Working Papers

2006 01

Friedman on Greenspan

Milton Friedman on Alan Greenspan:

Over the course of a long friendship, Alan Greenspan and I have generally found ourselves in accord on monetary theory and policy, with one major exception. I have long favored the use of strict rules to control the amount of money created. Alan says I am wrong and that discretion is preferable, indeed essential. Now that his 18-year stint as chairman of the Fed is finished, I must confess that his performance has persuaded me that he is right—in his own case…

It has long been an open question whether central banks have the technical ability to maintain stable prices. Their repeated failures to do so suggested that they did not—whence, in part, my preference for rigid rules. Alan Greenspan’s great achievement is to have demonstrated that it is possible to maintain stable prices. He has set a standard. Other central banks around the world, whether independently or by following his example, are following suit. The timeworn excuses for central bank failure to stem inflation will no longer do. They will have to put up or shut up.

posted on 31 January 2006 by skirchner in Economics

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Endogenising Alan Greenspan

With Alan Greenspan presiding over his final FOMC meeting today, John Berry defends his legacy against the self-indulgent puffery of The Economist:

Suppose the Fed, with an eye on the stock market, had raised rates instead. What would have happened? No one knows, of course. When one is constructing what economists call a counter-factual - - that is, an alterative scenario to what actually happened—such questions have to be addressed, and few if any of the Greenspan critics have bothered to do so.

Similarly, in 1999 the stock market was mesmerized by the prospective profitability of high-tech companies tied to the massive investment being made to get computer systems ready for the century date-change problem. That surge in investment and the big decline that followed in 2000 played at least as great a role in the investment-led recession that developed in 2001 as did the bursting of the stock market bubble.

In any event, the Fed did begin raising rates in mid-1999 because officials were concerned the economy was about to overheat. The stock market paid no attention and some 60 percent of the high-tech bubble developed after rates began to rise. The Fed would have had to crunch the economy to stop it.

The critics nevertheless assume that minor rate increases would have done the trick.

This is a key problem confronting Greenspan’s many critics.  It is the average level of real interest rates relative to a notional equilibrium rate over many months, if not years, that determines the effective stance of money policy.  It would have taken a very different path for the Fed funds rate to make a material difference to macroeconomic outcomes.

The Fed makes only marginal changes in interest rates, not because given 25 basis point moves are particularly important, but as a hedge against being wrong.  Unfortunately, these incremental moves lead many people to greatly exaggerate the importance of monetary policy.  It is also much easier for people to get their head around the idea of the economy responding to single influence, especially one seemingly subject to human control.  In reality, monetary policy is as much an endogenous response to prevailing economic conditions as a determinant of them.

posted on 31 January 2006 by skirchner in Economics

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Schmoozing in Davos

Vanguard’s John Bogle, heaping derision on the great and the good assembled at Davos:

This year I’ve decided not to call the pilot, pop on to Vanguard’s G-4 and jet to Davos. Partly because we don’t “do” corporate airplanes…I confess I looked at this year’s program before I made my decision. I’m only truly sorry to miss Morgan Stanley’s Steve Roach, whose persistent gloomy warnings about the global economy have yet to come home to roost.

By contrast, doomsday cultist Nouriel Roubini is completely star-stuck:

Hopefully, one will also have time to schmooze with celebrities: this year Angelina Jolie is not around as she is pregnant to Brad Pitt but a stable of glitterati, glamoratas, artistata and hollywoodatas is certain to add glamour cachet to the highest concentration of gurus, eggheads, policy wonks, corporate leaders, net geeks and nerds and movers&shakers ever put together…


UPDATE:  Another failed Roubini forecast:  ‘Jolie tells starstruck summit to stay focused’

DAVOS, Switzerland (Reuters) - Angelina Jolie told a summit of business leaders and politicians, many driven to distraction by the Hollywood siren, to concentrate on the real issues.

