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Wonkblog’s Matt O’Brien had a great reminder last week that Eurozone policymakers’ obsession with low inflation is fueling a monetary policy that is extremely damaging to the broader European economy and the lives of millions of Europeans. A recent paper, though, suggests the problem may be even worse then we thought.
Jessie Handburt, Tsutomu Watanabe, and David E. Weinstein recently published a paper that purports to have assembled “the largest price and quantity dataset ever employed in economics” to assess how well the official Japanese CPI is measuring inflation. The answer is ‘not so good’ – but the reason for that answer is scary. To wit:
We show that when the Japanese CPI measures inflation as low (below 2.4 percent in our baseline estimates) there is little relation between measured inflation and actual inflation. Outside of this range, measured inflation understates actual inflation changes. In other words, one can infer inflation changes from CPI changes when the CPI is high, but not when the CPI close to zero.
What does that mean? They draw two clear conclusions. Firstly, that national CPIs routinely overstate inflation – here is their (better) measure stacked against the official measure:
Since 1993, the official Japanese statistics show a net decline in prices of just a few percent, whereas the authors’ numbers show a decline close to 15%.
The other conclusion is that, even though over the long term the CPI overstates inflation, when inflation is low, the CPI is basically no better than a random guess as regards any particular measurement.
This means that while, on average, the CPI inflation rate is biased upwards by 0.6 percentage points per year, one can only say with 95 percent confidence that this bias lies between -1.5 and 2.8 percentage points. In other words, if the official inflation rate is one percent per year and aggregate CPI errors are the same as those for grocery items, one can only infer that the true is inflation rate is between -1.5 and 2.8 percentage points. Thus, a one percent measured inflation rate would not be sufficient information for a central bank to know if the economy is in inflation or deflation.
In case it wasn’t clear enough, Europe is definitely in the ‘flying blind’ zone:
As is more and more of the developed world in general:
This is, errr, kind of terrifying. Because what it all adds up to is the conclusion that monetary policy makers are throttling growth because they’re relying on data that is both inaccurate and imprecise. The inflation fears that have crippled Western recoveries for half-a-decade and running are based purely on phantoms.
Ryan Avent had a fantastic post Tuesday dismantling the rationale of the Fed, and specifically Jeremy Stein, for basically casting macroeconomic improvement to the wind for the sake of ill-defined financial stability. If you read Ryan’s post you’ll see precisely why this is backwards and, indeed, as likely as not to backfire.
The relatively meager contribution I’d like to make to the discussion is simply this – if the Fed truly believes that financial instability, despite being wholly absent from their legal mandate, is sufficiently important to trade off other desirable outcomes to pursue, then they should pick a target. One of the better decisions the Fed has made in recent years is more openly and rigorously defining targets – specifically, clearly defining the thresholds in widely-available and transparent measures of unemployment and inflation that may lead the Fed, once crossed, to raise interest rates, and disclaiming any potential rate raises before then. If the Fed wants us to take their approach to financial stability seriously, they should pick a variable or index and a threshold value and announce it. Absent doing so, we’ll all have to wonder whether less rigorous impulses undergird the Fed’s eagerness to find new reasons to raise interest rates even as unemployment is high and inflation low.
Let’s model a kingdom. In this model, the kingdom is a closed economy, and (very importantly) it is “well-normed” – it has strong norms relating to governance and society that tend to be widely honored and respected.
This kingdom is governed by two individuals: the king, and the wizard. Most formal power, as well as the titles of head of state and head of government, is vested with the king. The king has formally unlimited powers to tax and spend, raise armies, and adjudicate disputes, but in practice is limited by norms, sense of duty (symbolized in a sworn oath to serve in the interest of the whole kingdom and its subjects), and the patience of subjects; therefore, the king tends to maintain inherited intuitions to which their power has been delegated, like courts and military bureaucracy. The crown is hereditary – the first-born child of the king (this is a gender-progressive kingdom) inherits the crown, and in the past, though there have been occasional hiccups, most transfers of power have been peaceful and orderly.
The king must retain a wizard, who is charged in vague terms with independently securing the safety, security, and prosperity of the kingdom. The wizard bears a hat that grants them vast yet mysterious magical powers. Unlike the crown, which is symbolic, the wizard’s hat is in fact where the magical powers are vested, and is not hereditary. When the existing wizard dies, the king selects the next wizard, who receives a lifetime appointment. Extremely strong norms dictate that the king select whomever is widely acclaimed the wisest scholar in the kingdom, regardless of their personal feelings towards that individual or inclination to select an ally as wizard. Often the wizard will survive the king.
