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Giles Wilkes directed me to an interesting Financial Times article on the strong dollar:

In its April forecast for the global economy, IMF statistics suggested that global gross domestic product in nominal US dollar terms would hit $74.5tn this year, a contraction of $2.7tn from 2014. This compares with the $3.3tn US dollar recession in 2009, the steepest since records began in the early 1960s.

The IMF did not update its nominal GDP forecasts for 2015 on Tuesday but its downward revision of global GDP growth coupled with the dollar's continued strength since April suggests a deepening in the likely dollar-denominated GDP contraction. The dollar is up 6.8 per cent against a trade-weighted basket of major currencies this year.

The power of the US dollar as a means of trade payment, store of value and a reserve asset for the world is such that any strengthening in the greenback will be widely felt.

Emerging market countries, for instance, still buy most of their imports in dollars, meaning that the depreciation of their national currencies against the dollar has pushed up the price of imports and damped consumer demand.

I do think that the strong US dollar is having a moderate deflationary impact on the global economy. But I have some doubts about the mechanisms described in this article. I doubt that if it matters very much that imports are priced in dollars, or that the US dollar is "a means of trade payment, store of value and a reserve asset for the world". Nor does it matter that global NGDP is falling by around 3% in dollar terms, as workers in other countries are not paid in dollars. Europe will grow this year, despite sharply lower NGDP measured in dollar terms.

Yes, oil is priced in dollars. But commodity prices are not sticky, so it doesn't matter which currency is used. If the euro falls 20% against the dollar, it makes no difference if oil is priced in dollars, and falls 12%, or priced in euros and rises 8%. Either way, Americans and Europeans pay the exact same price in their local currency. Indeed the strong dollar is one of the reasons why commodity prices have fallen this year.

So why does the strong dollar matter? In a word, China.

Despite the recent tiny devaluation, the Chinese yuan is basically pegged to the dollar. Thus unlike the euro and the yen, the yuan did not depreciate sharply against the dollar. This means the yuan appreciated sharply against the euro, the yen, and most emerging market currencies. And this slowed China's economy. As China's growth rate declined their demand for commodities fell sharply. (This was also due to a switch out of heavy industry and towards services.)

Why am I being so picky? After all, the FT was correct that a strong dollar tends to weaken the global economy. I'm being picky because unless we understand the exact mechanism, then we might end up misjudging the effects of a strong dollar in the future. Suppose that in the year 2026 the dollar again strengthens. But this time China's currency is floating, and does not go along with the dollar. Instead, the yuan weakens along with the euro, the yen and the emerging market currencies. In that case I would not expect a strong dollar to have a deflationary impact on the global economy.

Shorter version of post: Never reason from a price change.

PS. Another possible mechanism is dollar-denominated debts become more burdensome. Yes, they are a sunk cost, and should not affect output. But if emerging market borrowers become less creditworthy, it might impact investment in the EMs.

PPS. I strongly recommend Ramesh Ponnuru's recent article on the Fed.

One of the concerns I have had about substantially expanding immigration to the United States, Canada, and other countries is that a large number of immigrants, not understanding the important role of economic freedom in raising our standards of living, will "vote it away." Recently I posted about one piece of counter-evidence in California. I think many commenters did not get the significance of that piece of evidence. I didn't give it as a slam dunk but, rather, as one important piece of evidence. Various commenters came up with alternate scenarios in which the legislative representatives who represented some of those immigrant-heavy districts would have voted for more government. They missed my point. The particular piece of legislation that these legislators voted against was so serious that I had started a conversation with my wife about moving out of California after I retire. To put that in perspective, she and I had agreed until then that the probability we will stay in the central coast of California is somewhere between 0.9 (me) and 0.95 (her).

While driving on Monday, I listened to a few minutes of Rush Limbaugh's radio show. Limbaugh is a strong critic of both legal and illegal immigration. Limbaugh stated that the change in the immigration law in 1965 made us a completely different country in 2015. Specifically, he claimed that the percent of Americans who were immigrants in 1965 was much lower than the percent today. He's right. That accords with these data from Brookings. In 1960, five years before the change in legislation, the foreign-born population was only 5.4% of the overall U.S. population. In 2010, after the legislation had been in existence for 45 years, that percent had more than doubled--to 12.9%. And those data--on the stock of population--are broadly consistent with the flow data on immigration from George Borjas in his article, "Immigration," in The Concise Encyclopedia of Economics. His data show that the number of immigrants to the United States between 1991 and 2000 was over 3.5 times the number between 1951 and 1960, the last decade before the change. Given that the U.S. population was not nearly 3.5 times as many in the 1990s as in the 1950s, the flow of immigrants decade by decade increased their representation in the U.S. population.

Why do I find this so interesting? Because that means that immigrants were not a big factor in voting in 1964 or even in 1972. Why is that interesting? Because the programs that are responsible for most of the growth in government spending after about 1950 occurred between those two years. I have in mind three: Medicare, Medicaid, and Social Security. Lyndon Johnson got Medicare and Medicaid into law in 1965. And, whereas Social Security was well established 30 years earlier, LBJ took advantage of the baby boom demographics to substantially raise Social Security payments. President Nixon, in a bidding war with Wilbur Mills, the powerful chairman of the House Ways and Means Committee and a potential Democratic rival for the presidency in 1972, took advantage of the same demographics (the baby boomers were still young) to raise Social Security benefits even more. All this happened without the immigrant vote being significant.

