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Tuesday, July 31, 2012

Still Learning from Milton Friedman

We can still learn much from Milton Friedman, who was born 100 years ago today. Here I focus on his role in the macroeconomic debates of the 1960s and 1970s, because they are so similar to the debates raging again today.

Friedman, Samuelson, and Rules Versus Discretion
First, go back to the early 1960s. The Keynesian school was coming to Washington led more than anyone else by Paul Samuelson who advised John F. Kennedy during the 1960 election campaign and recruited people like Walter Heller and James Tobin to serve on Kennedy’s Council of Economic Advisers. In fact, the Keynesian approach to macro policy received its official Washington introduction when Heller, Tobin, and their colleagues wrote the Kennedy Administration’s first Economic Report of the President, published in 1962.

The Report made an explicit case for discretion rather than rules: “Discretionary budget policy, e.g. changes in tax rates or expenditure programs, is indispensable…. In order to promote economic stability, the government should be able to change quickly tax rates or expenditure programs, and equally able to reverse its actions as circumstances change.” As for monetary policy a “discretionary policy is essential, sometimes to reinforce, sometimes to mitigate or overcome, the monetary consequences of short-run fluctuations of economic activity.”

In that same year Milton Friedman published Capitalism and Freedom (1962) giving the competing view on role of government which he then continued to espouse through the 1960s and beyond. He argued that “the available evidence . . . casts grave doubt on the possibility of producing any fine adjustments in economic activity by fine adjustments in monetary policy—at least in the present state of knowledge . . . There are thus serious limitations to the possibility of a discretionary monetary policy and much danger that such a policy may make matters worse rather than better . . . The basic difficulties and limitations of monetary policy apply with equal force to fiscal policy . . . Political pressures to ‘do something’ . . . are clearly very strong indeed in the existing state of public attitudes. The main moral to be had from these two preceding points is that yielding to these pressures may frequently do more harm than good. There is a saying that the best is often the enemy of the good, which seems highly relevant . . . The attempt to do more than we can will itself be a disturbance that may increase rather than reduce instability.”

Resolving the Disagreements
So there were two different views: the Samuelson view versus the Friedman view. The fundamental disagreement was not really over which instrument of government policy worked better (monetary versus fiscal), but rather over discretion versus rules-based policies. From the mid-1960s through the 1970s the Samuelson view was winning with practitioners putting many discretionary policies into practice.

But Friedman remained a persistent and resolute champion of his alternative view. At one time during the 1970s, F.A. Hayek even seemed to be siding with the discretionary approach, at least in the case of monetary policy. But Milton Friedman didn’t waver. In fact he sent a letter to Hayek in 1975 saying: “I hate to see you come out as you do here for what I believe to be one of the most fundamental violations of the rule of law that we have, namely discretionary activities of central bankers.” Fortunately, in my view, Friedman’s arguments eventually won the day and American economic policy moved away from such a heavy emphasis on discretion in the 1980s and 1990s.

The Debate Returns
But this same policy debate is back today. Economists on one side push for more discretionary fiscal stimulus packages. They argue that the stimulus packages of 2008 and 2009 either worked or should have been even larger. They also push for more discretionary monetary policy such as the quantitative easing actions. They are not so worried about discretionary bailout policy, discounting the increased moral hazard that lack of a credible rule implies. In these ways they are descendants of the Samuelson school.

Other economists argue for more stable fiscal policies based on permanent tax reforms and the automatic stabilizers. They also push for a return to more predictable and rule-like monetary policy.They argue that neither the discretionary fiscal stimulus packages nor the bouts of quantitative easing were very effective, pointing to the risks of increased debt or monetization of the debt. They worry about the consequences of the discretionary bailouts. In these respects they are descendants of the Friedman school.

Of course there are many nuances today, some related to the difficulty of distinguishing between rules and discretion. You can see this, for example, in discussions of nominal GDP targeting, where some see it as a rule and some see it as a license to proceed with whatever discretionary action it takes. Interestingly, you frequently hear people on both sides channeling Milton Friedman to make their case.

Resolving the Debate Again
While academics are still the main protagonists, the debate is not academic. Rather it is a debate of enormous practical consequence with the well-being of millions of people on the line. Can the disagreements be resolved? Milton tended toward optimism that they could be resolved, and I am sure that this is one reason why he kept researching and debating the issue so vigorously.

Here people on both sides can learn from him. First, while a vigorous debater he was respectful, avoiding personal attacks and never failing to answer a letter. Second, he had a strong believe that empirical evidence would bring people together. He was influenced by statistician Leonard (Jimmie) Savage: Yes, people would come to the issue with widely different prior beliefs, but their posterior beliefs—after evidence was collected and analyzed—would be much closer. In this way the disagreement would eventually be resolved. I think we saw this in the late 1970s and the basic agreements lasted for at least two decades.

Unfortunately, posterior beliefs in the macro area now seem just as far apart as prior beliefs were 50 years ago. Clearly we have a lot of work to do, and clearly we can learn a lot from Milton Friedman in deciding how to proceed.