As stated above, the wizard has vast powers, but they are mysterious and to some extent ill-defined. There is no user manual for the wizard’s hat, and often throughout history wizards have surprised themselves with the consequences of exercising their powers. Therefore, norms have developed that the wizards exhibit strong restraint in exercising their powers, even in times of emergency. Extremely strong norms have also developed against the king making formal or open requests of the wizard, as well as against the wizard interfering in the quotidian or terrestrial business of the king. In the past, there have been some violations of this norm in both direction, but for the most part it tends to persist. Consequentially, the wizard tends to be reclusive, speak carefully and opaquely, and avoid commitments to use their powers. There is much dispute among the subjects of the kingdom to exactly what the wizard is doing or could be doing, and when the wizard ought to exercise their powers.
Your assignment: model the governance and economy of this kingdom.
Obviously this is kind of an allegory. And I’m going to just blow it wide open by saying the king is the fiscal authority and the wizard is the monetary authority. And while it doesn’t quite match up with how the modern world works, I think it has some implications.
Now there is great sturm und drang in the econoblogobloid about whether Keynesianism or Monetarism is “right” and what “monetary offset” is and I just don’t get it at all because to me it all makes perfect sense together.
My theory is this – monetary policy dominates fiscal policy, but doesn’t always, or even usually, exercise that dominance to determine point outcomes. Instead, it usually determines range outcomes, and within those ranges fiscal policy exerts influence.
So for example if the monetary authority declares “the rule is that inflation will never exceed 2%” that means a whole range of outcomes are possible; just not those where inflation exceeds 2%. So fiscal policy can, by being expansionary or contractionary, have a substantial influence on inflation, unemployment, and GDP, just within the range of outcomes that are possible with below-2% inflation.
If the monetary authority declares “we will print $100 billion and buy bonds with it every month until unemployment hits 3%” that means a whole range of outcomes are possible, but all those outcomes must account for an additional $100 billion of “high-powered money” in the economy every month. So fiscal policy can, by being expansionary or contractionary, have a substantial influence on inflation, unemployment, and GDP, just within the range of outcomes that are possible with regular large monetary infusions.
If the monetary authority declares “we are targeting the path of NGDP and we will never let it deviate ever ever no matter what ever” that means a whole range of outcomes are possible; just not those where NGDP deviates from its price path. So fiscal policy can, by being expansionary or contractionary, have a substantial influence on inflation, unemployment, and real GDP, just within the range of outcomes that are possible with rock-solid 5% NGDP growth.
If the monetary authority declares a whole bunch of stuff, some of which is concrete, some of which is fuzzy, and some of which is muddled, well…many outcomes become possible. But many are not!
So the story of 2013 is not one where monetarism was right because the Fed got exactly what it wanted; it’s one where fiscal contraction couldn’t generate outcomes outside the bounds set by the Fed. But it does mean that outcomes could have been better had fiscal policy been less contractionary. Counterfactuals are hard, but that’s a reasonable one.
Now, I’m a believer in the power of monetary policy, so I think it would be great if the Fed set an NGDP target and committed to not only a growth target but a path target and that they were going to overcompensate to get us back to the pre-recessionary path. I even think an optimal NGDP target is something more like 7%, not Scott Sumner’s girly-man 5%. But what I don’t believe is that absent such direct, confident, dominating policy guidance from the Fed, that Fed policy still generates pinpoint outcomes or even tight ranges of outcomes. The economy improved in 2013. It could, and should, have improved more, and that’s on both the Fed and the Congress.
Now, as much as I really, really don’t like Arnold Kling, there are also some PSST dynamics out there that constrain the power of monetary policy, which is why the auto bailout was a really good idea, but barring massive systems collapse I think monetary policy can do pretty much all the heavy lifting of macroeconomic policy but that conditional on monetary policy fiscal policy can have some room for maneuver.
Note that this is pretty much 100% what both monetarists and Keynesians think when we’re not at the ZLB; all I’m saying is that it is also true at the ZLB, and that monetary policy really doesn’t change that much. We just think it does. Which is part of the problem, because money illusion is a real and serious thing, which goes back to why our NGDP target should be higher. In general countries that are better at avoiding recessions have a somewhat higher tolerance for inflation than we do.
