Music Videos on Boom and Bust

John Papola and Russ Roberts just put their Hayek versus Keynes rap video on youtube. It's called "Fear the Boom and Bust." But also go to their web page EconStories which has much more.

Also today PBS NewsHour aired a new Paul Solman video Unmasking Interest Rates: Honky-Tonk Style, which features Merle Hazard singing “Inflation or Deflation” along with me teaching Stanford Economics 1 students about monetary policy rules and the danger of keeping interest rates too low for too long.

Observe that the theme of both videos is that very low interest rates are a source of booms and busts.

Opinions versus Facts About the Chicago School

New Yorker writer John Cassidy argues in a recent article that free market-oriented Chicago school thinking was largely responsible for the financial crisis, and that, for this reason, interventionist-oriented Keynesian thinking has rightly replaced Chicago, which had previously “greatly influenced policy making in the United States.”

Cassidy makes his case mainly through a star witness, Judge Richard Posner, who Cassidy says “has shocked the Chicago School by joining the Keynesian revival.” Cassidy also reports the views of other University of Chicago economists about the Chicago School and its influence, but he dismisses many of them out of hand, especially John Cochrane and Gene Fama, who he calls “true believers” or “in the denial camp.” To his credit, Cassidy posted his interviews with these other economists on his blog. Nevertheless, relying on the interpretations of opinions of Posner or anyone else is an inherently subjective way to characterize a school of thought or to measure the extent of its influence on policy making.

Are there more objective, perhaps quantitative, ways? Consider, for example, measuring influence by the representation of members of a school in top economic positions in government where there is an opportunity to influence policy. And consider as a measure of an economist’s school, the university where he or she received the PhD. The data in the chart follows this approach. It shows the university PhD percentages of appointees to the President’s Council of Economics Advisers (CEA).

The blue line shows the percentage of presidential appointees to the CEA who have a PhD from Chicago. The red line shows the same for MIT or Harvard (Cambridge), one possible definition of an alternative to the Chicago school. The years from the creation of the CEA in 1946 until 1980 are shown along with each presidential term thereafter. Observe that the peak of the Chicago school influence was in the Reagan administration; it then dropped off markedly. In contrast Cambridge reached a low point of zero appointees to the CEA during the Reagan administration and then rose slightly to 20 percent in Bush 41, to 82 percent in Clinton, and to 100 percent in both Bush 43 and in Obama.

Blaming the financial crisis on the free-market influence of the Chicago school is certainly not consistent with these data. There were no Chicago PhDs on the President’s CEA leading up to or during the financial crisis. In contrast there was a great influx and then dominance of PhDs from Cambridge. And also notice that there were plenty of Chicago PhDs on the CEA at the time of the start of the Great Moderation—20 plus years of excellent economic performance. These data are more consistent with the view that the waning of the free-market Chicago school and the rise of interventionist alternatives was largely responsible for the crisis. But the main point is that there is no evidence here for blaming the influence of Chicago.

Of course, such measures are imperfect. Neither Milton Friedman nor Paul Samuelson served on the CEA, but their students did. And while PhDs from any insitution certainly do not fit in any one mold, the people who learned about rules versus discretion with Friedman likely had a different policy approach than people who learned about rules versus discretion with Samuelson. The data are robust when you look beyond the CEA to other top posts normally held by PhD economists. All assistant secretaries of Treasury for Economic Policy appointed during the Bush 43 and Obama Administrations had PhDs from Harvard. During the same period, all chief economists appointed to the IMF had PhDs from MIT, and, except for Don Kohn, who was promoted from within and Susan Bies who was appointed as a banker, all PhD economists appointed to the Federal Reserve Board were from Cambridge MA.

The GAO Audit of the Fed's AIG Bailout: Toward Increased Transparency?

Today's letter from Ben Bernanke to the GAO stating that the Fed would "welcome a full review by GAO of all aspects of our involvement in the extension of credit to AIG" is a step in the right direction. Importantly, the letter also indicates that the Fed "will make available to the GAO all records and personnel necessary to conduct the review."

A key set of records, which should be made available publicly, are the minutes of the Federal Reserve Board meeting, or meetings, where the decision to bailout AIG was made, along with the Board staff analysis relating to that decision. A full review would also require release of information (perhaps minutes from other Board meetings) where the decision not to extend credit for Lehman was made--a decision made just two days before. According to press accounts, and to Sorkin's book Too Big Too Fail, the AIG bailout was recommended to the Board by Timothy Geithner, who was then president of the New York Fed, but who was not, of course, a member of the Board. There is now much debate and conflicting testimony about the nature and even the existence of the systemic risk which is currently cited as a factor in the Board's decision.