The Oscar-winner and her beau Brad Pitt, whose child she is carrying, have reduced the global elite at Davos to star-struck autograph hunters, scrambling over each other to get a glimpse of the actress and her man.

UPDATE II:  Italy’s Economy Minister tells Nouriel where to go.  I happen to agree with Nouriel on EMU, except that I don’t see its prospective break-up as a ‘disaster.’  Still, it makes Nouriel’s bearishness on the USD all the more curious.

posted on 27 January 2006 by skirchner in Economics

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Flying on One Engine:  The Bloomberg Book of Master Market Economists

Flying on One Engine: The Bloomberg Book of Master Market Economists contains 14 essays by leading market economists on the US and world economies.  Economists working in financial markets produce some of the best analysis of contemporary macroeconomic developments, yet much of this research is only ever seen by wholesale clients.  While many economists enjoy high media profiles, the relentless dumbing-down of reporting on the economy and financial markets makes it difficult for some of the better economists’ voices to be heard.  Anyone looking for more considered analysis of economic and market developments that goes beyond the one line grabs in the mainstream media will find this book of interest.

The essays represent a range of views on the US and world economies, but remain largely ‘bubble’ and doomsday cult free.  David Malpass is typically upbeat in his essay ‘America’s Optimistic Future,’ demolishing the myth that US households don’t save and dismissing the notion of a ‘bubble’ in US housing. 

Thomas Mayer is suitably downbeat in his essay ‘Europe’s Political and Economic Future,’ concluding that ‘whether the readers of these lines will live to see Europe’s economic revival is an entirely different matter.’

John Ryding’s essay ‘Monetary Policy, Wicksell and Gold’ argues for a Wicksellian interpretation of US monetary policy at the expense of what he sees as the dominant Phillips curve paradigm.  Ryding fails to appreciate the extent to which US monetary policy is already firmly neo-Wicksellian and that the Phillips curve trade-off, however unreliable, is not necessarily incompatible with a neo-Wicksellian interpretation of monetary policy.

Ryding is one of several authors who point to the gold price as being indicative of the stance of US monetary policy.  The problem with this view is that gold is correlated with commodity prices in general, so it is far from obvious that it has any special properties as an indicator relative to other commodities.  David Rosenberg’s essay highlights the very restrained pass through of the recent bull market in commodity prices to producer and consumer prices, suggesting that commodity prices (including gold) are now a much less reliable guide to inflation pressures than they have been in the past.

Michael Rosenberg writes on US dollar cycles, arguing for a 20 to 30 decline in the US dollar’s value over the next two to three years.  However, Rosenberg is also sympathetic to the possibility that there has been an increase in the ‘sustainable’ current account deficit for the US, implying greatly reduced downside for the US dollar to restore external ‘balance.’  Indeed, there are those (like myself) who argue that the US current account deficit should if anything be wider, and that the recent deterioration in the current account balances of the Anglo-American economies contains a significant structural component that is here to stay.

The book’s only major flaw is the gushing and cringe-inducing introductions that editor Thomas Keene inserts at the beginning of each essay.  The biographies of the contributors speak for themselves and hardly require any embellishment from Keene.

posted on 27 January 2006 by skirchner in Economics

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The Doomsday Cult Comes to Reno

Warren Buffett is sounding more and more ridiculous:

“Right now, the rest of the world owns $3 trillion more of us than we own of them,” Buffett told business students and faculty Tuesday at the University of Nevada, Reno. “In my view, it will create political turmoil at some point. ... Pretty soon, I think there will be a big adjustment,” he said without elaborating.

