Yellen and Taylor on the Taylor Rule

 In her last speech, Janet Yellen argued that:

"For example, the Taylor rule is Rt = RR* + πt + 0.5(πt -2) + 0.5Yt, where R denotes the federal funds rate, RR* is the estimated value of the equilibrium real rate, π is the current inflation rate (usually measured using a core consumer price index), and Y is the output gap. The latter can be approximated using Okun’s law, Yt = -2 (Ut – U*), where U is the unemployment rate and U* is the natural rate of unemployment. If RR* is assumed to equal 2 percent (roughly the average historical value of the real federal funds rate) and U* is assumed to equal 5-1/2 percent, then the Taylor rule would call for the nominal funds rate to be set a bit below 3 percent currently, given that core PCE inflation is now running close to 1-1/4 percent and the unemployment rate is 5.5 percent. But if RR* is instead assumed to equal 0 percent currently (as some statistical models suggest) and U* is assumed to equal 5 percent (an estimate in line with many FOMC participants’ SEP projections), then the rule’s current prescription is less than 1/2 percent."

The point is clear, given the uncertainty about what the natural rate of unemployment and the equilibrium or natural rate of interest actually are, then there is some space for keeping the Fed Funds rate close to zero, where it is.

John B. Taylor cited the passage above to criticize Yellen's view. He said:

"So the main argument is that if one replaces the equilibrium federal funds rate of 2% in the Taylor rule with 0%, then the recommended setting for the funds rate declines by two percentage points. The additional slack due to a lower natural rate of unemployment is much less important. But little or no rationale is given for slashing the equilibrium interest rate from 2% percent to 0%. She simply says 'some statistical models suggest' it. In my view, there is little evidence supporting it, but this is a huge controversial issue, deserving a lot of explanation and research which I hope the Fed is doing or planning to do."

Taylor is okay with not having a clue about the natural rate of unemployment (tells you something about a theory that depends on a variable they never know where it is), but seems to think that the natural rate of interest is really 2%. I haven't seen the empirical analysis that shows that the natural rate of interest is 2%.

Frankly, if the methodology is the same as used for the natural rate of unemployment, meaning some average of the actual rates, I'd be somewhat underwhelmed. And I'm not even going to discuss the logical problems of the natural rate of unemployment (yes, there is no such thing). But if Taylor were right, we should have inflation around the corner. He has been complaining about the Fed policy for a while, and inflation hawks have suggested that hyperinflation would follow Fed expansionary policy for six years now. The question is when would Taylor and the inflation hawks be satisfied that inflation is not accelerating? The answer is probably never. The new Taylor rule should be hike the rate of interest in every circumstance then.

Blanchard and the lessons of the crisis, again

Olivier Blanchard has again posted on the lessons from the crisis, and one has reasons to be underwhelmed again (his previous attempt is discussed here). The general tone is the same as before, we don't know enough (#1 on humility is about that, but also #2 that suggests that we don't know enough about how financial markets operate). Caution here is at the service of an Hippocratic oath suggesting that an intervention carries an obvious risk of harm but a less certain chance of benefit.

His rule #4 says that macro-prudential regulations like capital controls "don’t work great. People and institutions find ways around them. In the process of reducing the problem somewhere you tend to create distortions elsewhere." So, first do no harm [no mention of George DeMartino's actual economic oath, by the way], and please don't use capital controls [that's why I remain very skeptical about the IMF's new view on capital controls; for more go here].

The lesson #3 is simply funny; what they didn't know that there are spillover and contagion effects? He is even making the mainstream sound worse than it is [for a more thorough discussion of what the mainstream learned and its limitations go here].

Last but not least there is lesson #5, which suggests that Central Bank Independence (CBI) does not work if the tasks go beyond inflation targeting. Note that he had defended as a change in macro the idea to raise the inflation target from 2% to 4% [seriously!]. Here he tells you that CBI has been "one of the major achievements of the last 20 years." The problem is not with CBI per se, but that with new demands on central banks (why the new demands appeared is an incognita, and he does not think is deregulation, or at least doesn't say so) CBI becomes more difficult.

There is no discussion of why CBI has been orthogonal to the so-called Great Moderation, caused by stagnant real wages and globalization. The problem with CBI is that by definition it imposes a rule of not coordinating with the Treasury on fiscal policy, and in some cases the central bank might be forbidden to do basic things like buying government debt (like the ECB). The justification is the fear of inflationary pressures, while the truth might be closer to Kalecki's view that fiscal and monetary policy are used to maintain a significant level of unemployment to keep workers in line.

So again it seems that Blanchard has learned nothing from this crisis. Mind you, John Taylor, Martin Feldstein and others are out there calling for higher interest rates. So, all in all, you might think that Blanchard, like Krugman and DeLong, is among the most moderate and reasonable in the mainstream. However, he is at the IMF, an institution that is still pushing fiscal austerity, and his inability (or unwillingness) to learn from the crisis has considerably more impact on economic policies around the world.

What's the deal with PPP?

