From SMP to OMT: ECB commits to destroy monetary transmission

This is not a humorous title, and this is not a funny post. A couple of days ago, the ECB announced after its Governing Council meeting that it would initiate a new program of sovereign debt purchases. The program is named Outright Monetary Transactions, which adds OMT to the endless list of acronyms that has emerged after the onset of the financial crisis. The program replaces the Securities Markets Programme (SMP), or, rather, extends it in a number of directions.

As mentioned in my post on the last ECB policy meeting, its need for emphasizing that what it does is not illegal strikes me as odd if not suspicious. At least I think it gives an impression that there is some bad consciousness involved. Or perhaps it is just a preemptive strike to silence those who think government bond purchases by the ECB are a violation of the Treaty of the European Union (or maybe it is done to cater the one country who cast a dissenting vote regarding the OMT). In any case, just as under the SMP, bond purchases will be conducted on secondary markets, and not directly from governments. The label “outright” otherwise does, according to some dictionaries, mean “direct”, “openly”, “without reservation or qualification” inter alia. But according to the Treaty, the market on which you acquire government debt sems of essence when it comes to aiding governments in fiscal trouble. I never understood this, but it is a distinction that enables the ECB to sidestep all issues about an independent central bank not being allowed to help out governments with their finances. It is like a situation where buying drugs from a drug producer is illegal, but going out on the streets to buy drugs is legal.

However, these legislative details appear entirely unimportant to the ECB, as its rationale for introducing the program is action towards restoring the monetary transmission mechanism in the Euro area—just as the SMP was. The argument is that the divergence in government bond yields are hampering monetary transmission in the Euro area, and thereby hampering the ECB’s efforts at attaining price stability—their primary mandate. I have still not understood this argument entirely (if at all), but Mario Draghi gave some explanation at the press conference to which I return shortly.

First, however, I should mention the main differences between the OMT and SMP. The main difference is that purchases under the OMT come with conditionality. Countries whose bonds the ECB buy, must meet relevant requirements set up by the European Financial Stability Facility/European Stability Mechanism (the IMF will also become a player of the game to the extent that it can monitor whether countries satisfy to conditions). Moreover, there are no limits to how much can be bought, but the purchases stop whenever the ECB’s objectives of “securing appropriate monetary transmission and the singleness of the monetary policy” are achieved. Alternatively, they stop if the country in question does not satisfy the conditions. Due to this conditionality, it is obviously not possible to hide which countries the ECB buys bonds from (even on secondary markets). Hence, both the amount of holdings and the nationality will now be disclosed (and ECB tries to score a “Transparency Point” on that fact). As with the SMP, purchases are going to be fully sterilized. So this is not quantitative easing, but the German member of the Governing council, Jens Weidman, who in all likelihood cast the dissenting vote, has nevertheless been stating that bond purchases were “too close to state financing via the money press for me”. Finally, the ECB gives up on its seniority status on bonds.

All in all, it appears as a further step away from the intentions of the Treaty on the European Union which in letter states that

“Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments (Article 123)”

It clearly represents an upgrade in the efforts of affecting government financing conditions. I mean, if it is not a scheme that represents a credit facility on favor of a union central government, which is prohibited, then I don’t know.  (The fact that the ECB is not in conflict with the second part of the Article doesn’t nullify this.) The conditionality aspect may comfort some, but to me it just makes it looks even more as a fiscal policy action. But still, the ECB maintains it is for monetary policy purposes only. At the press conference, there was one question in particular, which created important food for thought, and also allowed Draghi to explain this monetary policy aspect in more detail.

The question, posed by a reporter Draghi clearly respects, is the second part of a two-part question starting at 26:21 in the press-conference clip below:

The first part is a clarifying question on the announced maturities of the bonds eligible for purchase (up to 3 years to maturity). The second part is on the conditionality part and goes:

 “Now you mentioned that the OMT would be suspended, if countries didn’t fulfill the necessary conditions set out in the MoU. Now, given that these purchases are explicitly for monetary policy purposes, does this mean that you will suspend the ECB’s independence if the countries don’t fulfill the conditions? I don’t quite understand this contradiction. Maybe you could elaborate that for me?”

