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An ebook containing the papers and presentations from the European Central Bank’s central banking forum conference in Sintra Portugal is now available. Mario Draghi and his colleagues are to be greatly commended for running a forum that is so open to profound challenges to central banking orthodoxy.

The volume contains a paper by Olivier Blanchard, Eugenio Cerutti and me on hysteresis and separately some of my reflections asserting the need for a new Keynesian economics that is more Keynesian and less new. Here I summarize these two papers.

Hysteresis Effects

Blanchard Cerutti and I look at a sample of over 100 recessions from industrial countries over the last 50 years and examine their impact on long run output levels in an effort to understand what Blanchard and I had earlier called hysteresis effects. We find that in the vast majority of cases output never returns to previous trends. Indeed there appear to be more cases where recessions reduce the subsequent growth of output than where output returns to trend. In other words “super hysteresis” to use Larry Ball’s term is more frequent than “no hysteresis.”

This finding does not in and of itself establish the importance of hysteresis effects. It might be that when underlying growth rates fall recessions follow but that recessions have no causal impact going forward. In order to address this issue we look at the impact of recessions with different precursors. We find that even recessions that are associated with disinflationary monetary policies or the drying up of credit have substantial long run output effects suggesting the presence of hysteresis effects.

In subsequent work Antonio Fatas and I have looked at the impact of fiscal policy surprises on long run output and long run output forecasts using a methodology pioneered by Blanchard and Leigh. Since fiscal policy effects operate primarily through aggregate demand, this provides a way to avoid the causation question. We find that fiscal policy changes have large continuing effects on levels of output suggesting the importance of hysteresis.

I was struck that in a vote taken at the conference close to 90 percent of the participants indicated that they believe there are significant hysteresis effects. While there is much more work to be done, I believe that as of right now the right presumption is in favor of hysteresis effects despite their exclusion from the standard models used in almost all central banks.

Towards a New Macroeconomics

My separate comments in the volume develop an idea I have pushed with little success for a long time. Standard new Keynesian macroeconomics essentially abstracts away from most of what is important in macroeconomics. To an even greater extent this is true of the DSGE (dynamic stochastic general equilibrium) models that are the workhorse of central bank staffs and much practically oriented academic work.

Why? New Keynesian models imply that stabilization policies cannot affect the average level of output over time and that the only effect policy can have is on the amplitude of economic fluctuations not on the level of output. This assumption is problematic at a number of levels.

First, if stabilization policies cannot effect average levels of employment and output over time they are not nearly as important as if they can. Beginning the study of stabilization with this assumption takes away much of the motivation for doing macroeconomics.

Second, the assumption is close to absurd.  It is surely reasonable to assume that better policy could have avoided the Depression or the huge output losses associated with the financial crisis without having shaved off some previous or subsequent peak.

Third, contrary to the now common view that macroeconomics is best understood by studying the stochastic properties of stationary time series, the most important macroeconomic events are in some sense one off. Think of the Depression or the Great Recession or the high inflation of the 1970s.

The problem has always been that it is difficult to beat something with nothing. This may be changing as topics like hysteresis, secular stagnation, and multiple equilibrium are getting more and more attention.  As well they should. US output is now about 10 percent below a trend estimated through 2007. If one attributes even half of this figure to the effects of recession and assumes no catch up on this component until 2030 the cost of the financial crisis in the USA is about 1 year’s GDP. And matters are worse in the rest of the industrial world.

As macroeconomics was transformed in response to the Depression of the 1930s and the inflation of the 1970s, another 40 years later it should again be transformed in response to stagnation in the industrial world. Maybe we can call it the Keynesian New Economics.

My friends Mike Spence and Kevin Warsh, writing in yesterday’s Wall Street Journal, have produced what seems to me the single most confused analysis of US monetary policy that I have read this year (Brad DeLong has expressed related views).  Unless I am missing something — which is certainly possible — they make a variety of assertions that are usually exposed as fallacy in introductory economics classes.

My problem is not with their policy conclusion, though I do not share their highly negative view of QE.  There are many harshly critical analyses of QE such as those of Martin Feldstein that are entirely coherent and consistent with the macroeconomics of the last 50 years.  My differences are based on judgements about empirical magnitudes and relative risks not questions of basic logic.