In a previous post I suggested that there might some problems with using Purchasing Power Parity (PPP) measures of income per capita, the traditional measure of well-being used by the World Bank, for example. And although some might think that the main problems are basically empirical, my fundamental preoccupation is theoretical (see this paper, which in fact comes from my thesis).

PPP was developed by Gustav Cassel as an extension of the Quantity Theory of Money (QTM) to international matters. The quantity of money determined domestically the internal price level, and the exchange rate was determined as the ratio of domestic and foreign prices (or vice versa depending on how you define the exchange ratio), or in dynamic versions, the change in the exchange rate was defined as the difference of the inflation rates.

Wicksell was very critical of Cassel's theory, as I note in my paper [there were significant personal differences between the two main authors of the Swedish school, beyond their divergences on economic theory]. He basically suggested that the rate of interest, the natural rate determined by the productivity of capital and the savings decisions of economic agents, was the key variable, not the money supply. Hence, the bank rate, if it was lower than the natural rate, would not only generate his famous cumulative process of inflation, but it would also lead to flows of capital, provided that it was not in line with the bank rate of interest in other countries, and would basically determined the foreign exchange rate [note that Wicksell, and not the Keynes of the Tract, as is often argued, is the first, in 1919, to defend what we would today refer to as the uncovered interest parity condition].

From our perspective what matters here is that, even within the marginalist approach, the notion that the Quantity of Money, and prices, determine the equilibrium exchange rate is ultimately incorrect, once money is endogenous, as Wicksell assumed [note that the modern consensus in macroeconomics, both the New Keynesians and the so-called New Neoclassical Synthesis, assume an exogenous rate of interest, using some sort of rule, typically a variation of Taylor's rule]. Further, if we assume free capital movement, which implies a uniform rate of profit, marginalism would require that capital would flow to places in which it is scarce, and eventually (in the long run) the rate of profit or the natural rate of interest would be equalized.* Hence, the exchange rate that would be establish after the process is complete, would correspond to the uniform natural rate, which governs the bank rate, which as we saw is what Wicksell suggested determines exchange rate. So there must exist a natural exchange rate that corresponds to the natural rate of interest (and the natural rate of unemployment and its correspondent real wage, Friedman would argue).

It is obvious that there are 'imperfections' and the natural rate of interest is not equalized in the real world, so the exchange rate also deviates from the natural rate. But that isn't the main problem with the mainstream view. As we saw, the capital debates undermine the theoretical basis for a natural rate of interest, and hence for a natural exchange rate (or a natural rate of unemployment for that matter). Hence, it is the Keynesian (and Sraffian) institutional rate of interest, as determined by monetary authorities that rules the roost. The conventional rate of interest is then connected to a conventional exchange rate [then institutional factors become relevant, like the existence or not of capital controls, etc.].

Leave aside the theoretical problems of purchasing power parity measures, since they are NOT attractors of the actual exchange rates [the reasons why Argentina had a 1 to 1 exchange rate with the dollar for a decade, or Greece has a 'fixed' parity too are political and institutional], and even if for some purposes you may want to use PPP rates as a measure of material welfare, one may also be interested in actual market exchange rates for other purposes. Indeed, for most of the relevant matters that concern economic well being, particularly in peripheral countries, like the capacity to repay foreign debt and avoid default and import capital goods to promote growth, it is the market exchange rate that is central to convert incomes in different countries into a common numeraire.**

* The fact that capital does NOT flow to developing countries is something that still puzzles very much mainstream economists like Robert Lucas (see here).

** Which means that China is considerably less developed than Argentina and Brazil, even if it is growing fast, it has a regional hegemonic project, and is, by sheer size, one of the most important economies in the world.

Not so fast, the premature recovery problem

There is a certain brouhaha about the speed of the recovery. John Taylor says financial crises do not lead to slow recoveries (also Michael Bordo here). On the other hand, Krugman (and also Reinhart and Rogoff here) say that slow recoveries from financial crises are the norm. At stake, obviously, whether Romney is right and Obama is at fault for the slow recovery. Don't get me wrong, I would tend to agree that recoveries are relatively slow after a financial crisis, since deleveraging is a slow process.

Yet, that is not the main issue about this debate. The point is that ALL involved agree that the system has a natural (automatic) tendency to move back to the trend. Bordo refers nicely to Friedman's 'plucking' model. He reminds us, how it works:

"Friedman imagined the U.S. economy as a string attached to an upward sloping board, with the board representing the underlying long-run growth rate. A recession, in this view, was a downward pluck on the string; the recovery was when the string snapped back. The greater the pluck, the faster the bounce back to trend."

So the deeper the recession was, the faster would the recovery be. In other words, for the GOP economists (Taylor in this case) Obama is aborting holding back the economy and precluding what should be a premature or fast recovery. However, the point the critics make is that debt deleveraging makes the recovery slow, but it is more or less automatic anyway. Government is necessary to speed up something that markets, if they weren't imperfect, would do.