Matt Yglesias wrote a fun post on how massive conservative spending on elections may be causing conservative strategist inflation. What I think this post highlights implicitly is where the broader class of inflationistas goes wrong.
Let’s imagine that the Koch brothers wizarded the $400 million they spent on elections out of thin air. That created part of the conditions for inflation.
But there is a second, much more important condition for inflation – supply side constraints. The fact is that there are only so many elective offices, so many candidates, so many strategists and video produces and email spam writers. When you plow more and more money into a supply-constrained market you get rising prices without a corresponding increase in quality or quantity. That’s inflation.
For inflation to happen on an economy-wide scale you need not only for the monetary authority to create lots of money, you also need that money to exceed any corresponding increase in total output. So to believe that the Fed is about to hyperinflationatize us all into the Dark Ages you’d have to believe that there aren’t any more resources to mobilize with all that money, which is bonkers because lots of people don’t have jobs. Here is a cool map showing unemployment rates in lots of countries. They’re high. Is there nothing productive they could be doing?
Maybe not! Maybe you think that supply and production in energy markets can’t support more employment and that’s what makes now like the 70s. I disagree! But you have to make that case too, not just that “ZOMG FED PRINTING SO MUCH DOLLARS RUN FOR THE GOLDEN BUNKERS.”
the ultimate goldbug
So I’m a little late to this whole Game of Thrones thing, but I’m making up for it, having watched every episode in the last month as well as reading A Game of Thrones and making my way through A Clash Of Kings (my goal is to catch up with the show by the end of the season and read all the books by summer’s end). And since Matt Yglesias has been econ–blogging from GoT I figured I might as well get on that wagon while it’s still bandy. Also, it involves ragging on the "hyperinflation in America is imminnent!" set and while that’s like shooting fish in a barrel, sometimes shooting fish in a barrel is fun!*
Something that always puzzled me re: predictions of looming hyperinflation is where the predictors think the supply constraint is. Even if you accept certain assumptions about "money printing" that I would quibble with, it’s not an increase in the money supply that leads to inflation per se it’s growth in the money supply that oustripts growth in real goods and services. Assuming "velocity" is constant (whatever that means) to assume that mo money = mo debasement means you have to assume that level of goods and services is constant. If you magic a $20 bill out of nothing and hand it to me I might decide to give it to an unemployed person or stuff it in my mattress or buy something with an extremely elastic supply schedule like a nice haircut. But I might also buy gasoline! To assume that "all this new money" will lead to hyperinflation you have to believe that the economy is producing as much as it can produce or that there is some real constraint on the economy.
Here’s a great example – in A Clash of Kings, when Tyrion Lannister is scoping out King’s Landing (which has seen an enormous influx of refugees since war erupted) he makes this observation:
"The markets were crowded with ragged men selling their household goods for any price they could get…and conspicuously empty of farmers selling food. What little produce he did see was three times as costly as it had been a year ago."
This, of course, implies annualized inflation in King’s Landing of 200%. That’s hyperinflation! But the reason for it is not an influx of money (say, the Lannisters minting more gold to pay off the Iron Throne’s sovereign debt) but severe supply shortages – the war is both reducing the productive capacity and capital wealth of the Seven Kingdoms as well as massively disrupting transportation networks. This is firstly a nice example of the principles behinf Paul Krugman’s work on economic geography but secondly goes to show that hyperinflation a) doesn’t necessarily require an increase in the money supply just as an increase in the money supply doesn’t necessarily engender inflation and b) that hyperinflation is usually a symptom of underlying dysfunction and catastrophe. Certainly there are supply contraints in the modern American economy but given that commodity prices are falling and lots of people aren’t working while putting everyone back to work through monetary expansion would cause some inflation it wouldn’t evaporate all dollar-denominated wealth and it certainly wouldn’t do that while there are vast amounts of underutilized resources in the economy.
*Actually, as of late I’ve been more in to shooting fish in mid-air with a bazooka.
