Home > Economic policy, Economics - General > A note on the ineffectiveness of monetary stimulus (updated and corrected)

A note on the ineffectiveness of monetary stimulus (updated and corrected)

August 26th, 2013

A commenter on the previous post raised the idea, promoted by the “market monetarist” school, that monetary policy is so effective as to make fiscal policy entirely unnecessary, at least when interest rates are above the zero lower bound. My views on this issue were formed by the experience of the late 20th century, and in particular, the recession that began in 1990, following steep increases in interest rates. Having planned a “short, sharp, shock”, the RBA started cutting rates in January 1990.

They didn’t go for 25 basis point moves in those days. Over the period to March 1993, rates were cut by more than 12 percentage points, from 17.5 per cent to 5.25 per cent. Over the same period, unemployment rose from 6 per cent to nearly 11 per cent, a record for the period since the Depression, and stayed around that level well into 1994, until the adoption of the Working Nation package of fiscal stimuuls active labour market policies. As I said in the previous post, tight monetary policy can reliably cause recessions, but expansionary monetary policy in a deep recession is “pushing on a string”.

Update As pointed out by Mark Sadowski in comments, these are nominal rates of interest. To get the real rate, which is more relevant, you need to subtract the expected rate of inflation, which fell from around 7 per cent to around 4 per cent over this period (as measured by surveys, and by the premium for inflation-adjusted Treasury bonds). So, you get a 9 percentage point reduction in the real rate from 10 per cent to 1 per cent. This doesn’t make much difference to the story. Most economists would regard policy as contractionar/expansionary if real interest rates are above/below the long-run neutral level, about 3 per cent. So, we still have a shift from strongly contractionary to moderately expansionary.

However, market monetarists want to argue that the stance of policy should be assessed relative to a policy rule (Taylor rule or NGDP) that already incorporates a prescription of cutting rates when GDP falls and unemployment rises. This doesn’t make a lot of sense to me. It’s like arguing that Obama’s stimulus was actually a contractionary policy because it wasn’t as big as (according to a standard analysis based on Okun’s Law) it should have been. It’s partly a question of semantics, but it’s associated with the claim that, if only rates had been cut even more, we wouldn’t have had the recession, or would have recovered quickly. Having been around at the time, I disagree.

  1. August 28th, 2013 at 11:56 | #1

    @urban legend

    If they were fully flexible, then they would of dropped wages instead of firing people. Falling wages wouldn’t of been problematic as prices were also falling and you have assumed away money illusion.

    Though to be fair to you have flexible wages, but sticky prices (including debt contracts), you’d still have issues.

  2. Mark A. Sadowski
    August 28th, 2013 at 13:02 | #2

    @John Quiggin

    “A case of traps for young players, I’m afraid. In those days, the CPI included mortgage interest rates, so raising (lowering) interest rates produced an illusory increase in measured inflation. The actual reduction was more like 3.5 percentage points, from 6 to 2.5.”

    Fortunately FRED also has Australia’s household final consumption expenditure price index (HFCEPI) which has never included mortgage interest rates. Let’s repeat the analysis with it and see how much difference it makes.

    1) Nominal interest rates are a terrible measure of monetary policy stance.

    The following is a graph of Australia’s nominal short term interest rates (blue), year on year HFCEPI inflation rate (red) and real short term interest rates (green) from 1987 through 1996:

    http://research.stlouisfed.org/fred2/graph/?graph_id=134407&category_id=0

    Year on year HCEPI inflation fell from 7.0% in 1990Q1 to 1.5% in 1992Q4. Since short term interest rates fell from 15.8% to 5.7% during this time period this means real short term interest rates only fell from 8.8% to 4.2%.

    The 1993 and 1999 versions of the Taylor Rule assumes that a real interest rate of 2% is the long run real neutral interest rate. Admittedly the Taylor Rule’s assumptions may not be applicable to Australia, but 4.2% is still a very high rate of real interest by any standards. The lowest that Australia’s real short term interest rates fell to in the early to mid-1990s was 2.5% in the second half of 1993.

  3. Mark A. Sadowski
  4. Mark A. Sadowski
    August 28th, 2013 at 14:08 | #4

    @John Quiggin

    “On the second point, it’s a semantic difference, not a real one. I’m using an absolute measure of the stance of policy, you’re measuring it relative to to the Taylor rule which (in my terminology) prescribes expansion when unemployment rises.”

