Sweden prediction

Tyler Cowen argues that there is too much moralizing over the Swedish policy on Covid-19. I agree. I’d add that there’s way too much focus on Sweden’s decision not to lockdown, and way too little focus on other aspects of Swedish policy.

But I don’t entirely agree with this:

In the meantime, the Swedish economy has been among the least badly hit in Europe.

That claim is defensible, but perhaps a bit misleading. Right now we simply don’t have enough data to know how Sweden is doing relative to the most comparable countries. The Q2 GDP data is likely to be heavily revised.  So here’s my prediction:  When all the GDP data is in for 2020 (say in February 2021), it will seem like Sweden’s economic performance is fairly typical. A bit better than the Eurozone and a bit worse than the other Nordic countries (Denmark, Norway and Finland.)

Here’s one small piece of evidence in support of my claim:

[Sweden’s] economy has suffered less than the European average in recent months, but at least as much and possibly more than its Nordic neighbours.

PS.  I do believe that Sweden’s decision to avoid a lockdown slightly boosted its GDP, ceteris paribus, but not by a large amount.  And also keep this in mind:

According to the University of Oxford’s government response tracker, countries from France, Austria and Croatia to Norway and Finland now all have fewer restrictions than Sweden.

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More Good News on U.S. Employment


Total nonfarm payroll employment rose by 1.8 million in July, and the unemployment rate fell to 10.2 percent, the U.S. Bureau of Labor Statistics reported today. These improvements in the labor market reflected the continued resumption of economic activity that had been curtailed due to the coronavirus (COVID-19) pandemic and efforts to contain it. In July, notable job gains occurred in leisure and hospitality, government, retail trade, professional and business services, other services, and health care.

This is the opening paragraph of the Bureau of Labor Statistics’ news release today on the jobs numbers for July.

This is not nearly as good as the June numbers, which were very good. Nevertheless, any month in which the number of people employed rises by more than half a percent is a very good month. (Household data show that 142.2 million people were employed in June and that that had risen by 1.35 million in July, an increase of 0.9%.)

Also heartening for hospitality workers, who have taken the brunt of the job losses, is that their employment increased considerably. Here’s the relevant paragraph of the press release:

Employment in leisure and hospitality increased by 592,000, accounting for about one-third of the gain in total nonfarm employment in July. Employment in food services and drinking places rose by 502,000, following gains of 2.9 million in May and June combined. Despite the gains over the last 3 months, employment in food services and drinking places is down by 2.6 million since February. Over the month, employment also rose in amusements, gambling, and recreation (+100,000).

I have pointed out how much better the numbers would be if a bipartisan majority in Congress had not, in March, legislated a $600 per week unemployment benefit on top of normal state benefits. That benefit expired last Friday. If Congress does not renew that benefit, I expect an even bigger increase in August, which would be reported on September 4. I also expect, however, that Congress will renew a modified version of this benefit.

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Rethinking the Great Recession

When I studied history, I was perplexed as to how the US could have done things like the internment of Japanese-Americans in WWII or the Joe McCarthy witch hunts of the early 1950s. Today, as I observe the growing anti-Chinese hysteria, these events are becoming easier to understand.

When I studied economic history, I was perplexed as to why economists of that period were blind to the costs of an extremely tight monetary policy that drove NGDP sharply lower during the early 1930s. Today, having seen a similar blindness in regard to the Great Recession, I’m no longer so perplexed.

The Economist has a very good (but also very depressing) article discussing how the field of macroeconomics has changed during the past decade. I take no pleasure in being right 10 years ago when I warned that misdiagnosis of the Great Recession could lead to the same sort of “dark ages” of economics as developed during the 1930s (and we escaped from in the latter 20th century).

Kevin Erdmann recently wrote a book pushing back against many of the myths regarding the housing bubble and bust, and I have a book coming out next April (University of Chicago Press) on market monetarism and the Great Recession.  Until then, you might be interested in our joint Mercatus working paper, which presents some of the key ideas in both books.

PS.  The Economist article is excellent, but does have one mistake:

Several factors might yet make the economy more hospitable to negative rates, however. Cash is in decline—another trend the pandemic has accelerated.

Actually, use of cash (mostly as a store of value) has increased sharply under Covid-19.  That makes the economy slightly less hospitable to negative rates.  Cash is a substitute for negative rate bank deposits.

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Wasted ammunition?

The second quarter of this year saw what is probably the biggest fiscal stimulus in American history, in terms of increase in the budget deficit. And today we see the results: nominal GDP fell by 34.3% at an annual rate. That means the fiscal stimulus prevented a much bigger fall in GDP—right?

