Matt Nolan

It’s about the “right” counterfactual

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In a recent post, Mark Calabria from the Cato Institute took aim at the idea that the Lehman Brothers crisis was the “trigger” for a big crisis.

Now I do not disagree that there was, and would have been, a recession without Lehman Brothers – and even without the uncertainty caused by the lack of clarity around insurance of the shadow banking system which grew post August 2007.  However, these issues, and in turn the failure of Lehman Brothers did make the crisis significantly more severe than it would have been.

He appears to say that the failure of Lehman Brothers was a good thing (Note:  There is nothing wrong with wiping out the company – but the way it was handled, was a big driver of the global slowdown that was to come), and that the US was on the road to recovery post this.  So here we are focusing just on the US, not the contagion to other countries.  His evidence is the following graph:

Employment and consumption stopped declining not long after Lehman Brothers failed, and although the largest declines occurred WHEN Lehman Brothers failed this doesn’t mean the failure caused them – in fact, employment tends to lag the cycle and the drop may well have been the result of prior economic weakness … and the amazingly high fuel prices through the first half of 2008.

Now I agree that there were factors driving a recession prior to the failure of Lehman Brothers – but the impact of Lehman Brothers as an event is captured by asking what would have happened in the absence of the Global Financial Crisis that stemmed from it, and the full blown “bank run” on wholesale financial markets that had been building pressure from the start of 2008.  Going to FRED, grabbing consumption and population, and running a basic time regression in excel no less (so it’s easy to copy) we can get an idea of what the “trend” rate of consumption per capita was during the 1952-2012 period.  Armed with that, we can ask what the percentage difference is between this trend and actual consumption per capita outcomes.  This is:

Something is broken here – I will try to fix that up tonight.  The strange thing is that I can see the graph when editing the post … but it then wont let me do anything with it

Now we can start arguing that consumption per person was too high and a whole bunch of other things if we want to here.  However, this basic analysis clearly shows that the gap between trend consumption and actual consumption, something that should have a tendancy to head back to zero after a recession, actually deterioarted further … and has continued to deteroriate.  We look at business cycles “around trends” not “around levels” given that our counterfactual involves growth – and this makes this post by the Cato institute a bit misleading.

Saying that the downturn, or even the crisis, started with Lehman Brothers is wrong, I agree with the author here – however Lehman Brothers failure started a new dangerous stage of the crisis which, when combined with the persistent institutional failure in Europe, has made sure that the US economy has remained below potential.  A market monetarist would say that the Fed is truly responsible for this in terms of policy action, but even if we were to accept this it is undeniable that it is the “shocks” that have occurred in financial markets are the very things the Fed needs to respond to by “loosening policy”.

It’s failure is indicative of what was underlying the crisis, and the evidence shown in no way suggests that allowing its failure and initially ignoring the quiet, and then full scale, bank runs in wholesale financial markets was good policy.

Matt Nolan

QE3: Forward guidance, debt purchases, unemployment target

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As expected, the US Federal Reserve announced QE3 early this morning NZ time.

In the statement, they commit the the purchase of mortgage debt people expected (carrying on for an undefined period of time), they state they will keep the cash rate exceptionally low until at least mid-2015 (which was anticipated) – but they also say they will do more unless they get traction on the labour market.

This is reasonably significant.  They are fully testing their view that there is no structural problem in the labour market (which is empirically supported) and are banking on the idea that easier monetary conditions, combined with a credible commitment on the labour market will lead to households and firms finally bringing forward consumption and investment.

This makes more sense than prior policy.  The constant forecasting of “failure” in monetary policy in the US led to policy that can be seen as insufficient – the Fed was treating the risks of inflation (and thereby the outlook for the domestic economy) asymmetrically – obviously Woodford’s speech had an impact (although the projections still have a pretty slow improvement in the unemployment rate – would need to see employment rate forecast to really get a feeling for what they mean).

It may also be seen as reinforcing the view of market monetarists (eg Sumner) that the Fed’s expectations have a significant impact on expectations of real economic and labour market activity within the cycle (at least in response to large shocks – possibility of multiple equilibrium.  Note:  They wouldn’t see it the same way.).  This is a view I would like to see in more detail (eg what sort of expectations does this rely on, and what sort of conception of the real rate – are they are artifact of current monetary policy settings).

Although this is encouraging – when looking over here in NZ it is the European debt crisis that is impeding growth.  Yes, a stronger US economy will support growth in Asia and NZ helping remove large scale risks – but the European debt crisis continues to have a separate impact on NZ that is binding.

Update:  Having a read around on the piles of good sites discussing the issue, I ran into this post via Money Illusion.  Now, doesn’t this scream multiple equilibrium to you?  To criticise the Fed for rates being low and indicating a weak recovery, we need to blame the Fed for the drop in the natural interest rate – this has to imply that the Fed either created uncertainty, or is so far away from their mandate we’ve fallen into a “suboptimal” eqm.  You cannot blame the Fed for exogenous shocks (which you’d normally pin this on), so there MUST be an implicit multiple eqm argument behind NGDP level targeting – I find it conceivable, although potentially hard to test empirically … can someone send it to me please 🙂

Update II:  Good point from Scott Sumner:

In addition, they did move closer to level targeting, something I didn’t think was politically possible:

(Fed statement) To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.

What’s changed since June?  That’s pretty easy to answer; Woodford’s paper was obviously very influential, and that changed the politics on level targeting.

This is still consistent with flexible inflation targeting at the ZLB.  Of course, NGDP level targeting and inflation targeting share a lot of similarities – and to be fair, NGDP level targeting would be more transparent when faced with the ZLB problem.  In net terms I’m still a flexible inflation targeter – as the benefits of a predictable price level ex-ante from a point in time seem significant, and best served by doing that directly (through inflation targeting).  Of course, if the facts at my disposal change I’m happy to move around 🙂

Matt Nolan

“Sluggish” credit growth, where does NZ fit in?