Spence and Warsh do not focus on the inflation risks, financial stability risks or distributional risks from overly expansionary monetary policy.  Instead they assert a proposition that I have not encountered in 40 years as a professional economist—that overly easy monetary policy reduces business investment.  Indeed they blame the weakness of business investment during the current recovery on the Fed.

This line of argument is to say the least surprising.  Every major macroeconomics textbook whether Keynesian monetarist or classical in orientation teaches students that investment increases as real interest rates decline.  This is motivated in a variety of quite compelling ways.  It is noted that lower rates raise the present value of the returns from investment and so make them more attractive.  It is observed that lower rates mean lower borrowing costs or lower costs of drawing down liquid asset holding making the purchase of capital goods more attractive.  For these reasons millions of students have been taught that Hicks famous IS curve slopes downward.  Hundreds of empirical studies have found that investment responds to capital cost as theory predicts though the magnitude is open to debate.

What arguments do Spence and Warsh offer for their heterodox conclusion? They note rightly that monetary policy has been easy and investment has been weak in the current recovery.  This is a little like discovering a positive correlation between oncologists and cancer and asserting that this proves oncologists cause cancer.  One would expect in a weak recovery that investment would be weak and monetary policy easy.  Correlation does not prove causation.

They then argue that low rates somehow promote corporate stock buybacks and this is an alternative to real new investment.  I confess that I cannot follow the logic here.  I would have supposed that the choice between real investments and share repurchases would depend on their relative price.  If as Spence and Warsh assert QE has raised stock prices this should tilt the balance towards real investment.

Likewise I would have thought that by making the return to holding cash less attractive, easy money would tend to drive firms into making real investments.  And for the many firms that do not have huge hoards, it would bring down borrowing costs.

Perhaps Spence and Warsh are on to something that I am missing.  I’m curious whether they can point to any peer reviewed economic research or indeed any statistical work that backs up their views.  I am certainly open to any new evidence or new argument after all that has happened in recent years that easy money reduces business investment.  And there is plenty of room for debate over policy.  For now though I would put the Spence-Warsh doctrine that easy money reduces investment in a class of propositions backed by neither logic nor evidence.

The Canadian liberal party won an overwhelming victory in yesterday’s election.  Voters decisively rejected the ruling Conservative party and placed the Liberal Party far ahead of the left wing New Democratic Party.  This is obviously important for Canada.  But there are also two lessons here for American political observers.

First, polls often get it wrong.  As in Britain, and now the Canadian election, results were much more decisive than had been expected.  A Liberal majority looked extremely unlikely two months ago.  Even three days ago, I suspect Liberals would have been thrilled if they could have counted on a clear plurality of the vote.  An era when less than 10 percent of voters respond to pollsters, and where mass opinion changes rapidly, will be one where Election Day is again a day of drama.

Second in an era of extraordinarily low interest rates and slow growth, it is becoming increasingly clear that progressives do best when they reject austerity and embrace public investment.  The British Labour party and the Canadian NDP sought to demonstrate their soundness by embracing budget balancing as an objective.  Their results were terrible.

The Canadian Liberals on the other hand were rewarded for a very different choice.  As incoming PM Justin Trudeau told the Financial Times “people keep telling me we have made a risky choice in this time when there is this political mantra of balanced budgets as a way to demonstrate responsible leadership.  I am on the side of economists who say: Why put off investing when we have an opportunity now?”

Indeed many Canadian political commentators noted the strategic importance of the Liberals’ infrastructure pledge. Martin Patriquin in Maclean’s called the infrastructure plan “the all-important wedge to isolate the NDP”; Michelle Gagnon in CBC news identified the announcement of deficit-funded infrastructure spending  as “the first turning point”; and, as  noted on Bloomberg, “Trudeau entered the campaign in third place and his numbers began to increase after he broke from his rivals to favor three years of deficit spending, in part to fund an infrastructure blitz aimed at stoking Canada’s sluggish economy”.

More infrastructure investment is not just good economics.  It is good politics.  Let us hope that American presidential candidates get the word!

There are many compelling arguments for increasing American infrastructure investment. Capital costs are exceptionally low. Construction labor is highly available. Materials costs are low as commodity prices have fallen. Investment is low by historic standards. Investing today relieves the burden for deferred maintenance from future generations.

