Gold Bars and a Shotgun

One occupational hazard of being an economist is getting asked for investment advice. I sometimes respond to such queries with a recommendation of "gold bars and a shotgun." I'm joking, of course (and trying to dodge the question), but the idea appears in a more serious form in Steve Waldmann's argument that the rise in commodity prices reflects a broader loss of confidence in financial assets:

It is common to invest in commodities as an "inflation hedge". If the central bank prints too much money, you need wheelbarrows to buy bread. If you have a sack of wheat, you will have your bread whatever the central bank does. But if everyone buys wheat, the price of grains will rise, even if the central bank does nothing at all.

Just as the fear of a bank's insolvency can precipitate a run that drives a bank to ruin, loss of confidence in a central bank can provoke a great inflation. The Federal Reserve, much I might criticize it, has not gone on a printing spree. It has lowered interest rates, and altered the composition of bank assets by replacing less liquid with more liquid securities. But the most these measures should do is bring us back, monetarily speaking, to the status quo ante, back to a year ago when asset-backed securities were liquid. The Fed's actions are best described as antideflationary, not inflationary.

But confidence is a funny thing. Central bankers are supposed to be dour and dependable. The current crop is not. Rather than "taking away the punchbowl", central bankers have become the life of the party. Japan's central bankers hand out Yen like free acid. China's guy will give you a microwave oven and a DVD player if you draw him a picture (and sign Henry Paulson's name to it). Our man Ben is an Amadeus-cum-Macguyver, he's brilliant, unpredictable, he'll improvise a Delaware company from paper clips and vacuum up your derivative book with a toenail clipper. Even the ECB's Trichet, who at first comes off like a sourpuss, turns out to be alright, when you've got some Spanish mortgages to pawn.

Some of us think that something's wrong, and these guys we're drinking with aren't serious enough to fix it. We know that trillions of dollars in presumed housing wealth have disappeared, but we don't know who's ultimately going to bear the loss. Americans know that as a nation, we cannot afford our clothes, furniture, or gas, unless the people who are selling it to us lend us our money back. Economists fret about "imbalance" and "adjustment", but we've yet to see a serious plan, other than let's-keep-this-party-going.

So, we lose faith. When we lost faith in Northern Rock, Bear Stearns, Citigroup, or Lehman, the central bankers stepped into the fray, and stood behind them. So, we ask, who stands behind the central bankers? We take a peek, and all we see is our own money. Which we quickly start exchanging for something else.

Although commodity prices have been increasing for years, you'll notice that the very sharp run-up began last summer, at roughly the same time as the credit crisis. Commodities soared when interest rates were still high, but predicted to fall. Commodities are soaring today, even though US interest rates are now predicted to rise. Commodities have soared in euro terms, despite the ECB's refusal to drop interest rates....

But claims on future money are only promises, easily broken or devalued. A run on central banks, a flight from financial assets to stored goods, sacrifices the hope of future abundance for certain present scarcity. Governments can shut futures exchanges, confiscate gold, ban "hoarding, profiteering, and price-gouging". People will hoard anyway if they don't believe in the paper. People are losing faith in financial assets for good reason. Rather than organizing productive economies, the machinery of finance has recently functioned as an anesthetic, masking the pain while resources were mismanaged and stolen. We need a solid financial system, but confidence cannot be imposed or legislated. It will have to be earned. There has to be a plan. Earnest promises to do better soon won't suffice. Nor will yet another drink from the punch bowl...

His sentiments are seconded and amplified by Yves Smith, who writes:

In times of crisis, people look to leaders for guidance. But in our prevailing doctrine of free markets, there are no leaders, just agents interacting in ways purported to produce virtuous outcomes. And the parties who ought to step into the breach fail to understand the need for that role right now. That is why an old fashioned (and very tall) banker like Volcker is so reassuring. He handled a crisis; he's not afraid to take the reins or say things are bad and changes are needed.

