second footnote at the bottom.

The original article on which Krugman’s piece was based is even more interesting. The authors came to a very different conclusion from the professor, however, which has significant implications for today’s debates on monetary policy and the economy.

The U.S. dollar needs to depreciate, Dilma

Last week, I referred you to an incoherent attack on American monetary policy by Brazilian president Dilma Rousseff. She argued that “economies that issue reserve currencies,” i.e., the United States, “are resorting to undervalued exchange rates to ensure their share of global markets.”

There are two basic errors with this claim. First, the only reason the dollar is the world’s reserve currency is because other governments—including Brazil’s—want it to be. No one forced the Brazilians to buy $200 billion of U.S. assets over the past five years. Second, the U.S. dollar is not undervalued. If it were, we would be earning large current account and trade surpluses. Instead, we run deficits.

Dilma had it backwards. The United States has not been taking advantage of the rest of the world—it is the rest of the world that has been taking advantage of us. The only way to peaceably resolve the imbalances that have resulted from decades of protectionism by the surplus countries of the world is through a large depreciation of the U.S. dollar.