Here is another one. Maintaining our infrastructure directly benefits American families and businesses because with fewer potholes they have to spend less maintaining their vehicles. This effect turns out to be surprisingly large. TRIP, a transportation research group, estimates that the cost to motorists of driving on roads in need of repair in 2013 was $109 billion. [1. TRIP, Additional Vehicle Operating Cost per Motorist 2013] This includes only extra vehicle repair and operating costs, and not the delays caused by driving on poor roads, so is almost certainly an underestimate. On the other hand, even with proper polices some potholes would remain. To be very conservative assume that proper infrastructure investment policies would save motorists half the total, or $54 billion a year.

How large is this figure? It is comparable to total consumer spending of $49 billion on air transportation or $53 billion on personal computers [2. BEA National Income Table 2.4.5U: Personal Consumption Expenditures by Type of Product, 2013]. As another way of seeing its magnitude, it works out to 40 cents per gallon gasoline consumed in the United States [3. EIA SEDS Table F3: Motor Gasoline Consumption, Price, and Expenditure Estimates, 2013].

So if we were able to raise the gas tax by 40 cents and repair our highways and roads, we would create no new net burden on consumers: the benefit in reduced vehicle operating costs would at the very least offset their higher gas bills. In fact since our cost estimate is conservative, the net effect on consumers would most likely be positive. And as is fair, those who drive the most would both pay the most and benefit the most from reduced repair costs.

Even after a 40 cent gasoline tax, gas would still be only 82% as expensive as a year ago and 79% as expensive as 2 years ago [4. EIA Petroleum Data: U.S. All Grades All Formulations Retail Gasoline Prices, Monthly]. A gas tax to finance road repair is about as close to a free lunch as we can ever get in economics.

I had occasion to address a gathering of Congressional Medal of Honor recipients visiting Harvard last week. It was an opportunity to reflect on the meaning of courage, and also on the relationship between universities and the military. Our freedom, including our academic freedom, depends on the existence of a strong military, and of people who are prepared to serve in it. Universities have a responsibility to support the individuals and the institutions which defend that freedom.

The good news is that ROTC is back at Harvard, and that military recruiters are allowed on campus. The bad news is that our cooperation with the military appears to be contingent.  It reflects less a sense of our obligations of citizenship than our lack of major disagreement at this moment with the country’s military policies. I did not support the Don’t Ask Don’t Tell policy, nor the invasion of Iraq, but I do not believe that support for the military should be contingent on the political decisions of those who exert civilian control over it.

Given that the harmony between universities’ values and the military’s policies is unlikely to endure permanently, I think the issue of universities and the military is profoundly important.

Today the Federal Reserve will makes its most consequential announcement in years.  Much attention has rightly focused on whether the fed funds rate is increased.  Ultimately though what matters is the posture of monetary policy, which depends on both the fed funds rate tomorrow and the path of expected rates.  My views are clear; this is not the time for a tightening in monetary policy.

Whether the fed funds target is increased or not is obviously an indicator of monetary policy. A better reflection is the 2 year Treasury rate which is largely determined by expectations of the fed funds rate the fed will set over the next 2 years.  It is this 2 year Treasury rate that I will be watching as the market digests the Fed’s policy announcements and forecasts and Chair Yellen holds her press conference.

I think it likely that the 2 year will move contemporaneously with the fed funds rate.  If rates are not raised I’d expect the two year to fall and if they are raised, I’d expect it to rise.  But this is not certain.  A “hawkish” holding of the rate where the Fed moved towards locking in future increases could raise 2 year rates.  Conceivably but less likely a “one and done” type announcement could on balance lower expected rates and so 2 year yields.

The figure below shows that two year yields and the chance of a rate increase in September have mostly moved together but that very recently markets have started to anticipate policy tightening that is not rooted in a September fed funds hike.  I see a risk that the fed will not move this afternoon but will appease hawks with such firm language on future rate hikes that their overall impact will be contractionary.  This would be very unfortunate.

I have spent the last two days in Kiev attending the Yalta European Strategy meeting, where I have had the chance to discuss Ukraine’s economic reform efforts with key officials, including the finance minister and prime minister.  I was encouraged to see a country where, despite huge challenges, including Russia’s war of aggression against Ukraine, economic reforms are being carried out and receiving support from the international community.

The Ukrainian parliament will this week vote on a historic debt reduction agreement that finance minister Natalie Jaresko negotiated with Ukraine’s private-sector creditors. The case for approval is overwhelming, both because Ukraine has made a good deal and because disapproving the deal would be catastrophic for Ukraine’s economy. But approval of the debt deal is only one component of the ambitious economic cooperation among Ukraine, Europe and the United States – cooperation that is essential to the geopolitical moment.