Is that slam dunk evidence that immigrants don't vote freedom away more than natives do? No. But it's pretty strong evidence.

By the way, off topic with this particular post, but on topic with the immigration issue generally, George Borjas has a new paper that finds that the David Card results on the Mariel boat lift ("The Impact of the Mariel Boatlift on the Miami Labor Market." Industrial and Labor Relations Review 43: 245-257) were wrong. Recall that Card found that the increase in the Miami-area number of immigrants from Cuba had little effect on wages, Borjas has done a more-careful study in which he separates, in the data, high-school dropouts. He finds that they took a big hit on wages. Specifically, writes:

A crucial lesson from this literature is that any credible attempt to measure the wage impact of immigration must carefully match the skills of the immigrants with those of the pre-existing workers. The Marielitos were disproportionately low-skill; at least 60 percent were high school dropouts. A reappraisal of the Mariel evidence, specifically examining the evolution of wages in the low-skill group most likely to be affected, quickly overturns the finding that Mariel did not affect Miami's wage structure. The absolute wage of high school dropouts in Miami dropped dramatically, as did the wage of high school dropouts relative to that of either high school graduates or college graduates. The drop in the relative wage of the least educated Miamians was substantial (10 to 30 percent), implying an elasticity of wages with respect to the number of workers between -0.5 and -1.5.

Your debutante just knows what you need

But I know what you want -- Bob Dylan

Over at MoneyIllusion I did a post---partly tongue in cheek---pointing out that if Milton Friedman were alive today he might be forced to change his mind as to the proper definition of "money." When he was alive he preferred the M2 money supply, but I suggested that in the 21st century the quantity of coins seemed to better meet his (empirical) criterion for money.

As I expected some took it more seriously than it was intended, but some of the complaints were quite revealing. Consider this representative comment:

The chief problem with using coinage as any sort of indicator of monetary policy is that people decide how many coins to hold, not the Fed or any other monetary authority.
To paraphrase Mr. Dylan, the public knows how many coins they want, but the Fed determines how many they need.

I certainly understand the sense in which the coin stock could be viewed as "endogenous", i.e. not directly controlled by the central bank. But there's another sense in which it is no different from any other monetary indicator/target. When the Fed increases the monetary base it leads to a hot potato effect, which causes the following to happen:

1. The public wants to hold more M2, because with a bigger NGDP they feel they need to hold more M2.
2. The public wants to pay more for foreign exchange, because with a higher price level they need to pay more for foreign exchange.
3. The public wants to lend money at a lower interest rate (perhaps), because with larger real cash balances they need to offer lower rates to lend money.
4. The public wants to hold more coins, because with a larger NGDP they need to hold more coins to do their shopping.

The Fed does not directly control M2, exchange rates, market interest rates or the stock of coins. Those variables reflect the decisions of non-Fed actors. But Fed policy can push people to behave in such a way that those variables change. Thus it's not crazy to talk about the Fed targeting M2 (as Friedman preferred) or exchange rates (as Mundell often prefers) or interest rates (as Woodford prefers) or NGDP futures prices (as I prefer) or even the quantity of coins, as I half-jokingly considered.

If women consistently wore shorter skirts during booms than recessions (as someone once claimed) then it would not be crazy to talk about the Fed targeting average skirt length.

There's lesson here. People prefer to think about macro issues in concrete terms. I go to the bank, and I decide how many coins I will hold. I decide how much cash I will hold. Banks decide how much reserves they will hold. But guess what, the Fed decides the total monetary base. If they double the base, then you and the banks will WANT to hold a lot more coins, paper money and bank reserves, whether or not you currently think you will want to hold more. Goods, services, and asset prices will change in such a way that you actually want to hold more base money.

As individuals we control how much base money we hold. In aggregate, the Fed controls the total. The adjustment in goods, services, and asset prices necessary to reconcile those two sets of wishes is what lies at the very heart of monetary policy. It's the hot potato effect. If you don't really get this idea at an intuitive level, you'll end up spouting one fallacy after another. You'll focus on "concrete steppes", missing the big picture. You'll focus on credit, when you need to be focused on monetary policy. You'll focus on finance, when you need to be thinking in macroeconomic terms.

I'm speaking in Urbana, Illinois on open borders this Thursday.  Details here.


Alberto Mingardi

Portugal after the elections

Alberto Mingardi

The Portuguese elections may result in a gridlocked government. The center-right coalition won - but did not secure a working majority. The incumbents gained 37% of the votes, the Socialists 32%. The Left bloc reached 10% and the Communists, who were expected to win double figures, got 8 %.

With 99 seats in a 230-seat parliament, however, the ruling coalition fell 17 seats short of the needed majority.

As Paul Ames writes on

Without an agreement between the two main factions, Portugal could face a period of political uncertainty as the government struggles to push through its program and get next year's budget through parliament.

The Portuguese elections can therefore be both a factor helping to secure a more stable political scenario in the Eurozone--or, paradoxically, further endanger it. It has already been remarked that the political extremists had no chance to win in Portugal: the contest was basically between "mainstream" parties, both committed to fiscal consolidation. But it is also noteworthy that the governing coalition, which implemented tough austerity measures, regained consensus: just a few months ago (see the chart in this article) the Socialists were rising in the polls.

I don't know enough about Portuguese politics to speculate whether incumbent Prime Minister Pedro Passos Coelho will be able to form a minority government and gain support in the Parliament. Somehow he is in a position similar to Angela Merkel after the last elections. Merkel won even more unequivocally, but lacked a proper majority, and thus needed to ally with the social-democrats.

