Monetary policy only has an effect through changing inflationary expectations.

TO BE NOTED: From Bronte Capital:

"Mr Krugman and Mr Ferguson: a suggested interpretation (very long and ultra wonkish)

This post has an ultra-wonkish warning. Unless you enjoy graduate macroeconomics (soemthing I have never formally done) then you will probably not get many of the short-hand arguments in this post. For that I am sorry.

The main purpose of the post is to provide a basis for discussion amongst button-down modelling macro-economists.

I have just finished reading the blog exchange between Paul Krugman (the Nobel Prize winning economist) and the Niall Ferguson (the historian). As I consider myself a passable economist and a second rate historian this had me enthralled. Moreover, it had me reaching back into the dim recesses of my economics degree for a model. I have one which I will outline below.

The debate is about the meaning of recent kick up in long term interest rates. Mr Ferguson suggesting that it indicates that serious inflation is afoot – or else that the government will shortly have difficulty funding its debt. Mr Krugman has different interpretations – essentially coming down to the stimulus working. For Mr Krugman (the most famous torch bearer for academically rigorous Keynsianism) this debate is central to his world view.

The model needs to deal with the crisis as it is. It needs to be consistent with the facts on the ground of the crisis. It needs to include some kind of difference between real and nominal interest rates (that is some kind of measure of inflationary expectations). And it needs to build into it some kind of rationality for participants in the bond market – otherwise we are assuming away any meaning for the long term interest rate kick up.

It does not need to include a foreign sector or exchange rates because – well – this crisis is remarkably not driven by currency.

The model here – and several of the lemmas – come from Ted Sieper who showed me them during an undergraduate macroeconomics course in 1991. I figure Ted only invented some of it though I do not know who to credit beyond that. Some of it I invented.

I have titled this blog post “a suggested interpretation” after JR Hick’s classic 1937 paper because – well – I use an ISLM model. However it is a very-non-standard ISLM model so I will beg you sit with me through the introduction. I have not written out an ISLM model (or any other macro model) since 1992 – so if this is a little laboured it is because my macroeconomics is rusty. Moreover this model is presented at first away from the zero bound for nominal interest rates. I did not think about the zero bound much when I first looked at this sort of model – because (frankly) it was 1991 and the Great Depression and liquidity traps were an artefact of history. I build in the zero bound in the second part of this note – and that is where the really interesting observations start.

Let’s start.

A standard IS/LM model puts nominal interest rates (i) on the vertical axis and real income (Y) on the horizontal axis. I am going to change it up front (following Sieper) and put both nominal interest rates (i) and real interest rates (r) on the vertical axis and the log of the price level (log p) on the horizontal axis. Distances between nominal and real rates (that is vertical distances) measure expected inflation. For example if expected inflation is 5%, nominal rates are 8% then real rates are 3%.

Distances on the horizontal axis are changes in prices which is the whole point of putting logarithms of the price level on the horizontal axis.

You have to get the axis trick right from the beginning because the rest of my model will not make any sense without it. So just to hammer it home here are the labelled axes. Please do not think this is a standard ISLM model because you will not get anything that follows without noticing this.

Ok, now I am going to put in a Phelps-Friedman supply function. There is a natural level of income (Y) which is a function of real wages (w/p). There is a level of real wages which clears the labour market. However we assume [under most circumstance] that nominal wages (w) are more sticky than the price level (p) at least in the short run. If there is unexpected inflation then the price level is too high, real wages are lower than the “natural level” and there is “excess” employment. If the price level is too low then real wages will be too high – and there will be some unemployment. However as the wages and prices adjust to natural levels we wind up with the natural rate of employment.

Now lets detail an IS curve. In traditional fashion it is a curve which plots equilibrium in the goods market. The demand for goods (again traditionally) is consumption + investment. The supply is income. Consumption (C) is a function of income (Y) which is in turn a function of real wages. Investment (Y) is simply a function of the real interest rate. So here is my IS curve.

Now in the long run my real wage is the market clearing wage and income is fixed. (It’s that Phelps Friedman supply function). That says that Consumption is also fixed and hence the interest rate is fixed at a Wicksellian real interest rate.

The Long Run IS curve is thus horizontal at the Wicksellian Natural Interest Rate (r*). This is pictured below.

This long run curve is labelled IS(L,0) because it is the long run curve in period 0.

It’s a bit strange having a horizontal IS curve – but let us live with that.

Now let’s consider the short run IS curve. In the short run we assume that nominal wages (w) are fixed, but that prices change.

