Will Bernanke Take Aim at G.D.P.?

It’s a safe bet that the hottest topic in monetary policy is going to be raised when the Federal Reserve chairman, Ben S. Bernanke, takes questions from reporters Wednesday afternoon.

That would be nominal G.D.P. targeting, a concept lately endorsed elsewhere on this very Web site by the liberal economists Christina Romer and Paul Krugman (separately, and with very different degrees of enthusiasm) and long embraced by a diverse group of other economic thinkers.

It’s actually a pretty simple idea. The Fed has developed a policy of seeking to maintain inflation — the growth of prices and wages — at an annual rate of roughly 2 percent as the best way to meet its legal objectives of maintaining stable prices and maximizing employment. Proponents of G.D.P. targeting argue that the central bank instead should seek to maintain a steady rate of increase in the dollar value of the nation’s economic output, the nominal gross domestic product, an alternative measure that combines the rate of inflation and the rate of economic growth.

The Fed’s current policy, they argue, has failed to stimulate growth sufficiently, leaving more than 25 million Americans unable to find full-time work. A G.D.P. target, by contrast, would require the Fed to take more aggressive steps, like another round of asset purchases.

“It would work like this,” wrote Ms. Romer, a professor at the University of California, Berkeley, who was chairwoman of President Obama’s Council of Economic Advisers. “The Fed would start from some normal year — like 2007 — and say that nominal G.D.P. should have grown at 4 1/2 percent annually since then, and should keep growing at that pace. Because of the recession and the unusually low inflation in 2009 and 2010, nominal G.D.P. today is about 10 percent below that path. Adopting nominal G.D.P. targeting commits the Fed to eliminating this gap.”

As I wrote in Monday’s paper, this idea has garnered little apparent support inside the Fed.

One fundamental reason is that Mr. Bernanke and other Fed officials believe that the current system is working pretty well. Not well enough to heal the economy, of course, but in their view that is beyond the Fed’s power.

“My guess is that the current framework for monetary policy — with innovations, no doubt, to further improve the ability of central banks to communicate with the public — will remain the standard approach, as its benefits in terms of macroeconomic stabilization have been demonstrated,” Mr. Bernanke told a Boston audience in October.

The focus of that policy, which Mr. Bernanke described as “flexible inflation targeting,” is the Fed’s commitment to maintain inflation at about 2 percent a year. The Fed views the public belief that it will do so as perhaps its most valuable asset because it creates a stable environment for sustainable economic growth.

A switch to G.D.P. targeting would amount to a declaration of comfort with higher levels of inflation.

Many proponents regard this as the basic point of the proposal, arguing that the Fed has become overly fixated on the rate of inflation when it should be focused on the health of the economy, and that allowing — indeed, encouraging — a higher rate of inflation in the short term would help to stimulate growth.

Calling for a G.D.P. target rather than simply proposing an increase in the Fed’s inflation target, as some other economists have done, amounts in this sense to a marketing device, a piece of packaging.

“As far as I can see, the underlying economics is about expected inflation,” Mr. Krugman wrote in a mid-October blog post, “but stating the goal in terms of nominal G.D.P. may nonetheless be a good idea, largely as a selling point, since it (a) is easier to make the case that we’ve fallen far below where we should be and (b) doesn’t sound so scary and antisocial.”

So far, that sales pitch has failed to budge the Fed.

Paul Krugman and Cameron’s realism

I rarely write about this poor and benighted, yet still free, isle.

But Paul Krugman’s latest attack on the Government’s austerity policy – "Cameron’s Fantasy" – cannot go unchallenged.

He ridicules Cameron’s claim that fiscal discipline has brought down British borrowing costs and averted a debt crisis, more or less depicting him as clueless.

I happen to be a Krugman fan, not least because it is a delight to see a great economic mind at work – in real time, so to speak. He deserved to win the Nobel Prize, and he has been largely right about the shape of our global economic crisis over the last four years.

However, he is wrong about the specific case of Britain.

He displays this chart to show that US bond yields have fallen even further than gilt yields, and to show that they are doing so for deep structural reasons.