Krugman ideas are based on a recent paper on what he called the Fisher-Minsky-Koo model. Steve Keen has provided a full critique of a previous version here (h/t Lord Keynes who also provides an invaluable bibliography on debt deflations here). The essential point that generates an imperfection in the case of Krugman's model is that an external shock (a Wile E. Coyote moment in his terms, since agents finally notice the floor is gone) brings down the natural rate of interest, which becomes negative for a while (see my discussion on Krugman and the natural rate here). In that case, monetary stimulus is not capable of getting the economy naturally back on track, since the interest rate cannot fall below zero, and as a result agents cannot increase consumption enough to bring full employment automatically.

Hence, in the New Keynesian model of debt-deflation the change from more conventional neoclassical models is that they allow for a sudden (and exogenous) reduction in the debt limit that agents can borrow to reduce the natural rate. It's a financial shock (not a real one) that makes the rate of interest that would equilibrate investment with full employment savings (the inverse of consumption) negative. Agents suddenly understand that they would need a negative interest rate to satisfy their intertemporal consumption plans. From a post-Keynesian (I prefer classical-Keynesian but who cares), the problems are not related at all with the natural rate (yes the capital debates have shown that this makes no sense, where did I read that before?). So deleveraging has a direct effect on the ability of consumers to spend, and there would be no automatic bounce back if the equilibrium rate was not negative.

You may think it is a minor issue, and from a policy point of view it certainly the differences are minor. However, note that the New Keynesian version of the recovery suggests that markets are fundamentally, in the long run, efficient (again against logic and evidence) which is an essential totemic myth that they need to preserve.* And that has policy implications. Recoveries from financial crises are slow, as Krugman says, but not because the natural rate is negative. It is a political problem that involves class conflict. It is because agents that cannot consume out of wages (which have stagnated) cannot borrow themselves out of the crisis, and the federal government, the only one that can, will not do it for political reasons (to keep workers demands in line). That's why heterodox economists are not just for expansionary fiscal policy (and don't think that if the Fed signals more inflation investment confidence will pick up), but argue for higher wages, stronger unions, and debt relief.

* Let alone the funny thing that both sides in this dispute are basically arguing that the economy gravitates around a trend that is exogenous and attracts the actual economy (in a stronger or weaker way), and the way they actually measure the gravitational center (the natural trend) is by averaging the actual rates.

PS: And no, it's not a joke, they do actually sell that T-shirt!

Romney's economic plan and the confidence fairy

Romney's economic plan is out, and not surprisingly is all about confidence fairies. Glenn Hubbard, one of the co-authors (with John B. Taylor, Greg Mankiw and Kevin Hassett) argues in the Wall Street Journal that the recession has been caused by uncertainty. In his words:

As a consequence, uncertainty over policy—particularly over tax and regulatory policy—slowed the recovery and limited job creation. ...  the Obama administration's large and sustained increases in debt raise the specter of another financial crisis and large future tax increases, further chilling business investment and job creation.

So too much regulations and spending is what is causing the slow recovery. This is interestingly enough what the manuals of Hubbard, Mankiw or Taylor would say (all are supposedly New Keynesian economists, whatever that means), which still present the simple Keynesian model in which spending determines the level of output (the old 45o degree Hansen model, which encapsulates the logic of the multiplier).

So what is the solution for these GOP New Keynesians? Four points:
growth and recovery first, and it stands on four main pillars:

• Stop runaway federal spending and debt. The governor's plan would reduce federal spending as a share of GDP to 20%—its pre-crisis average—by 2016. This would dramatically reduce policy uncertainty over the need for future tax increases, thus increasing business and consumer confidence.

• Reform the nation's tax code to increase growth and job creation. The Romney plan would reduce individual marginal income tax rates across the board by 20%, while keeping current low tax rates on dividends and capital gains. The governor would also reduce the corporate income tax rate—the highest in the world—to 25%. In addition, he would broaden the tax base to ensure that tax reform is revenue-neutral.

• Reform entitlement programs to ensure their viability. The Romney plan would gradually reduce growth in Social Security and Medicare benefits for more affluent seniors and give more choice in Medicare programs and benefits to improve value in health-care spending. It would also block grant the Medicaid program to states to enable experimentation that might better serve recipients.

• Make growth and cost-benefit analysis important features of regulation. The governor's plan would remove regulatory impediments to energy production and innovation that raise costs to consumers and limit new job creation. He would also work with Congress toward repealing and replacing the costly and burdensome Dodd–Frank legislation and the Patient Protection and Affordable Care Act. The Romney alternatives will emphasize better financial regulation and market-oriented, patient-centered health-care reform.

In short, reduce taxes (the effective corporate income tax is well below 25% and several corporations do not pay much or anything in fact), which mainly helps the wealthy, and has little impact on income, cut spending (contradicting what they teach), cut and privatize Social Security and health programs, and more deregulation. The non sequitur with cutting welfare programs or the craziness (or dishonesty) of arguing for deregulation (eliminate Dodd-Frank) even if they call this disingenuously 'better financial regulation' is astonishing. And yes the idea is that somehow all these measures would create an environment in which job creators would feel safe to invest.

Brad DeLong and Menzie Chinn do a great job debunking this terribly poor and dangerous economic plan.