Finance Basic To Advance Level Knowledge

Just last week I noted that because of QE2 a real appreciation in China will occur one way or the other: either its currency will appreciate faster or its domestic prices will soar.   The former seems unlikely because of China's commitment to its export-driven growth strategy.  Consequently, China will most  likely stay tied to the Fed's QE2 monetary policy via its crawling peg and continue to allow domestic prices to soar.   I also mentioned that this real appreciation should contribute to a rebalancing of the global economy.  As if on cue, the New York Times reports the following yesterday: HONG KONG — Inflation is starting to slow China’s mighty export machine, as buyers from Western multinational companies balk at higher prices and have cut back their planned spring shipments across the Pacific. Markups of 20 to 50 percent on products like leather shoes and polo shirts have sent Western buyers scrambling for alternate suppliers. But from Vie...

Why should the Fed aim to stabilize total current dollar spending?  This figure makes it very clear why: changes in nominal spending get translated largely into changes in real economic activity.  Its impact on the price level is far less.  Of course, in an environment where inflation expectations get unanchored, like the 1965-1979 period, nominal spending shocks will have a greater impact on the price level and less influence on real economic activity.   And, over the long-run the trend growth rate of the real economy is determined by real factors.  But for business cycle considerations, it is hard to argue with a monetary policy goal of stabilizing nominal spending when looking at this figure. Update:   Check out Marcus Nunes who makes an even stronger case using the above figure.  He also looks at the 1965-1979 period referenced above.   Finally, Marcus provides a nice Beckworth smackdown regarding my use of nominal spending trends.

No, but today's GDP report indicates we are getting closer.  Total current dollar spending, as measured by final sales of domestic output, grew an annualized rate of 7.3%.  This is fantastic news. We need several more quarters of catch-up growth like this to bring nominal spending back to its trend.  Doing so would go along way in making a more robust recovery.  Here is a figure showing the updated final sales along with its 1987-1998 trend. (Click on figure to enlarge).) As I explain here , I pick this period's trend because it is the part of the Greenspan period where there were no wide, unsustainable swings in economic activity.  Moreover, 1998 is when the Greenspan Fed for the first time significantly deviated from past practice by lowering the federal funds rates even though the economy was experiencing robust economic growth.  George Kahn provides Taylor Rule evidence that supports this notion. Update : Bill Woolsey, who prefers a 1984-2007...

Jon Hilsenrath says the Fed is closer to adopting an explicit inflation target.  Inside the Fed, the idea resurfaced in the fall as the Fed debated the merits of initiating a $600 billion bond-buying program known as quantitative easing. In an Oct. 15 speech in Boston, Mr. Bernanke took another step, saying that Fed officials "generally judge the mandate-consistent inflation rate to be about 2% or a bit below." With inflation running at around 1%, he said there was a case for more Fed easing. An inflation target might be an easier sell when inflation is low; if it were adopted when rates were high, it would be seen as a reason for higher interest rates, which are never popular. [...] New challenges this year could put the inflation target back on the agenda. Several Republican lawmakers, concerned that the Fed is stoking inflation, have proposed narrowing the Fed's mandate to price stability, eliminating the employment part. [...] The controversial d...

Kantoos responds to my earlier question as to whether Germans dislike inflation or bailouts more. He says that this is a difficult question since Germans passionately detest both. What is known, though, is that because of these strong views there is a sort of  policy paralysis in Germany that leads to a non-optimal policy outcome: This would be the worst possible deal for the Eurozone that Germany could have made: The bailouts prolong the crisis without putting the burden, where it should be put: on the bondholders. And yes, these are in part German banks and insurances. The contractionary monetary policy on the other hand forces the periphery in an already suboptimal currency union to adjust even more than what would otherwise have been necessary with an adequate monetary policy. Sigh. On a lighter note, Merle Hazard has penned a new song about Germany's problems: And here you can find Merle Hazard's song on Ireland's problems.