We are at the end of a paradigm: large scale OTC markets, lightly regulated players and instruments, dollar as reserve currency, US as the most important global economic actors...

Hmmm... It is useful to remember the economic purpose of the financial system - to channel savings by households into investment by firms. Deep, liquid markets with lots of people trading lots of different types of assets can facilitate that function. However it does sometimes seem like the growth of resources devoted to finance - and the rewards of its practicioners - has outrun its economic purpose. Recent events (and the corporate financial scandals of 2000-01) have reminded people of the instability and market failures inherent in the financial system. So, yes, it is perhaps time for soul-searching, even angst, in the world of finance....

But that does not mean the gloom extends to the real economy... there are plenty of non-trivial problems, to be sure, but nothing (yet) compared to the early 1980's. The financial sector may be nostalgic for the Volcker era, which arguably marked the beginning of a long boom for finance, but the real economy suffered severely from the high real interest rates and strong dollar and the ill-fated dalliance with monetarism hardly seemed like commanding leadership at the time.

So where should you put your savings in times like these? I have no idea.

NB: OTC: over the counter.

Socratic Solow

Brad DeLong reflects on a semester's teaching with a socratic dialogue on the Solow model; an excerpt:

Akhilleus: So why are you morose then?

Glaukon: Because, looking back over my syllabus this semester, I realized that I spent five full weeks--one third of the semester--teaching them the Solow growth model...

Khelona: It's a fine model...

Glaukon: And yet when the rubber hits the road, it doesn't do us any good. It doesn't tell us anything first-order about the world--aside from post-WWII Japanese convergence from a bouncing-rubble B-29 testfield to a prosperous OECD economy.

Khelona: Actually, I don't think the Solow growth model explains that...

Glaukon: You don't?

Khelona: Post-WWII Japan converged to the OECD norm. And the Solow growth model has some convergence in it--if you start out really poor because your economy's capital stock has been turned into rubble or worse by B-29 strikes, you will grow fast because a low capital stock gives you a high social marginal product of investment and depreciation cannot be a drag on growth if there is no capital to depreciate. But these have always struck me as second- or third-order mechanisms in the story of post-WWII economic growth. Trade. Technology transfer. Institutional reform. The survival of the economic-mobilization components of the fascist Tojo dictatorship. The destruction of the other components of the fascist Tojo dictatorship. The ability of large firms to strike high-productivity bargain with their core workforces by shifting risks onto small-scale producer-suppliers and secondary-sector workers. The neocolonial origins of comparative development--that for Cold War-fighting reasons the U.S. was willing to cut Japan an enormous amount of slack in terms of market access that it was not willing to cut Mexico or Argentina or anyone else outside NATO. You know the story. You know the story better than I do.

Glaukon: Great! So now you've depressed me further--you have gotten me down from one example of the model at work telling us something interesting down to zero....

I also had my students spend quite a bit of time - though not quite a third of the semester - on the Solow model, and I have no regrets. This is partly for the reasons expressed a while back by YouNotSneaky!, who also had the classics on the mind, in a post titled "Socrates would have taught the Solow model":

Socrates thought there were two, maybe three, kinds of people in the world and that you could arrange them in a hierarchy;

1. Those who don't know but think they know.
2. Those who don't know but know they don't know.

and then maybe some lucky ones;

3. Those who know and know they know.

There aren't many people in the 3rd category. But for some reason we always expect our models to move us from the 2nd category to the 3rd. And we're not satisfied if the movement is from the 1st to the 2nd.

The Solow model basically says that "it ain't capital accumulation" which is the cause of sustained growth, it's something else, the magical so called "Solow residual" .....

There've been many people over the years that've concluded that since the Solow model doesn't "explain" growth (because it lumps its major cause into an exogenous residual) it is useless and only an excercise in mathematics.