If we increased prices a little we (by assumption above) drop real wages and hence raise income. Both sides of IS curve rise – because consumption also rises with income. But because the marginal propensity to consume is less than one the left hand side would not rise as much as the right hand side. Therefore there would be an imbalance. To get balance back into the goods market (ie to be on the IS Curve) we would need to raise investment. That happens when real rates fall. So – in the short run if we increase prices we have to reduce real interest rates to keep equilibrium in the goods market. The IS curve in the short run thus slopes down. [Thank god for that!]

This is pictured below – with the now usual nomenclature is the long and short run IS curves.

Ok – having got more or less traditional looking IS curves (despite the eclectic choice of axes) let us have a look at Money Market Equilibrium (ie the LM curve). An LM curve would typically have real money demand being equal to real money supply. Money demand (L) is negatively related to nominal interest rates (i) as they represent the cost of holding money and positively related to income (Y). Income – as usual – is a function of the real wage.

Real money supply is just the nominal money supply (m) divided by the price level (p).

Let’s represent that in equation form:

_{As before we consider the shape of a long run and then a short run LM curve.}

In the long run Y is determined (it’s the natural rate). Then as you increase the price level you reduce the real money supply. To get equilibrium in the money market you would also need to reduce the real money demand which you can do by increasing interest rates. The long run LM curve is thus upward sloping. (Again thank God for that.)

Just to rub that in I have drawn another picture.

Now a short run LM curve has another effect when prices rise. Prices rising drive down real wages and up income. This increases money demand – so to get equilibrium in the money market nominal rates would need to rise even further. The short run LM curve is thus steeper than the long run LM curve. I have pictured this below.

Now lets look at a long-run normal time equilibria. Assume that inflation is 5% and always expected to be 5%. As it is a long run equilibria we only need to consider the long run curves. Here is how it will look.

What we have is the LM curve shifting right by 5% per period. The gap between the nominal and real interest rates is 5%. The actual inflation equals the expected inflation.

We can put the short run curves on this – and they look as follows:

OK – now lets model a simple monetary shock. Suppose that there is a sudden and permanent increase in the rate of growth of money supply. We would then expect to be at a long term equilibria say 7% out – and moving out by 7% per year.

We have a new LM curve in period 1 which is to the right of the old one. I have drawn it below and labelled it LM(L,1*) being the shocked curve in period 1.

As we now expect more inflation the gap between nominal interest rates and real interest rates must be larger (that gap is after all inflationary expectations). The new equilibrium will have a sustained 7% gap between nominal and real interest rates. The inflationary expectations will have to equal the realised inflation to that point – so the two lines measured in blue in the above diagram should be of equal length.

Note that the inflationary shock has driven up nominal interest rates in the short run and down real interest rates. The fall in real interest rates causes an increase in income. Monetary change increases short run income. This is entirely consistent with the 80s observed data on monetary “surprises”. When there was a monetary surprise of increased money supply it was associated with increases in nominal interest rates.

I think this is a minimal IS LM model with a reasonable distinction between nominal and real interest rates and a reasonable model of a rational bond market.

Now I need to make an observation which was first made to me by Ted Sieper. I have here a model with rational expectations, a Phelps Friedman expectations determined supply curve and whoa – monetary policy has economic effects. One guy called Robert Lucas Jnr won a Nobel Prize and in part his citation referred to his (definitely faulty) proof that such a thing was impossible. That is the famous so-called “Policy Irrelevance Proposition” (PIP). Well here is the counter example. And if you go look at any proof of the PIP you will find that they either assumed no distinction between nominal and real interest rates or they assumed a vertical LM curve. No – I am not kidding. One of Lucas’s most famous results is bunkum based on faulty maths.

And I do not mean to harp on about it but Lucas’s faulty result poisoned what I think is a very productive well in macroeconomics. Lucas “proved” that rational expectations and an expectations adjusted vertical supply curve made monetary policy irrelevant. However when you looked out the window central banks were clearly using monetary policy to some effect – hence everyone concluded that rational expectations is a bad modelling tool and dumped it.

But the Lucas proof was faulty. There was no reason to dump rational expectations due to the lack of correlation between central bank action and Lucas’s theory. And we have lost the use of a very neat – and quite natural assumption in many macro models.

I need to say this because – as a simplifying assumption I am arguing in this post that the bond market is more or less rational when it is repricing the long end of the curve. [If the argument between Krugman and Ferguson comes down to one side arguing the bond market is wrong or irrational then we are truly lost…] So can all the Keynsians out there not get really annoyed when I use a rational expectations hypothesis – please… Just accept that Lucas's result is wrong...