One of the difficulties confronting the doomsday cult is that it requires a vivid imagination like Buffett’s to construct plausible scenarios that would give rise to serious concern about external imbalances, at least for countries with floating exchange rates.  Their worst case scenario - a ‘disorderly’ adjustment in foreign exchange markets - is something the doomsday cult should in fact welcome, since it is the shortest and most painless route to reducing imbalances.  It makes no sense to worry about the supposed disease as well as the cure.  One of the main advantages of having a floating exchange rate is that it insulates the domestic economy against external shocks.  It is far preferable to wear any adjustment to external imbalances on the exchange rate than on domestic growth.

posted on 25 January 2006 by skirchner in Economics

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Why I Don’t Lose Any Sleep Over the US Consumer

By his own admission, Stephen Roach is having trouble getting his colleagues and clients to take him seriously:

There was little sympathy for my long-standing complaint about the excesses of the asset-dependent American consumer.  Few seemed concerned that an income-short consumption dynamic might falter as the housing bubble now started to deflate.  Actually, few seem concerned about the US housing bubble, period…The group was nearly unanimous in believing that there was only modest downside to US consumption, at worst.

I don’t lose any sleep over the outlook for consumption either, yet reading the popular press, one could be forgiven for thinking that consumption was the single biggest risk to the growth outlook in the US and globally.  Since consumption is a large share of GDP measured on an expenditure basis, it necessarily figures prominently in terms of the contribution to growth.  This leads many to think of consumption as the main driver of growth.  Yet consumption is typically very stable as a share of GDP, suggesting a long-run equilibrium relationship between income and consumption. 

Concerns over the contribution of housing wealth in driving consumption are greatly exaggerated.  If anything, the increased availability of new financial products that allow individuals to better access their housing wealth will enable them to more effectively smooth their consumption over time, contributing to reduced volatility in GDP growth.

posted on 24 January 2006 by skirchner in Economics

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Why there is No Money in Monetary Policy

David Altig has a short history of the demise of monetary aggregates in the conduct of US monetary policy.  The recent outcry over the Fed’s decision to discontinue publication of the M3 aggregate suggests many people viewed M3 growth as being somehow a more reliable guide to the stance of US monetary policy than the Fed funds rate.  The implication among some of the populist investment newsletter writers has been that the Fed has something to hide.  A previous post has argued why this view is mistaken.  Altig nonetheless argues that it’s a pity that the role of money in monetary policy has been downgraded, without saying why in his post.  Let me suggest at least one reason.

Changes in the stock of real money balances have the capacity to push individuals off their demand curves for these balances, inducing portfolio balance effects that may in turn influence the economy-wide asset prices and yields that determine aggregate demand.  Changes in the stock of real money balances are likely to first work their way through goods and financial market disequilibria well before impacting prices.  This is both a real and nominal story (as argued in this post, even in the long-run, the neutrality of money could conceivably fail).  M3 and other monetary aggregates could thus have some predictive power for asset prices and real output.  This is ultimately an empirical question, but does suggest that growth rates in money are something that policymakers might want to consider as an information variable, even when targeting an interest rate as their main operating instrument.  As I argued in a review of Tim Congdon’s book, Money and Asset Prices in Boom and Bust, this is the only sense in which we should care about growth in broad money under an interest rate targeting regime. 

However, this is a far cry from saying that one can simply read-off from growth rates in money and credit that the stance of monetary policy is too loose or too tight, based on some a priori view of what constitutes reasonable growth rates in these aggregates.  The people most inclined to do this are the fever-swamp Austrians, who argue that every tick in the business cycle must be attributable to a fiat money supply error on the part of the Fed.  These are the same people who argue that money demand is too complex a phenomenon for the Fed to be able to calibrate an appropriate growth rate in the money supply.  That is perfectly true, which is why the Fed doesn’t even try.  Yet the fever-swamp Austrians are implicitly claiming enough knowledge about money demand to determine whether monetary policy is too loose or too tight, just by observing simple growth rates in money, credit and even asset prices.  This is what Hayek would term a ‘fatal conceit’ and is a travesty of Austrian economics.

UPDATE:  Larry White challenges me to name names.  The fever swamp reference is my attempt to distinguish between respectable and less respectable exponents of views that draw on the Austrian tradition.  Larry White, George Selgin, Kevin Dowd, and Leland Yeager all fall within the respectable category and I would be very surprised to find them holding to the self-contradictory position I’m attributing to others.

