U.S. Politics

NGDP targeting has been gaining popularity recently. But targeting market-based inflation forecasts will be about as good under most conditions [1], and we have good markets that forecast the U.S. inflation rate [2].

Those forecasts have a track record that starts in 2003. The track record seems quite consistent with my impressions about when the Fed should have adopted a more inflationary policy (to promote growth and to get inflation expectations up to 2% [3]) and when it should have adopted a less inflationary policy (to avoid fueling the housing bubble). It’s probably a bit controversial to say that the Fed should have had a less inflationary policy from February through July or August of 2008. But my impression (from reading the stock market) is that NGDP futures would have said roughly the same thing. The inflation forecasts sent a clear signal starting in very early September 2008 that Fed policy was too tight, and that’s about when other forms of hindsight switch from muddled to saying clearly that Fed policy was dangerously tight.

Why do I mention this now? The inflation forecast dropped below 1 percent two weeks ago for the first time since May 2008. So the Fed’s stated policies conflict with what a more reputable source of information says the Fed will accomplish. This looks like what we’d see if the Fed was in the process of causing a mild recession to prevent an imaginary increase in inflation.

What does the Fed think it’s doing?

  • It might be relying on interest rates to estimate what it’s policies will produce. Interest rates this low after 6.5 years of economic expansion resemble historical examples of loose monetary policy more than they resemble the stereotype of tight monetary policy [4].
  • The Fed could be following a version of the Taylor Rule. Given standard guesses about the output gap and equilibrium real interest rate [5], the Taylor Rule says interest rates ought to be rising now. The Taylor Rule has usually been at least as good as actual Fed policy at targeting inflation indirectly through targeting interest rates. But that doesn’t explain why the Fed targets interest rates when that conflicts with targeting market forecasts of inflation.
  • The Fed could be influenced by status quo bias: interest rates and unemployment are familiar types of evidence to use, whereas unbiased inflation forecasts are slightly novel.
  • Could the Fed be reacting to money supply growth? Not in any obvious way: the monetary base stopped growing about two years ago, M1 and MZM growth are slowing slightly, and M2 accelerated recently (but only after much of the Fed’s tightening).

Scott Sumner’s rants against reasoning from interest rates explain why the Fed ought to be embarrassed to use interest rates to figure out whether Fed policy is loose or tight.

Yet some institutional incentives encourage the Fed to target interest rates rather than predicted inflation. It feels like an appropriate use of high-status labor to set interest rates once every few weeks based on new discussion of expert wisdom. Switching to more or less mechanical responses to routine bond price changes would undercut much of the reason for believing that the Fed’s leaders are doing high-status work.

The news media storytellers would have trouble finding entertaining ways of reporting adjustments that consisted of small hourly responses to bond market changes. Whereas decisions made a few times per year are uncommon enough to be genuinely newsworthy. And meetings where hawks struggle against doves fit our instinctive stereotype for important news better than following a rule does. So I see little hope that storytellers will want to abandon their focus on interest rates. Do the Fed governors follow the storytellers closely enough that the storytellers’ attention strongly affects the Fed’s attention? Would we be better off if we could ban the Fed from seeing any source of daily stories?

Do any other interest groups prefer stable interest rates over stable inflation rates? I expect a wide range of preferences among Wall Street firms, but I’m unaware which preferences are dominant there.

Consumers presumably prefer that their banks, credit cards, etc have predictable interest rates. But I’m skeptical that the Fed feels much pressure to satisfy those preferences.

We need to fight those pressures by laughing at people who claim that the Fed is easing when markets predict below-target inflation (as in the fall of 2008) or that the Fed is tightening when markets predict above-target inflation (e.g. much of 2004).

P.S. – The risk-reward ratio for the stock market today is much worse than normal. I’m not as bearish as I was in October 2008, but I’ve positioned myself much more cautiously than normal.


[1] – They appear to produce nearly identical advice under most conditions that the U.S. has experienced recently.

I expect inflation targeting to be modestly safer than NGDP targeting. I may get around to explaining my reasons for that in a separate post.

[2] – The link above gives daily forecasts of the 5 year CPI inflation rate. See here for some longer time periods.

The markets used to calculate these forecasts have enough liquidity that it would be hard for critics to claim that they could be manipulated by entities less powerful than the Fed. I expect some critics to claim that anyway.