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Via Tyler Cowen on Twitter was this article, combined with the comment “credit growth sluggish”.  The view here is that the 4% growth in private sector credit is too weak when compared with historic averages – and that the goal of the Fed should be to focus on the “quantity of credit” here, rather than target the price.

Now in New Zealand we have similar data here.  According to this, private sector credit growth was 2.3% year-on-year (or 3.2% if we exclude repurchase agreements – which is preferable IMO).  This compares to a decade-long average of 7.3%pa (8.3%pa), and if we were solely quantity focused this would seem insufficient.  [Note:  I did decade instead of history, as the implicit inflation target moved significantly over the decades – a factor that pushes this figure around.  Would be best to look at “real growth” for a longer-term focus]

I’m not concluding anything from this per se – it is just interesting that NZ analysts are running around getting concerned about inflation and rising credit growth, while analysts in the US, who are observing stronger credit growth than we are, are generally complaining that more needs to be done.  Tbf, their unemployment rate is a lot higher, and their output gap is correspondingly larger (presumably).

But with underlying inflation in the lower end of the RBNZ’s target, credit growth numbers objectively soft, and the unemployment rate undeniably elevated I feel that the inflation calls may be a touch overplayed.  [Note:  A relative price lift in construction due to a rebuild in Canterbury is not inflation – it is a signal of scarcity, as prices are supposed to be].

The Hand

Is Getting an Advanced Degree a Good Idea in this Economy?

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This is a guest post by Kate Manning, an independent writer.  Her bio is at the end of the piece.

As a note, this post is focused exclusively on the situation in the United States – the trends in other countries (such as New Zealand) have been significantly different.

Read more

Matt Nolan

Thinking about the US output gap

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Via Marginal Revolution I noticed the argument that a drop in lifetime wealth may have reduced potential output, thereby implying that there is a smaller output gap (permanent loss in productive capacity).

Now, I share Scott Sumners concern about this view. It is true that a negative permanent wealth shock will in turn lead to lower consumption – but in of itself this does not imply that it leads to lower output, which is what GDP and potential GDP are measures of.

Tyler Cowen put up the best defence of it when he stated “Simplest response to Sumner and Yglesias is that we may have had a biased estimate of the previous trend, for bubble and TGS-related reasons.” [note, he improved the defence further in response to Krugman here], but I think we need to go a step further and ask “how could we have been past some long term potential output before”?  In truth we need an explanation that works for why potential rose and why it fell that uses the idea of wealth.

In order to understand why potential may have risen then fallen we need to ask what factors were influencing the expectations of individuals so that they supplied too much labour/invested in too much capital.  We can’t just say “they consumed more” because without the ability to produce we consume more by borrowing and importing – which leads to the increase in consumption and imports canceling out in GDP.  We need a reason why production, output, GDP, was higher.

For this we need to rely on expectations.  Start with the drop.  Suddenly wealth is lower – wealth is the stream of returns on an asset, in the aggregate sense it is the discounted sum of expected income/output that is expected in the economy.  A drop in wealth here suggests that peoples expectations of future potential output have fallen – for better or worse.  As a result, your expected return on investing is lower – whether that be in skills for work, or whether it be capital in your job.

On the other side, suddenly wealth expectations are higher.  Income now has a greater expected rate of return in the future, you are more willing to invest now.

There is a case to be made that, if the rate of return is higher now, you will be willing to invest in order to reap the benefit.  Furthermore, you would be willing to supply more labour in order to achieve the capital gain (a return) associated with those “higher house prices” in the future.

If your wealth expectations suddenly fall, you are not willing to invest as much in the future, as the expected real rate of return is lower.  You are not willing to work as much given that the return on savings will be lower.  As a result, “potential output” would have declined.

Note:  You could in turn read these the other way around, it depends on the magnitude of “income” and “substitution” effects from the change in the expected real rate of return in the economy.

Note 2:  This is an entirely supply based argument, as it is about potential output.  Potential output is the “supply” notion of the economy, while many of the other cyclical issues we discuss are “demand” based.

Sidenote

These shocks exist for any view of “potential output”.  And this doesn’t mean potential isn’t a useless concept – it just means that maybe there is a more solid variable we can use to tell us the same thing without the confusion.

Conveniently we measure the UNEMPLOYMENT RATE, and we have a relatively clear and fixed idea of what the natural rate of unemployment is.  As a result, the gap between these two is a lot more useful to look at when trying to ascertain whether we are below or above potential IMHO.

Update:  Scott Sumner discusses why this doesn’t make sense for the US.  However, I think it is a partially workable argument for NZ given the inflationary pressures we were experiencing, the high participation rate, and the amazingly low unemployment rate all prior to the crisis.

Matt Nolan

A note on redistribution

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There is a point to keep in mind following the state of the union address in the USA.

We may believe that more redistribution is required to meet/maintain our social contract.  That is fine.  We may believe that more redistribution is “morally right”.  That is fine.

But lifting taxes in of itself isn’t redistribution.  The higher revenue from taxes must then be passed on to the poor – providing it directly as a transfer is the most obvious way.

Having the government lift taxes, and then arbitrarily use it for “industrial policy” or some other pet project is not redistribution – it is a large institution taking advantage of its position to waste other peoples resources for its own sense of pleasure.

If society wants redistribution it should get it, but this implies higher benefit payments (or policies that increase equality of opportunity directly) not just higher taxes.  It involves actually redistributing income, not taking it and pissing it in the wind.