The ECB, according to Kantoos and Scott Sumner ,  is effectively targeting a stable nominal GDP path for Germany.  Moreover, it is doing a fine job at it.  Kantoos further shows that nominal wage growth is being stabilized around 2% a year.  I take that to mean the ECB is not just effectively targeting nominal GDP, but nominal GDP per capita for Germany.  This comes close to what I think is an ideal goal for monetary policy for reasons discussed here .  Now while the ECB's monetary policy may be great for Germany it is too tight for the periphery of the Eurozone.  Because this one-size-fits-all monetary policy makes it difficult for the the Eurozone  to solve its current problems, the European countries seemingly face the tough choice of giving up their currency union experiment or giving up their national sovereignties to make the currency union more functional. Ryan Avent notes , though, that there is a third way to solve this problem: have th...

Late last year I was making arguments like this one about how QE2 would work: [T]he recovery view begins with notion that a successful QE2 will first raise inflation expectations.    The increase in  inflation expectations, however, also implies higher expected nominal spending (i.e. higher future nominal spending means higher future inflation).  Higher expected nominal spending in an economy with sticky prices and excess capacity should in turn lead to increases in expected real economic growth.  Finally, this higher expected real economic growth should increase current real long-term yields.  Given the fisher equation, this understanding implies that the rising long-term nominal yields are occurring because of both higher expected inflation and higher real yields. Thus, contrary to the sales pitch made by Fed officials that QE2 would lower yields, we should expect to see yields ultimately increase if QE2 is successful.  Below is an ...

Martin Wolfs reports on the concerns President Hu Jintao of China shared on his recent trip to the United States “The current international currency system is the product of the past.” Thus did Hu Jintao, China’s president, raise doubts about the role of the US dollar in the global monetary system on the eve of last week’s state visit to Washington. Moreover, he added, “the monetary policy of the United States has a major impact on global liquidity and capital flows and therefore, the liquidity of the US dollar should be kept at a reasonable and stable level.” He is right on both points. In criticising US fiscal and monetary policies and, in particular, the Federal Reserve’s policy of “quantitative easing”, Mr Hu was following a well-trodden path. In the 1960s, Valéry Giscard d’Estaing, then French finance minister, complained about the dollar’s “exorbitant privilege” . John Connally, US Treasury secretary under Richard Nixon, answered when he described the dollar as “our...

It is highly suggestive of an excess money demand problem. This poll finds that concerns about a "lack of money/low wages" is the most important financial problem American face.  This concern trumps healthcare costs and too much debt.  Now, the respondents may be thinking more in terms of not having enough income rather than not having enough medium of exchange, but still given all the talk about balance sheet recessions it is interesting that this "lack of money/low wage" concern is more important than too much debt. Here is a summary figure of these concerns since March, 2009: (Click on figure to enlarge.) Between the findings from this Gallup poll and the data shown in this post , you can forgive me for thinking that maybe, just maybe there still is an excess money demand problem.

Was the Great Recession of 2007-2009 the result of a large reallocation of workers out of the housing sector after it busted or was it the consequence of a collapse in nominal spending that could have been prevented by policy? Arnold Kling and Bob Murphy have been arguing the former while Scott Sumner and Brad DeLong have been arguing the latter.  Here is how Murphy explains the former also known as the "recalculation" view: [A]fter an unsustainable boom period, the economy needs to "recalculate" and figure out where the excess workers (from the bloated sectors) need to go so that the economy can resume a stable, sustainable growth... Kling (and the Austrians) are arguing that this recession is not simply about a lack of generic "spending" but rather is tied to the preceding housing boom. In particular, during the boom, workers were sucked into construction (and other related occupations). Once the housing bubble collapsed, these excess worker...

In the past I said yes, now I say no.  The reason being is that there is something more fundamental going on than household balance sheets being a mess .  To see the real problem, consider the standard story told as to why weakened household balance sheets pose such a problem to a robust economic recovery.  Here is how Ryan Avent tells it: In the years prior to the crisis, households accumulated a lot of debt, which was offset by rising asset prices. Those asset prices then collapsed and many households are now desperately attempting to pay down their debts. Because they're heavily indebted, efforts to spark a recovery by encouraging household spending or residential investments are likely to go nowhere; people are simply too broke. Mark Thoma agrees : Households have no choice but to set aside part of their income to both rebuild the asset side of the balance sheet and to pay down their debts. This is one of the main reasons why recovery from these “balance s...