Moreover – and it is important to observe this – monetary policy again becomes irrelevant whenever the LM curve is vertical. And guess what – the LM curve becomes vertical at the zero bound to inflation – and so we have the standard (but usually faulty) result. But I guess I should model that more formally… as in this model unfortunately the curve becomes horizontal… it does not matter how far or fast prices are falling – nominal rates don’t go below zero…

Embedding the zero bound in this model

It is commonly observed that nominal interest rates cannot rationally stay below zero. The LM curves I drew in the models above have some very strange properties at the zero bound.

I quite purposely did not have any of my curves (IS or LM) above touch the zero nominal interest rate point – but lets do it now. Here is the long run inflationary equibria curve from above redrawn with the short run LM curve actually touching zero. The rates can’t go below zero – so it does not matter how far prices fall you can’t get negative nominal interest rates… the LM curves go horizontal when nominal interest rates hit zero.

If we are being formal (dotting i’s, crossing t’s, button down macro modelling as Mr Krugman advocates every now and again) we should note that there is – in the short run – some point on this LM curve whereby price levels can’t go any lower without there being deflation. Of course that point is dependent on the previously stable level of inflation – a point that would be moving right every period. Sorry I am getting little beyond my ability to do simple sketches. But I suspect the LM Curve has a period in which it is vertical to the zero until it just becomes as drawn above. Can we ignore this until someone comes up with a better modelling idea?

Now lets seriously shock the IS curve – the sort of shock that makes the zero bound operational – which is for instance what might happen if the banking system collapses…

Ok – now here we are – and its pretty clear that fiscal policy is just effective – because it moves the IS curve right. A move of the IS curve to the right means less deflation is necessary and real wages are less out of kilt.

Monetary policy only has an effect through changing inflationary expectations. If you can induce inflationary expectations then you will need to find a gap between the IS curve and the LM curve such that the gap equals the inflationary expectations. Do that and you will wind up with a very sharply negative real rate of interest.

And you can get there only by say inducing 5% continuous inflationary expectations.

However there is a real problem here – which is that you need to induce inflationary expectations in an environment of falling nominal wages and falling prices – which is tricky to say the least.

You can do it by credibly promising to be reckless (Krugman, Hempton helicopter post). But you can’t do it by being responsible.

Then there is the question as to how reckless you need to promise to be…

If the IS curve has any reasonable slope you need to be massively reckless credibly.

If you do only small changes in money supply then you remain stuck at the zero bound – you do not credibly induce inflation and hence the monetary policy is irrelevant.

Strange result – policy irrelevance holds for small but not big changes in money conditions… and it holds ONLY if you change expectations…

Short summary…

At this point I am coming out at Krugman’s side of the argument – and I think if we model multiple periods we are firmly on Krugman’s side as the yield curve flattens above zero – which is what happened last week.

If anyone wants to do the rest of buttoning this down I will be a keen critic. However the PhD in economics did not ever beckon. I am doing the funds management thing instead...

Oh and if one of those button-down macro-modelling economists can do it thoroughly I would love to put in an external sector. I am trying to understand Spain.

John

Posted by John Hempton "

Markets could behave in ways described by the classical and New Classical theories, but they need not

TO BE NOTED: From the FT:

"Economists clash on shifting sands

By Robert Skidelsky

Published: June 9 2009 18:52 | Last updated: June 9 2009 18:52

History is replete with famous intellectual battles. In the natural sciences, these have usually led to decisive victories, with good science ousting bad. There are few Ptolemaic astronomers left, or believers in the phlogiston theory of combustion. In the social sciences, the situation is different. There have been famous battles galore, but no decisive victories. Indeed, it is characteristic of the social sciences that their battles are interminable, temporary defeats being followed by the regrouping of the defeated forces for a renewed assault.

That economics is not a natural science is clear from the inconclusive engagements that have punctuated its own history. A hundred years ago the classical theory reigned supreme. This “proved” that free markets were automatically self-adjusting to full employment. They were either continually at full employment or, if disturbed by an outside shock, rapidly returned to it. The only thing capable of wrecking the workings of the market’s invisible hand was the visible hand of government interference.

Then along came the Great Depression of 1929-32 and John Maynard Keynes. Keynes “proved” that markets had no automatic tendency to full employment. This failing of the invisible hand justified government policies to maintain full employment.