Political instability in Portugal can hardly be good for the rest of the Eurozone. After Portugal and Greece, the third election to watch out for will take place in Spain. Here, political extremism has been on the rise for quite a while, with the left-wing populists of Podemos gaining consensus, not least because of a huge corruption scandal. The way in which these three countries manage to deal with fiscal consolidation and, hopefully, return to growth in the next few year will be crucial for the future of the Eurozone.

CATEGORIES: Eurozone crisis

David R. Henderson

Mark Thoma on NAFTA

David Henderson

Yesterday, economist Mark Thoma wrote a piece on Donald Trump's claim that NAFTA was a disaster. It's titled "Is Donald Trump right to call NAFTA a 'disaster'?"

I thought Thoma would say it wasn't a disaster because, however imperfect NAFTA was--and it was imperfect--it was a step toward free trade. (It was also a customs union, which isn't the same as free trade but, on net, it was a step toward free trade also.) Thousands of tariffs were cut, sometimes to zero, on Mexican products sent to the United States and on U.S. products sent to Mexico. When taxes (tariffs are taxes) are cut on goods that you buy, you're better off.

But that's not how Thoma judged NAFTA. Instead, he wrote:

Is he right? Was NAFTA a disaster? The answer to that question depends on how we measure the results. For the U.S. -- where the Bill Clinton administration sold the agreement as a job-creating policy because U.S. exports would grow by more than its imports -- the agreement has not lived up to its promise.

Estimates vary, but it appears that somewhere in the neighborhood of 350,000 to 700,000 jobs were lost due to the agreement, and when these workers eventually found new jobs, their incomes fell slightly (though some claim that incomes went up modestly).

Of course, Thoma has every right to use whatever standards he wants to judge trade agreements. He chooses the standard that Bill Clinton chose. I find that strange given that he is an economist and economists tend to judge trade agreements by how much they benefit not just producers, but also consumers. Indeed, probably over half the benefits to a particular country from a trade agreement is the gain in variety of, and drop in prices of, imports.

But Thoma says not a word about consumers.

CATEGORIES: International Trade

Questions non-economists ask when I tell them I'm homeschooling my sons:

1. What makes you think you're qualified to teach them?
2. Who are you to decide what your kids should study?
3. What about socialization?
4. How come you're not teaching [insert pet subject here]?
5. Won't this hurt your kids later in life?
6. Aren't you hurting your kids' development right now?
7. When will they interact with girls?
8. Isn't there more to life than academics?
9. Aren't you undermining social cohesion?
10. Why are you turning your kids into brainwashed freaks?

Questions economists ask when I tell them I'm homeschooling my sons:

1. Doesn't it take a lot of time?


The other Feature Article on Econlib today is "Phools and Their Money," Arnold Kling's review of Phishing for Phools: The Economics of Manipulation & Deception by George A. Akerlof and Robert J. Shiller.

A highlight, after Arnold gives their first example of manipulation, Cinnabon (which, by the way, I have literally never eaten, tempted as I have been):

Even if they fail to prominently display calorie counts, I do not think that Cinnabon's success relies on deception. Nobody confuses iced cinnamon rolls with kale salad. Pretty much everybody who eats them has some sense that this is not health food. If Cinnabon is guilty of something, it must be manipulation, through the use of smell and location. But what are they supposed to do--set up shop in remote locations with no foot traffic and emit a smell of liver and onions?

Overall, I do not think that the authors chose well in starting with the Cinnabon example. They do not make the case that people who buy cinnamon rolls are doing something that those consumers would rather not be doing. Instead, it just seems that such consumers are doing something that Akerlof and Shiller find reprehensible. They need to come up with an objective way of making the distinction between satisfying consumer wants and manipulating consumers. It is demagogic to rely on one person's disgust at another person's consumption of fatty foods.

And Arnold's ending:
Akerlof and Shiller are Nobel Laureates, which they earned with previous research. That is what makes this book so disappointing. People may enjoy reading Phishing for Phools, but it is lacking in real intellectual nutrition. It is the literary equivalent of a Cinnabon.

I've made this point before, but it's worth repeating, given all the recent talk about the Fed relying on the Phillips Curve. The Phillips Curve model only works when the business cycle is driven by demand shocks. When we are hit by supply shocks the Phillips Curve actually slopes upward; inflation is higher during recessions.

It's the Fed's job to prevent demand shocks, which means it's the Fed's job to make the Phillips Curve model false. So why are they relying on that model to predict an upswing in inflation as unemployment falls below 5%?

Here's an easier way to think about it. Imagine a single mandate, where the Fed keeps inflation right at 2%, all of the time. In that case the Phillips Curve is horizontal; there is zero correlation between inflation and unemployment. Now assume Congress adds a second mandate---employment. The Fed would do a bit more expansionary policy when unemployment was high, and vice versa. They would still keep inflation stable at 2%, on average, but allow some year to year fluctuation in inflation to smooth out unemployment. A bit more than 2% inflation when unemployment is high, and a bit less than 2% inflation when unemployment is low. In that case inflation will be countercyclical, exactly the opposite of the prediction of the Phillips Curve model.

So why is the Fed using the Phillips Curve to forecast inflation?

And why is it that when I mention this simple point, right out of EC101, so many economists give me a "funny look"?

PS. I do understand that the Fed can't entirely prevent demand shocks, and hence occasional periods of procyclical inflation. But surely they should set policy in such a way that they forecast an outcome that is consistent with their policy goals.