In keeping with the spirit of letter sent today, there is no reason why the Board should not regularly release detailed minutes of such crucial meetings just as the Federal Open Market Committee does. Currently, the only minutes available for those Board meetings that involved the "unusual and exigent circumstances" clause were for the March 14, 2008 and March 16, 2008 meetings, which related to Bear Stearns. The Board released these on June 27, 2008, three months after the meetings took place, but it has not released minutes from the Board meeting on AIG or related meetings of more than a year ago.

There is a stark contrast between the relatively high degree of transparency of FOMC decisions and the lack of transparency of Board decisions. To see this, compare the most recent FOMC minutes with the Board minutes of March 2008 cited here, or with no minutes at all. Increasing the transparency of the Board meetings to the level of the FOMC meetings would improve public discourse on these important decisions.

More on "Too Low For Too Long"

Much continues to be written this week about whether interest rates were too low for too long in the period 2003-2005 . David Papell posted a useful guest analysis on Econbrowser this morning showing that the target federal funds interest rate was too low in 2003-2005 when you use the overall GDP price measure of inflation in the Taylor rule; he also shows that the target interest rate would not have increased in 2008 as Ben Bernanke argued in his Atlanta speech.

In Bernanke Challenged on Rates' Role in Bust, Jon Hilsenrath reports results in the Wall Street Journal that show that 70 percent of economists of an informal survey agreed that "Excessively easy monetary policy by the Federal Reserve in the first part of the decade helped cause a bubble in house prices" (78 percent of business economists).

I was interviewed today on CNBC's Kudlow Report about my Wall Street Journal reply to Ben Bernanke. Among other things Larry Kudlow asked about Thomas Hoenig’s calculation that real interest rates were below zero in the past decade for about as much time as they were in the turbulent 1970s. This bar chart from Thomas Hoenig's January 7 speech gives the details which are very striking.

Also some asked about the specific reference to the finding of Athanasios Orphanides and Volker Wieland that interest rate were too low for too long if you use private sector forecasts of inflation rather than the Fed's forecasts in the Taylor rule. Here is the link to the July/August 2008 Review of the St. Louis Fed, the same issue where the Jarocinski-Smets piece mentioned in my Wall Street Journal article appeared.

From Fiscal Stimulus and Fiscal Anti-Stimulus

In an interesting new paper, University of Chicago economists Thorsten Drautzburg and Harald Uhlig calculate the impact the $787 billion fiscal stimulus package passed last year. Previous research, such as the paper by John Cogan, Tobias Cwik, Volker Wieland and me (CCTW), assumed that the higher taxes needed to pay interest on the increased debt caused by the bigger deficits were of the lump-sum variety with no distortions. Drautzburg and Uhlig more realistically assume that future marginal tax rates must rise. Because higher marginal tax rates reduce supply, they find that “the output loss in the medium-to-long term is substantially larger than in the lump-sum tax version” of CCTW. The results are illustrated in Figure 2 of the Drautzburg-Uhlig paper which shows that the longer-term losses outstrip any shorter-term gains very quickly. The paper is one of several technical papers presented at the conference "New Approaches to Fiscal Policy" at the Federal Reserve Bank of Atlanta last week

Learning from the Great Inflation

Many are worried that the exploding Federal debt and the expanded Federal Reserve Balance sheet will lead to a large increase in inflation. But when and how fast? A session at the recent American Economic Association meetings on the Great Inflation of the late 1960s and 1970s provides some historical perspective on the question. Andrew Levin of the Federal Reserve Board staff and I presented one of the papers. We looked at the timing of the inflation increase and the monetary responses.

As this chart from our paper shows, the increase in inflation was not sudden. The chart plots CPI inflation and a measure of inflation expectations based on the Livingston expectation survey. Inflation was in the 1-1/2 percent range through the early 1960s. Then, starting around 1965, it gradually started to rise and by the end of the 1970s it was in double digits. There were several boom-bust cycles during this period as the Fed fell behind the curve, attempted to catch up by raising interest rates, and then eased again before inflation returned to low levels. We found that monetary policy was significanly affected by political factors during the period. It was only after Paul Volcker was appointed Fed Board Chairman in 1979 that inflation was brought back down, but by then signficant damage had been done. And even then there was one more pull back from tightening during the 1980 election. So this is one plausible way that inflation might rise again. Of course it does not have to be this way. With increased globalization and interconnectedness of markets, inflation could rise more quickly. Or with a policy correction we could completely avoid an another great inflation.