For 30 years or so Keynesianism ruled the roost of economics – and economic policy. Harvard was queen, Chicago was nowhere. But Chicago was merely licking its wounds. In the 1960s it counter-attacked. The new assault was led by Milton Friedman and followed up by a galaxy of clever young disciples. What they did was to reinstate classical theory. Their “proofs” that markets are instantaneously, or nearly instantaneously, self-adjusting to full employment were all the more impressive because now expressed in mathematics. Adaptive Expectations, Rational Expectations, Real Business Cycle Theory, Efficient Financial Market Theory – they all poured off the Chicago assembly line, their inventors awarded Nobel Prizes.

No policymaker understood the maths, but they got the message: markets were good, governments bad. The Keynesians were in retreat. Following Ronald Reagan and Margaret Thatcher, Keynesian full employment policies were abandoned and markets deregulated. Then along came the almost Great Depression of today and the battle is once more joined.

Haunters of the blogosphere will know that the main ground of the current engagement is about the effect of the “stimulus”. FT readers will have caught a faint whiff of the intensity of this battle in Niall Ferguson’s column of May 30, headed “A history lesson for economists in thrall to Keynes”. Prof Ferguson and Paul Krugman, the economist and New York Times columnist, had previously locked horns at a public symposium in New York on April 30. The historian had asserted that large fiscal deficits would push up long-term interest rates. This implied they would have a zero stimulatory effect: public spending would simply “crowd out” private spending. An enraged Mr Krugman responded on his blog that Keynes had proved that such crowding-out could occur only at full employment: if there were unemployed resources, fiscal deficits would not drive up interest rates without also expanding the economy. Prof Ferguson’s ignorant remarks only confirmed that “we’re living in a Dark Age of macroeconomics, in which hard-won know-ledge has simply been forgotten”.

However, this is not a debate between economists and historians. It is a battle within the economic profession – between the New Class-ical Economists and the New Keynesians. What is fascinating is that it is an almost exact rerun of the debate between Keynes and the British Treasury in 1929-30. The Treasury view was that bond-financed public spending was bound to diminish private spending by an equal amount. Keynes replied that if this were true it would apply to any new act of private spending. “In short, the fatalistic belief that there can never be more employment than there is is altogether baseless”.

Later the Treasury retreated to a more defensible position. The danger of extra government spending, it came to argue, lay not in the “physical” crowding out of resources but “psychological” crowding out. If doubts arose about the government’s solvency – a concern Prof Krugman has acknowledged – it might lead to capital flight, which would push up the cost of government borrowing.

Are we doomed to rehearse the same arguments time and again? In this particular debate, I am on Prof Krugman’s side, but I do not agree that Prof Ferguson’s position represents a retreat to a phlogiston state of economics. This is to take economics to be like a natural science, which Keynes never believed it was, because he thought its subject matter was much too variable over time.

Keynes’s view was that we need different economic models at different times. The beauty of his General Theory of Employment, Interest and Money was that it was general enough to accommodate a variety of models applicable to different conditions. Markets could behave in ways described by the classical and New Classical theories, but they need not. So it was important to take precautions against bad behaviour. Ultimately, the Keynesian revolution was a triumph not of good science over bad science, but of good judgment over bad judgment.

Lord Skidelsky’s ‘John Maynard Keynes: The Return of the Master’ will be published by Allen Lane in September

Copyright The Financial Times Limited 2009"

It is striking how many of those most alert to the deflation danger are either veterans of Japan’s Lost Decade or close students of it

TO BE NOTED: From A Fistful Of Euros:

"David Takes On Goliath and Loses: The Ferguson - Krugman Exchange by Edward Hugh

“As long as excessive debt is not digested, both monetary and fiscal policies are inefficient. There is not much of an alternative. Either to let the economy collapse, in order to reduce debts, and then use fiscal policy to revive it, or inundate the insolvent economy with public credit, to avoid the collapse, and loose the ability of fiscal policy to pull it out of a prolonged lethargy. Either a horrible end or an endless horror.”
After the Crisis: Macro Imbalance, Credibility and Reserve-Currency: André Lara Resende

Well, I think the title to this post makes my view on the high-profile shenanigans we are currently witnessing on the part of two widely respected contemporary intellectuals clear enough, even if Paul would probably respond that he is perfectly well able to take care of himself, thank you very much. Nonetheless, looking at the way the tone of his most recent and most public debate with Niall Ferguson has deteriorated (yes, it is Niall I’m talking about here, and not Sir Bobby, although sometimes even I have my doubts), let me confess, I am not entirely convinced on this point (Niall Ferguson’s argument can be found summarised in his Financial Times Op-Ed here, and in his rejoinder letter to Martin Wolf reproduced by the FT Alphaville’s ever interesting Izabella Kaminska here, while Paul Krugman’s “input” to the debate can be found here, here, and here).