Many economists who currently support large minimum wage hikes claim that the best research now shows that such an increase would not cause significant drops in employment. However, their conclusion relies on a dubious reading of the literature. Dozens of recent empirical studies show significant employment reductions from minimum wage hikes, with some of these analyses using the newer "case study" approach, as opposed to the traditional regression analysis. Furthermore, serious methodological criticisms have been leveled against even the best of the studies used to justify increases in the minimum wage. Finally, even on their own terms, the studies purporting to show that the minimum wage is benign can justify only modest hikes: these studies' own results are consistent with the claim that aggressive minimum wage hikes will cause many unskilled workers to lose jobs.
This is the second paragraph in this month's Econlib Feature Article "Large Increases in the Minimum Wage Are Likely to Destroy Jobs," by Robert P. Murphy.

Another excerpt:

However, in the present article, I focus on the narrow issue of the empirical estimates of the employment effect of a minimum wage hike. I cite the recent literature showing that this is still an open question even if we consider only modest hikes. Furthermore, even if we stipulate the results in the 2010 Dube et al. paper, we still should be wary of the popular minimum proposals, because the proposed increases are so large. Ironically, it would be more accurate to say that there is no evidence to justify large increases in the minimum wage.

One of the best paragraphs:
Now the interesting thing is that when we perform this exercise, it turns out that the lower bound falls smack dab within the traditional consensus. In terms of coefficients, the orthodox regressions found that the minimum wage variable fell in the range of negative 0.100 through negative 0.300, whereas (in the quotation above) Dube et al., in their preferred model, report that it's probably not worse than negative 0.147. This is neither the intellectual revolution nor the green light for policymakers that Krugman and others would have us believe.

The whole piece is excellent.

The papers for the Tullock Memorial Conference are now up, including my presentation on "What I Learned from Gordon Tullock."  If I had more time, I would have spent it discussing Tullock's undersung analysis of dictatorship.

University of Chicago economist Richard H. Thaler, probably the most important founder of "behavioral economics," is a fantastic storyteller. In his latest book, Misbehaving, he tells, roughly chronologically, of his initial doubts about the standard economist's "rational actor" model and how those doubts led him to set his research agenda for the next 40 years. In chapter after chapter, he tells of anomalies--bits of evidence that are inconsistent, sometimes wildly so--with the various economic models and of his debates with the proponents of those models. In Thaler's telling, he always won the debates. One would expect him to say that, but as someone who did not start out on his side of the debates, I think he often did win.
This is the opening paragraph of my "The Case for 'Misbehavior,'" my review of Richard H. Thaler's new book, Misbehaving. It appears in the Fall issue of Regulation. (Scroll down.)

An excerpt that illustrates one of his main themes:

Consider what he calls the endowment effect. In laying out the effect, Thaler presents the results of two versions of a question he asks his students. In version A, he tells them that they have been exposed to a rare disease that they have a 1 in 1,000 chance of contracting. If they get the disease, they will die within a week. They can take an antidote that, with certainty, will prevent death. How much, he asks, are they willing to pay for the antidote? A typical answer is $2,000.

Then he presents the same students with version B, telling them that they can choose whether or not to enter a room in which they will have a 1 in 1,000 chance of getting that same disease. The question: how much do they have to be paid to be willing to enter the room? The answer should be something close to $2,000, possibly a little higher to reflect what economists call the "wealth effect:" if they are paid to accept a small risk, they are slightly wealthier than if they must pay to avoid a small risk. But the typical answer? $500,000. Thaler calls this phenomenon the endowment effect because, he explains, "the stuff you own is part of your endowment" and "people valued things that were already part of their endowment more highly than things that could be part of their endowment." He gives numerous other examples that, I suspect, will ring true with most readers.

Thaler's response to those who think that people become more rational when the stakes are higher:
One of the arguments that economists often make against Thaler's view of humans is that most of his evidence comes from low-stakes situations in which the gains from being rational are not large. However, they assert, when the gains are large, humans tend to be much more careful. But, using evidence from the National Football League's entry draft, Thaler makes a strong argument against this view.

NFL teams are multi-multi-million-dollar enterprises, and their draft picks represent multi-million-dollar decisions. Surely, if there is strong evidence of rationality, it would be in the NFL. But Thaler shows that NFL owners and managers seem to make poor draft decisions. For instance, he discusses the considerable evidence that teams are better off "trading down"--that is, swapping a single early-round draft pick for multiple later picks--and trading away a draft pick this year for multiple picks in future drafts, and yet few teams do this. He even tells of a conversation he had about these issues with Dan Snyder, owner of the Washington Redskins, which led Snyder to send two of his top managers to talk to Thaler and his colleague Cade Massey. Their subsequent draft picks showed that they ignored Thaler's advice. And, as anyone who follows the Redskins knows, they paid dearly, highlighted by the bonanza of high-round draft choices they traded away for a single pick in 2012, which they used to draft Robert Griffin III.

But Thaler and Sunstein drastically understate the problems that arise because the people in government doing the nudging are also Humans, not Econs. And bureaucrats have generally bad incentives to nudge in the "right" direction. On this point, I laid out my criticisms in more detail in my review of Sunstein's 2013 book Simpler ("Simpler? Really?" Fall 2013.)