Well, that might be true, but how would we know? We have models, but these models certainly don’t predict that NGDP would fall at a 34.3% rate in a quarter where disposable income is actually rising. And not just rising, but (according to the BEA) rising at an almost insane annual rate of 42.1%.  In real terms it was even higher, due to deflation:

Real disposable personal income (DPI)—personal income adjusted for taxes and inflation—increased 44.9 percent in the second quarter after increasing 2.6 percent in the first quarter.

Why do I mention disposable income? Because the models that predict fiscal stimulus will boost the economy are based on a transmission mechanism that runs from more fiscal stimulus to more disposable income to more spending. Thus our (Keynesian) models don’t really explain why NGDP fell so sharply in Q2.  Indeed, if anything these models predict an extraordinary boom.

You might respond that our common sense does provide an answer—people were afraid to go out shopping due to the virus. I accept that theory. But as far as I know there are no models that predict fiscal stimulus will be effective when people are afraid to go out shopping. And with the new Q2 GDP data there is also no empirical evidence that fiscal stimulus boosted GDP.

Before discussing the policy implications of all this, a few caveats:

1. Yes, I understand “ceteris paribus”. It’s plausible that the fiscal stimulus had some positive effect.  After all, even during periods where the virus is the dominant factor, disposable income does matter at the margin.

2. A very large budget deficit in Q2 was appropriate, as standard public finance theory says you should take in less tax revenue during a severe slump, and spend more on unemployment compensation. Then there’s spending on the virus itself.  I accept all of that. A big deficit was inevitable and appropriate.

What I question is the part of the deficit that was motivated solely by the desire to boost disposable income. For instance, why give $1200 to middle class people with stable jobs who were actually benefiting from a decline in the cost of living? That seems like wasted ammunition.  What were they expected to do with the money?  Why not just do enough stimulus to keep disposable income stable, if the problem is that people are afraid of spending?  Why a 44% (annualized) real increase?

In fairness to the other side, the fiscal stimulus this time around was larger and timelier than I expected. I would have expected gridlock in DC to slow the process. Nonetheless, it seems plausible to me that the massive fiscal stimulus was mostly wasted, due to the reluctance of people to spend. Ironically, this might be the one recession where it would have been better to delay the fiscal stimulus until 2021.  If we get a vaccine this winter (which experts seem to think increasingly likely) then perhaps people will become more willing to shop in 2021. That’s when the fiscal stimulus might have been effective, at least if you buy the underlying Keynesian model.

For myself, I believe monetary stimulus would be more effective in boosting the economy in 2021, at a much lower cost. Monetary and fiscal policy are very different. Monetary stimulus does not exhaust ammunition; rather it actually creates ammunition by raising the natural rate of interest. Fiscal stimulus really does exhaust ammunition.

Despite the preceding comments, I actually believe the economy received too little stimulus even in Q2 of this year.  I would have preferred to see monetary policy be expansionary enough to prevent disinflation.  It wasn’t.  So I’m not one of those conservatives who argue that “stimulus” doesn’t help in a slump.  Rather, I favor monetary stimulus (which is basically costless) over fiscal stimulus that imposes a heavy burden on future taxpayers.  If there’s a vaccine this winter, then I believe that monetary stimulus alone (done properly) could give us a V-shaped recovery.

In the past, I argued that fiscal stimulus did boost GDP in Q2 of 2008, but did not boost GDP for 2008 as a whole. That’s because the Fed responded to Bush’s spring of 2008 tax rebate by tightening money to slow inflation (CPI inflation peaked at 5.5% in mid-2008.) The rest is history.

In my view the recent fiscal stimulus did slightly boost NGDP in Q2, but the gains are likely to be taken away in 2021.  We’ll do a bit less monetary stimulus in 2021 because of all of the fiscal stimulus done in 2020, money that was basically wasted.

PS. Yes, the unannualized drop in NGDP was much smaller than 34.3%, but still pretty horrific by historical standards.

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Should we root for second best policies?

The Fed is currently contemplating a set of monetary policy changes that might be viewed as “second best”. These include yield curve control and average inflation targeting. With yield curve control the central bank would peg the yield on longer-term Treasury bonds. This was Fed policy during the 1940s. Under average inflation targeting the central bank tries to make up for an inflation undershoot or overshoot, so that inflation will average 2% over the business cycle.

In my view, these are second best policies.  Holding down long-term interest rates might be expansionary, but it also might end up being contractionary.  After all, contractionary monetary policy can easily decrease long-term interest rates by reducing expectations of inflation and economic growth.

Average inflation targeting might be expansionary during a recession, but it also might lack credibility for exactly the same reason that the current inflation targeting regime lacks credibility; there is no hard and fast commitment to make up for inflation undershoots, just an intention to try to do so.