However, there are plenty of examples over at the Mises Institute blog of this phenomenon and it is a common enough theme in popular libertarian and conservative discourse about monetary policy that claims inspiration from Austrian ideas.  Anyone who asserts that given growth rates in broad money, credit or asset prices are in themselves proof of a fiat money supply error is implicitly making a statement that they know what the correct growth rates should be.  Since these growth rates are largely market-determined and only loosely connected with monetary policy, they are also implicitly criticising the market process.

It should also be noted that those claiming the Austrian mantle are hardly alone in this.  The Economist magazine does it all the time and it is routine for popular economic commentary to point to point to growth rates in money, credit and asset prices as being symptomatic of ‘excess liquidity.’  My point is that anyone claiming to represent the Austrian tradition should know better.  Larry White clearly does. I just wish there were more of him.

posted on 22 January 2006 by skirchner in Economics

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In Brief

• Jeffrey Sachs as underpants gnome.

Fever-swamp milliners: tin foil lining optional extra.

Milton Friedman on the dangers of Austrian business cycle theory.

• Marxism in China: not dead yet.

posted on 21 January 2006 by skirchner in Misc

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Is Bernanke a Conservative?

Forbes columnist Hunter Lewis poses the question ‘Is Ben Bernanke a Conservative?’  As Lewis himself indicates, this question is poorly defined, since not only is there no single conservative position on macroeconomics and monetary policy, there are in fact furious debates on these subjects within the conservative and libertarian tradition. 

Having read much of Bernanke’s academic work, I would argue that Bernanke, like any good economist, is first and foremost an empiricist.  He takes the positions he does because the evidence points him in that direction.  Consequently, he is difficult to typecast.  For example, Bernanke is perhaps best known for his work on exogenous credit crunches as a source of economic downturns.  This work is somewhat at odds with the monetarist view that credit crunches are an induced or endogenous response to monetary contraction.  At the same time, Bernanke and other researchers at the Federal Reserve Board have recently presented empirical research that supports quantitative approaches to monetary policy transmission in the context of the zero bound problem for nominal interest rates.  This was the origin of the criticisms of Bernanke as ‘printing press Ben,’ yet these views would find few objections from those in the classical monetarist tradition, such as Milton Friedman and Allan Meltzer.  This eclectic approach explains why many of his academic colleagues had no inkling of his Republican leanings prior to his appointment as a White House economic advisor.

Bernanke was appointed to run a fiat money regime, so criticising him for failing to uphold various hard money doctrines is beside the point.  Such criticism fails to distinguish between intra and inter-regime choice.  Much of this criticism naively assumes that the Fed is the source of every economic fluctuation and that the adoption of some pet hard money scheme would cause the business cycle to go away.  It is ironic that in recent years it has been central bankers like Greenspan and Bernanke who have upheld the view that markets and not monetary policy should determine growth rates in broad money, credit aggregates and asset prices.

posted on 20 January 2006 by skirchner in Economics

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An Inflation Target for Japan?

I have an article in Business Week arguing that 2006 may see the Bank of Japan drop its opposition to a formal inflation target:

With the termination of quantitative easing, the Bank of Japan will no longer have an inflation commitment guiding policy. This is an undesirable situation, since it leaves Japanese monetary policy without any formal policy guidance, and gives the market and the public nothing on which to condition expectations for the future path of interest rates, potentially impairing the effective transmission of monetary policy. Indeed, the lack of a nominal anchor for policy facilitated Japan’s slide into deflation from the mid-1990s.

posted on 19 January 2006 by skirchner in Economics

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PIMCO’s Bill Gross: The End is Nigh!

PIMCO’s Bill Gross, quoted in a Barron’s cover story, keeping the doomsday cult alive:

U.S. investors should accelerate their exposure to non-dollar stocks, because the dollar as a currency is doomed.