Thaler answers that he and Sunstein "went out of our way to say that if the government bureaucrat is the person trying to help, it must be recognized that the bureaucrat is also a Human, subject to biases." He expresses his frustration that "no matter how many times we repeat this refrain we continue to be accused of ignoring it." But the accusation is understandable, as they keep advocating government intervention.

The best way to show that they do not ignore this problem is for them to advocate taking large amounts of power out of the government's hands. As I've written elsewhere, one way to reduce government power and make people more aware of government's activities--after all, many of the problems Thaler cites are due to people's being unaware--is to get rid of tax withholding. That way, people can be more aware of their tax bill, which is one of the major costs of government. He has not yet advocated that idea.

Maybe we should nudge him.

I recently argued that banks do not play an important role in monetary policy. Rather we need to focus on the supply and demand for base money, which is mostly determined by central bank policies. The blog Spontaneous Finance recently commented as follows.

In an Econlog column published a few days ago, Scott urges us to "stop talking about banking". Monetary policy is independent he says, a separate phenomenon.

He gives the following example:

You print more currency than the public wants to hold, and they'll bid up prices. How do you inject it without banks? Simple, pay government worker salaries in cash. Or buy T-bonds for cash. Cantillon effects don't matter, unless the central bank is doing something bizarre, like buying bananas.

This is an unrealistic story. Does any central bank print money and pay government salaries? No. At least not in the developed world. From whom do central banks buy T-bond? From...banks, and from funds, which then leave the newly acquired cash in...banks. Or which purchase other assets to replace those T-bonds, in which case this cash also ends up in banks. And in truth, the hot potato effect described by Leland Yeager can easily get interrupted by the operational realities of the financial sector. In short, financial institutions can wear heat protection gloves. There is no need for IOR for excess reserves to build up. The implementation of monetary policy remains subject to strong structural rigidities (it isn't the goal of this post to list such rigidities, although it may be the topic of a later one).

Against all evidence, Sumner keeps denying that banks, their business models, their regulation, and their accounting standards, play a role in transmitting monetary policy, booms and busts. He (as well as Hetzel) considers himself a follower of Milton Friedman's monetarism. Yet Friedman seemed to understand more about banks than Sumner does. Indeed, Friedman and Schwartz partly blamed bank accounting standards (in particular mark-to-market accounting) for the catastrophic banking collapse (and money supply collapse) of the Great Depression.

I completely agree with Friedman and Schwartz that banking played a major role in the Great Depression. But that's because we were mostly on the gold standard, and the price level (and NGDP) at that time was determined by changes in the supply and demand for gold. Central banks had almost no direct influence on the supply of gold, but did have some influence on gold demand.

The same was true of the banking system. A wave of bank failures in the US, combined with near zero interest rates, led to a surge in demand for bank reserves. These reserves had to be backed by the government gold stock (or at least 40% backed), and hence banking turmoil led to more central bank demand for gold. It also led to more private demand for gold (called hoarding.) This all had a deflationary impact, as gold gained purchasing power. As soon as FDR started devaluing the dollar in April 1933, gold demand no longer held back the recovery and prices started rising. The banking system became a non-issue until the dollar was re-pegged to gold in January 1934.

Under a fiat money regime the central bank has unlimited control over the supply of base money, so changes in commercial bank demand for reserves are not an important factor, unless the central bank has some inhibition about expanding its balance sheet during a period where they have (foolishly) allowed interest rates to fall to zero. Or, even worse, paid interest on reserves.

One other point. Prior to 2008, an injection of money by the Fed went overwhelming into cash, not the banking system. What did go into banks was mostly immobilized as required reserves. But over 97% of new money created by the Fed between August 2000 and August 2008 went into cash held by the public, of which the vast majority was $100 bills. Prior to 2008, the Fed steered NGDP mostly by controlling the supply of "Benjamins."

Screen Shot 2015-10-04 at 1.25.55 PM.png
Now it's true that the new money initially went into armored cars, and then banks, before spilling out into cash in circulation. But that detour took just a few days at most, and had no important macroeconomic consequences.

Between August 2007 and May 2008 the Fed sharply slowed the rate at which it injected $100 bills into the economy. We all know what happened as a result of currency growth slowing to zero:

Screen Shot 2015-10-04 at 1.50.59 PM.png
PS. It's actually sort of unusual for a recession to be triggered by a sharp slowdown in the rate of growth in currency---usually it's caused by the Fed failing to accommodate a rise in the demand for currency.

PPS. I know that central banks do not give newly created money to public employees---my point was that it wouldn't matter if they did.

PPPS. Here's the data for August 2008, (NSA)

Bank deposits at Fed = $10.454 billion
Vault cash used for required reserves = $35.337 billion
Vault cash not used as reserves = $17.123 billion
Cash held by the public = $775.500 billion

That means the currency stock was $827.960 billion and deposits at the Fed were barely 1% of the money created by the Fed. The rest was currency (held by the public or banks.) Unless you understand monetary policy prior to 2008, you can't really understand the subject.

HT: Marcus Nunes

CATEGORIES: Monetary Policy , Money

Market forecasts are often wrong. But they remain the least bad way we have of predicting the future. In the past, we've paid a heavy price when the Fed ignored market forecasts. In September 2008, the TIPS markets predicted very low inflation while the Fed predicted very high inflation. The Fed refused to ease money policy and we paid a heavy price when it turned out the markets were correct.