Draghi answers:

“On conditionality  . . . The assessment of the Governing Council is that we are in a situation now where you have large parts of the Euro area in what we call a bad equilibrium. Namely, an equilibrium where you have self-fulfilling expectations, you may have self-fulfilling expectations, that generate, they feed upon themselves, and generate adverse, very adverse, scenarios. So there is a case for intervening through, in a sense break these expectations, which by the way don’t only concerns the specific countries, but the whole Euro area as such. But then, and this would justify the intervention of the central bank, but then we should not forget why countries have found themselves in a bad equilibrium to start with. And this is because of policy mistakes. That’s why we need both legs to fix, in a sense, this situation: to move from a bad equilibrium into a good equilibrium. If the central bank were to intervene without any action on the government side, without any conditionality, it would not be effective. It would not be effective, and it would loose its independence. At the same time we see that we are in a bad equilibrium, and therefore policy actions, though convincing doesn’t seem to produce, or [inaudible] to produce, in a relatively medium term, the results for which it is geared. So that’s why we need both legs, for this action, and I think, hope, this answers your question”

The question hints to a contradiction that Draghi never gets to. Perhaps the question is not formulated entirely clear on this issue, so Draghi spends time explaining conditionality and why it is necessary. During this, he clearly states that the high yields on some government bonds are not fundamentally based. They are a result of a “bad equilibrium” brought about by self-fulfilling expectations, e.g., due to “unwarranted” expectations about the disruption of the Euro area. As it affects the whole Euro area, it is of concern for the ECB (by the Treaty, the ECB must not care particularly about single countries, so it is important for the ECB to emphasize that the debt crises in some countries hamper all countries).

The rest that follows is strange. Draghi concedes that the bad equilibrium is triggered by bad fiscal policy in some countries. Does this mean that the excess yields are partly a country-specific fiscally-based risk premium and an “unwarranted” Euro-break-down premium? Or is it only an unwarranted Euro-break-down premium triggered by bad fiscal policy? This is not spelled out and will leave market unsure as to when the ECB will “pull” out of a given country’s bonds. In either case, why is conditionality then needed to eliminate the self-fulfilling expectations? This can only be because it is believed that an improvement in fiscal performance is a necessary condition for the elimination of self-fulfilling expectations. This is consistent with Draghi stating that without conditionality, ECB purchases will have no effect, and ECB’s independence would be lost. So he is effectively admitting that the SMP was an ineffective construct, and even one that gave away ECB independence. However, improvement in fiscal performance is not considered sufficient to eliminate the bad equilibrium, so that is why the OMT must be implemented to bring about a good equilibrium. And presumably if it works, then the ECB does not loose its independence.

I think one can construct a consistent story behind the multiple equilibrium theory and the corresponding fiscal-monetary program needed to bring down yields, but how that in any way relates to the ECB’s independence is vague. It seems that Draghi is simply saying that if purchases are effective, then the ECB has maintained its independence!

The reporter’s question may have had a different connotation—one that really fleshes out a contradiction in the OTM scheme. At least for me, this particular Q/A triggered the following question: If a country does not live up to the conditions, will the ECB accordingly abandon it, and thus accept the resulting disruption of the monetary transmission; i.e., accept that the whole Euro area will be left in a bad equilibrium? By letter of the OMT scheme, to which the ECB have committed, it should. But in reality it ultimately depends on the credibility of this “threat strategy”;  i.e., of whether the ECB is really willing to abandon a country. As is well known, a commitment is only as good as the credibility of its support. I.e., the actions taken when some breaks the rules (in game theory, this is what is meant with credibility of “off-equilibrium” strategies, or, perfect Nash equilibrium strategies).

Here I see the contradiction: On the one hand, the OMT is emphasized to be initiated for the sake of monetary policy transmission purposes only, but it will be stopped vis-a-vis countries that violates the associated conditions. But by the ECB’s own logic such a violation will ruin the very same transmission mechanism, as it will trigger a bad (or, worse) equilibrium. Hence, if the ECB should obtain credibility about its commitment to this program, it must be willing in some circumstances to ruin the monetary transmission mechanism, send the entire Euro area into a bad equilibrium, and thereby be willing to make it hard for them (by their own logic) to fulfill its objective of price stability. So to be in accordance with the Treaty and its own objectives, the ECB has committed to a scheme where the “threat strategy” that will give credence the its commitment will make it impossible to live up to the Treaty! Talk about setting up traps for yourself!

So not only have the ECB embarked on a program that is the most blatant fiscal rescue plan ever seen by an independent central bank, it has also done it in a way that is bound to create insurmountable challenges for itself down the road. I honestly think that the ECB should have stuck with monetary policy, and left the fiscal problems where they belong: in the hands of governments. This was indeed the idea behind the Treaty in the first place as I understand it from Article 123.

Oh, and at the press conference, there was actually one, yes one, question about monetary policy, more specifically the interest-rate decision. It was on whether the ECB had thought of a change, and we were told it had not. Nobody seemed to care one bit.