Thursday, July 26, 2012

Benefits of More Fed “Action” Do Not Exceed Costs

Both the New York Times and the Wall Street Journal ran front page stories yesterday reporting that the Fed is yet again about to take action. “Fragile Economy Said to Push Fed to Weigh Action” said the Times. “Fed Moves Closer to Action” said the Journal. Both stories report that the benefits of such actions in the past have exceeded the costs, but there is precious little evidence for this. In an interview in the latest issue of MONEY Magazine I was asked about this:

What’s your assessment of the Federal Reserve’s recent actions to help spur the economy?  The Fed has engaged in extraordinarily loose monetary policy, including two round s of so-called quantitative easing. These large scale purchases of mortgages and Treasury debt were aimed at lifting the value of those securities, thereby bringing down interest rates. I believe quantitative easing has been ineffective at best, and potentially harmful.

Harmful how? The Fed has effectively replaced large segments of the market with itself—it bought 77% of new federal debt in 2011. By doing so, it creates great uncertainty about the impact of its actions on inflation, the dollar and the economy. The very existence of quantitative easing as a policy tool creates uncertainty and volatility, as traders speculate on whether and when the Fed is going to intervene again. It’s bad for the U.S. stock market, which is supposed to reflect the earnings of corporations.

On a more technical level, the latest issue of the International Journal of Central Banking published an article by Johannes Stroebel and me raising doubts about the benefits of the mortgage-backed securities (MBS) purchase program (part of QE1), and the costs of the resulting large balance sheet go well beyond concerns about inflation.

Saturday, July 14, 2012

One of the Most Important Lessons of Modern Macroeconomics

I completely agree with John Cochrane when he writes in his review of my book First Principles that the “preference for rules is one of the most important lessons of modern macroeconomics” and that it is still the major point of disagreement among those writing about economic policy today. As John nicely puts it, the disagreement is about “rules vs. discretion, commitment vs. shooting from the hip, and more deeply about whether our economy and our society should be governed by rules, laws and institutions vs. trusting in the wisdom of men and women, given great power to run affairs as they see fit.”

The disagreement can be seen all over the place. Compare First Principles with Paul Krugman’s End This Depression Now or with Joe Stiglitz’s The Price of Inequality. (All three books published by W.W. Norton, by the way). Many have said that this difference is the main takeaway from the Harvard and Stanford debates between me and Larry Summers.

But even among those of us who agree about the lesson, there are differences in how you go about applying it as John Cochrane points out in reviewing the chapter “Who Gets Us In And Out Of These Messes.” For example, John expresses some skepticism about my proposal to achieve more rule-like behavior in monetary policy through legislation, mainly because the proposal is too “middle-of-the-road,” simply requiring that the Fed report its rule or strategy and narrow its mandate.

I am very open to discussing alternatives, but it is important for the discussion to set the record straight on one point. John Cochrane characterizes my so-called Taylor rule paper published in 1993 as follows: “The Taylor rule was originally an empirical description of Fed actions in the 1980s, a description of how the Fed acted to implement its dual mandate. It only slowly became a normative description of what the Fed should do.” Actually from the start the Taylor rule was meant to be normative. It was the outcome of a search over many years for good policy rules using monetary theory and empirical models with rational expectations and rigidities. And it has only one normative target—a 2 percent inflation rate—along with a process of minimizing fluctuations around that target and around whatever is the given natural rate of output or unemployment.

In any case, the big question is how to apply this "most important lesson." George Shultz offers some ideas in his interview today in the Wall Street Journal where he emphasizes the importance of rules-based policy with a football game analogy (without predictable rules, no one will play).

Monday, July 9, 2012

Beware of a Revival of Misleading Economic Claims

As the 2012 campaign season gains steam we are beginning to hear the same economic claims we heard two years ago during the mid-term election. In 2010 much of the debate was about (1) whether the 2009 stimulus package was a success or a failure, and (2) whether the large deficit and rapidly growing federal debt were nothing to worry about or a serious danger. At least as indicated by the outcome of the 2010 election, those who argued the failure and danger side carried the day, with increased stimulus spending, growing debt and a slow economy at the top of voters’ concerns, which resulted in an unprecedented political shift in Congress. In my view, the economic facts were also consistent with the failure and danger position, and are even more so today.
Nevertheless, the same old claims that the debt-increasing stimulus was a success are being made again. In my view they should still be challenged and debated. An example was on yesterday’s ABC’s This Week, where Steve Rattner claimed that there is a bipartisan consensus of economists that the 2009 stimulus was a success, referring to a 2010 working paper by Mark Zandi and Alan Blinder as evidence. Rattner’s claim went unchallenged on the show, but it should have been challenged because it is false.
First, there is certainly no consensus that the stimulus was effective, as evidenced, for example, in debates I had with Zandi and Blinder back in 2010. The main points of refutation, which I summarized on this July 29, 2010 blog, are still valid.