I have been watching debt negotiations closely for more than 30 years, since the Latin American crisis of the 1980s. Ukraine has gotten as good and fast a deal as any I have ever seen.

The deal has many virtues:

• It reduces the principal value of Ukraine’s debt and eliminates principal payments for the next four years.

• It unlocks substantial support from the International Monetary Fund and other international financial institutions on a large-scale.

• It brings forward the day when Ukraine can attract significant private capital flows.

• It establishes clear principles that will enable Ukraine to defer all principal payments on its obligation coming due to Russia.

Even if Ukraine’s economy does very well, the “value recovery instrument” issued as part of the debt deal, which aligns debt repayment with economic growth, is shrewdly designed so that the vast majority of future growth will still flow to the Ukrainian people, not to its creditors. This is because: (i) the instrument only kicks in at scale in a decade; (ii) it is subject to repurchase on the open market and to subsequent renegotiation; and (iii) it is carefully designed to ensure that only the initial benefit and not the continuing benefit of Ukraine’s growth flows to creditors.

In the unlikely event that Ukraine’s parliament disapproved the deal, all these benefits would be lost. International financial support would dry up as Ukraine would be seen as unable to carry through on commitments. Confidence in the stability of Ukraine’s currency and banking system would be put at risk. And its leverage vis-a-vis its debt to Russia would vanish.

So I hope and expect that the Ukrainian parliament will ratify the debt deal in the very near future. To paraphrase Churchill, this may not be the end, or even the beginning of the end of Ukrainian economic reform, but it may be the end of the beginning.

Make no mistake – the United States and Europe have an immense stake in Ukraine’s economic success. Our leaders rightly assert that military force is often not the right solution to international conflict. Enabling Ukraine to provide greater improvements in living standards for its citizens than Russia does would be a major triumph for the West. In this regard what we do for Ukraine is likely more important than what we do to Russia.

Support for Ukraine should not be seen as foreign assistance to a striving economic reformer, though it is that. Rather, with Ukraine invaded, support should be seen as investment in forward defense of core U.S. and European security interests. If Ukraine succeeds economically, investments will pay for themselves several times over as loans are paid back with interest, and as Russia’s government is both deterred by Ukraine’s stronger economy and pressured by its economic example.

Historians will wonder why the international community has invested more than 10 times as much money in supporting a recalcitrant Greece as in supporting a reforming Ukraine, since the start of their crisis.  Perhaps intra-European Union loans are in some special category, but as of this moment the IMF’s potential exposure to Greece is $41 billion compared to only $22 billion for Ukraine.

Now is the moment for Ukraine at long last to embrace the market and the rule of law.  It has the best, most market-oriented economic team in its history. And it is the time for global community to do whatever it takes—much more than is being done today—to provide support at a critical juncture.

 

Two weeks ago I  argued that a Federal Reserve decision to raise rates in September would be a serious mistake.  As I wrote my column, the market was assigning a 50 percent chance to a rate hike. The current chance is 34 percent. Having followed the debate among economists, Fed governors and bank presidents I believe the case against a rate increase has become somewhat more compelling even than it looked two weeks ago.

Five points are salient.

First, markets have already done the work of tightening.  The U.S. stock market is worth $700 billion less than it was 2 weeks ago and credit spreads have widened noticeably.  Financial conditions as measured by Goldman Sachs or the Chicago Fed index have tightened in the last 2 weeks by the impact equivalent of more than a 25 BP tightening.  So even if resisting inflation required a 25 BP tightening as of two weeks ago, this is no longer the case.

The figure below makes a crucial point.  It shows that even though the federal funds rate is very low (negative one and a half percent after adjusting for inflation), financial conditions are helping the economy less than in previous years when interest rates were much higher.

Second, the data flow suggests a slowing in the U.S. and global economies and reduced inflationary pressures.   Employment growth appears to have slowed down, commodity prices have fallen further, and the general data flow has been on the soft side.  Comprehensive measures of data surprises, such as the Bloomberg Economic Surprise Index, bear out this impression and the Atlanta Fed’s GDP Now model is currently predicting only 1.5% growth in Q3.

Third, the case for concern about inflation breaking out is very weak.  Market based expectations suggest that inflation over the next decade on the Fed’s preferred core pce basis is near record lows and well below 2 percent.  The observation that 5 year inflation, 5 years from now is expected to be below target calls into question arguments that current low inflation is somehow transitory.