So, since the thunder and lightening that such high profile exchanges generate tends to obscure more than it reveals, let me be so bold as to add my own 2 centimes worth - even if, apologies in advance, the whole affair ends up being most terribly “wonkish”. If you want to save yourself a good deal of trouble, and heart searching, the central point is a simple one: are long term US interest rates rising because investors are worrying about having to buy so much public debt (as K would point out, what else were they thinking of doing with the money - which isn’t really “money” at all, but, oh, never mind), or are they rising because investors expect the time path of US short term interest rates to move steadily upwards? It’s as easy, or as hard, as that. So now, you decide!

Someone To Watch Over You

Amidst so much disagreement one point is, at least, agreed common ground: Paul Krugman is a macro economist, while Niall Ferguson is a historian, one who believes, if we are to take him at his word, that cats may sometimes look at kings, and live to tell the tale. Let’s see if he’s right.

The other point we are all agreed on, I think, is that yields on 10 year US treasuries have been rising of late, and this phenomenon lies at the heart of the debate. Indeed, if I read him aright, this is Niall’s main point of current concern.

On Wednesday last week, yields on 10-year US Treasuries – generally seen as the benchmark for long-term interest rates – rose above 3.73 per cent. Once upon a time that would have been considered rather low. But the financial crisis has changed all that: at the end of last year, the yield on the 10-year fell to 2.06 per cent. In other words, long-term rates have risen by 167 basis points in the space of five months. In relative terms, that represents an 81 per cent jump.

Where we are not agreed - the economists and the historians among us that is - is over the significance to be placed on this evident fact. Although, having said this, Niall does rather seem to suggest that the development is some sort of litmus test for his view, since he argues it “settled a rather public argument between me and the Princeton economist Paul Krugman”. Now what was it they used to say about rushing in where angels fear to tread!

Of course, Niall is no fool, he is an excellent historian, and I greatly enjoy reading his books, but he really, really should know better than to get himself involved in the kind of technical argument which his experience and background ill equips him for. Citing the Chinese central bank as authority for your monetary views (see below) may go down well with the after dinner port-and-stilton set, but it is hardly rigorous argument, and Niall must surely well know that.

It’s The Expectation On Long Term Yield, Silly!

The Fed probably won’t make any adjustments to the size of the Treasury purchase program before its next policy meeting on June 23-24, in part to avoid reinforcing perceptions policy is reacting to swings in yields, according to Jim Bianco, president of Chicago-based Bianco Research LLC.

“The Fed wants to operate in predictable ways,” Bianco said. “They are also trying to not just look arbitrary, which makes people think ‘I can’t ever go to the bathroom because there could be a press release that the Fed changed the buybacks.’ That’s been a real concern: ‘Wow, I just went to the bathroom and lost $2 million dollars.’”

The thing you should always bear in mind when you enter the fray in areas where others have the benefit of the expertise is that there may be more than one available interpretation for the phenomena, and, as is so often the case in science, the counter intuitive explanation may have more going for it than the layman may grant at first sight (wasn’t that the sun I just saw hurtling past across the sky). In this sense, the recent rise in long term US treasury interest rates has just provided some of us with a fascinating example of a phenomenon that those economists who have busied themselves studying the use of quantitative easing in Japan have been flagging for some time, and that is, that long term interest rates may indeed be unduly influenced by longer term inflation expectations, but not necessarily in the way a layman Niall and others may imagine they are.

Longer term inflation expectations - or so it is argued by a broad spectrum of monetary economists - may work against the fluid operating of a quantitative easing regime in or on the boundary of a liquidity trap not because investors fear that a country like the United States is about to become the new Zimbabwe, but precisely because they know it won’t. Indeed, as I frequently find myself saying of late, the United States is not Argentina, gee, it isn’t even Italy, by which I mean that investors know perfectly well how Ben Bernanke and his colleagues over at the Federal Reserve will react to a situation where inflation is perceived as rising above their target range - they will start to raise short term interest rates, and it is this expectation of future increases in short term rates which ironically cause longer term interest rates to rise, in just the way they are doing right now, in what is almost a text book case study in the United States. As Krugman’s former PhD student Gauti Eggertsson put it in one highly relevant paper (Eggertsson and Ostry: 2005, see references below).