[3] – I’m accepting the standard assumption that 2% inflation is desirable, in order to keep this post simple. Figuring out the optimal inflation rate is too hard for me to tackle any time soon. A predictable inflation rate is clearly desirable, which creates some benefits to following a standard that many experts agree on.

[4] – providing that you don’t pay much attention to Japan since 1990.

[5] – guesses which are error-prone and, if a more direct way of targeting inflation is feasible, unnecessary. The conflict between the markets’ inflation forecast and the Taylor Rule’s implication that near-zero interest rates would cause inflation to rise suggests that we should doubt those guesses. I’m pretty sure that equilibrium interest rates are lower than the standard assumptions. I don’t know what to believe about the output gap.

Book review: Fragile by Design: The Political Origins of Banking Crises and Scarce Credit, by Charles W. Calomiris, and Stephen H. Haber.

This book start out with some fairly dull theory, then switches to specific histories of banking in several countries with moderately interesting claims about how differences in which interest groups acquired power influenced the stability of banks.

For much of U.S. history, banks were mostly constrained to a single location, due to farmers who feared banks with many branches would shift their lending elsewhere when local crop failures made local farms risky to loan to. Yet comparing to Canada, where seemingly small political differences led to banks with many branches, it seems clear that U.S. banks were more fragile because of those restrictions, and less competition in the U.S. left consumers with less desirable interest rates.

By the 1980s, improved communications eroded farmers’ ability to tie banks to one locale, so political opposition to multi-branch banks vanished, resulting in a big merger spree. The biggest problem with this merger spree was that the regulators who approved the mergers asked for more loans to risky low-income borrowers. As a result, banks (plus Fannie Mae and Freddie Mac) felt compelled to lower their standards for all borrowers (the book doesn’t explain what problems they would have faced if they had used different standards for loans the regulators pressured them to make).

These stories provide a clear and plausible explanation of why the U.S. has a pattern of banking crises that Canada and a few other well-run countries have almost entirely avoided over the past two centuries. But they suggest the U.S. banking crises should have been more unique among mature democracies than was actually the case.

The authors are overly dismissive of problems that don’t fit their narrative. Commenting on the failure of Citibank, Lehman, AIG, etc to sell more equity in early 2008, they say “Why go to the markets to raise new capital when you are confident that the government is going to bail you out?”. It seems likely bankers would have gotten better terms from the market as long as they didn’t wait until the worst part of the crisis. I’m pretty sure they gave little thought to bailouts, and relied instead on overly complacent expectations for housing prices.

The book has a number of asides that seem as important as their main points, such as claims that Britain’s greater ability to borrow money led to its military power, and its increased need for military manpower drove its expansion of the franchise.

Book review: The Great Degeneration: How Institutions Decay and Economies Die, by Niall Ferguson.

Read (or skim) Reinhart and Rogoff’s book This Time is Different instead. The Great Degeneration contains little value beyond a summary of that.

The other part which comes closest to analyzing US decay is a World Bank report about governance quality from 1996 to 2011 which shows the US in decline from 2000 to 2009. He makes some half-hearted attempts to argue for a longer trend using anecdotes that don’t really say much.

Large parts of the book are just standard ideological fluff.

The CFTC is suing Intrade for apparently allowing U.S. residents to trade contracts on gold, unemployment rates and a few others that it had agreed to prevent U.S. residents from trading. The CFTC is apparently not commenting on whether Intrade’s political contracts violate any laws.

U.S. traders will need to close our accounts.

The email I got says

In the near future we’ll announce plans for a new exchange model that will allow legal participation from all jurisdictions – including the US.

(no statement about whether it will involve real money, which suggests that it won’t).

I had already been considering closing my account because of the hassle of figuring out my Intrade income for tax purposes.

Book review: The Signal and the Noise: Why So Many Predictions Fail-but Some Don’t by Nate Silver.

This is a well-written book about the challenges associated with making predictions. But nearly all the ideas in it were ones I was already familiar with.

I agree with nearly everything the book says. But I’ll mention two small disagreements.

He claims that 0 and 100 percent are probabilities. Many Bayesians dispute that. He has a logically consistent interpretation and doesn’t claim it’s ever sane to believe something with probability 0 or 100 percent, so I’m not sure the difference matters, but rejecting the idea that those can represent probabilities seems at least like a simpler way of avoiding mistakes.

