Fed up with the full empoyment target?

The debate on Bernanke's views on inflation targeting -- whether it should be 2 or 4% -- as I noted in a previous post is peculiar, to say the least. After all the Fed has a dual mandate, and inflation preoccupations have to be tempered by the pressing question of unemployment. The preoccupation in some quarters is that the Fed has already accepted as a matter of fact that it has single mandate (see here and here). It seems to me that critics (e.g. Krugman, DeLong and others) are correct for the wrong reasons.

The graph below shows the effective Fed Funds rate in the last three recessions (represented by the shaded areas). The rate of interest falls in all three during or just before the recession.

Further, after the trough of the recession the Greenspan Fed took 46 and 35 months to start raising the rate in the previous two recessions. So far, 35 months after the last trough, the Bernanke Fed has not increased the rate. This time around it has done Quantitative Easing allowing for lower long term rates too, which was not done during the Greenspan era. If anything the Fed has done more now than under Greenspan, and unless you believe in the inflation expectations fairy, the old Eccles maxim is still true, monetary policy now is like pushing on a string.

So how is that critics of the Fed are correct and I believe that the dual mandate (full employment and inflation) is gone. Well look at the graph below. It shows the Fed Funds, again, with the 10 year Treasury bonds rate.

Notice that the Fed eventually raises the Fed Funds sufficiently to surpass the bond rate, and invert the yield curve. The point is to slowdown the economy, and avoid full employment. Even in the 1990s, when Greenspan allowed the bubble to continue and unemployment to fall below the then official limit of 6%, he eventually took action, when wages started to increase. Full employment has not been a target, but keeping workers demands for higher wages checked has been very much part of the reaction function. Jamie Galbraith has written about it (go here for a technical paper). So the Fed has a single target mandate, but is not an inflation target, it is a "fear of full employment target."

The Fed can do practical things like helping distressed borrowers (with defaulted or underwater mortgages), but it cannot directly increase spending, and in the absence of private spenders (domestic or foreign), or local governments, it must be the federal government. Bernanke is not the problem right now. Geithner is (and so is Congress).

PS: The New Keynesian view that if you increase expected inflation spending goes up is now defended by Brad DeLong. He says: "an extra $100 billion of quantitative easing boosts the expected price level ten years hence by 1%--and boosts expected inflation after the next decade by an average of 0.1%/year. That is enough to spur higher spending and a more rapid and satisfactory recovery." I'm not against QE per se, the idea of maintaining long term rates low. But the notion that it would lead to inflation (printing money generates inflation) and that expected inflation generates a boost in productive spending is clearly another confidence fairy story.

Brad DeLong on Carmen Reinhart

Great post by Brad DeLong, about misplaced fatalism. His comments are based on a video (you can see the whole thing in his post) debate between Krugman and Reinhart. He says:

"A word about the content: I continue to find Carmen Reinhart’s fatalist view puzzling. She agrees with me that we’re facing a demand-side problem — but insists that this problem can’t be solved quickly, that we need to go through many years of painful deleveraging that leave millions of potentially productive workers idle. I agree that this is probably what will happen, given the political realities. But surely this is a huge failure of policy, not something we should accept as inevitable. It’s truly bizarre, if you ask me, to say that our economy suffers from too little spending, and that nothing can or should be done to increase that spending."

He then uses a variation of an ISLM to explain his and Reinhart's views. Translating, political fatalism seems appropriate in the US, but theoretical fatalism is out of place. Agreed!

PS: Also worth reading is Cassidy's take on Obama's speech. An antidote to the fatalism above.

It's the model stupid!

Brad DeLong, that together with Krugman has been a force for sanity within the mainstream, arguing for more fiscal expansion, shows why we need heterodox economists.  He says in a recent post:

This is a bad time to be an economist. If you were fresh from the womb and had no past opinions to defend, if you had never said anything notable before, it might be a fine time to be an economist. If you are one of those soap-opera characters who has complete amnesia and no memory of anything that they ever said or did or any intellectual position they took before January 1, 2010, it might be a fine time to be an economist. But for the rest of us--we who are now looking back at our opinions and analytic judgments and statements and pronouncements of the past 15 years and thinking: "how could I ever have been so stupid; how could I have missed so much?"--it is a bad time to be economist?

Four years ago we economists were writing learned papers about the "Great Moderation": about how it looked as though the governing institutions of the world economy had finally learned how to control and moderate if not completely eliminate the business cycle--the epileptic seizures of the economy that leave us with pointlessly high unemployment, pointlessly idle capacity, and pointlessly rusting away machines in spite of there being no fundamental cause for machines to be idle, factories closed, and workers unemployed.

Funny, I know of several economists that suggested that an economy based on debt-led consumption, on the basis of asset bubbles, was not sustainable and that a crisis was coming.  It would be tedious to cite all, and I'm lazy and don't want to find links to their papers, but a limited list of names (do a google search) would include Dean Baker, Jane D'Arista, Jerry Epstein, Jamie Galbraith, Wynne Godley, Thomas Palley, Bob Pollin and Lance Taylor (before hand I'm sorry for any significant omissions).  I knew enough to be sure that it was not sustainable.

But I'm glad that the best in the mainstream admit that it was stupid not to see it coming. I would suggest to him that part of the problem of the inability of the mainstream to see it coming is their theoretical framework.  The consensus macroeconomic model, based on an IS curve, a monetary policy rule, and a Phillips Curve with a natural rate of unemployment, in particular because it assumes that the economy automatically returns to the natural rate, is a flawed basis for understanding the real world.

Zingales vs. DeLong: Eccles wins!

So Luigi Zingales, from the University of Chicago, said that "the current crisis is not a demand crisis, it is a trust crisis," as quoted in Brad DeLong's post. DeLong replies that "bad government policies certainly produced a trust crisis," and "as a consequence, all across the economy agents cut back on their expenditures on currently-produced goods and services." In other words, this is a confidence crisis that led to a demand crisis.

Marriner S. Eccles, the chairman of the Fed during the depression, wrote in his autobiographic book, Beckoning Frontiers, that "confidence itself is not a cause. It is the effect of things already in motion. (...) What passed as a 'lack of confidence' crisis was really nothing more than an investor's recognition of the fact that new plant facilities were not needed at the time." Put clearly, lack of trust is the result of lack of demand. I suppose, in Chicago and Berkeley, Eccles, and common sense, are démodé.