Is the Fed Sadistic?

Kevin Drum, Mother Jones:

Arnold Kling [libertarian] on current Fed policy:

I call it neutron-bomb monetary policy. The banks are still standing, while the people are getting killed. I don't think that is the explicit intent of the Fed, but the structure of the organization makes it much more responsive to the thought process of bankers than to that of ordinary Americans.

Scott Sumner [conservative monetarist]:

Central bankers are a bunch of well-meaning (or at worst amoral) people who act like sadists because they have the wrong model in their heads....What the Fed considers normal, I consider sadistic. Not just this Fed, but earlier Fed’s, and foreign central banks as well. If I knew there was 10% unemployment, I couldn’t sleep at night knowing the markets were predicting only 1% inflation, whereas the target was 2%. I’d keep asking myself; “Why not do more stimulus? We’d improve both the unemployment and inflation situations at the same time.”

Andy Harless [pro-business conservative?]:

How does the Recession allow the government to bail out banks? With the recession going on, people are afraid to do anything risky with their assets, so they keep them deposited in banks, earning no interest. Banks can then invest these deposits in Treasury notes and credit the interest on those Treasury notes to their bottom line, thus improving their balance sheets.

...Now this bailout program is not without its risks. The biggest risk is that the economy will recover, which would be a disaster for the program....So the success of this bailout program depends on avoiding recovery, avoiding increases in inflation expectations, and avoiding major declines in Treasury note yields. Now do you understand why the Federal Reserve Bank presidents — representatives of the banking sector — are the most hawkish voices at the FOMC’s policy meetings?

And of course, Paul Krugman [liberal]:

Why are people who know better sugar-coating economic reality? The answer, I’m sorry to say, is that it’s all about evading responsibility.

In the case of the Fed, admitting that the economy isn’t recovering would put the institution under pressure to do more. And so far, at least, the Fed seems more afraid of the possible loss of face if it tries to help the economy and fails than it is of the costs to the American people if it does nothing, and settles for a recovery that isn’t.

The Fed has very few admirers anywhere on the ideological spectrum these days.

Unemployment Falls Through Economic Growth via Okun's Law

The middle of the depression had some of the fastest growth in US history!

Delong:

[T]he reason the unemployment rate was dropping from its high of 24%... was... serious real economic growth... five of the eight years from ’33 to ’40 [saw] real GDP [grow] by more than 8% a year!...

seven different theories of recession

Grasping Reality with Both Hands
Confront economists' theories of depressions and what (if anything) the government should do about them and you find yourself immediately confronted with what look to be at least seven different theories:

• Monetarism, the doctrine of Irving Fisher and Milton Friedman, that a depression is the result of the money stock falling too low, where the money stock is the economy's sum total of liquid assets that are generally accepted as and held in people's portfolios for the usefulness as means of payment.
  
• Wicksellianism, the doctrine of Swedish economist Knut Wicksell, that a depression happens when the workings of the banking system lead the market rate of interest to be above the natural rate of interest that balances the supply of funds saved and the demand for funds to finance business investment.
  
• Minskyism, the doctrines of Hyman Minsky--and also Walter Bagehot and Charles Kindleberger--that a depression happens because of a panic and a flight to quality, as everybody tries to sell their risky assets and cuts back on their spending in order to try to shift their portfolio in the direction of safe, high-quality assets--which, of course, everybody cannot all do at the same time.
  
• Austrianism, the doctrine that because of past irrational exuberance and over- or malinvestment, that there is nothing of social value a large chunk of the labor force can do other than sit on its hands unemployed and wait for circumstances to change and profitable employment opportunities to open up.
  
• Vulgar Keynsianism, the doctrine that depressions happen because something has reduced the flow of aggregate demand.
  
• Hickianism, something you have forgotten from intermediate macroeconomics courses of a decade or two ago that involves IS and LM curves, which is actually a combination of monetarism (LM) and Wicksellianism (IS).
  
• Post-Keynsianism, which seems to be a combination of Wicksellianism and Minskyism.

The Rise of Finance in America

Read this entire article. Highly recommended. Tells about the rise of finance and the political problems that brings.
The Quiet Coup - Magazine - The Atlantic:

"From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically. From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007.

The great wealth that the financial sector created and concentrated gave bankers enormous political weight—a weight not seen in the U.S. since the era of J.P. Morgan (the man).

Three cheers for the death of old economics | Anatole Kaletsky - Times Online: "The dirty little secret of modern economics is that the models created by central banks and governments to manage the economy say almost nothing about finance. Policymakers who turned to academic economists for guidance in last year’s crisis were told in effect: “The situation you are dealing with is impossible: our theories prove that it simply cannot exist.”