As you might have noticed, in my initial minimum wage-related salvo against Don Boudreaux, I used a somewhat unusual graph:
Needless to say, it did not come from nowhere. In fact, it came from a lot of thinking and a decent amount of work, partially inspired by, curiously enough, Don Bourdreaux’s “Catalog” project, as well as by Scott Sumner’s work in general as well as his frustration with conceptual understandings of inflation. Rather than beat around the bush any more, though, I’m going to tell you what I’ve created, then explain it and defend it, then provide examples:
I have created a new econometric index. It consists of dividing the nominal price or value of something across time by nominal GDP per capita and representing it as a percentage. This divides out the currency unit, and so is an index measure of quantity, not price. I am calling the index, as well as the index unit, the “Percappy” (plural “percappies”).
Now – why?
It is theoretically and empirically sound. The Percappy tells us what share NGDP-per-capita could obtain a single unit of a given thing at a given time. It requires only three measurements – GDP, population, and the nominal price/value at a given moment in time – none of which need to be additionally weighed, balanced, or adjusted in any way. It does not need to be controlled for inflation over time, since inflation would affect equally both numerator and denominator. It does not need to be controlled for PPP or exchange rates across national borders as long as correct local prices are used.
It tells us something new and useful. The Percappy tells us, essentially, what share of per-capita national income it would take to acquire a single unit of some good, service, or financial product. This allows us to easily compare living standards (again, controlled perfectly for inflation) across time as well as across national borders, even diagonally (for example, you could compare other countries’ present consumption frontiers to the United States’ current consumption frontier).
It is analytically powerful. With a minimum of computation and weighting, using only easily-accessible publicly-available data, many different things can be compared – the prices of goods, services, commodities, financial products, and even more (as we shall soon see) can be compared while controlling for any number of factors that tend to complicate such comparative analyses.
It is simple to understand. Unlike inflation, which is conceptually challenging and whose definition is not universally agreed on, both the idea and the process behind the Percappy is very simple and easily understood – it answers the question
“how much more or less of some thing can be bought in different times and places?” by dividing prices by per-capita national income.
What it doesn’t tell us (and other limitations). It tells us very little about inflation or exchange rate fluctuations unless a large amount of data is computed and compared. The Percappy index is powerful because it easily divides away these factors to look at “objective” standards of living; but the trade-off is that it can tell us very little about the monetary, financial, fiscal, and other policy-related factors that may drive those changes. It also tells us nothing about quality. Also, historical prices can be hard to come by.
Let’s look at some examples. Firstly, a simple one – the price of a McDonald’s hamburger over time (note: log scale; all prices are per-unit and all measurements in %; the formula is 100P/[GDP/POP])
Unsurprisingly, we are richer in terms of McDonald’s burgers than we used to be. What about some other delicious items?
Interestingly, while Oreos and Hershey’s Bars seem to both be trending downwards (albeit not as sharply as McDonald’s burgers) Cornflakes seem to have bottomed out in the early-to-mid ’90s and have since climbed back to 1960s levels.
What about some other consumer prices people care about?
FRED has only been keeping track since 1990, but clearly we’re not doing well on that score.
But the true power of this is to tabulate more than just common consumer prices. What about the value of the S&P 500?
What about the average dividend of the S&P 500?
And, to be fair to the goldbugs, what about gold?
Hopefully even these examples, as simple and unprocessed (and, thanks to Google Spreadsheets, amateurishly presented) as they are, show some of the power of this index. Essentially, it can “crunch” almost anything, including (at least in theory), other indices (I’m thinking about feeding it the Case-Shiller index).
I am hoping other people think this project has some value – if you do, you can help! Here’s how (bleg time):
1) Data! Find historical prices is harder than you might think! If you can send me time-series price data of just about anything I would be quite grateful – or, you can do it yourself! It’s pretty easy. This could be easily crowdsourced.
2) Mathematica. I got this software and I love it, but haven’t quite figured it out yet. Especially the “get large volumes of data into it so you can crunch with with panace” part. Any Mathematica aficionados out there want to send me tips?
Here’s hoping people find this useful, helpful, interesting, worth picking up on or helping out with, or some combination thereof.
A simple problem – let’s say the central bank has a 2% inflation ceiling. Ergo, if it records inflation expectations as over 2%, it will take action to lower those expectations, usually raising interest rates as a way of draining the money supply, which also has the effect of decreasing total economic activity. Additionally, everyone knows this, so when some activities or events occur that would ceteris paribus increase inflation expectations markets presume the central bank will act to quash inflation and therefore adjust their overall expectations of economic activity. This will probably manifest itself as a reluctance to invest.