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White Paper, Great Economists and (really) Bad Science

In Denmark, where I come from, academic economists are often used in the media. Whenever there is a political debate on an economic issue or policy proposal, TV and newspapers call out for economists to get their views and analyses. The norm is that journalists try to cover most views on a given issue, and that the economists in question try to be as balanced as possible. Ideally, the economists act as a sort of independent “expert witnesses”. Of course, personal opinions will to some extent color what a given economist will focus on, but one line is never crossed: An academic economist never endorses a given politician or party publicly. If that happens, the credibility of the economist as a reliable source for journalists drops to zero and the scientific reputation among peers drops to a low. When crossing the line, the economist effectively becomes a politician, which is a completely different trade. (As universities are state funded, one is obliged to make it very clear that if one makes a political statement, which of course is not illegal, then it is in the capacity as a private individual and not as an academic economist.)

The reason why I write this, is that in the US things work very differently on these matters. As is well known, a presidential election is coming up in November where President Barack Obama will take on Republican Mitt Romney. As seen here from a list of Mitt Romney supporters, academic economists of all vintages and qualities are not afraid of making an official endorsement. To me, this in itself is a cross of a line, which hampers these economists’ future statements in terms of the scientific objectivity many would ideally see academic economists live up to (their employers are often not the state, so they may not care?). As N. Gregory Mankiw indeed writes in the Introduction to one of the editions to his undergraduate text “Principles of Economics”:

“Economists try to address their subject with a scientist’s objectivity. They approach the subject of the economy in much the same way as a physicist approaches the study of matter and a biologist approaches the study of life: They device theories, collect data, and then analyze these data in an attempt to verify their theories”

However, the endorsement per se is only the beginning of a story of scientific objectivity that is currently stirring the debate. The core is the publication of a “White Paper” by economists R. Glenn Hubbard, N. Gregory Mankiw, John B. Taylor and Kevin A. Hassett. This White Paper is called “The Romney Program for Economic Recovery, Growth, and Jobs” and is thus an unconditional endorsement of Mitt Romney as new president and, in particular, of his proposed changes in economic policy. What is particularly remarkable in this paper is that the authors use academic references to back up their affirmative views on Romney’s policy proposals. I.e., they have not only crossed the line in terms of showing their colors, but they use the methods of their economic profession in the process of being politicians. The result is a horrible mess, which has received strong criticism.

Paul Krugman notes that the authors are trying to “destroy their own reputations”, while Brad DeLong meticulously, and very critically, dissects the paper and its particular use of references to back up its claims. (Note to Brad’s sports analogy: He observes that dishonest referencing sends you to the showers in the US but earns you four red cards in Europe; well, one red card sends you to the showers in Europe!) Ezra Klein has interviewed many of the researchers who are being cited and find that they mostly think that their research lends no support to Romney’s politics. John Taylor has a rebuttal where he notes that

“But the research papers and books that are cited are quoted correctly and do provide supporting evidence. As Scott Sumner reports ‘when I looked at the paper I couldn’t find a single place where they had misquoted anyone.’ ”

(N. Gregory Mankiw on his blog, which nowadays is mostly a link hub, just links to, well, a few links.)

I have no doubts that the white paper does not contain any misquotes as such. Sure, there is a simulation in Altig, Auerbach, Kotlikoff, Smetters and Walliser which shows that some tax reform gives a gain in GDP of up to 1%. This is, however, not inconsistent with the cited authors being in disagreement with the conclusions of the white paper (in the example, according to Ezra Klein, Auerbach did not think the simulation had much to do which the Romney tax plan as that plan is not sufficiently spelled out). As long as researches share their work with the public, it is an occupational hazard to be cited, as well as to be cited in a way that backs conclusions you may not agree with.

This is not the problem either. The problem is that the white paper is written with a political premise, and that the academic evidence is picked selectively to back up the premise. Gone is the objectivity that Mankiw elsewhere states is a goal to strive for. Gone is therefore science. What is left is Bad Science. Bad science is not illegal, it is not even malpractice—bad science is made by many economists all the time. It is just particularly disturbing when highly regarded economists (some of whose work I admire a lot) engage in bad science. It does indeed tear their reputation to pieces, and makes you suspicious whether their next NBER working paper or text book has a gist of “Paid for by Romney for President, Inc.”

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May in August at the ECB

After the recent meeting at the ECB’s Governing Council, it was decided to keep the policy rate fixed at its record-low level of 0.75%. As the (bleak) economic outlook has not changed markedly since the last meeting, it seems a sensible decision given the ECB’s mandate.