The Future of Oil: Four Scenarios

Standard and Poor's

The Gulf goes dry
In this scenario, Iran closes the Strait of Hormuz to oil tankers. Oil prices spike sharply. World oil supplies would be cut by about 20%. World strategic petroleum reserves are tapped extensively, but even so, oil prices rise to $250 per barrel. The world economy moves into recession, on the order of the 1980-1982 downturn. The U.S. is the hardest hit of the major economies, with real GDP dropping 5.2% below the baseline in late 2007, implying a major recession, and the unemployment rate reaching 7%. Consumer price inflation hits 10% next year as oil prices soar. The impact on Europe is smaller, but because the Continent started with weaker growth, the recession is just as big. Japan has a recession of similar size.

Both in terms of the price effect and the supply impact, the models are being pushed well outside their historical range, and the dislocations could be even more painful than this projection implies. This is by no means a worst-case scenario but closer to a best case given the closure of the Strait. We think (and certainly hope) this is an unlikely scenario.

	2004	2005	2006	2007	2008
Real GDP (% chg.)	4.5	3.5	2.7	(1.6)	4.0
Consumer spending (% chg.)	3.7	3.5	2.0	(2.5)	2.7
CPI (% chg.)	2.7	3.4	4.1	9.6	0.2
Core CPI (% chg.)	1.8	2.2	2.6	4.2	4.1
Oil price (WTI) ($/barrel)	41.0	56.6	91.7	238.2	106.9
Unemployment rate (%)	5.5	5.1	4.9	6.7	7.0
S&P 500 index	1133	1207	1218	793	965

structural unemployment vs cyclical unemployment

Brad Delong:

Over at Slate, James Ledbetter says that he cannot referee between the two gangs of economists warring over the causes of high unemployment.

But he is wrong.

He can.

Here is how:

Suppose that you have not cyclical unemployment generated by a collapse in aggregate demand but structural unemployment generated by mismatch, suppose you have a situation in which the structure of demand by consumers is different from the jobs that workers are capable of filling. Suppose--this is Berkeley, after all--that we were in a nice equilibrium in which some workers were baristas making lattes and other workers were yoga instructors teaching classes and that all of a sudden we have had a big shift in demand: that consumers decide that they want few moments of wired, frenetic caffeination and more moments of inner peace.

What would we expect to find happening?

We would expect, first, coffee bars to stand empty as people hoarded their quarters for the next yoga lesson. We would expect coffee bars to fire baristas, and to close down. But we would also expect yoga studios to be crowded, and yoga instructors to be teaching extra classes, and working long hours, and raising their prices, and training ex-baristas to chant properly, do the downward-facing dog and the lizard, and teach others how to achieve inner peace.

The size and duration of the excess unemployment of ex-baristas might be substantial and long-lasting. It takes quite a while to retrain a barista as a yoga instructor. Those seeking training might have a difficult time getting the attention of and apprenticing themselves to the yoga instructors doing land-office business--given how mercenary and grasping and eager to catch the wave of the market we all know yoga instructors to be.

But depression in the coffee-bar sector and unemployment among ex-baristas would be balanced by exuberance in the yoga-studio sector, rising prices for yoga lessons, and long hours and high wages for yoga instructors.

That is what 'mismatch' structura unemployment looks like--one sector depressed with a lot of idle excess labor, a second sector booming with rising wages and prices.

Minneapolis Federal Reserve chair Kocherlakota seemed to believe that our unemployment is structural which would not be affected by Fed policy:

...it is hard to see how the Fed can do much to cure this problem [of unemployment] ...the Fed does not have a means to transform construction workers into manufacturing workers.

As Krugman noted:

...Kocherlakota would have us believe that there’s a big problem of mismatch because manufacturing is trying to hire, while construction has slumped. But here’s the employment reality:

Bureau of Labor Statistics

Manufacturing employment has slumped, not risen — in fact, it has fallen more than construction employment. The problem is lack of overall demand, not worker mismatch.

Benign Bubbles vs Mean Minsky Bubbles

Paul Krugman:

while bubbles are in general a bad thing, just how bad depends a lot on the context — in particular, whether the inflation of the bubble has been accompanied by a big increase in leverage on the part of those buying the inflated assets.

Consider the stock bubble of the late 1990s. It was crazy, and when it popped U.S. households suffered a capital loss of about $5 trillion. This was bad, and helped cause a recession. But it never rose to the level of economic catastrophe.

Similarly, the stock market crash of 1987 had almost zero impact on the economy. A decline in prices is usually a good thing, so the popping of a bubble can be beneficial. The world would be a worse place if tulips were still worth their weight in gold like they were during the great tulip bubble. The crash in oil prices in the 1980s was devastating to big exporters like the USSR and the Persian Gulf, but it was a boon the the world as a whole. The decline in housing prices should make life easier because everyone needs a home and now they are cheaper, but the artificial financial crunch due to leverage caused a much broader problem.

What was the difference? First, a lot of financial institutions — which are highly leveraged — were holding [housing] securities ... So the housing bust undermined the financial system in a way the stock bust never did.

Second, households also leveraged themselves up in the housing boom, in a way they for the most part didn’t with stocks (yes, there were people buying dotcoms on margin, but they were not typical). So the housing bust created a balance-sheet crisis for the household sector in a way that the dotcom bust didn’t.