It is a false comparison. Britain is not the world’s paramount strategic and reserve currency power. It does not have latitude to trifle with global markets.

(Yes, I know, Japanese, German, Swedish and Danish yields are also falling, but these countries have large current account surpluses. The three Europeans are fiscal saints. Japan is still the world’s top creditor, with nearly $3 trillion in net assets.)

There was a horrible moment in the weeks leading up to the elections last year when it became clear that the vigilantes were indeed waiting to pounce on Britain.

This is a news piece I wrote at the time, citing the Unicredit team, and Unicredit was not alone.

"I am becoming convinced that Great Britain is the next country that is going to be pummelled by investors," said Kornelius Purps, Unicredit's fixed income director.

Mr Purps said the UK had been cushioned at first by low debt levels, but the pace of deterioration has been so extreme that the country can no longer count on market tolerance: "Britain’s AAA-rating is highly at risk. The budget deficit is huge at 13pc of GDP and investors are not happy. There will have to be absolute cuts in public salaries or pay, but nobody is talking about that.

"Sterling is going to fall further over coming months. I am not expecting a crash of the gilts market, but we may see a further rise in spreads of 30 to 50 basis points."

That was the mood in March 2010. The spreads were ballooning out to worrying levels.

Britain has won a reprieve because the Coalition has held rock solid and stuck to its policies. Perhaps there might be some safe margin for loosening now, but not much.

There was of course never any danger of a Greek/Irish/Portuguese outcome, given the Bank of England’s willingness to backstop the system with QE equal to 19pc of GDP).

However there was a risk of yields creeping up to Spanish levels and also something very familiar to Treasury mandarins, a disorderly flight from sterling. (As opposed to the orderly fall we have had, and which has been a lifesaver for parts of manufacturing industry.)

Needless to say, we can never prove this either way.

Britain has rescued itself twice over the last century by a radical mix of fiscal tightening on the one hand and monetary stimulus with devaluation on the other. We did it in 1931-1932 after liberation from the Gold Standard, and we did it again in 1992-1993 after liberation for the Europe’s Exchange Rate Mechanism (when Cameron had a ring-side seat as an aide to Chancellor Norman Lamont).

The trick worked both times. We largely avoided the Great Depression. We outperformed in the 1990s.

One can see why Professor Krugman dislikes this argument. It would question the primacy of Keynesian fiscal policy.

Perhaps fiscal policy is less potent than claimed. Or perhaps there is something specific about Britain, evidence that economics is really a subset of anthropology.

David Cameron is running Britain, not the United States, Germany, or Japan. We are a nation of flat-footed and humble shopkeepers over here. We don’t like theory. We like only realism.

My goodness are these economists such ideologues

It's not just Labour politicians who have been laying into David Cameron's conference speech that "the only way out of a debt crisis is to deal with your debts", or his claim that the Government's austerity programme has given the country record low interest rates. Labour has got plenty of heavy weight support from the economics profession for its point of view. Take this piece from the FT's Martin Wolf (£), or in the US this from Paul Krugman, and again from Brad DeLong.

OK, so these are all the usual suspects, but as I've argued before, they've got a point in suggesting that record low interest rates in fact have not a lot to do with getting to grips with the nation's debts and absolutely everything to do with the fact that the economy is going down the pan. I wouldn't have put it quite so colourfully, but here's what Brad DeLong has been telling his students at Berkeley.

Right now record-low interest rates are not a tool for improving the economy. They are a consequence of the fact that the British economy is 100% scr—d and about to become 150% scr—d. The risk that other investments in Britain will go south as the double-dip hits is sufficiently large that investors are terrified and willing to buy British Treasury debt at absurd and outlandish prices.

You'll only know for sure that the economy is on the mend once interest rates begin to rise again, as investors switch out of gilts into growth orientated assets such as equities.

But where these neo-Keynsians go wrong is in failure to recognise the extreme dangers for Britain of financial market and sovereign debt contagion. They don't seem to realise what a perilous, knife edge, position the UK is in. Aggretating all debt together – sovereign, household, private sector and banking – the UK is far and away the most indebted country on the planet.