But people! When you thought you knew (it's capital accumulation!) and then you learn that you don't know (it can't be capital accumulation!) you've learned something just as important and valid as if you've acquired a "positive knowledge"....

Moses Abramowitz called the Solow residual a "measure of our ignorance" - and that is indeed a useful thing. I've posted previously on the joys of growth accounting (measuring the residual).

The Solow model is somewhat unsatisfying because it (i) attributes growth to an exogenous constant and (ii) it does not do a good job of explaining the vast differences in incomes between countries. But it is invaluable as a starting point for teaching economic growth because

• It forces students to really learn some key economic concepts, like:
• the implications of diminishing marginal returns
• the difference between levels and growth rates
• The subsequent research on economic growth - endogenous growth theory and the neoclassical counter-reformation as well as the renewed emphasis on institutions (which admittedly is not really new) - can be understood as attempts to resolve the dissatisfaction due to (i) and (ii).

So while Solow doesn't really answer the questions that we would like growth theory to answer, it is tremendously useful for learning some economics and about how economics works.

Bubblicious

The issue of "bubbles" in asset prices, and whether and how monetary policy should respond to them, is getting renewed consideration.

Federal Reserve Governor Frederic Mishkin gave a speech last week examining the question "How Should We Respond to Asset Price Bubbles?" He argued - consistently with current policy - that the Fed should not attempt to pop bubbles with interest rate increases, but they should take them into account in their role as overseer of the banking system.

The Wall Street Journal ran an interesting feature on bubble research at Princeton, where Ben Bernanke was chairman of the economics department before going to Washington.

Moody's Blues

Credit ratings play a crucial role in financial markets, providing a system of classifying assets by their riskiness. In many cases, funds limit the type of assets they can hold based on their debt ratings, and the ratings are a major determinant of the market value of assets (even the Fed uses them to determine what assets it will accept as collateral for loans). Three companies - Fitch, Moody's and Standard & Poor's - dominate the market for rating assets. These rating agencies have come in for quite a bit of criticism as the recent problems in financial markets have made some of their ratings seem too generous in retrospect. And now this, from today's Financial Times:

Moody’s awarded incorrect triple-A ratings to billions of dollars worth of a type of complex debt product due to a bug in its computer models, a Financial Times investigation has discovered.

Internal Moody’s documents seen by the FT show that some senior staff within the credit agency knew early in 2007 that products rated the previous year had received top-notch triple A ratings and that, after a computer coding error was corrected, their ratings should have been up to four notches lower.

News of the coding error comes as ratings agencies are under pressure from regulators and governments, who see failings in the rating of complex structured debt as an integral part of the financial crisis. While coding errors do occur there is no record of one being so significant.

Moody’s said it was “conducting a thorough review” of the rating of the constant proportion debt obligations – derivative instruments conceived at the height of the credit bubble that appeared to promise investors very high returns with little risk. Moody’s is also reviewing what disclosure of the error was made.

Inflation Targeting and Global Supply Shocks

Does the worldwide increase in the price of energy and food present a challenge for inflation targeting? In a Project Syndicate column last week, Joe Stiglitz wrote:

The World’s central bankers are a close-knit club, given to fads and fashions. In the early 1980’s, they fell under the spell of monetarism, a simplistic economic theory promoted by Milton Friedman. After monetarism was discredited – at great cost to those countries that succumbed to it – the quest began for a new mantra. The answer came in the form of “inflation targeting,” which says that whenever price growth exceeds a target level, interest rates should be raised. This crude recipe is based on little economic theory or empirical evidence; there is no reason to expect that regardless of the source of inflation, the best response is to increase interest rates....