Is it really that hard for monetary policy restore total current dollar spending to trend?  As an advocate of nominal GDP level targeting, I certainly believe the Fed is capable of such a task and have been making the case for sometime.  Skeptics, however, typically throw out some version of the Fed " pushing on a string " argument as a rebuttal. While appealing, this view ignores the best data point we have on this question: the Great Depression.  As is well known, nominal spending fell in half during this time and slowly recovered during the decade. As is also well known, FDR's monetary easing--devaluing the gold content of dollar and not sterilizing gold inflows--and the nominal expectations it created were key to restoring nominal spending.  The recovery path was not perfect, but eventually total current dollar spending returned to its pre-Great Depression trend as seen in the figure below: This is a remarkable accomplishment given the dire circumstances o...

Well, at least Bob Murphy does over at Mises.org.  He attempts to tear apart the case I made for QE2 in the National Review Online. Strangely, his blistering attack never once addresses the key point of my argument: QE2 is an imperfect attempt to address the on-going excess money demand problem.  He commits a host of  mischaracterizations about my article that all stem from his avoidance of  this issue.  My takeaway from the piece is that Bob Murphy does not take seriously monetary disequilibrium.  If Bob Murphy wanted to do a reasonable critique of my piece, then he should have questioned whether there really is an on-going excess money demand problem as I claim. Instead his piece amounts to anti-Keynesian rant where among other things he labels me a "Monetarist-Keynesian." Come on, everyone knows that I along with Scott Sumner, Nick Rowe, Bill Woosley and Josh Hendrickson are known around the economic blogosphere as Quasi-Monetarists! Fortunately, Jeff...

  Tim Duy and Andy Harless call me out for being critical of the the Fed's low interest rates in the early-to-mid 2000s and for being critical of the Fed for failing to stabilize total current dollar spending.  They say I cannot have it both ways.  They argue that in order to keep nominal spending stable in the early-to-mid 2000s, the Fed had to push the federal funds rate below its neutral rate level for an extended period.  Therefore, it is unfair for me to assign blame to the Fed for the credit and housing boom.  Scott Sumner and Bill Woolsey have also raised this question to me in the past.  So what do we make of it? I am being inconsistent?   Though it may not convince everyone, there is a way to reconcile my two criticisms of the Fed.  The key to doing so is appropriately specifying the trend growth of nominal spending. I will define it here as the trend growth rate over the 1987-1998 period for several reasons.  First, its the par...

With the release of the 2005 FOMC transcripts we learn that the Fed was aware of the housing boom but failed to alter monetary policy.  Among other damning evidence, we find this gem in the December 2005 FOMC meeting.  It shows the real federal funds rate compared to the Fed's estimate of  the equilrium or neutral real federal funds.  There is a striking gap that emerges during the early-to-mid 2000s.  This indicates the Fed was highly accommodative and aware of it. This monetary ease was an important contributor to to the credit and housing boom for reasons explained here and here . So much for Alan Greenspan's challenge for someone to " prove him wrong" in his leadership of the Fed.  As Yves Smith notes , what makes these and other revelations about this period particularly frustrating is that the Fed continues to shirk blame for the crisis.

Paul Krugman is spot on here : [P]olitically conservative economists arguing for something like nominal GDP targeting, and pleading with their perceived political allies to stop talking nonsense, are going to be disappointed. Yep, Scott Sumner , Ramesh Ponnuru , and I  know this all too well. Nonetheless, we keep trying and hope that some conservatives are listening.

One goal of QE2 is to raise inflation expectations.  According to the latest Cleveland Fed data on expected inflation, QE2 is doing just that: (Click on figure to enlarge.) Though far from perfect, QE2 should be considered successful on this objective.  Raising inflation expectations is important for two complementary reasons. First, absent any negative productivity shock, higher expected inflation indicates the Fed is also raising expectations of future total dollar spending (that is how the prices will rise).  Higher nominal spending, in turn, means the real economy should be improving too, given sticky prices and excess economic capacity.  Such an improved economic outlook will cause households and firms to increase current spending. Second, higher expected inflation also increases the opportunity cost of holding low-yielding liquid assets like money and treasuries. This will encourage folks to adjust their portfolios away from money and treasuries to highe...