In the circumstances, it is a miracle that we've got the low interest rates we have. Other nations are being punished by markets for far less. The UK has managed to avoid similar treatment only because it has retained market confidence and thereby its triple A credit rating. This in turn has been secured by taking pre-emptive action on the deficit.

Had the UK stuck to the much milder consolidation plans of the last government, it's highly likely that the triple A would now be lost. To reflect the supposed credit risk, we would in such circumstances now have long term interest rates similar to those of Spain and Italy. The US, which this summer lost its triple A, is not a valid comparison here, because it's still the world's reserve currency and in unstable times will therefore suck money in from all over the world. It's fantasy to think that a UK economy running 10pc budget deficits into the indefinite future would enjoy the same privilege.

Now admittedly, Spain and Italy are in an even more precarious position. Membership of the euro precludes the monetary activism that has been applied in the UK, where long term rates have been manipulating down through quantitative easing. Even so, it's hard to believe markets would have continued giving Britain the benefit of the doubt without a credible deficit reduction strategy. Long term rates would have been several percentage points higher than they are.

Nevermind what that would have done to the over indebted household sector, rates at this level would by now also have invoked another banking crisis. As we have seen in the eurozone, once the sovereign becomes impaired, so does the banking system. The triple A is a kind of banking gold standard – it is the asset class that gives depositors confidence in the safety of their money. (For further reading on the linkages between the eurozone's sovereign debt and banking crises, see my column for Friday's edition of The Daily Telegraph).

So there is a sense in which they are both right – Cameron and Brad DeLong. Personally, I'm very suspicious of any entrenched ideological position. The first rule of public policy is that it has to remain adaptable. Unfortunately, the debate over the deficit has become extraordinarily ideological and very polarised. These economists are just as guilty of it as the politicians. That's a very bad development.

Growing Businesses Cut Payrolls, Too

Casey B. Mulligan is an economics professor at the University of Chicago.

In many industries, sharp employment cuts during the recession cannot be attributed to a lack of demand.

Today’s Economist

Perspectives from expert contributors.

The standard narrative of the 2008-9 recession and lack of recovery has been that the financial crisis, housing crash, excessive debt and other factors caused consumers to spend less, and businesses to invest less. With the private sector spending less, employers had a hard time selling their products, so they had to lay workers off, cut back on new hiring, or both.

Perspectives from expert contributors.

As Paul Krugman put it, “Businesses aren’t hiring because of poor sales, period, end of story.”

Yes, consumer spending dropped sharply, as did business investment, in 2008 and 2009. But that observation does not tell us whether low employment is a result of low spending or if the reverse is true.

I agree that a few important industries, including manufacturing, home construction and much of the retail sector, did, and still do, suffer from significantly low demand. Those industries vividly illustrate the demand narrative — but they are only a minority of the overall private sector.

The lack-of-demand hypothesis is incorrect for a large fraction of the economy. The chart below illustrates output, revenue and employment from the United States wireless telecommunications industry (that is, cellphones). This industry has clearly not been suffering from a drop in customer demand.

Since 2007, the number of mobile connections has increased almost 20 percent, to 303 million from 255 million. The Bureau of Economic Analysis estimates that consumer spending on mobile communications increased 15 percent (not inflation adjusted) over that time frame.

Despite continued demand growth, employers in the wireless telecommunications industry sharply cut employment, at an even greater rate than employers in other industries. After growing 6 percent from 2005 to 2007, the industry’s employment had fallen 14 percent by 2010.

There is no way to blame that sharp employment drop on “poor sales.”

This pattern is not limited to the cellphone industry. Other industries sharply cut back their employment even while their revenues were falling little, if at all; the employment loss from such industries numbers in the millions.

To examine this issue more systematically, I used the industry economic accounts published by the Bureau of Economic Analysis. Industries can be examined at varying levels of detail: I divided the private sector into 21 industries and classified them according to the percentage change in their revenue between 2007 and 2009. The table below shows the results.