Once again the TIPS markets are predicting the Fed will fall short of its inflation target. Fortunately, this time the macroeconomic consequences of a mistake are likely to be smaller, as the economy has adjusted to 1.5% trend inflation. But it does slightly increase the risk of recession, and long term there may be a price to pay if the Fed loses credibility, or suddenly lurches toward 2% inflation at the top of the business cycle---which is the worst possible time.

Some argue that TIPS spreads are not a good indicator of inflation expectations, as TIPS are less liquid than conventional T-bonds. However there is a completely unrelated market that is sending us the same signal---fed funds futures. As the following graph shows, the market expects the fed funds rate (red line) to rise at a slower rate than the Fed estimates (blue lines.)

Screen Shot 2015-10-03 at 10.33.54 AM.png
Notice that the market forecast for the end of 2017 is only about 1%---which is equal to the forecast of Minnesota Fed President Kocherlakota, who is viewed as being a bit eccentric by other Fed officials. That's a warning that anyone who tells the truth about monetary policy is likely to be viewed as a bit crazy. As someone who has claimed for years that a tight money policy in 2008 caused the Great Recession, I sympathize with Mr. Kocherlakota.

As always, interest rates are tricky to interpret, as they are both indicators of policy and (endogenous) indicators of the state of the economy. As long as the Fed has at least some credibility, some intention to keep inflation in the ballpark of 2%, then long run interest rates are endogenous---they reflect the market expectation of the condition of the economy. On the other hand the Fed has some discretion about what to do this December.

If I'm right then I would interpret these market forecasts as follows:

1. The near term forecast (end of 2015) implies the market believes Fed policy will be too tight.

2. The longer term forecast (end of 2017-18) implies the market thinks NGDP will grow by much less than the Fed thinks NGDP will increase. As a result of that slow NGDP growth, the Fed will be forced to keep rates lower than it currently expects in order to prevent inflation from deviating dramatically from the 2% target. (In other words, to keep inflation in the 1% to 2% range, rather than falling into negative territory.)

As I said at the opening, markets are sometimes wrong. But if I were a betting man I'd bet on the markets, not the Fed. This is one more reason why we need policy guided by NGDP futures markets, not a committee of 12.

This morning I watched the final short video in the 5-part Love Gov series. Now that I've seen them all, I would rank them, from top to bottom, 1, 2, 5, 3, 4.

In this one, Alexis finally develops some backbone.

Alberto Mingardi

A snapshot of Portugal

Alberto Mingardi

In the Wall Street Journal Joseph Sternberg has a thorough op-ed on Portugal, which is heading to a national election tomorrow.

No party comparable to the Spanish "Podemos" or the Greek "Syriza" has emerged in Portugal that may have a chance of achieving power, even though the country has been implementing tough austerity measures. And yet, as Sternberg writes, "Both of Portugal's major parties, the ruling center-right Social Democratic Party and the center-left Socialist Party, are committed to staying the course".

Interestingly, Portugal's transition to democracy after the Salazar regime dates back to 1974: the same year as Greece's after the military regime, and one year before Franco's death in Spain. So, the somewhat popular thesis that populism tends to stick in Spain or Greece because they are "new" democracies seems to be falsified by the Portoguese case.

If Portugal appears "the perfect example of a eurozone bailout plan gone right--enough reform to stimulate growth but not enough to trigger anti-Europe political movements," Sternberg points out that more reforms are needed. "The public debt still is 130% of GDP, the government still is running a deficit, and the current growth rate won't be sufficient to improve the debt ratio on its own. And this is before accounting for the fiscal drag of a largely unreformed public pension system in a country with a rapidly aging population and with millions of its young people fleeing to Britain, Germany and elsewhere in search of job opportunities."

Let's see if the next government will deliver.

CATEGORIES: Eurozone crisis

I've done scattered posts discussing the flaws in alternative approaches to monetary economics. Here I'd like to try to show some underlying themes in these critiques. I'll briefly discuss 4 common myths:

1. The trade view
2. The fiscal view
3. The banking/finance view
4. The Cantillon effects view

In my view all four of these approaches miss the big picture, because they don't focus on how changes in the supply and demand for base money drive NGDP through the hot potato effect. At the same time I understand why people are drawn to these fallacies, as the hot potato effect is really hard for most people to understand, and indeed even many economists don't really get it.

1. Recently I argued that the Japanese could raise their NGDP by 20% if they depreciated the yen. One commenter discussed the policy from a trade perspective---looking at exports and imports as a share of NGDP, trade elasticities, etc. But these miss the big picture, and confuse a change in the real exchange rate reflecting non-monetary forces, with a change in the nominal exchange rate engineered by the central bank.

When the central bank changes the nominal exchange rate from its previously expected path, it also changes the long run expected path of NGDP and the price level by an exactly equal amount. This is because money is neutral in the long run and hence monetary policy has no long run effect on the real exchange rate. If you depreciate the nominal exchange rate by 20%, it will cause the price level to rise proportionately in the long run, as the real exchange rate will be unaffected. Thus in the long run, any currency depreciation caused by central banks affects the price of domestically produced goods by exactly as much as the price of imported goods. In contrast, a currency depreciation caused by more domestic saving can affect the real exchange rate in the long run.

2. Another common mistake is to assume that monetary policy becomes much more important if it is used to "monetize the debt." If you go back to the period before 2008, the base was about 6% of GDP. Thus a $1 increase in the monetary base would raise NGDP by about $16. Most estimates suggest that an extra dollar of government spending would only raise NGDP by $1 or $2. (Even assuming no monetary offset.) That's not to say that fiscal policy can't have any effect, but the total effect on aggregate demand will be almost the same, regardless of whether the government does or does not accompany a monetary injection with an equal fiscal injection. Most people put way too much weight on things like helicopter drops. It's monetary policy that determines NGDP; helicopter drops don't solve any fundamental problems associated with the zero bound--such as Krugman's "expectations trap." That's why Japan's NGDP kept falling despite big increases in Japan's budget deficit, financed by printing money.