A central bank following a Taylor rule raises interest rates in response to inflation above target and output above trend. Conversely, unless the zero bound is binding, the central bank reduces the interest rate if inflation is below target or output is below trend (an output gap). If the public expects the central bank to follow the Taylor rule, it anticipates an interest rate hike as soon as there are inflationary pressures in excess of the implicit inflation target. If the target is perceived to be price stability, this would imply that quantitative easing has no effect, because commitment to the Taylor rule would imply that any increase in the monetary base would be reversed as soon as deflationary pressures had subsided.

Indeed talking of the Taylor rule, none other than John Taylor himself recently came out and argued that -applying his rule - the Federal Reserve would need to start once more to raise interest rates in the near future, “My calculation implies we may not have much time before the Fed has to remove excess reserves and raise the rate,” he said recently at an Atlanta Fed conference. And if John can do the calculations so too can other investors.

Of course the United States Federal Reserve is not at this point following a Taylor-type rule (although Bernanke is a known supporter of some sort of inflation targeting) but let us not get bogged down in that minor, rather technical detail, the key issue is that long term interest rates are influenced more by the expected time path of short term rates than by any other single factor, and if, instead of beating about the bush, we go right to the heart of the matter, what do we find, well Lo & Behold, only last Friday:

The dollar advanced the most against the yen in more than three months and rose versus the euro as economic data showed evidence the U.S. recession is easing, boosting demand for the nation’s assets. The greenback climbed this week as a government report indicated slower deterioration of the labor market, supporting bets dollar-denominated assets will gain as the U.S. leads the global economy out of its slump…..

The dollar also gained against the yen on speculation the Federal Reserve will raise interest rates later this year, reducing the advantage of borrowing in the U.S. to fund purchases elsewhere. Traders added to bets the central bank will increase its target rate for overnight loans between banks by its November policy meeting, according to futures traded on the Chicago Board of Trade. The contracts show a 66 percent chance of a rate increase by then,compared with 24 percent odds a week ago.

Well, there you are, investors (I have no idea whether they are being rational or not) simply act as theory predicts, and chaffe at the bit (sometimes called “getting ahead of themselves”) to take positions in anticipation of expected future hikes in US interest rates, something which sends rates rippling upwards all along the yield horizon. Incidentally, can someone kindly tell me where I have to write to become a formal member of the “Thank God For Bloomberg” brigade, since where would we really be without those dedicated scribes, who will, incidentally, obviously provide so much material for future generations of historians? (Incidentally, you can find a very good summary of just what a headache the volatility in US government bonds is proving to be for Bernanke in this Bloomberg article, from which the Bianco quote above was taken).

So, far from the position being as Niall imagines it is, with investors demanding enhanced premiums for holding US assets due to their fear of impending inflation, what we have here is a kind of see-saw process, whereby bad economic data, which leads investors to anticipate interest rates being held low in the US for some considerable time, raises risk sentiment (see this post: Don’t Get Carried Away Now) and sends them off into riskier emerging market assets (with Big Ben playing sheet anchor) in the process sending the grenback to ever lower levels, while positive economic news makes playing carry with the USD as one of your currency pairs increasingly riskier, and thus leads the punters themselves to retreat, sending the dollar cruising back up again. All of which is very counterproductive, since given the knife edge character of the current US “recovery” all it does is slow things down (since the cheaper USD is good for exports) and ramp up the deflationary pressure.

But this story about investors being nervous about holding US Treasuries due to the high inflation risk, well, as far as I am concerned, go tell it to the marines, or at least to the those people over at the Chinese central bank (you know, the ones who have been running up all those dollar reserves) who Niall seems to regard as his economic authority in these matters.

“Monetary expansion in the US, where M2 is growing at an annual rate of 9 per cent, well above its post-1960 average, seems likely to lead to inflation if not this year, then next. In the words of the Chinese central bank’s latest quarterly report: “A policy mistake … may bring inflation risks to the whole world.””

What we have here, is what the late Niklas Luhman would have termed a “narrative discourse”. Repeating the same arguments ad infinitum may produce a pleasing to sensation among the theory’s adherents, but that does not make them “true”, nor is it a substitute for rigourous economic analysis, or a basic understanding of what is actually going on. It does go down well with the port and stilton set though, and would undoubtedly make one VI Ulyanov (aka Lenin) turn merrily over in his mausoleum, since evidently he was right: “every cook can and does govern”.