In two of the industries, education and health care, revenues grew more than 2 percent (in fact, their increase was about 10 percent), and their employment increased, as is shown in the table’s top row. Five other industries summarized in the next row had a revenue increase but still sharply cut their employment. Four others had minor revenue declines and cut their hiring sharply, too.

The number of full-time equivalent employees declined 2.2 million in those nine industries combined, even though it seems that those industries had enough sales to maintain their employment. Something else motivated them to cut employment and motivated them to forgo an opportunity to hire some of the many workers laid off by declining industries.

As I wrote before much of the employment decline happened, I think “some employees face financial incentives that encourage them not to work, and some employers face financial incentives not to create jobs.”

That’s why even growing business are now getting by with substantially fewer employees.

Local and National Stimulus

Casey B. Mulligan is an economics professor at the University of Chicago.

It’s a lot easier to move spending from one area to another than it is to create spending anew. That’s why it may be too much to ask the federal government to use its ability to spend to get the recovery going.

Today’s Economist

Perspectives from expert contributors.

In 2009 the New York Yankees opened their new stadium on the north side of East 161st Street, replacing the historic stadium on the south side of the street. Not surprisingly, 2009 spending by consumers, news organizations and entertainment businesses, among others, on the north side of East 161st Street was a lot more than it had been in years past. It all started from the Yankees’ spending at the new location.

Perspectives from expert contributors.

So a spending advocate might assert that this episode is proof that spending by one organization can stimulate spending by others, because the spending by the others on the north side of the street surged at exactly the same time that the Yankees started having their people work there.

Of course, such an analysis is flawed, because it ignores what happened on the other side of the street. Much of what happened north of East 161st Street was just a displacement of activity from the south side, rather than a creation of new activity. Even the construction workers building the stadium may well have been drawn from other tasks.

This pattern is not special to the Yankees’ move. A number of studies have shown that consumer spending associated with a sports team to a large degree displaces spending in other areas and displaces spending on other leisure activities; a family is unlikely to conclude that because there’s a new team in town or a new stadium, it should sharply increase its spending on entertainment.

Yet ignoring the displacement effects is exactly what Paul Krugman and Dean Baker have done in their praise of recent studies that use “cross-state variation in stimulus spending per capita to estimate the employment effects of the stimulus,” studies comparing states that received more stimulus to states that received less.

Spending from the American Recovery and Reinvestment Act (a.k.a., the “stimulus”) could be very much like the stadium spending — a locality that received more stimulus spending merely enjoyed a displacement of activity into its area from localities that received less spending, and that nationally little or no additional spending occurred as a result of the legislation.

If you want to know about the national effects of the stimulus, at least part of the analysis has to look at the nation as a whole. The same is true of the national effects of changes in labor supply. If one group suddenly becomes more willing to work, it is possible that the group solely takes jobs from the rest of the population, with no new jobs being created for the nation as a whole.

That’s why, in addition to looking at the experiences of specific groups and specific regions, I have examined the effects of supply and demand on national employment. (Professor Krugman and Dr. Baker assert in so many words that I ignore national employment, though my papers on the subject look very much at national aggregates. For example, see Figure 3 and Figure 6 of this paper and Table 2, Table 3, Figure 2, Figure 3, Figure 4 or Figure 5 of this paper).

I found, for example, that national employment increases during the summer precisely because young people are more willing to work. Not surprisingly, the summer surge of young job seekers does seem to reduce employment of the rest of the population, but the net national effect is still almost a million more jobs in the summer.

For now, it appears that government spending reduces private spending, even while it may benefit specific regions or groups.

Exceptions to Keynesian Theory

Casey B. Mulligan is an economics professor at the University of Chicago.

While taxpayers have been wondering if all of the extra government spending of the past couple of years has actually served to impede the recovery, Keynesian economists have been asking them to keep faith in the promise that government demand is the secret to economic recovery. Now Paul Krugman, an outspoken Keynesian stimulus advocate, admits that Keynesian theory has many exceptions.

Today’s Economist

Perspectives from expert contributors.