... the bubbles we should fear are those that lead to leverage, and set us up for a Minsky moment.

Undoing Past Wrongs

Some people think that the current economic problems (housing bubble, etc) were caused by overly loose monetary policy and that the remedy is to tighten monetary policy now.  Loose monetary policy was probably one contributor to the housing bubble (although I don't blame it for the current recession), but tighter monetary policy won't fix the recession.  Even if it were a mistake, doing the opposite thing won't automatically fix anything.  If you injure a friend's foot with an axe while cutting firewood during a wilderness camping trip and it gets gangrene, the best way to save your friend may be to cut it off with the axe rather than to forswear axe use entirely and do without firewood for heat and cooking.  If you drive over a pedestrian, the solution is not to go into reverse and run back over them, but to take them forward to the hospital. 

In the current situation, nobody has an actual model of the economy that explains why higher interest rates (and lower inflation) would be beneficial and yet some  people are calling for it. 

Recessions in nominal vs in real GDP

Matthew Yglesias "A different way of looking at it is to think of the recessions in nominal terms. Here’s Nominal GDP from 1980 to 1985:

The double-dip was associated with some flattening of Nominal GDP growth, but the deviation isn’t gigantic. What’s more, the super-rapid “catch-up” growth in real output that led us out of the recession didn’t involve anything unusually looking in nominal terms relative to the pre-recession trend. What happened was that the composition of nominal growth switched to one that involved less inflation and more “real” growth.

Compare that to more recent events:

That’s an entirely different kettle of fish. In nominal terms, we experienced a dramatically bigger recession than happened in the early eighties. Normally people think of “real” GDP as more important (that’s why they call it real) but for many purposes nominal numbers are very meaningful. My mortgage payments are denominated in nominal terms, as are my cable & phone bills, my salary, and various other contracts I’m involved with. When a huge gap opens up between the actual and trend levels of nominal economic activity, that means the best-laid plans of firms and households are all thrown out of whack. This is probably a situation the Federal Reserve could ameliorate if they were willing to produce enough inflation to push the price level back into line with trend, but if they continue to insist on a policy of opportunistic disinflation the adjustments will take longer.

Who does the Fed work for?

Matthew Yglesias:
As you read about Kansas City Fed President Thomas Hoenig’s plan to increase the unemployment rate by pushing inflation even further down below target, it’s worth asking yourself “How does a person get to be President of the Kansas City Fed?” Well, you get picked by the Board of Directors. And who picks the Board? Local bankers, mostly:

Each Federal Reserve Bank has a nine-member board of directors: The member banks elect the three Class A and three Class B directors, and the Board of Governors appoints the three directors in Class C. Directors are chosen without discrimination as to race, creed, color, or national origin. The directors in each class serve staggered three-year terms.

Class A directors of each Reserve Bank represent the stockholding member banks of the Federal Reserve District. Class B and Class C directors represent the public and are chosen with due, but not exclusive, consideration to the interests of agriculture, commerce, industry, services, labor, and consumers; Class B and Class C directors may not be officers, directors, or employees of any bank. In addition, Class C directors may not be stockholders of any bank. The Board of Governors annually designates one Class C director at each District Bank as chair of the board of directors and another Class C director as deputy chair.

This system has never made any real sense. The Fed’s Open Market Committee is an important maker of public policy. There’s no reason private firms should have such a large role in its governance. But many aspects of Fed governance have escaped scrutiny in recent decades thanks to the perception that the Volcker, Greenspan, and Bernanke era Feds were doing a good job. Increasingly, however, it’s clear that the Fed is not doing a good job—it seems incapable of hitting its inflation target, for example— which should spark increased discussion of the matter.

The People Who Sell Their Forecasts to Paying Clients Believe the Stimulus Is Working - Grasping Reality with Both Hands

I don't know of any firms selling forecasts who think that fiscal stimulus programs don't work. Nor do I know of any real business cycle forecasters. Are there any?

The People Who Sell Their Forecasts to Paying Clients Believe the Stimulus Is Working - Grasping Reality with Both Hands: "Only those who make their nut one way or the other by pleasing Republicans claim that it isn't. Jackie Calmes and Michael Cooper are on the case:

Jackie Calmes and Michael Cooper: Now that unemployment has topped 10 percent, some liberal-leaning economists see confirmation of their warnings that the $787 billion stimulus package President Obama signed into law last February was way too small. The economy needs a second big infusion, they say. No, some conservative-leaning economists counter, we were right: The package has been wasteful, ineffectual and even harmful to the extent that it adds to the nation’s debt and crowds out private-sector borrowing.

These long-running arguments have flared now that the White House and Congressional leaders are talking about a new “jobs bill.” But with roughly a quarter of the stimulus money out the door after nine months, the accumulation of hard data and real-life experience has allowed more dispassionate analysts to reach a consensus that the stimulus package, messy as it is, is working. The legislation, a variety of economists say, is helping an economy in free fall a year ago to grow again and shed fewer jobs than it otherwise would...

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