When pointing out the weak correlation between calorie consumption and obesity, he says he doesn’t know of an “obesity skeptics” community that would be comparable to the global warming skeptics. In fact there are people (e.g. Dave Asprey) who deny that excess calories cause obesity (with better tests than the global warming skeptics).

It would make sense to read this book instead of alternatives such as Moneyball and Tetlock’s Expert Political Judgment, but if you’ve been reading books in this area already this one won’t seem important.

Book review: The Righteous Mind: Why Good People Are Divided by Politics and Religion, by Jonathan Haidt.

This book carefully describes the evolutionary origins of human moralizing, explains why tribal attitudes toward morality have both good and bad effects, and how people who want to avoid moral hostility can do so.

Parts of the book are arranged to describe the author’s transition from having standard delusions about morality being the result of the narratives we use to justify them and about why other people had alien-sounding ideologies. His description about how his study of psychology led him to overcome his delusions makes it hard for those who agree with him to feel very superior to those who disagree.

He hints at personal benefits from abandoning partisanship (“It felt good to be released from partisan anger.”), so he doesn’t rely on altruistic motives for people to accept his political advice.

One part of the book that surprised me was the comparison between human morality and human taste buds. Some ideologies are influenced a good deal by all 6 types of human moral intuitions. But the ideology that pervades most of academia only respect 3 types (care, liberty, and fairness). That creates a difficult communication gap between them and cultures that employ others such as sanctity in their moral system, much like people who only experience sweet and salty foods would have trouble imagining a desire for sourness in some foods.

He sometimes gives the impression of being more of a moral relativist than I’d like, but a careful reading of the book shows that there are a fair number of contexts in which he believes some moral tastes produce better results than others.

His advice could be interpreted as encouraging us to to replace our existing notions of “the enemy” with Manichaeans. Would his advice polarize societies into Manichaeans and non-Manichaeans? Maybe, but at least the non-Manichaeans would have a decent understanding of why Manichaeans disagreed with them.

The book also includes arguments that group selection played an important role in human evolution, and that an increase in cooperation (group-mindedness, somewhat like the cooperation among bees) had to evolve before language could become valuable enough to evolve. This is an interesting but speculative alternative to the common belief that language was the key development that differentiated humans from other apes.

Despite strong opposition, a little progress is being made at informing consumers about medical quality and prices.

Healthcare Blue Book has some info about normal prices for standard procedures.

Healthgrades has some information about which hospitals produce the best outcomes (although more of the site seems devoted to patient ratings of doctors, which probably don’t make much distinction between rudeness and killing the patient).

Insurers are trying to create rating systems, but reports are vague about what they’re rating.

One objection to ratings is that

such measures can be wrong more than 25 percent of the time

A 25 percent error rate sounds like a valuable improvement over the current near-blind guesses that consumers currently make. Does anyone think that info such as years of experience, university attended, or ability to make reassuring rhetoric produces an error rate in as low as 25 percent? Do medical malpractice suits catch the majority of poor doctors without targeting many good ones? (There are some complications due to some insurers wanting to combine quality of outcome ratings with cost ratings – those ought to be available separately). Are there better ways of evaluating which doctors produce healthy results that haven’t been publicized?

More likely, doctors want us to believe that we should just trust them rather than try to evaluate their quality. I might consider that if I could see that the profession was aggressively expelling those who make simple, deadly mistakes such as failing to wash their hands between touching patients.

Book review: This Time is Different: Eight Centuries of Financial Folly by Carmen M. Reinhart and Kenneth S. Rogoff.

This book documents better than any prior book the history of banking and government debt crises. Most of it is unsurprising to those familiar with the subject. It has more comprehensive data than I’ve seen before.

It is easier reading than the length would suggest (it has many tables of data, and few readers will be tempted to read all the data). It is relatively objective. That makes it less exciting than the more ideological writings on the subject.

The comparisons between well governed and poorly governed countries show that governments can become mature enough that defaults on government debt and hyperinflation are rare or eliminated, but there is little different in banking crises between different types of government / economies.

They claim that international capital mobility has produced banking crises, but don’t convince me that they understand the causality behind the correlation. I’d guess that one causal factor is that the optimism that produces bubbles causes more investors to move money into countries they understand less well than their home country, which means their money is more likely to end up in reckless institutions.