3. Another common mistake is to assume banks play an important part in the transmission of monetary policy. That's wrong for several reasons. First, far less of the new money goes into banks than most people assume (except when rates are zero.) Before 2008, more than 90% of new money went into cash held by the public, and even that figure was artificially held down by required reserves, which was just a tax on banking and in no way central to the process. The excess reserves were less than 1% of the base. If reserve requirements had been abolished, then reserves would have been a tiny portion of the base, while cash would have been 95% to 98%. Even if the entire banking system did not exist, the Fed would have conducted monetary policy in much the same way. They would buy bonds from bond dealers, and pay for them with currency. That's actually pretty much how they ran things prior to 2008, except that the new money would spend a few days as bank reserves, before going out and circulating as cash. They could target NGDP just as effectively with that system, as with the current system.

Nor does the fact that banks hold bank reserves make them special. Reserves are just base money. Drug dealers also hold lots of base money, but it doesn't mean they play an important role in the monetary policy transmission mechanism. If drug dealers demand more money, the Fed will usually accommodate that demand to keep prices stable. Ditto for if banks suddenly demand more reserves.

The best argument for banks being special is that their demand for reserves is highly elastic at the zero bound. So the share of the base held by banks soars at this point. But this fact has nothing to do with bank deposits and loans, which are the mechanisms by which most people think banks are important. Another argument is that banks are important because bank deposits are a medium of exchange. That's true, but it only impacts the price level to the extent that it impacts real demand for base money. If creating a banking system caused the demand for base money to fall by 20%, then it would cause the price level to rise by that amount. Except that the Fed would almost certainly offset the effect with a reduction in the base. Similarly, if drug legalization caused the demand for base money (cash) to fall by 20%, then it would cause the price level to rise by that amount. Except that the Fed would almost certainly offset the effect with a reduction in the base.

Of course banks are very important and provide valuable services to the economy, as do electric power companies. It's hard to imagine life without banks or electric power companies. But those are supply side benefits, and as we've seen in Zimbabwe a central bank can dramatically boost NGDP even if the supply side is in horrible shape. Thus if you are looking at factors that impact NGDP growth, you need to focus on the supply and demand for base money. And since central banks have virtually unlimited ability to change the base supply in such a way as to offset shifts in base money demand, you want to focus on central banks, not commercial banks. Don't confuse money and credit.

Note, I'm not saying that monetary stimulus can't indirectly cause more (real) lending to occur. It can, just as it can indirectly cause more electric power plants to be built. But those are secondary effects resulting from a combination of rising NGDP and sticky wages.

So why do central bankers think banking is so important? Because they use a flawed targeting procedure that accidentally makes banking more important. Because real world central banks target nominal interest rates rather than NGDP futures prices, a banking panic can lead to a tighter monetary policy. But fundamentally the central bank is causing the tighter policy; it just doesn't understand that fact.

4. The same sort of mistake is made when people focus on Cantillon effects. When the Fed injects new money it generally buys bonds. The effect of the extra money (if permanent) is profound, whereas the effect of the bond purchases is trivial. If they used a different procedure such as paying public employee wages with the new money, the only difference would be that bond dealers would lose out on a bit of revenue from selling bonds to the Fed. But the commissions are so infinitesimal in the (highly liquid) bond market that the secondary effect is trivial compared to the direct effect of a permanent increase in the monetary base. It doesn't matter "who gets the money first." Cantillon effects only become important if the central bank buys something wasteful like bananas, which quickly rot.

Does any of this change at the zero bound? Not much. The bond commissions become bigger because more bonds are purchased. Maybe the Fed buys MBSs issued by GSEs, but even these are backed by the Treasury. They are risk free for the Fed. The Fed now pays interest on reserves, which makes the newly injected reserves much like government debt. QE is essentially swapping one form of debt for another. And the addition of interest on reserves means the Fed now has two tools to impact base demand (IOR and reserve requirements) but nothing fundamental has changed.

The base is called "high powered money" because permanent increases in the base have a massive impact on the nominal economy. All the other issues (trade, fiscal, banking/finance and Cantillon effects) are minor sideshows by comparison. Keep your eye on the big picture when analyzing NGDP.

And when analyzing living standards in the long run, even NGDP becomes a minor footnote. In that case it's supply-side factors that matter. If you want to focus on the impact of banking or fiscal policy, you'd be much better off ignoring their interaction with monetary policy, and looking at their effect on productivity--the supply-side forces that matter in the long run.

PS. There are of course many other fallacies, such as the idea that deflation is caused by bad demographics, or overproduction, or international trade, or less lending, or any number of other non-monetary factors. I'll address those in a future post.

A few weeks ago, Robin Hanson posed a lunchtime challenge: What is the difference between Left and Right?  The point of the question, of course, is not to explain how every self-styled leftist differs from every self-styled rightist.  The point is to identify unifying themes that generalize broadly across time and space.

There are many prominent candidates, like:

1. Leftists care more about equality, rightists care more about efficiency.
2. Leftists care more about the poor, rightists care more about the rich.
3. Leftists are more secular, rightists are more religious.