Let’s say unemployment is 10%, inflation is 1%, and real GDP growth is 1%. Let’s further say that the central bank is willing to tolerate an unlimited amount of RGDP growth but refuses to budget on its inflation ceiling. Let’s further say that any activation of idle labor will necessitate some inflation due to short-to-medium-run supply inelasticities. And let’s say everyone knows all of this.
Let’s say some large positive exogenous shock causes a boom in labor demand in some sector or another. This model would predict a largely zero-sum net gain in employment or economic growth, as the increase in activity in that sector will be offset by a decline elsewhere. The only net increase would be that commensurate with accommodating short-to-medium run supply inelasticities – that is, there can be some net gain every period, but only enough that it doesn’t push up prices very much.
Consequently, the Committee anticipates that the unemployment rate will decline only slowly toward levels that it judges to be consistent with its dual mandate.
did ya miss me?
Thinking about the Wolfson Prize whilst walking about DC this evening, a notion struck me:
There are three futures for Europe. The first is total federation and integration. This seems, at the moment, unlikely. The second is constant crisis and panic with long periods of recession and tepid growth in-between, similar to the United States between the Civil War and the Great Depression. That choice is woefully undesirable. Barring either of those, it seems as thought the Eurozone may have to be, if not unwound, reduced in scope.
But how do you leave the Eurozone? Specifically in the current crisis, forgetting the logistical nightmare of endless private contracts denominated in euros, the sovereign debt is also denominated in euros; to leave the euro and refuse to pay back creditors in euro is default, the outcome everyone is trying so hard to avoid. So how can you leave the euro?
Well, I had one idea. Let’s say this – Greece leaves the Euro and re-institutes the drachma as the national currency at an initial 1:1 exchange rate. Obviously this rate will not last, and the drachma will plummet in value, leaving Greece poorer in the sane, proper way that independent nations do so – monetary devaluation. Yet Greece now has to pay its debts. How can they do this?
What if the European Central Bank offered Greece a special privilege – the Greek treasury can, up to a certain limit, exchange drachmas for euros at a 1:1 rate with the ECB. Greece can then turn around and use those euros to pay its pre-drachma debts.
Now clearly, the ECB will be taking a loss here. However, it won’t be a bailout – as far as Greece is concerned they are paying their debts fair and square with tax revenues. So there is no (or at least much less) moral hazard. Also, this avoids the dread specter of inflation that has so gripped the ECB. So even though they take a loss, it’s an outcome where a) Greece still pays 100%, b) the creditors are paid back in full in Euros, and c) there is no default, bailout, or inflation.
This still leaves the question of private debts; I’m not sure a program like this could work for every contract denominated in euros between a Greek and a non-Greek party. You wouldn’t want to allow anyone other than the Greek treasury to exchange drachmas for euros at a fixed, favorable rate, since you’d have a mad dash to dump the drachma in anticipation of devaluation. But if you could at least solve the sovereign debt problem perhaps the magic of the market could work out private debts on a case-by-case directly negotiated basis.
Anyway, just an evening thought on the issue d’jour.
In what I guess could become a series about mental errors, reading Lords of Finance has reminded me of another common mental error people make: failing to realize they’re betting. Essentially, baked into every action and decision humans make is a probability assessment of future conditions. Some of these are screamingly obvious, of course; ie, “gravity, ergo, don’t drive off a cliff” or “that’s a rocket – rockets explode!”
But sometimes in our more complex decisions we forget this, which leads to decisions like “hyperinflation of the dollar is imminent, ergo buy gold” when really the analysis should be “if monetary collapse in the United States is imminent, buy bottled water and ammunition.”
The decision from Lords of Finance that really sticks out for me is the Treaty of Versailles, which essentially set out pretty baldly with the aim of vengeance, but made a crucial error to extract part of that vengeance through contentious reparations. When you buy a nation’s bonds you are betting on that nation’s success, but the Allies acquired such vast quantities of German debt it would clearly destabilize and cripple the German economy (not to mention the provisions of territorial loss and other provisions designed towards the aim of collective punishment). From a financial standpoint the Allies made a huge bet on German bonds and immediately went about ensuring those bonds would default. Clearly they didn’t think about the fact that they were essentially rigging the house against them since they allowed their thinking to be clouded by the resentments of the war but that’s what they did.