That is somewhat unfair - inflation targeting is grounded in economic theory. In particular, it provides a mechanism to improve the credibility of monetary policy in the face of the time-consistency problem (the discovery of which earned a Nobel Prize for Kydland and Prescott). Anyhow... Stiglitz continues:

Today, inflation targeting is being put to the test – and it will almost certainly fail. Developing countries currently face higher rates of inflation not because of poorer macro-management, but because oil and food prices are soaring, and these items represent a much larger share of the average household budget than in rich countries. In China, for example, inflation is approaching 8% or more. In Vietnam, it is even higher and is expected to approach 18.2% this year, and in India it is 5.8%. By contrast, US inflation stands at 3%. Does that mean that these developing countries should raise their interest rates far more than the US?

Inflation in these countries is, for the most part, imported. Raising interest rates won’t have much impact on the international price of grains or fuel...

It should be noted that the countries Stiglitz mentions are not inflation targeters; the practice is more common among high income countries like Australia, Canada, New Zealand and the UK. The issue of how central banks should respond to commodity and energy price shocks applies in rich countries, too (though to a lesser degree because food and energy have less weight in the price indexes of high income countries). Back to Stiglitz:

Raising interest rates can reduce aggregate demand, which can slow the economy and tame increases in prices of some goods and services, especially non-traded goods and services. But, unless taken to an intolerable level, these measures by themselves cannot bring inflation down to the targeted levels. For example, even if global energy and food prices increase at a more moderate rate than now – for example, 20% per year – and get reflected in domestic prices, bringing the overall inflation rate to, say, 3% would require markedly falling prices elsewhere. That would almost surely entail a marked economic slowdown and high unemployment. The cure would be worse than the disease.

So, what should be done? First, politicians, or central bankers, should not be blamed for imported inflation, just as we should not give them credit for low inflation when the global environment is benign. Former US Federal Reserve Chairman Alan Greenspan, it is now recognized, deserves much blame for America’s current economic mess. He is also sometimes given credit for America’s low inflation during his tenure. But the truth is that America in the Greenspan years benefited from a period of declining commodity prices, and from deflation in China, which helped keep prices of manufactured goods in check....

At VoxEU, Axel Leijonhufvud makes a similar argument:

Critical to the central banking doctrine was the proposition that monetary policy is fundamentally only about controlling the price level. Using the bank’s power over nominal values to try to manipulate real variables such as output and employment would have only transitory and on balance undesirable effects. The goal of monetary policy, therefore, could only be to stabilise the price level (or its rate of change). This would be most efficaciously accomplished by inflation targeting, an adaptive strategy that requires the bank to respond to any deviation of the price level from target by moving the interest rate in the opposite direction.

This strategy failed in the United States. The Federal Reserve lowered the federal funds rate drastically in an effort to counter the effects of the dot.com crash. In this, the Fed was successful. But it then maintained the rate at an extremely low level because inflation, measured by various variants of the CPI, stayed low and constant. In an inflation targeting regime this is taken to be feedback confirming that the interest rate is “right”. In the present instance, however, US consumer goods prices were being stabilised by competition from imports and the exchange rate policies of the countries of origin of those imports. American monetary policy was far too easy and led to the build-up of a serious asset price bubble, mainly in real estate, and an associated general deterioration in the quality of credit. The problems we now face are in large part due to this policy failure.

To be clear, the Fed is not an explicit inflation targeter, though it does seem to have an informal "comfort zone" of 1-2% for core inflation (i.e. inflation calculated with food and energy prices removed).

Inflation targeting has generally considered to be a success: it is credited with helping to reduce and stabilize inflation, and anchor inflation expectations in the countries that have adopted it.

The problem now arises of responding to external shocks (although Leijonhuvfud sees a failure in the Fed's past response to positive shocks - of course, there weren't too many complaints at the time...). Accommodating the shock - i.e. allowing the inflation rate to rise above the target level - would damage credibility, but maintaining the target means reducing aggregate demand so that the average price level meets the target - this means lower, or even negative, changes in the prices of other goods.

Supply shocks, a.k.a. "cost push inflation," are not a new dilemma for monetary policy, but this is the most significant instance of this problem since inflation targeting became widespread in the 1990's.