To my mind, though, all these theories overintellectualize Left and Right.  Neither ideology is a deduction from first principles.  Not even close.  What binds Leftists with fellow Leftists, Rightists with fellow Rightists, is not logic, but psycho-logic.  Feelings, not theories.

What's my alternative?  This:

1. Leftists are anti-market.  On an emotional level, they're critical of market outcomes.  No matter how good market outcomes are, they can't bear to say, "Markets have done a great job, who could ask for more?" 

2. Rightists are anti-leftist.  On an emotional level, they're critical of leftists.  No matter how much they agree with leftists on an issue, they can't bear to say, "The left is totally right, it would be churlish to criticize them." 

Yes, this story is uncharitable and simplistic.  But clarifying.  Communists and moderate Democrats are vastly different, but they have something in common: Free markets get on their nerves.  Nazis and moderate Republicans are vastly different, but they too have something in common: Leftists get on their nerves.  Within each side, the difference between moderates and extremists is the intensity of their antipathy, not the object of their antipathy.

To see my point, imagine two grand conventions.  The first is for all self-identified Leftists.  The second is for all self-identified Rightists.  Now imagine a grand Compromise Statement able to command the assent of 80% of the attendees.  I say the Left's Compromise Statement will consist in a bunch of complaints about markets.  And I say the Right's Compromise Statement will consist in a bunch of complaints about Leftists.

To be clear, my theory of Left and Right is tentative.  If you know of relevant evidence one way or the other, I'm listening.

The Catalonian regional election was won by the separatist parties, which are now heading towards independence following their leader, Presidente Arturo Màs. This would create much trouble at the national level. The Partido Popular of Mr Rajoy perhaps hasn't reacted in the smartest way. The Wall Street Journal reports that Xavier García Albiol, regional leader of the Popular Party, commented that "The vote, with a very high turnout, has made it very clear that a majority of Catalans don't want to break with Spain". And yet the success of the secessionists appears unambiguous.

Jan Marot at has some interesting take-aways from the Catalonian elections.The most intriguing point, to me, is the fourth:

Since there is no EU roadmap for the independence of regions within member states, a swift secession of Catalonia would automatically exclude the new nation from the European Union and the euro. However, looking at the economic strength of Catalonia, as well as its democratic, hugely pro-European society, it is likely that neither Brussels, nor many EU-member-states, would have the appetite to punish a Catalan Republic. There will be vigorous pressure for compromise, and creative solutions. As far as nationality is concerned, Spain's constitution highlights that citizens "living abroad" can keep their Spanish passport. Thus, it is likely that the citizens of a Catalan Republic -- even without membership of the EU -- would still keep their EU-citizenship in an unprecedented anomaly.

This would be very interesting to watch. The Catalonian secessionists have long been saying that they want to remain part of the EU and of NATO. But the Spanish government is holding the line that secession would mean de facto expulsion from the EU.

This might well be true, since the EU is, after all, basically a cartel of existing nation states. EU Commission President Juncker has come out on Catalonia, taking a position that actually favours, surprise surprise, the Spanish government. Interestingly enough, Juncker's remarks were far more sober in their English than in their Spanish version.

One interesting question is whether being so steadfast on secession would actually be good, taking the viewpoint of the EU ruling class' own self-interest. I wonder if actually openly recognising the right of self-determination within exiting European member-states won't help the eurocrats in getting what they really want: that is, more transfer of power to Brussels, in the context of a "federal" Europe. Could it be that newer smaller states are okay with renouncing some of their prerogatives more easily than old nation states?

Of course, with the exception of Scotland, what most secessionist movements are opposed to is the drainage of resources from their pockets to the benefit of other areas within the same national boundaries. This rhetoric of "exploitation" may be exaggerated but if there is some truth in it, it is easy to see that Catalonia (or Lombardy or Bavaria) seceding may entail a few headaches for profligate national governments.

There would be room here for the EU to act as a mediator, to propose guidelines for ordered secession, to guarantee impeccable democratic procedures in the process. The secessionists should be all for it, as making sure one is renouncing his Spanish passport but not to Schengen is also a good way to assure the world that there are not looking forward to establish a parochial, xenophobic small state. The eurocrats should be for it, too. They always claim they do not have enough of a political role. Will they try to gain one?

CATEGORIES: Eurozone crisis

I claim that betting stifles hyperbole, the fuel of Big Government.  In this sense, my Betting Norm has an underlying libertarian agenda.  One could object, however, that killing hyperbole is a double-edged sword.  Sure, it deprives statists of the chance of oversell government.  But it also deprives libertarians of the chance to oversell liberty.  If hyperbole dies, isn't the status quo the real winner?

Not really.  In the modern world, economic growth is the norm.  So as long as government's absolute size stays fixed, economic growth steadily erodes government's role in society.  And over time, every new industry that the government failed to foresee is at most lightly regulated.

Furthermore, entrepreneurs and scofflaws are constantly looking for clever ways to circumvent existing laws.  As long as regulations stay fixed, their practical impact naturally shrinks year after year.  Imagine what the United States would look like today if governments stopped passing new laws in 1970.  Airline and trucking regulation would still be on the books, but they'd be pretty easy to dodge with the help of the internet.  It wouldn't be Libertopia, but it would be a lot more libertarian than our status quo.

So does the betting norm favor the status quo or liberty?  Both.  It favors the legal status quo.  Over time, however, a stagnant legal status quo naturally decays into de facto laissez-faire.

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