The ECB is steering the economy (plus a survey of nautical metaphors), by Scott Sumner

Here’s Paul Krugman suggesting that the ECB has been in a liquidity trap for years:

And yes, Europe is very much in a trap. Inflation is falling because the economy is weak, and the economy is being weakened in part by falling inflation. That’s the Japan syndrome. It leads eventually to actual deflation, but to the extent that there’s a red line (or more accurately, an event horizon), it’s crossed when monetary policy starts being limited by the zero lower bound, which happened years ago.

On one level this makes no sense, as the ECB has been almost continually raising and lowering interest rates ever since it began in 1999. Indeed the ECB has cut rates many times in the past few years, and raised them several times in 2011.

I’d guess that Krugman is thinking of something else, the fact that risk free market interest rates in the eurozone are quite low, and hence the ECB might not be able to conduct a highly expansionary monetary policy even if it wanted to. I don’t agree, but that’s a defensible argument.

But that argument does not mean that fiscal austerity in the eurozone has reduced output. The reason is very subtle, so I’ll start with a nautical metaphor. Let’s assume a ship is going west, and something goes wrong with the steering wheel. It cannot be turned in a counterclockwise direction, and hence the captain cannot turn toward the southwest. But the wheel can move clockwise, and hence the captain can turn toward the northwest. Now assume that in 2011 the captain turns the wheel toward the northwest, and then occasionally nudges the boat this way or that. In that case the inability of the wheel to move in the counterclockwise fashion would not restrict the captain from going in the direction he chose, and hence would not be constraining the ships direction. Any wind that buffeted the ship would not throw it off course, as the captain would simply adjust the steering.

The ECB starting raising rates in 2011, from 1.0% to 1.5%. Those rates are still quite low, and it’s possible that a rate cut to zero in 2011 would not have helped all that much. But that doesn’t matter. The ECB was steering the ship, and hence the new Keynesian model applies. The fiscal multiplier was zero, as the ECB would have simply offset the impact of more fiscal stimulus with tighter monetary policy. It’s revealed preference 101.

[Technically my metaphor requires a weird steering wheel that determines absolute direction, not direction relative to current course. But you get the idea.]

Nautical metaphors are an excellent way to learn monetary economics. Here are 7 more:

1. The Fed should steer the nominal economy between the Scylla of high inflation and the Charybdis of high unemployment (or better yet between 4% and 6% NGDP growth.)

2. Because of policy lags, many people believe steering the economy is like piloting a huge tanker. It responds slowly to a shift in the rudder. In fact, policy lags are much shorter than many people assume.

3. Monetary offset prevents fiscal stimulus from having an expansionary effect. If I am steering a ship and my daughter starts to push on the steering wheel, I push back with equal force. This keeps the boat on that path that I choose. My daughter (fiscal policy) doesn’t get to choose the path for NGDP.

4. Fiscal and monetary policy are not equivalent ways of impacting nominal spending. Fiscal stimulus is costly, analogous to revving up an engine with more costly fuel being added (future distortionary tax increases.) Monetary policy is costless. Therefore it makes more sense to think of monetary policy as a setting of the steering wheel. It doesn’t cost more to set the steering wheel at one setting compared to another. It’s not "more" it’s "different." Setting a NGDP target at 5% doesn’t require any more costly fuel than 4%, for two reasons. You probably would not have to do any more open market purchases, as a higher NGDP target raises base velocity. And even if you did OMPs are essentially costless.

5. Nick Rose likes to point out that if you want higher nominal interest rates and higher NGDP growth, you have to cut interest rates in the short run. This would be like a ship with a steering wheel that had to be turned right to move the ship left.

6. The central bank should target the forecast, but very few actually do so. They should set policy so that expected NGDP growth equals target NGDP growth. Failing to do so is equivalent to a captain setting the steering wheel at a position where he expects to end up in Boston, even though the ship’s destination is New York. So adjust the steering Captain Ben! You should expect to arrive at the place that you wish to arrive. BTW, an NGDP futures compass might help the captain.

7. The liquidity trap is a tough one. Interest rate targeting could be compared to a steering mechanism that works fine except when you need it most; it locks up in rough weather. Alternative mechanisms include QE, which would be like side jets that help steer the ship, or forward guidance. Forward guidance would be like shooting a long cable to the spot you want to arrive at, and then using a winch to reel in the ship.

OK, the last one is a bit far fetched. But hey, I grew up in Wisconsin and never saw salt water until I was 20 years old (at 3am while driving in Tampico, Mexico.) So I’m a bit rusty with some of the nautical terms.

Bonus analogies: ECB = Costa Concordia.

Pre-Abe BOJ = Sargasso Sea.


via EconLog

A Rorschach Test to Distinguish Keynesians from Non-Keynesians

(Don Boudreaux) Which of the following individuals – Smith or Jones – does more to raise the living standards of millions of middle-class people? Smith, using only his own funds and funds voluntarily invested in his enterprise, invents a vaccine that inoculates people successfully against cancer, pneumonia, broken bones, acne, heartburn, and erectile dysfunction.  This vaccine, taken […]

via Cafe Hayek – Article Feed

Don’t follow the money, by Scott Sumner

I’d first like to thank David for his very kind introduction.  It’s an honor to be invited to do a stint as a guest blogger at one of my favorite blogs.  I do plan to keep my other blog ( going, but at a reduced rate.  I won’t be able to answer all the comments at both blogs, but will answer some.  