Willem Buiter takes a much different view from Stiglitz and Leijonhufvud. In a Maverecon blog post, he asks "who or what causes inflation?" and answers:

This one is easy. In a fiat money world, central banks cause inflation, or, more precisely, only central banks are resposible for inflation. Other shocks, real and nominal, can influence the general price level if the central bank does not respond swiftly and determinedly, but these non-central bank-induced changes in the general price level can always can be offset by the central bank, given enough time, freedom to act and courage.

So, in the medium and long term (at horizons of two years and over, say) central banks choose the average rate of inflation. Not globalisation; not indirect taxes; not bad harvests; not OPEC and the price of oil; not the Chinese and their exchange rate management. There is no oil inflation, food inflation or cost-push inflation. There is just inflation. Inflation may be accompanied by changes in key relative prices - in the real prices of oil, of food, of oil and of labour for instance - if other relative demand and supply shocks accompany the inflationary impulses created by the central bank. Large increases in the real price of food will be bad news to food importers (including most urban households) and good news to rural food producers and exporters. But don’t confuse it with inflation....

I am willing to grant the old-Keynesians and new-Keynesians among us, the empirical regularity that at very high frequencies, the fact that most nominal commodity prices (and prices of non-core goods in general) are flexible (both ways), while most nominal core goods and services are sticky in the short run. So relative demand or supply shocks that cause the relative price of non-core goods to go up will tend to do so in the first instance through an increase in the nominal price of non-core goods rather than through a reduction in the nominal price of core goods and services; likewise relative demand or supply shocks that cause the relative price of non-core goods to do down will tend to do so in the first instance through a decline in the nominal price of non-core goods rather than through an increase in the nominal price of core goods and services.

So for a given stance of past, current and future monetary policy (as measured by the sequence of past, present and contingent future policy rates), relative demand and supply shocks that cause an increase in the relative price of non-core goods (the kind of shocks we are seeing globally today), will temporarily raise inflation above the level at which it would have been without these relative demand and supply shocks but with aggregate demand and supply at the same level. Such general price level blips work their way through the system quite swiftly; much of it is gone within a year, virtually all of it within two years. They do not ’cause inflation’.

Or, as Milton Friedman famously put it, inflation is always and everywhere a monetary phenomenon.

See also Mark Thoma's comments on Stiglitz and on Leijonhuvfud.

Update (5/15): The FT's Martin Wolf urges Britain to stay on target. He says: "The lesson of the 1970s was simple: letting inflation rip, to avoid pain in the short run, greatly increased pain in the long run. The UK must not repeat that error."

The Economic Consequences of Mr. Bickle?

According to the FT's Alphaville blog, Robert Mundell is claiming that "Taxi Driver" played a crucial role in economic history:

The 1976 classic, directed by Martin Scorsese with Robert De Niro as the bitterly alienated protagonist [Travis Bickle], gave the world De Niro’s catchphrase “You talking to me?,” and also introduced a young Jodie Foster. But what does it have to do with the world economy?

John Hinckley, the deranged would-be assassin who attempted to kill Ronald Reagan in 1981, claimed that he was inspired by it. He said that his action was an attempt to impress Foster. (The movie features a scene in which a mohawked De Niro attempts to assassinate a politician.)

According to Mundell, the wave of sympathy for President Reagan that was engendered by the assassination attempt deterred Democrats in Congress from voting against his proposed tax cuts. Due to this accident of history, the US administered a big fiscal stimulus at the same time that Paul Volcker at the Federal Reserve was administering tight money. This, for Professor Mundell, was vital in creating the era of prosperity that followed.

“Taxi Driver is the most important movie ever made from the standpoint of creating GDP,” Mundell told delegates. “It’s the movie that made the Reagan revolution possible. That movie was indirectly responsible for adding between $5 trillion and $15 trillion of output to the US economy.”