So very 2005.

posted on 17 January 2006 by skirchner in Economics

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Greenspan’s Legacy

The Economist has a tired and predictable piece on Greenspan’s legacy:

The Economist’s long-running quarrel with Mr Greenspan is that he chose not to restrain the stockmarket bubble in the late 1990s or to curb today’s housing bubble.

My long-running quarrel with The Economist is that this argument is nonsense.  Peter Hartcher attempted to string a book out of this argument, with disastrous consequences that I review hereElsewhere, The Economist says ‘One should not exaggerate Mr Greenspan’s influence—both good and bad—over the economy,’ before going on to do precisely that.  The Economist’s cover story, ‘Danger Time for America,’ contains the usual tired predictions of housing-related economic ruin.  According to The Economist:

The problem is not the rising asset prices themselves but rather their effect on the economy. By borrowing against capital gains on their homes, households have been able to consume more than they earn. Robust consumer spending has boosted GDP growth, but at the cost of a negative personal saving rate, a growing burden of household debt and a huge current-account deficit.

The Economist just assumes that all this is a bad thing.  It is in fact a sign of economic strength, not weakness.  The Economist remains as wedded as ever to Bretton Woods era economics.

I picked up a copy of the second edition of Peter Garber’s classic Famous First Bubbles the other day.  The conclusion has a great passage explaining why The Economist’s incantations in relation to ‘bubbles’ are the hallmark of intellectual confusion:

“bubble” characterizations should be a last resort because they are non-explanations of events, merely a name that we attach to a financial phenomenon that we have not invested sufficiently in understanding.  Invoking crowd psychology - which is always ill defined and unmeasured - turns our explanation to tautology in a self-deluding attempt to say something more than a confession of confusion.

posted on 13 January 2006 by skirchner in Economics

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Dow 12,500

Brian Wesbury is characteristically upbeat on prospects for the Dow:

Since the third quarter of 2001, after-tax corporate profits have surged 80%, interest rates have fallen, and yet the S&P 500 is up less than 8%. During this same time period the P-E ratio, based on trailing earnings, has fallen from roughly 37 to 18. A capitalized profits model, which discounts profits at current interest rates, shows the market more undervalued than at any time in modern history. The fundamentals suggest that today is a good time to own stocks.

...the past five years will prove to be just another pothole in a continued bull market. While 11,000 gives us something to cheer about, a 12,500 Dow this year is imminently (and eminently) doable, as is another decade of continued prosperity.

posted on 12 January 2006 by skirchner in Economics

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Wonkette as Hayekian

P J O’Rourke on Ana Marie Cox’s Dog Days:

Dog Days is comparable to Friedrich Hayek’s The Road to Serfdom. Albeit the prose makes Hayek’s seem elegant and pellucid. But Hayek’s first language was German. Cox’s first language is blog.


posted on 12 January 2006 by skirchner in Culture & Society

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The Death of Newspapers

Joseph Epstein on the disintermediation of print media:

About our newspapers as they now stand, little more can be said in their favor than that they do not require batteries to operate, you can swat flies with them, and they can still be used to wrap fish.

I buy one newspaper a week, but since that is only for the TV guide, it doesn’t really count.  I couldn’t even be said to read the on-line versions.  So where do all those links come from, you might ask?  The answer is Google News Alerts.

posted on 11 January 2006 by skirchner in Economics

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In Brief

Saul Eslake’s five-year outlook.

• Some predictions for prediction markets.

Barry Ritholtz updates the gold bugs’ favourite Rorschach tests.

David Smith on the dovish UK Shadow Monetary Policy Committee.

• Former Treasury Secretary John Stone on the politicisation of the National Archives.

posted on 10 January 2006 by skirchner in Misc

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Dollar Crashes, Comets and Yield Curve Inversions

Alan Reynolds reviews forecasts for 2006, before giving us something real to worry about:

Washington Post columnist Steven Pearlstein just wrote about the “remarkably rosy scenario” of the “economic pundocracy” (though he’s a member). On the same day, Robert Samuelson brushed off all the “sunny predictions” and offered a variation of Pearlstein’s shopping list of things that might go wrong. The dollar might crash, for example, which they almost certainly said last year. Or we might be hit by a comet…

Because inflation is going to be drifting down to 2.4 percent or less for the foreseeable future, there is no “conundrum” in explaining why 10-year bond yields remain low. And there is no plausible rationale for pushing the fed funds rate higher while inflation is heading lower. If the Fed does that, it will be a mistake. Maybe a big mistake.