I always get a bit annoyed when I hear people talk about investors putting money "into" markets. I suppose that at an individual level this might make some sense. You could take some of your money and purchase stocks. But is the money actually going "into" the stock market? If so, where does the stock market keep all the money that people invest?  In a box? Or does money simply go through markets, as the person selling me the stock is presumably taking an equal amount of money out of the market?
On October 19, 1987, a record number of shares of stock were purchased on Wall Street. Does this mean that investors put a lot of money "into" the market that day? If so, why did stock prices fall by 22%?
Some might argue that the phrase "putting money into a market" is a harmless metaphor for describing rising asset prices. But why not just say "rising asset prices"?  And I’m not at all sure that it is harmless. I also see people discuss monetary policy from the perspective of where the money goes, not just the supply and demand for money itself. And yet if existing money doesn’t actually go into markets, then newly created money doesn’t either.
Of course central banks generally inject new money by purchasing assets. So the effect of monetary policy might depend in some important way on the choice of assets being purchased. After all, doesn’t the law of supply and demand predict that an increased demand for an asset will raise its price?
At a recent conference Larry White mentioned that Milton Friedman had argued that the gold standard was wasteful, as it led to a higher real price of gold and thus socially unproductive gold mining activity. Larry pointed out that real gold prices actually rose after the government stopped buying gold at $35 an ounce. Friedman had forgotten that switching to a fiat money system might lead to higher inflation, which would encourage more private demand for gold (as an inflation hedge.)
The same process may occur when the Fed purchases Treasury securities. During the 1950s the Fed purchased relatively few Treasuries. Then during the 60s and 70s there was a dramatic increase in the rate at which the Fed bought Treasury securities. So what happened when the Fed put all this money "into" the Treasury market? Surprisingly, T-bond prices plummeted between the 1960s and early 80s. This occurred because monetary policy doesn’t just affect the Treasury market, it also affects the "money market". And by ‘money’ I mean the monetary base, the type of money directly produced by the Fed. The base began increasing rapidly in the 1960s and 70s, boosting inflation and nominal GDP (NGDP) growth, which pushed nominal interest rates sharply higher. So talk of the Fed putting money "into" markets is not a harmless metaphor for rising asset prices, it can lead to very serious errors. People think that monetary injections boost NGDP because they raise bond prices, whereas they actually boost NGDP even more on those occasions where the policy reduces bond prices.
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When interest rates are close to zero, Fed purchases of Treasury securities are a drop in the bucket. There’s very little direct impact on Treasury prices. However Fed policy has an enormous impact on NGDP growth, which then impacts T-bond prices indirectly. At the zero interest rate bound the Fed purchases much larger quantities of Treasury securities, but even in that case the major factor driving T-bond yields and prices is the level and growth rate of nominal GDP. Low nominal interest rates result from a low level of NGDP relative to trend, and/or a low growth rate of NGDP.
As a first approximation, at the macro level it doesn’t much matter what the Fed purchases. Nor does it matter who gets the money "first." There is no advantage from getting the money first. Whatever impact monetary policy has on Treasury prices, the effect will occur regardless of whether the Fed buys Treasury securities or rare earth metals. Interest rates might go up or they might go down, but that will be because of what’s happening in the money market, not the Treasury market. Short-term interest rates often decline when the Fed injects new money into the economy, but that was equally true back in the days when the Fed purchased gold. 
Of course if the Fed bought a thinly traded good such as a rare earth metal, that market would be distorted. But the macro effects would be roughly the same. We don’t know exactly why home prices rose so much in America, Australia, New Zealand, Britain and Canada around 2001-06. Nor do we know why prices subsequently plummeted in the US, but not the other 4 countries. But you can be sure that it was not because newly created money was going "into" the 5 housing markets during 2001-06.


via EconLog

The politics of science fiction

Science fiction is an inherently political genre, in that any future or alternate history it imagines is a wish about How Things Should Be (even if it’s reflected darkly in a warning about how they might turn out). And How Things Should Be is the central question and struggle of politics. It is also, I’d […]

via Marginal Revolution

China moves against Bitcoin

China’s biggest Bitcoin exchange was forced to stop accepting renminbi deposits on Wednesday, sending the price of the virtual currency tumbling in one of its biggest markets globally. You will find more here, and FT coverage here.  Since Tuesday, the price of Bitcoin in China has fallen more than thirty percent.  Here is my earlier […]

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‘Why Do Measures of Inflation Disagree?’

This is useful and worth having in the archives for later reference: Why Do Measures of Inflation Disagree?, by Yifan Cao and Adam Hale Shapiro, FRBSF Economic Letter: In January 2012, the Federal Reserve’s policymaking body, the Federal Open Market…

via Economist’s View

‘Hoovernomics Explains the Economy’

Michael Froomkin: Hoovernomics Explains the Economy, by Michael Froomkin: This one chart tells you much of what you need to know about the fiscal side of the US economy: we’re dealing with a recession/depression Herbert Hoover style — by cutting…

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‘Four Missing Ingredients in Macroeconomic Models’

Antonio Fatas: Four missing ingredients in macroeconomic models: It is refreshing to see top academics questioning some of the assumptions that economists have been using in their models. Krugman, Brad DeLong and many others are opening a methodological debate about…

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