It’s pretty easy to see how various types of government spending might reduce employment, rather than increase it: a number of government programs have been reducing the incentives for people to work, and reducing the incentives for business to hire.

Perspectives from expert contributors.

Unemployment insurance is an example (among many) of how the work incentives of so-called stimulus programs operate. Unemployment insurance payments to individuals cease as soon as the individual starts to work again. I agree that such payments are compassionate, and may well be the right thing to do, but economists have long recognized that such compassion is not free: unemployment insurance reduces employment, rather than increasing it, because it penalizes beneficiaries for starting a new job.

Without offering any proof that incentives suddenly ceased mattering, stimulus advocates, and even the Congressional Budget Office, have recently ignored this effect. Many of them aim to prove the potency of unemployment insurance and other components of the stimulus law by insisting that the recession was caused by a lack of demand, and that any public policy that raises aggregate demand must be a big help.

Even if they’re right that the recession was a result of low demand, it does not follow that the way to recovery is to destroy supply, too. Before we turn away from one of the basic lessons of economics, we ought to have some evidence of the fundamental Keynesian proposition that “incentives to seek work are, for now, irrelevant.”

(Another tendency of Keynesians is to “prove” their supply claim by pointing to the existence of unemployment. Of course, unemployment exists in large numbers, but that does not tell us whether, and how much, incentives affect employment rates.)

Part of my research has been to examine episodes, from the current downturn, of changes in the willingness and availability of people to work. If, as Keynesians have been insisting, the incentives to work are in fact irrelevant in a recession, then none of these episodes would be associated with employment changes. (In their view, an increase in the number of people willing to work would just increase, one for one, the number of people who are unemployed.)

I looked at seasonal changes in labor supply. I looked at the increase in supply of workers to the nonresidential construction industry (workers who were leaving home building after the crash). I looked at the increase in the supply of elderly workers. I looked at the increase in supply of workers in Texas. In all of these recession-era episodes, more supply meant more jobs, and less supply meant fewer jobs.

(I also looked at some recession-era demand changes to see if they were at all constrained by supply, and they were — very much as they were before the recession.)

There is still no evidence to confirm the fundamental Keynesian proposition that supply doesn’t matter.

Rather than completely discard that proposition, Professor Krugman has recently formulated a theory of exceptions to the Keynesian theory, which he believes can help explain some of my findings:

Here’s the question: why do patterns of employment over time that are, in fact, normally supply-driven continue to be visible even during a demand-side slump? And here’s the answer: businesses make long-term decisions that influence hiring patterns over time, and those decisions continue to shape their behavior even when there is a surplus of labor.

In other words, Keynesian theory has exceptions that have to do with business’s long-term hiring decisions. For example, businesses have lived through enough seasonal cycles to know that they can normally make more money when their hiring patterns are responsive to the seasonal availability of people to work, so businesses continue to be responsive to the seasonal pattern of labor supply even during a deep recession when there are plenty of workers available throughout the year.

I don’t understand how Professor Krugman explains that the nonresidential construction industry took advantage of the plentiful supply of home builders after housing crashed (he also has no explanation for my minimum wage findings, Christmas seasonal findings or elderly employment findings). He also fails to explains why some business hiring patterns survive the recession intact, while other practices are completely different (e.g., businesses used to think they needed 138 million payroll employees, but by 2009 they got by with fewer than 130 million).

But even if Professor Krugman were correct that the ghost of labor supplies past haunts the recession through business’s long-term decisions, how can he be so sure that the labor-supply effects of government spending programs would not also have the same effects they did in the past?

For example, employers found that people were more difficult to hire and retain when a generous safety net was available. In this way, unemployment insurance would continue to reduce employment even after the recession began because employers have learned that the more generous the safety net, the more they must get by with fewer workers.

Would Keynesian stimulus spending work only when it came as a surprise? Or only when the spending was outside the range of prior business experience? Keynesian economists have not even begun to answer these questions. For now, Keynesian theory has so many exceptions that we might as well discard it.