Scott Sumner directs us to a Financial Times piece that claims the Bank of England is secretly targeting a nominal GDP growth rate of 5%.  As a proponent of nominal GDP targeting, I was intrigued and wanted to see if the UK data supported this claim.  So I created the figure below using the IMF's IFS database.  It shows the natural log of UK nominal GDP data for the 1990:Q1-2010:Q3 along with a fitted trend for the 1990:Q1-2007:Q4 period. (Click on figure to enlarge.) This slope of the trend line indicates an average nominal GDP growth rate of 5.3%.  It seems plausible, then, that the Bank of England is actually targeting nominal GDP.  This is not entirely surprising given there are respected economic commentators in the UK like Martin Wolf and Samuel Brittan that endorse the idea. Of course, it would be even better if the Bank of England were targeting the nominal GDP level and thus aimed to close the NGDP gap in the figure above. However, given the grief...

Ryan Avent writes : Chinese inflation is running consistently higher than American inflation, which is scarcely above 1%. That translates into rapid real appreciation despite the slow movement in the nominal exchange rate. And that should produce a decline in Sino-American imbalances, which seems to be emerging. Ryan Avent can correct me if I am wrong, but I suspect some of that run up in Chinese inflation is the result of QE2.  Chinese monetary authorities are forced to create more yuans to buy up the new QE2 dollars in order to maintain the crawling yuan-dollar peg.  The actual and expected increase in yuan, in turn, is contributing to the rise in China's inflation rate. In short, China is importing the Fed's QE2-driven monetary policy.  If this real appreciation actually leads to meaningful rebalancing in the global economy, then QE2 may be what ends Bretton Woods 2 .

Randall W. Forsyth points to two recent developments as part of a broader change in the global monetary system: The new world monetary order continued to evolve with two separate developments Tuesday.  Japan said it would join China in buying debt securities to support beleaguered European sovereign creditors. In so doing, the world's No. 2 and No. 3 economies were acting to try to hold together the euro as a viable alternative to the world's reserve currency, the dollar, from the No. 1 economy, the U.S.  At the same time, China permitted trading of the renminbi in the U.S. for the first time -- a significant step in the RMB becoming a full-fledged international, convertible currency...[These two developments] are both part of the loosening of the global monetary system away from its dollar-centric mooring. Maybe so, but there there are many hurdles for alternative currencies to clear before there arises any meaningful threat to the dollar's reserve status.  Just ...

It has taken a beating lately from Paul Krugman. First, he says the Texas economy is not so special in terms of handling the recession. He makes this claim based on a comparison of the unemployment rate in Texas with that of New York. Second, he notes its budget problems are well, Texas-sized with a $25 billion budget hole.  Thus, he concludes its conservative-based polices are not a model for other states to follow.  Are his critiques valid? On the fist point, Ryan Avent points out that Krugman's use of the unemployment rate is misleading because there has been a large migration to Texas where there has been hardly any to New York.  Thus, a significant part of the unemployment rate in Texas during the recession comes from there being so many newcomers while that is not the case in New York.   Further evidence undermining Krugman's first critique can be seen in the following figure.  It shows that the employment growth rate has been far stronger in Texa...

The answer is no for most of us.  If, on the other hand, you live inside a Florida prison then the answer is yes.  For the economies inside Florida prisons now use honey buns as a medium of exchange .  And as Nick Rowe has tirelessly explained , recessions can only occur when there is an excess demand for the medium of exchange. I am not sure, though, what a prison economy recession would look like... (HT Tyler Cowen )

Why do we continue to get the following line of reasoning about QE2 and interest rates reported in the press? The trouble [with QE2] is, though yields fell sharply between August and November as the markets anticipated the new program, they have risen since it was formally announced in November, leaving many in the markets puzzled about the value of the Fed’s bond-buying program.  This particular quote comes from the New York Times , but it is ubiquitous in the press.  As I and others have said before, a truly successful QE2--one that helps revive the economy--should ultimately lead to higher bond interest rates.  Yes, yields may initially fall but an economic recovery should be accompanied by rise in interest rates as the demand for credit increases.  Amazingly, after spending several paragraphs raising doubts about whether QE2 is working because of rising yields, the NY Times article closes with this from Brian P. Sack, the head of the NY Fed trading desk: “Rat...