Many, however, forget that the mandate of the ECB is to secure stable prices in the Euro area, which by the ECB is defined as a HICP inflation rate close to, but not above, 2%. It is currently at 2.4%, so it is difficult to accuse the ECB for being particularly hawkish. But the policy rate setting, and how it was aligned with the mandates of the ECB, were not what made the headlines.

Instead, most focus was on how the ECB could possible help saving the European debt crisis. To be clear, it is not the job of the ECB, and it is not within is legal mandates. It is supposed to act independent of fiscal matters. Nevertheless, many commentators and market participants criticized the ECB for not laying out any firm strategy for helping fiscally distressed countries (like, e.g., Spain). Well, I would say that the ECB itself is to blame for this de jure unwarranted focus on fiscal policy measures. It has earlier been running a Securities Markets Programme (SMP) where they have bought up public debt on a massive scale (thereby violating the intent of the Treaty on European Union). So the ECB has been acting in a way that clearly has undermined its credibility as a central bank independent of governmental preferences and pressure. (How this can generate excessive debt issuance and fiscal relaxation I have noted before.)

To make matters worse, Mario Draghi made a sequence of openings for fiscal action in his introductory statement to the press conference following the meeting of the council. Here are a couple of central passages (coming way before the analyses leading to the policy rate decision!):

“Exceptionally high risk premia are observed in government bond prices in several countries and financial fragmentation hinders the effective working of monetary policy. Risk premia that are related to fears of the reversibility of the euro are unacceptable, and they need to be addressed in a fundamental manner. The euro is irreversible. (…) The Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective. In this context, the concerns of private investors about seniority will be addressed. Furthermore, the Governing Council may consider undertaking further non-standard monetary policy measures according to what is required to repair monetary policy transmission. Over the coming weeks, we will design the appropriate modalities for such policy measures.”

Not a very firm statement. “May” appears twice, so you can’t blame them for making commitments in this respect. Nevertheless, it doesn’t take much intelligence to acknowledge that when somebody has to emphasize that they contemplate actions that will actually satisfy the laws, then they are in the business of trying to bend the laws to the limit.

Under the SMP, the loophole that carried the ECB through was that they did not buy up government debt directly from governments, but on the secondary markets. In other areas of economic exchange such activity are sometimes referred to as money laundering. Now, the loophole seems to be that the financial markets are mispricing government bonds. It is interesting that an institution which otherwise operates under a free markets doctrine has the power to determine the “right” price on a bond. But since lots of the risk premia arise from investors’ putting a positive probability on a collapse of the Eurosystem, then the ECB can apparently deem the price wrong as “the euro is irreversible”.

Hence, conditional on its axiom that the euro is irreversible, the ECB has now opened the way for any action it desires in a fiscal direction, as this will be interpreted as consistent with central bank independence and attaining its objective of price stability.

It is an amazing play with words and an amazing way of toying around with letters of a Treaty. It appears that in Europe, no Treaty can withstand the shortsightedness of politicians and (some) central bankers.

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A week of records in Euroland, Denmark and Wimbledon

Last week saw the ECB lower its policy rate to the lowest level in its history. A meager 0,75 % is the rate on main financing operations. Not much, not surprising, and probably not what will make much of a difference for the dire straits of the European economies.

The rate cut was the impetus for a record in Denmark as well in last week. Apart from Frederik Løchte Nielsen’s unbelievable feat of becoming the first ever Danish Wimbledon champion (in doubles with English Jonathan Marray), the central bank of Denmark also cut rates thereby introducing a negative deposit rate (for 7-day deposits) for the first time in history. Denmark has therefore essentially hit the zero lower bound of interest rates with the overnight rates at precisely zero, and a loans rate of 0,2 %.

In the figure below one sees the Euro policy rate and Danish policy rate since the inception of the Euro. As Denmark in 1999 continued its fixed nominal exchange rate policy, now with the Euro replacing the D-Mark as the anchor, the policy rate has more or less followed the Euro rate. This is to be expected for a small open economy where credibility of the policy is only disrupted in times of turmoil, leading to occasional upwards deviations in the Danish policy rate so as to defend the parity.

This has also been the picture ever since this policy was firmly adhered to in the mid 1980s. The rule of thumb was that the Danish central bank followed any movement in the German or, now Euro, interest rate. A small interest-rate differential, however, was to be expected as a “price” of being outside the Euro; e.g., one could see it as a combination of a liquidity and risk premium on the Danish currency.

This differential is seen in the figure below. In times of turmoil, like in the fall of 2008, the Danish central bank has had to defend the parity by keeping rates above the Euro rate for a period. But as the ECB in late 2011 lowered rates again (after two increases) mainly in light of the European debt crises, something happened that gave new meaning to the term “defending your currency”. Suddenly, investors did not find bonds of Euro countries particularly attractive, and they started to invest in Danish bonds, driving the yields on short-term bonds into (slightly) negative territory.