The book ends with tentative guesses about which countries are about to become mature enough to avoid sovereign debt crises. Among the seven candidates is Greece, which is now looking like a poor guess less than a half year after it was published.

Book review: Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse by Thomas E. Woods Jr.

This book describes the Austrian business cycle theory (ABCT) in a more readable form than it’s usually presented. Its basic idea that malinvestment creates business cycles, and that central bank manipulation of interest rates can cause malinvestment, is correct. But when Woods tries to argue that only errors by a government can cause business cycles, his ideological blinders become obvious. He’s mostly right when he complains about government mistakes, and mostly wrong when he denies the existence of other problems.

He asks why businesses made a “cluster of errors” that added up to a big problem rather than independent errors which mostly canceled each other out. The only answer he can find is misleading signals sent by the Fed’s manipulation of interest rates. He doesn’t explain why businessmen fail to learn from the frequent and widely publicized patterns of those Fed actions. It’s unclear why groupthink needs a strong cause, but one obvious possibility that Woods ignores is that most people saw a persistent trend of rising housing prices, and didn’t remember large drops in housing prices over a region as large as the U.S.

He shows no understanding of the problems associated with sticky wages which are a key part of the better arguments for Keynesian approaches.

He wants to credit ABCT with having predicted this downturn. If you try to figure out when was the last time it didn’t predict a downturn (the early 1920s?), this seems less impressive than, say, Robert Shiller’s track record for predicting when bubbles burst.

His somewhat selective use of historical evidence carefully avoids anything that might present a picture more complex than government being the sole villain. He describes enough U.S. economic expansions to present a clear case that credit expansion contributed to the ensuing bust, and usually points to a government activity which one can imagine caused excessive credit expansion. But he’s unusually vague about the causes of the expansion that led to the panic of 1857. Could that be because he wants to overlook the role that new gold mining in California played in that inflationary cycle?

He mostly denies that free market approaches have been tested for long enough to see whether we would avoid business cycles under a true free market. He points to a few downturns when he says the government followed a wise laissez faire policy, and compares the shortness of those downturns with a few longer downturns where the government made some attempts to solve the downturns. When doing this, he avoids mention of the downturns where massive government actions were followed by mild recessions. Any complete survey comparing the extent of government action with the ensuing economic conditions would provide a much murkier picture of the relative contributions of government and market error than Woods is willing to allow.

The most interesting claim that I hadn’t previously heard is that a large decrease in the money supply in 1839-1843 coincided with healthy GNP growth, which, if true, is hard to explain without assuming Keynesian and monetarist theories explain a relatively small fraction of business cycle problems. My attempts to check this yielded a report at http://www.measuringworth.org/usgdp/ saying GDP in 2005 dollars rose from $31.37 in 1839 to $34.84 in 1843, but GDP per capita in 2005 dollars dropped from $1884 in 1839 to $1869 in 1843. Declining GDP per capita doesn’t sound very prosperous to me (although it’s a mild enough decline to provide little support for Keynesians/monetarists).

He tries to blame the “mistakes” of credit rating agencies on an SEC-created cartel of rating agencies. That “cartel” does have some special privileges, but he doesn’t say what stops bloggers from expressing opinions on bond risks and developing reputations that lead to investors using those opinions in addition to the “cartel”‘s ratings (Freerisk is a project which is planning a sophisticated alternative). I say that anyone who understands markets would expect the yield on the bonds to provide as good an estimate of risk as any alternative. Credit rating agencies must be performing some other function in order to thrive. An obvious function is to mislead bosses and/or regulators who don’t understand markets into thinking that the people making investment decisions are making choices that are safer than they actually are. It appears that the agencies performed that function well, and helped many people avoid being fired for poor choices.

His discussion of whether WWII spending cured the Great Depression points out that mainstream theories falsely predicted a return to depression in 1946. But it’s unclear whether all versions of Keynesianism make that mistake, and it’s unclear how ABCT could predict the U.S. would be much more prosperous in 1946 than at the start of the war.
Here’s an alternative explanation that lies in between those theories: wages were being kept too high for supply and demand to balance through 1941. Inflation and changes in government policy toward wage levels during WW2 eliminated the causes of that imbalance.

Arnold Kling has a good quasi-Austrian alternative here and here.