The federal funds rate was deliberately pushed above the 10-year bond yield in 1969, 1973-74, 1979-81, 1989 and 2000. By no coincidence, the economy was in recession in 1970, 1974-75, 1980-82, 1990 and 2001.

posted on 09 January 2006 by skirchner in Economics

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A Tale of Two Stock Market Forecasts

Fortune profiles the views of Roger Ibbotson in its investment review for 2006:

In May 1974, in the depths of the worst bear market since the 1930s, two young men at a University of Chicago conference made a brash prediction: The Dow Jones industrial average, floundering in the 800s at the time, would hit 9,218 at the end of 1998 and get to 10,000 by November 1999.

You probably have a good idea how things turned out: At the end of 1998, the Dow was at 9,181, just 37 points off the forecast. It hit 10,000 in March 1999, seven months early. Those two young men in Chicago in 1974 had made one of the most spectacular market calls in history.

Curiously, the profile then presents the work of Robert Shiller as a challenge to Ibbotson’s approach.  Brad DeLong recently reviewed the original forecast that later became the foundation for Shiller’s (2000) Irrational Exuberance:

In 1996 Yale economist Robert Shiller looked around, considered the historical record on the performance of the stock market, and concluded that the American stock market was overvalued. Prices on the broad index of the S&P 500 stood at 29 times the average of the past three decades’ earnings. In the past, whenever price-earnings ratios had been high future long-run stock returns had turned out to be low. On the basis of econometric regression studies carried out by him and by Harvard’s John Campbell, Shiller predicted in 1996 that the S&P 500 would be a bad investment over the next decade. In the decade up to January 2006, he predicted, the real value of the S&P 500 would fall, and even including dividends his estimate of the likely real inflation-adjusted returns to be earned by investors holding the S&P 500 was zero.

The rest, as they say, is now history.

posted on 06 January 2006 by skirchner in Economics

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More True Confessions of Brad Setser

Brad Setser on his macroeconomic hypochondria:

What’s new.  I always worry.  I just now worry about a (somewhat) new and evolving set of things.

Like the song says, don’t worry, be happy!

Speaking of happy, Mark Mahorney is wishing everyone a Happy New Year.  Well, almost everyone:

everyone except the name caller, the perma-bears, commie-lovers…Everyone except all of those people.

posted on 05 January 2006 by skirchner in Economics

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Is Iran to Blame for the Bond Yield ‘Conundrum’?

Kevin Hassett, drawing on Robert Barro’s work on ‘Rare Events and the Equity Premium,’ asks whether the prospect of a show-down over Iran’s nuclear program might be responsible for low bond yields:

If Barro is right, long-term rates may depend on low- probability geopolitical variables. And the effects may be enormous, perhaps even dwarfing the effects of traditional variables such as the deficit.

Barro clarified this connection in a recent interview: “A small increase in this kind of risk—as an example, due to the Sept. 11th events—leads to a noticeable response in real interest rates. When this probability goes up, the risk-free rate goes down because people put more of a premium on holding a relatively safe asset.”…

there has been a movement that is consistent with the Barro story. Intrade.com offers a futures contract that pays off if the U.S. or Israel bombs Iran between now and the end of March 2007. That probability has soared in recent weeks, and stood at a sobering 31.6 percent on Dec. 30…

Iran, not Iraq, may be the big story of 2006, both politically and economically.

I prefer a monetary policy credibility explanation for low bond yields, but would agree that Iran will loom large this year.

posted on 04 January 2006 by skirchner in Economics

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