In my view, first best policies would involve level targeting (of prices or better yet NGDP) and a “whatever it takes” approach to monetary expansion to hit those level targets.  That’s the only policy regime that would give me confidence that the Fed would actually hit its target over the very long run.

So here’s the question.  Should we view the adoption of second best policies as a step forward, even if not optimal?  Or would they be a step that makes the optimal policy less likely?  That is, would average inflation targeting involve the opportunity cost of rejecting level targeting?

What do you think?

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The business cycle drives investment

The Economist has an article discussing research on the link between the housing cycle and the investment cycle:

The housing market has generally been both a reliable predictor of downturns and, frequently, a proximate cause. Serious housing troubles preceded nine of the 11 recessions between the end of the second world war and the start of 2020. One exception is the dotcom bust, which was preceded by only a modest housing slump. The other is the recession of 1953, which was triggered by demobilisation after the Korean war. Here housing was a completely innocent bystander.

In the Keynesian model, investment shocks drive the business cycle.  But there’s actually little evidence for that claim, as in almost any business cycle model the investment sector will be highly procyclical.  Milton Friedman’s “permanent income hypothesis” predicts that people will tend to smooth consumption over time, as their income fluctuates.  Think of a farmer that earns $40,000 in bad years and $100,000 in good years.  The farm family may consume each year as if their income were $70,000/year.

Friedman’s model predicts that consumption will be less cyclical than average, which means that investment will be more cyclical than average.  Even during recessions, consumption spending on food, clothing, haircuts, education, health care, etc., will dip only slightly, even as spending on houses and business equipment falls sharply.

Most recessions (excluding the present slump) are caused by tight money, which reduces NGDP growth.  Because nominal wages are sticky in the short run, employment falls when NGDP falls.  This reduces national output and national income.  Consumption smoothing causes the fall in output to fall disproportionately on the investment sectors (residential and business.)

Housing is almost always an “innocent bystander”, not the actual cause of recessions.

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Hummel on Posner and Garrison on Keynes

I followed a recent email discussion about Judge Richard Posner’s 2009 article in the New Republic in which he tried to revive John Maynard Keynes’s contributions to macroeconomic understanding.

Jeff Hummel, as per usual, had some cogent comments:

I read this and found it somewhat interesting. Posner does a fairly good job explicating Keynes’s General Theory (although I think I did a more persuasive job of making Keynes’s theories plausible when I taught intermediate and graduate macro). But except for Posner’s complaints about mathematics and his emphasizing the distinction between risk and uncertainly, I think he was quite unfair to mainstream economists. Posner is obviously grossly unfamiliar with the actual views of mainstream macroeconomists . For example, a fall in money’s velocity is precisely equivalent to what Keynes means by hoarding or passive saving, and nowadays nearly all macro and monetary economists, including even Austrians such as George Selgin, Lawrence H. White, and Steve Horwitz accept that negative velocity shocks can cause recessions. Almost the only major features of Keynes’s theory that aren’t incorporated in New Keynesian approaches are an interest-inelastic consumption function, full price rigidity, and a self-generating deflationary cycle.

I still consider the best exposition of Keynes’s views is in Roger Garrison’s Time and Money: The Macroeconomics of Capital Structure. It is the only exposition I’ve seen (I haven’t read Skidelsky) that shows how the more socialist parts of The General Theory smoothly integrate with the rest of Keynes’s views. Garrison also offers one of my favorite quotations about Keynes, not in his book, but in an article. He writes that Keynes argued:

Wage rates (1) will not fall because of unions or wage rigidities inherent in the market process, or (2) will fall but without making matters any better and possibly making matters worse because of the accompanying fall in the price level, or (3) should not be allowed to fall because of considerations mentioned in (2).

And then in a footnote, Garrison adds:

Keynes appears to be adopting a strategy usually confined to the legal profession: “My client didn’t borrow your urn; it was in perfect condition when he returned it: and it was already broken when you lent it to him.

See Keynes’s bio and Keynesian Alan Blinder’s entry on Keynesian Economics in The Concise Encyclopedia of Economics.

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This is how it’s supposed to work

Back in the early stages of the 2006-09 housing collapse, the economy behaved as it is supposed to behave. Housing construction fell by more than 50% from January 2006 to April 2008, but there was only a tiny rise in unemployment, from 4.7% to 5.0%. Jobs shifted from housing construction to other sectors. That’s how things work when the Fed is keeping NGDP growing at an adequate rate. You move along the production possibilities frontier, not inside the line. Indeed we would have done even better if not for the modest slowdown in NGDP during late 2007 and early 2008.

Then the Fed let NGDP growth collapse in the second half of 2008, and almost all sectors started shedding jobs. The unemployment rate soared to 10% as we moved inside the PPF.