Um... I'm not quite sure what to say about that, but, setting aside my disagreement on the merits of Reagan's economic policies (see, e.g., this earlier post), here are several thoughts:

• It was also very crucial that Hinckley missed - as an opponent in the 1980 Republican primary, Vice President Bush had referred to Reagan's economic proposals as "voodoo economics."
• Reagan did have a complicated relationship with movies, as this story told by former House Speaker Tip O'Neill reminds us:

  When Reagan commented on O'Neill's huge oak desk, the Speaker said it had once belonged to Grover Cleveland. Replied Reagan: "You know, I once played Grover Cleveland in the movies." O'Neill had to correct him: "No, Mr. President. You're thinking of Grover Cleveland Alexander, the ball player."

• Movies are endogenous - the same climate of disaffection that made films like "Taxi Driver" resonate with the public also led to the political shifts that allowed Reagan to be elected.

Black on Stimulus Package

Lewis Black is skeptical about the effectiveness of fiscal policy:

The Economist Rap

I am so un-hip that I was unaware of the existence of "Nerdcore" rap, until Chris Blattman (and Tyler Cowen) pointed me to this hip-hop homage to "The Economist" magazine:

Psikotic – The Economist

Does this mean it is, indeed, hip to be square?

Gas Tax: Clinton Trusts Her Gut (Not Economists)

Hillary Clinton seems to be resorting to the "truthiness" defense of the gas tax holiday proposal. The Times' campaign blog reports:

This morning, George Stephanopoulos began his televised interview with Senator Hillary Rodham Clinton by asking if she could name a single economist who supported her plan for a gas-tax suspension.

Mrs. Clinton did not.“I’m not going to put in my lot with economists,” she said on the ABC program “This Week.” A few moments later, she added, “Elite opinion is always on the side of doing things that really disadvantages the vast majority of Americans.”

Throughout the exchange, Mrs. Clinton argued that she trusted her own eyes and ears instead. “This gas tax issue to me is very real,” she said, “because I have been meeting people across Indiana and North Carolina who drive for a living, who commute long distances, who would save money.”

Senator Barack Obama has derided the gas-tax suspension as a gimmick that would save consumers little and cost thousands of jobs. Kara Glennon, a member of the audience at a town-hall-style meeting, seemed to agree. Gas prices are “not academic” for her, she told Mrs. Clinton, because she makes less than $25,000 a year — and then she accused Mrs. Clinton of pandering. “Call me crazy, but I listen to economists because I think I know what they studied,” she said.

Thank you, Ms. Glennon. The American people may be smarter than Clinton and McCain (who first proposed the idea) give them credit for; Reuters reports:

The poll also found that Americans were divided over one of the hottest issue in the campaign, a gasoline tax suspension. Forty-nine percent think lifting the tax is a bad idea, while 45 percent approve of the plan.

Meanwhile, the economics profession continues to reject and denounce the idea: over 150 economists, including some prominent names, have signed a statement opposing it (for more, see this earlier post).

Update (5/6): Speaking of truthiness, Stephen Colbert applauds Clinton and McCain for their "courage in the face of so-called experts," and urges them to take the gas tax holiday a step further:"Backing a policy experts think is a terrible idea just proves you are ready to be president," he says. Indeed. Here is the web version of the economists' open letter opposing the holiday, which continues to accumulate signatures. At Econbrowser, James Hamilton analyzes the effects of higher gas prices and explains why he signed the letter. Greg Mankiw finds that the proposal has an unsurprising origin.

Update #2 (5/6): Krugman says we're overreacting.
Update #3 (5/7): No, we're not, say Mankiw, and deLong, who believes "it is important that presidential candidates fear economists."

Inflation Under a Microscope

Check out this nifty interactive graphic from the Times decomposing the year's increase in the Consumer Price Index into its component parts. It vaguely reminds me of something one might see in a under a microscope in science class, or maybe a stained-glass window...