This caused pressure on the parity in upwards direction. So to defend it, i.e., to avoid an appreciation, the Danish policy rate was lowered further than the Euro rate, bringing forth a negative interest-rate spread.

The spread in policy rates is currently -0,55 %, but the policy actions last week did not cause that. Rates were simply adjusted by the same amount as the ECB. So, Denmark is currently experiencing times where to defend our currency we have to be more expansive than the record-breaking ECB. If the ECB should lower rates further, the zero lower bound on loans rates may bind, but this should be a minor problem: You can always avoid an appreciation of your currency by creating more of it.

Even though this expansive stance is beneficial for the struggling Danish economy per se, the backdrop of this situation (which was unthinkable when I was “raised” as an economist); however, is a sheer horror story. The Euro area is bleeding as politicians have repeatedly and consistently ignored the rules and regulations they have created to make up for the bad fiscal incentives a currency union creates. Adding new rules (like the new fiscal compact) is probably too much too late, as it is hard to be convinced that politicians should suddenly stop thinking and acting in a shortsighted and selfish manner.

Posted in Monetary policy | Tagged , , , , | 1 Comment

One more time for the world: There is no simple relationship (if any) between Taylor-rule coefficients and policy preferences

The lack of a relationship between the size of the coefficients in a Taylor rule for monetary policy conduct and the underlying preferences for stabilization of macroeconomic goals is well known. I often have it as a check subject in my exams in monetary economics. When I present the result to students first time—it is fleshed out in Lars Svensson’s “Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets” (European Economic Review 41, 1997, 1111-1141) for a simple backward-looking IS/AS model—I often state that many tend to overlook this, and that it is a common misconception that, e.g., a relatively high coefficient on the output gap in the rule indicates a relatively high preference for output gap stabilization.

I sometimes fear that I thereby make the classic mistake of putting up a straw man in lack of better motivation for why this is an important result to emphasize. But I just became aware of a new example of the peculiar endurance of this misconception. In John Cochrane’s positive and very appetizing review of John Taylor’s new book, “First Principles” (W. W. Norton & Company, Inc., 2012), Cochrane writes:

The Taylor rule actually stands quite a bit to the left of the “inflation targeting” tradition that says central banks should only respond to inflation, ditching the whole GDP response — because, in John’s words (p. 127)

‘Some Federal Reserve officials worry that a focus on the goal of price stability would lead to more unemployment. But history shows just the opposite.’

John answers that the  “dual response” really is a “single mandate.” It is a a worthy effort, but one I find strained. The reason for the GDP response is, explicitly in the models, to accomplish a tradeoff between inflation and output volatility.

There are two intertwined mistakes here. As Svensson’s model clearly shows, even a strict inflation-targeting central bank, i.e., one that only cares about inflation stability, would respond optimally to the output gap. So following Taylor’s rule would be a good idea (given that the “magic numbers” 1.5 and 0.5 somehow were appropriate for all countries over the globe). Why is that? Well, output may be a good predictor for future inflation. So it serves as an intermediate target worth responding to—even for a completely right-wing “inflation nutter”. It is not a goal variable per se.

Therefore, it is also false to claim that the reason for the GDP response is “explicitly in the models, to accomplish a tradeoff between inflation and output volatility”. To emphasize this point with a different model example, note that in the simple New Keynesian model, a Taylor rule with only a response to inflation will actually be one that may secure the optimal tradeoff between inflation and output volatility. This has been known at least since Clarida, Galí and Gertler “The Science of Monetary Policy: A New Keynesian Perspective” (Journal of Economic Literature 1999, 1662-1007).

All of these matters are simple facts which are completely orthogonal to your own policy preferences, to whether you favor the Taylor-rule approach to monetary policymaking or not, and so on. So one more time for the world: There is no simple relationship (if any) between Taylor-rule coefficients (their size or existence) and policy preferences.

But at least I apparently don’t put up straw men during teaching on this point. Hopefully the point will sink in over time, however.

Apologies up front in advance if I have misinterpreted Cochrane’s post in this dimension.

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Countdown for Krugman

I recently wrote that I thought Paul Krugman wrote slightly too many blog posts, and that too many spent time commenting on them, and commenting on others’ comments and so on and on—a “Krugman multiplier“. Now an explanation for Krugman’s exceptional blog productivity is beginning to offer itself.