Second, the Zandi-Blinder paper is not really bipartisan, certainly not in a Democrat versus Republican sense. Mark Zandi is on the record as saying “I’m a registered Democrat” in a Washington Post interview, and Alan Blinder is certainly not a Republican. Moreover, both were active advocates of the 2009 stimulus package before it was passed. Sometimes people say Zandi was an adviser to John McCain, but that is not true. McCain Campaign Adviser Doug Holtz-Eakin did ask Zandi and many other economists for their forecasts during the 2008 campaign, but Zandi did not advise McCain on policy.

Saturday, July 7, 2012

Gross Capital Flows Grow in Importance

My Wall Street Journal article yesterday Monetary Policy and the Next Crisis touches on a growing research area in international finance that focusses on gross capital flows as distinct from the current account. For example, in his Ely Lecture at the American Economic Association Meetings this year, Maury Obstfeld argues that “large gross financial flows entail potential stability risks that may be only distantly related, if related at all, to the global configuration of saving-investment discrepancies.” And in a recent Princeton working paper, Valentina Bruno and Hyun Shin write that “Current account gaps have traditionally been considered as the drivers of cross-border capital flows. However, the most notable feature of international finance in recent decades has been the dramatic increase in gross capital flows that dwarf current account gaps.”

One obvious policy implication is that international economic policy groups such as the G20 should pay more attention in their "Mutual Assessment Process" to gross international capital flows rather than focus entirely on current account imbalances.

So far, however, the research (including Obstfeld’s Ely Lecture) has not dealt much with the impact of monetary policy on these flows, and that was the main purpose of my Wall Street Journal piece. The paper by Claudio Borio and Piti Disyatat Global Imbalances and the Financial Crisis: Link or No Link? shows that these flows rather than the current account or a global saving glut were the key international factors in the recent crisis. This chart of the U.S. balance of payments is from their paper. It nicely illustrates the importance of gross flows in comparison with the current account.  

Wednesday, July 4, 2012

Debt Fireworks Continue On This Independence Day

On Independence Day two years ago I wrote a piece comparing America’s exploding debt projection (from the 2009 and 2010 Congressional Budget Office’s Long Term Budget Outlook) with the fireworks on the 4th of July. As I later put it in First Principles (p. 101) the debt projection's "soaring upward climb resembles the fireworks on America's Independence Day. But rather than remind us of America's founding, it portends America's ending.” Here is the chart I was referring to, hoping that the Congress and the Administration would get their act together so CBO would be able to project something more responsible in 2011.

Well, after two more years of Long Term Budget Outlooks (2011 and 2012) the CBO projections unfortunately look virtually the same. The problem has not been fixed as my grand daughter requested in my Economics 1 class at Stanford nearly three years ago. In fact, only one thing has really changed. CBO put a ceiling on its projections. They now stop reporting the debt to GDP ratio once it hits 250% or more, as if Congress finally voted for such a debt ceiling in a binding way. CBO used to go out 75 years, but now they just stop when things look really bad. So, as shown below, the latest projection (in green) now stops in 2042 when the debt hits 247 percent of GDP.

Of course, stopping the projection like this does not change anything of substance, and it certainly is not a way to fix the problem.

Monday, July 2, 2012

How Departures From Economic Freedom Can Affect Freedom In General

In a recent speech at Stanford (video here) former Wells Fargo Chairman and CEO Dick Kovacevich told the full story of how he was forced to take TARP funds even though Wells Fargo did not need or want the funds. The forcing event took place in October 2008 at a now well-known meeting at the U.S. Treasury with Hank Paulson, Ben Bernanke, as well as several other heads of major financial institutions.

In his speech, Kovacevich first described how he and the other bankers were told at that meeting that they had to accept the funds. He then paused and said to the Stanford audience: “You might ask why didn’t I just say no, and not accept TARP funds.” He then explained: “As my comments were heading in that direction, Hank Paulson turned to Chairman Bernanke, who was sitting next to him and said ‘Your primary regulator is sitting right here. If you refuse to accept these TARP funds, he will declare you capital deficient Monday morning.’ This was being said when we were a triple A rated bank. ‘Is this America?’ I said to myself.”

At that time Wells Fargo was in process of acquiring Wachovia and such a declaration would have killed the deal. According to Kovacevich: “It was truly a godfather moment. They made us an offer we couldn’t refuse.” It was also truly a deviation from the principles of economic freedom, such as those I have highlighted in my book First Principles—predicable policy, rule of law, reliance on markets, limited scope for government. One can debate whether those deviations were appropriate, but they were clearly deviations.

During the question and answer period after his talk, I asked Dick Kovacevich why more business people were not speaking out on this important issue. He explained how he had in fact waited a long time after he left Wells Fargo before speaking out because he did not want to risk some kind of retribution. He said he thought many others had a “fear” of speaking out.”

In their book Free to Choose Milton and Rose Friedman wrote about this problem: “Restrictions on economic freedom inevitably affect freedom in general, even such areas as freedom of speech and press.” (p. 67) They quoted from a letter they received from business executive Lee Grace. I was reminded of this letter when I heard Dick Kovacevich answer my question. In the letter Grace had said “We grow timid against speaking out for truth…government harassment is a powerful weapon against freedom of speech.”