But back to the basic thread, putting all this pressure on public officials at this point is a completely counterproductive exercise, since the surge in long term interest rates - produced by the rise in expectations that the central bank will move to reign-in inflationary pressures sooner rather than later, simply leads to further signs of weakness in the US economy, which means the expectation once more grows that rates will stay lower longer, and on and on we go. But of course, as Niall Ferguson points out, it is none other than Bernanke himself who has most recently and most evidently been expressing concern about the future size of the Federal deficit, and again this would seem to me to be a reflection of the political pressure that this mistaken narrative is exerting. Accodring to the Wall Street Journal:

The Fed must decide, perhaps as soon as its June 23-24 policy meeting, whether to increase its purchases of Treasury bonds. It is on course to buy $300 billion worth of bonds by September. If investors perceive the Fed’s actions as an effort by the central bank to facilitate bigger deficits, they could conclude inflation is coming and flee Treasurys, pushing interest rates up. Mr. Bernanke’s comments were aimed at thwarting that perception.

Counter intuitively, the only real way to break this spiral is for Bernanke to commit to holding rates near the zero bound for an extended period of time - or to “commit to being irresponsible” in the immortal words of Eggerston and Woodford. At this point I find myself asking if it isn’t ALL Princeton monetary economists - including Lars Svennson - Niall doesn’t like rather than his simply Krugman holding in bad rather odour, which I could have understood more as a dislike of his fairly well known political views than as a rejection of a far more technical corpus of economic analyses, which I am sure Niall would have to admit he is insufficiently equipped to really get to grips with.

Personally, I have no idea whatsover as to the properties semi-conductors may exhibit at temperatures below absolute zero, but then I would not join issue with a theoretical physicist who mentioned preposterous sounding processes by starting off saying “well when I heat milk in a saucepan, eventually it boils” Still, if you are foolish enough to stick your neck in the noose, in the noose it will go!.

As Eggertsson points out in the Japan context long-term interest rates depend on expectations about future short-term interest rates and the risk premium, and neither of these depends on the quantity of long-term bonds in circulation or on the monetary base at zero interest rates (my emphasis thoughout), and this is a technical finding - which may ultimately be right or wrong, but I doubt that the opinion over at the Chinese central bank counts as evidence one way or another, nor does it seem reasonable to say that a growth in M2 of 9 per cent a year “seems likely to lead to inflation if not this year, then next” without a much more rigourous technical analysis, since if Niall can be so sure of this, the people over at the Bank of Japan would almost certainly like to know how.

And then, gettinmg horribly wonkish, we have the so called portfolio channel, and how this can undermine government attempts to steer down interest rates at the long end of the yield curve by purchasing longer term bonds (see Bernanke and Reinhart: 2002), since as Eggertsson and Woodford found, making the normal assumptions implicit to a general equilibrium model, purchases of long-term government bonds have no effect on long-term yields if expectations about future interest rates remain constant.

It has been suggested that the irrelevance results outlined above can fail due
to a portfolio channel (see, e.g., Meltzer, 1999; McCallum, 2000; and Coenen and
Wieland, 2003). If the monetary base is expanded by purchasing assets other than
short-term governments bonds, the BoJ may be able to change the prices of those
assets. One example is purchases of long-term government bonds, a policy the BoJ
has in fact adopted. Eggertsson and Woodford (2003), however, cast doubt on the
effectiveness of such a portfolio channel, arguing that in a general equilibrium
model, purchases of long-term government bonds have no effect on long-term
yields if expectations about future interest rates remain constant.

The reason is that the long-term interest rate depends on expectations of future
short-term interest rates and a risk premium. Neither of these, however, depends on the quantity of long-term bonds in circulation or on the monetary base at zero interest rates. Open market operations involving purchases of long-term bonds, but which provide no credible indication about the duration of the quantitative easing policy, are thus unlikely to be effective.

Of course, all of this is highly obscure and technical. Fortunately the debate does have its lighter moments, as for example when Niall cites Krugman as the point of reference for the savings glut idea:

“Did I not grasp that the key to the crisis was “a vast excess of desired
savings over willing investment”? “We have a global savings glut,” explained Mr
Krugman, “which is why there is, in fact, no upward pressure on interest rates.”

In fact, as those of us who have been following the liquidity debate over the last years well know, the global savings glut thesis is famously an idea which was first initially advanced not by Krugman but by none other than Ben Bernanke, and even more to the point the whole issue goes back well before the onset of the present crisis. Or this point:

“It is hardly surprising, then, that the bond market is quailing. For only on Planet Econ-101 (the standard macroeconomics course drummed into every US undergraduate) could such a tidal wave of debt issuance exert “no upward pressure on interest rates”.”