The New York Times, who hosts Krugman’s blog, have introduced a counter on their web edition such that you can only read ten articles per month. So, only ten Paul Krugman blog posts per month if that’s your only reason for visiting NYT. A rough guesstimate tells me that this amounts to around only ten to twenty percent of his output. The problem with this, of course, is that you then has to be careful when picking a post to read (if you don’t feel that you want to pay for potential scientific commentary). With Krugman’s indisputable talent for picking inviting titles, this is a daunting task. I just spent one of my ten shots at the post “Eurodämmerung“, which is mainly a link to a YouTube video of the final of Wagner’s Götterdämmerung. Great music, but a little disappointing.

And, of course, I had to see what “Raygunomics” was. As you can see from the screen shot, this will be the last I can get from Krugman this month. As you can also see, it was indeed really funny, and well worth the click:

Copyright: New York Times, 2012. All rights reserved.

Good luck to the New York Times with this new pricing initiative. I will consider the offer, but maybe I will be able to free-ride on the Krugman multiplier, and get his more substantive posts elsewhere?

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When ”failure” in economics is ”success” and vice versa?

This post fully lives op to the mantra of the blog, as it contains a lot of “stochastic ramblings” (a nod to Greg Mankiw’s mantra of “random observations”). “Stochastic” as I wander unplanned around important subjects on the developments of economic sciences, and “ramblings” as most of it is scientifically unsubstantiated talk with little coherency, which just emerge from my gut. You have been warned.

The backdrop of the following is a festive occasion. An occasion I am truly and deeply happy about. The Institute of New Economic Thinking (INET), which is partly funded by George Soros, has given a grant to establish a center on Imperfect Knowledge Economics (IKE) at the University of Copenhagen. It was therefore a deservedly happy colleague, Katarina Juselius (who will be director of the center) that opened the program marking the launch of the centre. Katarina Juselius and Søren Johansen have for a few years now worked on applying Søren Johansen’s econometric methods (which could have got him a Nobel Prize in my honest opinion) to asset pricing behavior together with Robert Frydman and Michael D. Goldberg. They, in turn, have developed a new concept of rational behavior that takes into account that agents may not know the true underlying probability distributions (i.e., Knightian uncertainty). This theory is presented in their 2007 book “Imperfect Knowledge Economics: Exchange Rates and Risk”. The new center is devoted to this line of research.

The executive director for INET, Robert A. Johnson, gave a speech on the necessity of new thinking (well, isn’t new thinking always needed?). The audience was presented with a standard statement of the kind “I know mathematics, and I like math, but . . .” followed by the now well-established, and politically correct, tirade against excessive use of mathematics in economics, and the potential blame one can put on the profession for not having foreseen the current financial crisis, since it mistook math for beauty and/or the truth. I could not help smiling. Not so much because this kind of statement is an extremely cheap shot at economics, but mostly because the IKE modeling and the co-integrated VAR model are both using math with hair on the chest. But maybe the math used is sufficiently ugly to be politically correct? I don’t know, but Robert A. Johnson concluded his talk with some words on economic education, where the punch line was that any economics student should learn to be critical towards the models and concepts they are presented with. I can only concur, and is happy that this is what we actually teach at my department. Indeed a group of our students has just won an international econometrics game, and the spokesperson for the group indeed said that the Copenhagen students were better because they were more critical towards the assignment, methods, and so on. In all fairness, some students, representing “critical students” (I don’t hope we have non-critical students), later talked about what they saw as a dogmatic current teaching with undue emphasis on mathematics and rational expectations. I wonder how these students will receive IKE and the co-integrated VAR: these are models made by very dogmatic persons (indeed, I hope the authors believe in what they are writings). Right now it seems that to some, “anything different” is better.

Roman Frydman talked about limits of knowledge and, of course, promoted his research with Goldberg, Juselius and Johansen. Most of the time was devoted to a critique of current paradigms in economic thinking and why it is important to break them. On this occasion, Frydman was understandable in a good mood, so the critique against “mainstream” thinking was not as stern as in his writings with Goldberg. Occasionally, in these writings they get quite vile and confrontational. As emphasized by Kevin Hoover in his review essay of Frydman and Goldberg’s recent book, “Beyond Mechanical Markets: Asset Price Swings, Risk, and the Role of the State“, there is something about talking about “The Orwellian world of ‘Rational Expectations’ ” that doesn’t make people embrace your new ideas right away. I may add that they also use metaphors as “A World of Stasis and Thought Uniformity”. Even though their thoughts here wander towards Germany, they thoughtfully do not draw the parallel to other kinds of (earlier) German thought uniformity. In any case, they apparently feel it necessary to be insulting to help sell their new, very interesting, ideas. I would probably have spent more time trying to pitch my ideas, instead of labeling a whole profession mindless sheep. (They do, e.g., write that the Rational Expectations Hypothesis “leads economists to imagine a world of perfect knowledge and universal thought uniformity” (p. 65); i.e., it is a theory that controls scientists. Please count me out.)