The recent analysis presented by Fed Vice Chair Stanley Fischer asserting to the contrary relies on assumptions about exchange rates and inflation.  When actual empirical estimates are used his conclusions are substantially weakened.  Indeed as the figure below shows, there is no correlation of late between deceleration in inflation and import share looking across PCE components.

Also on inflation, it bears emphasis that (i) we have some room for inflation acceleration (ii) prices are now fully 2 percent below a 2 percent inflation path taking off from 2010, (iii)  the Phillips curve is so unstable that it provides little basis for predicting inflation acceleration.  To take just two examples — first, unemployment among college graduates is 2.5 percent yet there is no evidence that their wages are accelerating. And unemployment in Nebraska has been below 4 percent for the last 3 years and growth in average hourly earnings has been basically constant at the national average level.

Fourth, arguments of the “one and done” variety or arguments that the Fed can safely raise rates by 25 BP as long as it’s clear that there is no commitment to a series of hikes are specious. If as some suggest a 25 BP increase won’t affect the economy much at all, what is the case for an increase? And when the same people argue that 25 BP will have little impact and that it is vital to get off the zero rate floor, my head spins a bit.

In a highly uncertain world, the Fed cannot be both data dependent and predictable with respect to its future actions. Much better that it stick with data dependence than that it put its credibility at risk by seeking to mitigate a current rash action by trying to reassure with respect to future steps.

I understand the argument that zero rates are a sign of pathology and the economy is no longer diseased so policymakers have to increase rates.  The problem is that the case for hitting the brakes in an economy with sub-target inflation, employment and output is not there; regardless of whether the brakes are to going to be pressed hard or softly, singly or multiple times.

From the Vietnam War to the Euro crisis, from the Iraq war to the lessons of the Depression we surely should learn that policymakers who elevate credibility over responding to clear realities make grave errors.  The best way the Fed can maintain and enhance its credibility is to support a fully employed American economy achieving its inflation target with stable financial conditions.  The greatest damage it could do to its credibility would be to embrace central banking shibboleth disconnected from current economic reality.

Fifth, I believe that conventional wisdom substantially underestimates the risks in the current moment.  It bears emphasis that not a single post war recession was a predicted a year in advance by the Fed, the Federal government, the IMF or a consensus of forecasters.  Most were not recognized till long after they started.  And if history teaches anything it is that financial interconnections are pervasive and not apparent till it’s too late.   Russia’s 1998 default, problems in subprime lending, and the Asian financial crisis were all moments when financial dislocations had far more pervasive effects than was generally expected.

We know that the world’s largest economy, China, is in its most uncertain state since it began economic reform in 1979 and may well be experiencing a larger volume of capital flight than any economy in history.  We know that the central banks  of Japan and Europe are likely to have to double down in the months ahead on already extraordinary quantitative easing.  We know that American households, firms and markets are processing what appears to a kind of “reverse 1990s” moment of sharply decelerating productivity growth.  We know that liquidity conditions in markets have worsened and there is at least some reason to believe that “positive feedback” trading strategies where investors sell when prices go down may well have become increasingly important.  We know the current U.S. recovery is in its 7th year and that confidence in public institutions is at a low ebb.

More likely than not, these fears are overblown and 2015 and 2016 will not go down in financial history.  If so, and the Fed does not act, inflation will start to accelerate, volatility will subside and policy can step in.  Regret may come in the form of inflation a few tens of basis points too high or a bit of euphoric relief in markets.  If on the other hand, some portion of these fears are warranted and the Fed tips towards tightening, it risks catastrophic error.

Now is the time for the Fed to do what is often hardest for policymakers.  Stand still.

September 9, 2015

 

I was very glad to see Ukraine reach a deal involving reduction in the principal value of its debt with major creditors. This would not have happened without the tenacity and determination of Ukrainian finance minister, Natalie Jaresko, and Ukraine’s political leadership. Congratulations also to the IMF and the U.S. Treasury for their strong efforts. Read more

Tomorrow Greece votes. No one can know the outcome yet. Indeed, my bet is that a third of the voters are not yet sure how they will vote. If polls could not get the British election right, I doubt that they can get this one right. Anything can happen, and it would not surprise me if the vote is a landslide, one way or the other. Read more