Well I’m sorry Niall, but there is another place where a tidal wave of debt issuance has exerted “no upward pressure on interest rates”, and that place is planet Japan. And

Even A Stopped Clock Is Right Twice a Day

Which takes me over to the rather historical issue of stopped clocks, and what has now been happening to Japan over the last decade and a half. At times even Daily Telegraph economics correspondent Ambrose Evans Pritchard has something interesting to say, since, of course, even stopped clocks are not wrong all the time. The point he makes here is very, very relevant:

“It is striking how many of those most alert to the deflation danger are either veterans of Japan’s Lost Decade or close students of it: Albert Edwards at Société Générale, Russell Jones at RBC Capital, Nobel laureate Paul Krugman, the Fed’s Ben Bernanke, and Athanasios Orphanides, who helped draft the Fed’s study on the Japan trap. “People always thought Japan’s bond yields had to rise, but they kept falling and Japan is still not really out of deflation,” said Mr Edwards. Indeed, 20 years after the Nikkei peaked at over 39,000 it stands today at 9,280. Interest rates are 0.01pc. The yield on two-year state bonds is 0.34pc. Still there is not a whiff of inflation.”

And guess what, Japan gross debt to GDP is about to push its way skywards through the 200% mark in the next year or two, which makes this retort to the FT’s Martin Wolf (who had the temerity to question Niall’s arguments):

Mr Wolf blithely writes: “Historically well-run economies are certainly able to support higher levels of public debt very comfortably.”His favourite macroeconomics textbook may make this claim. But the annals of history provide very few cases of economies with public debts in excess of 100 per cent of gross domestic product that were either well-run or very comfortable.

look frankly quite ridiculous, since while it may well be the case that Japan is neither well run nor a comfortable place to be (no comment, I have no opinion), it is still the world’s second largest economy, so hardly an irrelevant comparison, and the Japanese government has been shoveling JGBs onto the market for years without the much predicted surge in interest rates.

So what exactly are we being offered here, an empirically testable prediction, or just another load of old waffle?

At the end of the day what I think is, if I were a historian and not an economist, then I might like to be just a bit more modest in what I had to say (and even more modest in how I said it), be a bit more prepared to listen, and if at the end of the day if I still found I wanted to differ from the experts I would at least try to understand what exactly it was they were trying to say first. Otherwise, I might find myself worrying that I was being more of a Xenophon than a Thucidydes, since while both were reputedly excellent generals, the latter stuck to what he was good at (writing history) while the former offered us a version of philosophy in his life of Socrates which frankly made the man look more of a port and stilton bufoon than anything else. And it would worry me to think that over two thousand years later people might still be remembering me more for what I was bad at than for anything else.

Appendix

Extract From - Monetary policy with a zero interest rate, Lars E O Svensson, speech at SNS, Stockholm, February 17, 2009

Why not just increase the money supply in order to create expectations of a higher future price level? As long as the interest rate is zero then households and firms, as we have already seen, are indifferent about the choice between money and securities such as Treasury bills or bonds. An increased supply of money will then have no effect other than households and firms holding more money and fewer bills and bonds. However, at some time in the future the economy will return to normal, the interest rate will be positive and households and firms will no longer be indifferent when choosing between money and these securities. Somewhat simplified, we can say that the money supply will once again become approximately proportional to the price level. A larger money supply in the future will lead, all else being equal, to a higher price level in the future. If the central bank could thus credibly commit to a permanent and lasting increase in the money supply, the expected future price level would rise. The problem here is, however, that there is no way for the central bank to make a credible commitment to a larger money supply in the future. There is nothing to prevent the central bank from reneging on such a commitment and reducing the money supply in the future in order to reduce future inflation and keep it in line with the inflation target.

Experience from Japan’s period of “quantitative easing” also shows that the extreme expansion of approximately 70 per cent of the monetary base between March 2001 and March 2006 did not noticeably affect expectations of inflation and the future price level.17 For example, the yen did not depreciate as it should otherwise have done. Firms and households clearly believed that the expansion of the monetary base was temporary and not permanent, which subsequently proved to be true. The monetary base fell back to normal levels when the interest rate was later raised to above zero.

Even if short-term interest rates are zero or close to zero, bond rates at longer maturities may still be positive. If the central bank therefore buys long-term bonds it may perhaps be able to squeeze down the long-term interest rates somewhat, which should stimulate the real economy. The central bank can also promise to keep the policy rate at zero for a prolonged period in
order to create expectations of lower future interest rates and a more expansionary monetary policy in the future.

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