Something that was definitely new in Frydman’s talk was an announcement that the most recent paper he and Goldman, Juselius and Johansen had completed had just been submitted to the American Economic Review. Yes, he actually mentioned the name of the journal, which is a bit unusual. Of even more interest was his ensuing comment, said with a smile, that he did not have high hopes for acceptance. It got a laugh from the audience, but it struck me as being quite serious. It touches on the basics about quality measures in research. Normally, publishing in a journal like AER would be taken as a good sign. But clearly, in the case of these authors, who challenge Stasi thought uniformity, an acceptance would be a failure. It would mean that they are part of the uniformity they try to escape. So my guess is that Frydman actually hopes for a rejection, as this will confirm that he is up against Orwellian forces. If they are accepted at the AER, all he and Goldberg have written about the profession is at worst wrong, or at best outdated. So, conventional success would be failure for the new thinkers. This is the core issue: How is quality measured of truly new thinking? Is it of good quality when it is acknowledged by some academics, but not the majority? Is it bad quality if the majority embraces it?

All these important scientific matters did not get much attention in the press (and what they did pick up, they mostly got all wrong). What did get a lot of attention, on the other hand, was that George Soros himself came for the opening. This fact made me arrive in good time, as I anticipated that the conference venue and surroundings would be blocked by “Occupy Wall Street”-type protesters. After all, we are talking about a financial speculator of Olympic proportions who more or less singlehandedly brought down the British Pound in the early 1990s and who is convicted for insider trading in France. I reckoned he would be the symbol of all the financial speculation everybody is turning against after the crises started. But there were no protesters in sight. I found out that I was completely out of sync with reality. Soros is now considered a “good” speculator (whatever that is), and his criticism of financial speculation in recent times and his philanthropic activities have apparently made him politically correct. The most left-wing newspaper in Denmark gave him relatively good press, and they are normally hunting down anybody earning more than a million a year (in whatever currency).

Soros was featured in a conversation with my colleague Niels Thygesen, where the subject was mainly the current European crisis. Soros was not optimistic for the Euro, and conveyed a quite strong aversion towards Germany and the leading role it plays. Also he criticized the ECB’s alleged adoption of a “German Bundesbank model” of anti-inflationary policies. Much to my surprise, Soros saw such a price-stability objective as one that could be compatible with deflation. In relation to the main subject of the event, Soros mentioned that he had never examined rational expectations as he found it unrealistic. But he mentioned quite a few alternative theories he had developed over the years.

Finally, it was interesting that several speakers felt a need to emphasize their nationality, ethnicity and religion. This is normally, for good reasons, considered irrelevant at academic events. I will, however, follow suit and note that I am as pale as one can be, and born in the outskirts of Aarhus, which is located in Jutland, Denmark (and I have no God that I know of). A prominent feature of people from Jutland is humility. That is why I cannot help ending my ramblings by noting that this new center is simply doing what such a center should do (and is going to do): Carry on basic research on a high level. But apparently, to get attention and money, one must as a minimum present one’s work as revolutionary and as a complete change of paradigm, while desecrating years of “failed thinking” in the profession. With my ethnic background, I am not cut for that game.

But I do acknowledge that for a festive occasion, the truth that “we are going to do what we have always been doing” is definitely not a good sales pitch.

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US Output Gap: Still negative

John Taylor recently showed how the United States is currently much farther away from returning to “potential output” compared with the recession of the early 1980s, where above-average output growth during the recovery secured a return to the potential output path. Apart from the obvious implications for the evaluation of the current US recovery, this has led to a deeper discussion about the dangers of extrapolating “potential” output from past values (e.g., maybe the 2007 value was just too high?).

James Bullard of St. Louis Fed argues (pdf of speech) that the financial crisis lead to a very persistent negative wealth shock that has pushed potential output down. Hence, the output gap is not necessarily as negative as simple statistical detrending methods may suggest. In consequence, there could be a danger that the US is about to repeat the mistakes of the 1970s where the output gap was believed to be negative, but in retrospect was determined not to have been. The result was a too loose monetary policy with ensuing high inflation. This is, e.g., argued by John Cochrane here, although he doesn’t endorse the wealth shock idea. Neither does Paul Krugman here, based on the strong argument that fall in asset prices doesn’t destroy productive capacity.