The recent Covid-19 shock is even bigger, but there are a few heartening signs that we’ll avoid the worst. The Covid-19 epidemic has caused saving rates to soar much higher, as consumers hold back on buying many services. This depresses interest rates, with 30-year mortgage rates recently falling below 3% for the first time ever. This surge in saving also tends to boost sectors less impacted by Covid-19, such as housing construction:

US homebuilder confidence back at pre-pandemic levels

US homebuilder confidence jumped in July, taking it back to levels seen before the pandemic rattled the US economy as the 30-year mortgage slipped to a record low, data on Thursday showed.

The National Association of Home Builders’ Housing Market Index jumped to 72 in July from 58 the previous month. That exceeded economists’ forecasts for a reading of 60, according to a Reuters survey, and matched its reading in March.

It’s a myth that low interest rates are good for the economy. That’s “reasoning from a price change”. Low rates are often caused by a slump in investment demand, which is bad for the economy. But higher saving rates are good for the housing sector. If monetary policy is adequate, we should see a V-shaped recovery once the worst of the epidemic is behind us.

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Monetary economics: The three heresies

In the wake of the Great Recession, the field of monetary economics has developed at least three heresies—schools of thought that reject mainstream monetary models. In my view, all three models are largely reactions to an important failure in mainstream models. The fact that these three heresies differ from each other largely reflects the fact that they came from different ideological perspectives.

In Thomas Kuhn’s theory of scientific progress, a widely accepted model may run into problems when faced by empirical facts that seem inconsistent with the prediction of the model.  This leads to a period of crisis, and new models are developed to address the empirical anomalies.  I believe that this has happened in monetary economics.

Consider the following claim, which reflects the views of most mainstream economists, circa 2007:

“A policy of reducing interest rates to very low levels is highly expansionary.  When combined with massive fiscal stimulus it can lead to high inflation and/or a sovereign debt crisis.”

Over the past three decades, the Japanese have done something quite similar to the hypothetical policy mix described above.  And yet there has been no significant inflation and no debt crisis. That’s an anomaly that needs to be explained.

At the risk of oversimplification, here’s how three new schools of thought addressed this anomaly:

1.  MMTers suggest that governments of countries with their own fiat money face no limits on how much they can borrow.  They recommend that central banks in those countries set interest rates at zero.  Inflation would only become a problem if spending exceeded the capacity of the economy to produce, in which case higher taxes were the solution.

2. NeoFisherians argue that low interest rates are not an expansionary monetary policy; rather they represent a contractionary policy that will lead to lower rates of inflation.

3. Market monetarists argue that lower interest rates are not expansionary or contractionary, indeed to suggest that interest rates constitute a monetary policy is to “reason from a price change.”  Japanese rates were low because previous tight money policies had reduced trend NGDP growth to near zero.

So there are three new heterodox models, none of which agree with the mainstream model, and none of which agree with each other.  How did we end up with such a mess?

The important anomalies that were observed in Japan, Switzerland and elsewhere after 2008 made it almost inevitable that alternative models would be developed.  But why three?  The answer lies in that fact that even prior to 2008, there were important splits in the field of monetary economics.

Those who favored a more left wing interpretation of the Keynesian model (including so-called “Post Keynesians”) tended to strongly reject quantity theory oriented approaches to monetary policy.  In one sense, MMT can be seen as the most anti-quantity theory model ever developed.  Its tenets are almost the polar opposite of monetarism on a wide range of issues.

A more right-leaning group were used to employing a somewhat more classical (flexible price) model of macroeconomics.  In these models, the Fisher effect is far more important than the liquidity effect.  Thus it was natural for more classically inclined economists to gravitate toward an explanation of the Japanese anomaly that emphasized the Fisher effect—the way that changes in inflation expectations are strongly correlated with changes in nominal interest rates.  This eventually led to the NeoFisherian model.

A middle group coming out of the monetarist tradition, dubbed market monetarists, emphasized the importance of a wide range of linkages between money and interest rates, including the liquidity, income and Fisher effects.  This group accepted the monetarist view that changes in interest rates were a sort of epiphenomenon of monetary policy changes.  It rejected the assumption that changes in interest rates can tell us anything useful about changes in the stance of monetary policy.

Elsewhere I’ve described why I prefer market monetarism to mainstream models, MMT, and NeoFisherism, so I won’t repeat those points here.  (I am currently writing a paper on the Keynesian/NeoFisherian dispute.) But I will say that the mistake of equating interest rate changes with monetary policy is something like the original sin of macroeconomics.  It has caused all sorts of confusion, and gave birth to three very heterodox models.

This post is illustrated with the famous Goya print entitled “The Sleep of Reason Produces Monsters.  Let me just say that in my view the failure of mainstream economists to accurately describe the relationship between interest rates and monetary policy produced two quite misshapen beasts and one very beautiful baby.

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