Ben Bernanke's AEA Speech

On New Years Day I wrote a piece on the surprising increase in the number of references to the Taylor rule in 2009. Little did I know that two days later Federal Reserve Board Chairman Ben Bernanke would start off 2010 with a speech with 50 more references at the American Economic Association (AEA) meeting in Atlanta. The speech was largly an attempt to refute the now commonly held view that the Fed held interest rates too low for too long in 2002-2005. I was in Atlanta and though I could not go to the speech I read it afterwards and expressed by disagreement first in a Bloomberg interview with Steve Matthews and later in a CNBC interview with Larry Kudlow and will follow up with more details; note that a working paper prepared by seven Fed Board staff was released just before the speech. Others have raised questions about the speech from a variety perspectives, including David Beckworth, Caroline Baum, David Leonhardt, Mike Shedlock, Judy Shelton. There is much for the Financial Crisis Inquiry Commission to digest.

From Woodford to DeLong On Monetary Policy Rules

Surprisingly, the Taylor rule was referred to more frequently than ever in 2009. According to Google Scholar more articles referred to it than in any year since 1993 when John Lipsky, now First Deputy Managing Director at the IMF, first called the rule by that name. Many more pieces appeared in blogs or in the news media.

The increased commentary is surprising because the Fed did not change its interest rate target once during 2009. Most likely the reasons for the attention are that: (1) the rule is cited as evidence that interest rates were “too low for too long” in 2003-2005 thereby helping to cause the financial crisis, (2) the rule can be used to help determine when the Fed should or will increase its interest rate target above zero, (3) the rule is used by some to determine how much quantitative easing is needed.

Many excellent pieces were written, in my view, including several by Michael Woodford of Columbia and Vasco Curdia of the New York Fed on adjusting policy rules during financial crises. 2009 also saw the release of the 2003 FOMC transcripts with telling references to the Taylor rule by Ben Bernanke. Columns by Michael McKee of Bloomberg and Gene Epstein of Barron’s were clear and insightful.

At the other end of the spectrum was Brad DeLong’s recent Taylor rule blog post, which unfortunately contains serious errors. For starters, he asserts that “John Taylor in the long run wants ‘Taylor Rule’ to mean any statistically-fitted reaction function in which interest rates respond to inflation and the output gap and not to the one rule he fitted over 1987-1992.” In my original paper I did not “statistically fit” a reaction function over 1987-1992 or any other period for that matter. The coefficients of the rule in that paper were derived from monetary theory and models developed during the 1980s. As I explained in the paper, using a variety of quantitative economic models, I found, through stochastic simulations, that such a rule worked well in stabilizing inflation and real GDP. Statistically fitting such a rule over a short five-year span would make little sense and adding earlier years would have made even less sense because Fed policy during the 1970s was terrible. To illustrate how the rule would work in practice I pointed to episodes when the rule was similar and also to episodes when it was different from what the Greenspan Fed was doing. There are no reaction function regressions in that paper.

De Long also tries to make the case that a policy rule which was statistically fit by San Francisco Fed economist Glenn Rudebush is an improvement over the rule I proposed. That estimated rule has a larger coefficient on the output gap and therefore gives lower interest rate settings now. It implies that the interest rate will remain at zero for a very long period which is what DeLong advocates. He likes that estimated version, but curve fitting without theory is dangerous. In the case of policy rules, it can perpetuate mistakes: the higher coefficient on the gap may be due to periods when the funds rate was too low for too long. Also interpretation of the lagged interest rate in fitted regressions is very difficult.

DeLong provides no demonstration that a higher coefficient on the output gap is an improvement over my original proposal. The recent review paper by me and John Williams, Director of Research at the San Francisco Fed, reviews the debate over the size of that coefficient and shows why a higher coefficient is not robust. Moreover, others, such as Bob Hall, argue that the coefficient on the output gap should be lower, not higher, than in the Taylor rule because of uncertainty of measuring the output gap. DeLong does not mention such alternatives.

DeLong is wrong about what he claims “John Taylor in the long run wants.” Don't we all want good monetary policy? If there is a better policy rule that improves economic performance, then I am all for it, and I don’t much care what you call it. In 2008 I proposed adjusting the Taylor rule with the Libor-OIS spread to deal with the turbulence in the financial markets. The Curdia and Woodford papers analyzed that proposal and improved on it by changing the coefficient on the Libor-OIS spread. Their analysis was not based on statistical curve fitting, but rather on good monetary economics, which is what we need more of right now.