The heart of the matter is that the output gap is a phantom which is immeasurable. We observe output, but we don’t observe what it is compared to in order to produce an output gap. And what it is compared to is also quite different from writer to writer and named more or less appropriately. For example, “potential output” is a strange term. I read that as output when all resources are used to full extent. So in the strong version it is an outcome of a centrally planned slavery economy (where all work, say, 16 hours per day); in the milder version it is the efficient level of output. But nobody, and in particular not monetary policymakers, would attempt to steer the economy such that output should match efficient output.

So, what most have in mind—but don’t say much in the US—is a version of the concept of the “natural rate of output”. Since that term was coined by Milton Friedman, many Keynesians shy away from it; for mostly the wrong reasons. In New-Keynesian theory, the natural rate of output is a well-defined concept: Output in the absence of distortions created by price and wage rigidities. Targeting this output level is feasible for monetary policy. The level may for many reasons be lower than efficient output. These reasons, however, predominantly arise from frictions that are outside the scope of monetary policy. New Keynesian theory also has a theoretical shot at how to measure the output gap using only observables. The idea was synthesized by Jordi Galí in his 2010 Zeuthen Lectures at University of Copenhagen, now published as “Unemployment Fluctuations and Stabilization Policies. A New Keynesian Perspective” (The MIT Press), and it builds on the ideas put forth by Galí, Gertler and López-Salido in “Markups, Gaps, and the Welfare Costs of Business Fluctuations”, Review of Economics of Statistics 89 (2007), 44-59.

The approach is based on theoretically identifying the welfare reducing fluctuations in an economy, and in Galí (2011) he narrows them down due to the presence of monopoly power in the goods and labor market. Specifically, the associated markup’s involved in price- and wage setting result in too low output and employment, but, more important for monetary policy, cause inefficient fluctuations in output when prices and wages are subject to nominal rigidities. These fluctuations will be reflected in variations in output relative to the efficient level. As noted above, measuring the associated output gap requires knowledge about the unobserved efficient output level or the natural rate of output (output under flexible prices, which may be inefficient). However, the theory shows that fluctuations in either output gap measure will be driven by fluctuations in the price and wage markups. These, in turn, are theoretically shown to be proportional to observables: Labor’s share of income (in logs) and the unemployment rate, respectively.

Output relative to the efficient level can then be computed as a weighted average of these measures. This requires calibration of just two theoretical parameters. The Frisch elasticity of labor supply and the decreasing return to labor in production. Below, I choose the values of the benchmark in Galí (2011), which imply a Frisch elasticity of 1/5 and decreasing return to labor at 1/4 (which secures a reasonable average price markup). The computed output gap is sensitive to the choice of these two values, but only with respect to the average of this output gap measure. The fluctuations, which are of interest for monetary policy, are largely invariant to changes within realistic bounds.

Based on data from the St. Louis FRED database, I compute the theory-based, welfare-relevant output gap for the US, 1959q1-2011q4. This is shown in the figure below, which is essentially a version of Galí’s (2011) Figure 2.1. It is seen that output is always inefficiently low, and that there are substantial fluctuations around an average welfare-relevant output gap of -4,8%. The fluctuations around the average is what I consider relevant for monetary policy, and one sees that currently, output is below this average. So, the output gap is still negative; and of a non-negligible magnitude; by this theoretically-based approach, US output is around 2% below the natural rate of output (and nearly 7% below the efficient level—but this latter number is sensitive to calibration).

“Going backwards,” one can use this output gap measure together with actual output data in order to recover the natural rate of output. This is done in the figure below:

In the last two figures, I take the above figure and zoom in on the periods that John Taylor focuses on, in order to assess the differences between the current recession and the recession in the early 1980s. So I present below the same numbers for the sub periods considered by Taylor: 1981q1-2011q4 and 1981q1-1985q4. Note that the scaling are the same, such that the vertical distance of the figure is 10% of output in both instances (i.e., the distance between the horizontal lines is 1% of output).

It appears correct that the US recovery is slower currently than in the 1980s. However, the recovery only begins in the middle of the considered 5-year span (third quarter of 2009), whereas it starts earlier in the 5-year span in the 1980s considered by Taylor. Moreover, the simple “potential output” figures used by the CBO and Taylor are very smooth, and it is notable that by using the theory-based measure, there was still a negative output gap in the fourth quarter of 1985 of around 0.75% . Only in mid-1987 was the gap closed.

So, while the recovery now indeed seems slower, it did take more time in the 1980s than what the “potential output” figures may suggest. Interestingly, the theory-based natural rate measure grows equally slow in both periods. From 2007-2011 the natural rate of output grew on average at 1,4% annually, while from 1981-1985 the number was 1.2%. In both periods, growth in the natural rate is hampered by periods of no growth.

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