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Status update on the macroeconomy

August 30, 2011

If you have been really up on the economy these days, don’t read this. It’s all gonna be stuff you’ve heard before. That’s doubly true if you follow Sumner, Rowe, Glasner and Beckworth.

My theory of the supply side of recessions is that there is a shock that triggers stupid policy responses which in turn worsen the economy. That theory has fit the current recession quite nicely, with the recession triggering extended unemployment insurance, higher minimum wages, banking and corporate bailouts, higher health care costs, regime uncertainty and a misguided stimulus package that just diverted funds to inefficient government programs. To a neo-classical economist, the policy responses seem motivated by a desire to gut the economy, not fix it. Eventually, cooler heads might prevail and stop messing things up further. Through price changes and entrepreneurial adjustment, the economy can self heal, but not with continuous fresh wounds inflicted every day. I don’t expect much from Congress, but there is one area where I, and others, were truely disappointed: Monetary policy. Sure, politicians are stupid and shortsighted and controlled by special interests, but what about the Fed?

Nominal GDP over the last few years:

The Fed has one tool, OMOs, and can target one nominal variable. If the price of that one variable is too low, they can print money until the price goes up. If the price is too high, they can sell bonds and reduce the money supply until its price falls. I agree 100% with Scott Sumner and the other quasi-monetarists that the variable the Fed should target is the level of GDP. If we had our way, the graph above would be a straight line. That would stabilize people’s incomes and spending levels, as well as stabilize expected inflation (assuming supply shocks are unexpected).

Here’s expected 5 and 10 year inflations:
5 Year:

10 Year:

Just when the TIPS spread showed just how incompetant the Fed was, they discontinued measuring it. Before Fall 2008, the Fed did an incredible job keeping inflation expectations stable and predictable. Neither 5 nor 10 year expectations strayed far from 2.5% inflation, which although a bit high, is at least reasonable. Now we’ve got this chaotic level of expectations and occasional severe deflation. If the Fed had any of the credibility they obsess over so much, both graphs would be a lot more stable. Here’s actual inflation:

Note: The CPI doesn’t even include owner-occupied housing, which, if added, would make the deflationary shock look even worse.

At the beginning of the recession, prices don’t go down, they go up. That is consistent with a supply side recession.

As production becomes more difficult, due to financial shenanigans, etc, the supply curve shifts left causing P to go up and Q to go down. However, then the Fed overreacts and reduces demand (NGDP) for basically all products at once, causing the demand curve to shift left, dropping Ps and Qs. Don’t be fooled by large money aggregates alone. It’s spending that matters:

If the coin is locked up in chests, it is the same thing with regard to prices, as if it were annihilated. . . . As the money and commodities. . .never meet, they cannot affect each other.” – Ricardo

Some prices adjust faster than others when hit by an economy wide demand shock. In the absence of monetary disequilibrium, relative price changes represent the effects of supply and demand in that individual market. However, when the whole economy is hit by a demand shock, some prices adjust more quickly than others. For example, commodities adjust nearly instantaneously, whereas wages and houses fall the slowest. Which areas of the economy are the most out of equilibrium? Why, wages (unemployment) and housing.

People don't get nominal wage cuts, pretty much ever.

I am pessimistic because the Republicans are tripping over each other to promise even tighter money and none of the Democrats seem bright enough to understand all this. There are always tons of things politicians could do to help the microeconomy, but there’s a big easy one the Fed could do: Print more money!

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