Gilt yields are signalling a depression

As you can see from the chart below (or perhaps not given the quality of the reproduction, for which apologies), UK government bond yields have fallen to historic lows the depths of which even six months ago would scarcely have been believable – less than 2.5pc on ten year gilts. These are the sort of levels that until recently only ruled in Japan.

Those of us who have been calling the top of the bull market in bonds for the best part of the last two years are left with egg on our faces. I’m hardly alone. Step forward Bill Gross, John Paulson, Jim Rogers and a litany of other self styled market “experts”. And those who got it right? Well I hate to pay him the complement, but among others Paul Krugman, whose religiously preached Keynsian analysis of the crisis has, in this regard at least, been spot on. For this is not just a UK phenomenon. It’s happening just about everywhere, bar the troubled debtor nations of the eurozone, where the very real possibility of default has sent bond prices in the other direction.

If you believe much of the European press, rising bond yields in Italy, Spain and much of the rest of the eurozone even as they plummet virtually everywhere else is all an Anglo Saxon conspiracy designed to sink the euro. (See the excellent blog by my colleague, Ambrose Evans Pritchard, for more on this) Why won’t the bastards lend to us, they ask? It is because you don’t have the natural corrective of a floating exchange rate, is the answer, but Europe’s political class refuses to listen.

So why is this happening? Why is it that despite ever more mountainous government debt, investors want to keep buying into the non-eurozone version of it? There are three things going on here. The first is that central banks have set short term rates at close to zero in an effort to stimulate demand, and judged by comments from the US Federal Reserve and the Bank of England this week, look set to keep them there for at least the next two years. A more hawkish tone has been set by the European Central Bank, which in part explains why the bond prices of debtor eurozone nations are doing so badly, but in the round, policy is being kept as stimulative as it can.

In the hunt for yield, that drives money out of short term deposits into near cash equivalents such as longer dated government bonds, which in turn drives down the yields on those bonds.

Second, the market has begun to anticipate further bouts of “quantitative easing”, or purchases by central banks of government bonds, both in the US and Europe. If the purpose of such purchases is to drive yields lower in the hope that investors will either spend or invest the money in higher risk assets, you kind of wonder whether there’s any sense in doing any more. Bond yields are sinking without any help from central bankers. But in any case, markets anticipate more of it.

Yet the single most important factor that underlies all this is that when householders, businesses and the financial sector aren’t spending and investing, a savings surplus accumulates which has to go somewhere. In the search for safe havens, it goes first and foremost into government debt, where it is used to provide the demand which the private sector has decided to remove. When governments attempt to reduce their demand for debt, as is beginning to happen at the moment with fiscal austerity programmes, you get a self feeding pressure of excess demand on limited supply, and yields fall even further.

What these yields are pointing to then, is a depression. In such an environment, corporate profits will suffer and insolvencies will rise. Equity markets suffer accordingly.

If I was a Treasury mandarin, I’d be urging the Chancellor to bring forward his debt raising programme to take advantage of these extraordinarily low interest rates. I doubt the chance to lock in long term debt at rates of as little as 2.5pc – way below the current, near 5pc, inflation rate – will occur again for an awfully long time.

But of course, the Treasury cannot do this. In the interests of transparency, it has already announced how much it is going to raise and in what form for this financial year. The next opportunity for altering that schedule is not until the Autumn statement. You can see the amount of debt the Government is planning to issue this year from the table below – in gross terms, it is already a new record.

And as the second table shows, despite ever more voluminous issuance, the amount the government is paying for its debt has been falling steadily.

George Osborne, the Chancellor, likes to see this phenomenon as a vote of confidence in his deficit reduction strategy. Unfortunately, that’s only part of the story. As I say, they’ve had similar yields in Japan for years now, with no sign of a credible deficit reduction strategy in sight and public debt spiralling up towards 250pc of GDP.

Unfortunately, low gilt yields are more indicative of impaired private sector demand than they are of Government resolve. What the economy appears to need, and I really do hesitate to say this, is a good old fashioned bout of inflation, but then we’ve already got that in the UK, and to perpetuate might seem only to replace one problem with another. Yet there are few more effective ways of eroding the doomsday machine of excessive debt.