    Let’s repeat the analysis with the HCEPI and then I’ll address this point.

    2) Even real interest rates are a very poor measure of monetary policy stance.

    The following is the 1999 version of a Taylor Rule for Australia (red) graphed along side the short term interest rates (blue) and the residual (green) from 1987 through 1996:

    http://research.stlouisfed.org/fred2/graph/?graph_id=134496&category_id=0

    Note that the residual increased from 1.1% in 1990Q1 to 8.1% in 1992Q4 and the lowest it would get in the early to mid-1990s was 2.0% in 1995Q3. Regardless of one’s opinion of the various parameters one thing is clear, by the standards of a simple rule monetary policy got much tighter, not easier from 1990Q1 to 1992Q4.

    Conceptually the real neutral interest rate is associated with the real interest rate level which implies that monetary policy is neither expansionary nor contractionary. In the long-run, the real neutral interest rate is determined by economic fundamentals such as the long-term savings behaviour, productivity, population growth etc. But in the short run, the real neutral interest rate is affected by the disturbances to the economy that influence the prospect of closing the output gap in the medium term, in particular the size of the output gap itself.

    Thus when unemployment is above the natural rate, as it was from 1991 on, the short run real neutral interest rate is likely to be below the long run real neutral interest rate. It may not be as low as the rate given by a Taylor Rule, but nevertheless real short run interest rates were relatively high throughout the early to mid-1990s. Thus I find it difficult to believe that anyone could possibly think that Australia’s monetary policy was expansionary in the early to mid-1990s.

  5. August 28th, 2013 at 16:46 | #5

    @Zac

    The problem other than debt (which is a very big issue itself) is that you can’t have negative future price expectations (at least not something significant), due to the cost of production (including research and development) is incurred before the time of selling the product. The result is very slow price adjustments compared to inflation, Japan perfectly illustrates this (flexible wages and deflation), as it took more than five years for the (late 98 – late 2005) for the CPI to fall from about 105 to 100.

  6. August 28th, 2013 at 17:00 | #6

    @Tom

    I think you need to be clearer about what you are talking about.

    I (and I don’t think I’m alone in this) define inflation as the change in the price level, so I don’t see how you can have ‘very slow price adjustments compared to inflation’. Inflation *is* the price adjustment.

    Ernstine,

    I got half way through a response to your post, but then I thought life is too short, and your vaguely insulting questions too long. Sorry.

  7. crocodile
    August 28th, 2013 at 17:27 | #7

    I (and I don’t think I’m alone in this) define inflation as the change in the price level

    An interesting thread. Isn’t inflation a decrease in the value of the unit of account. Price level change being the result rather than the cause.

  8. Ernestine Gross
    August 28th, 2013 at 18:35 | #8

    The prices in some market segments change much faster than those in other segments (eg prices of financial securities markets change very rapidly in comparison to say prices of major physical capital goods that are sold at a fixed price many months before delivery). The relative speed of changes in quantities, wages and prices is the subject of the work by the authors I mentioned in my predecessor post.

    CPI is taken to be a measure of ‘inflation’ but clearly it does not include asset prices (but debt influences some asset prices faster than others and consumer finance interest rates – credit cards – seem to be invarient to what the cash rate is – they are the very very slow changing relative prices (interest rates) on the way down).

    It might be nice to live in a world where the quantity theory of money holds and we could all agree on what ‘inflation is’ and what causes it. ‘The world’ does not wish to cooperate, it seems.

    No offense intended, vaguely or otherwise.

  9. Zac
    August 28th, 2013 at 18:35 | #9

    @crocodile

    Two words for the same thing.

  10. sdfc
    August 28th, 2013 at 19:21 | #10

    The CPI is a very narrow measure of inflation. The blinkered CPI inflation targeting regime of the Great Moderation (what a joke that term is) saw central banks ignore monetary (credit) inflation with disastrous consequences.

  11. John Quiggin
    August 28th, 2013 at 19:27 | #11

    @Mark A. Sadowski

    “Tightening relative to a monetary rule” is another way of saying as “Not relaxing as much as the monetary rule prescribes”. It doesn’t matter which you use, as long as we are clear that we are using the world “expansionary” differently.

    I could quibble more about the numbers, but even on your own numbers, we see the real interest rate falling from 8.8 per cent to 4.2 per cent, while unemployment went up like a rocket. You say that this was 8 per cent too high, which implies that we would have hit the zero nominal lower bound on your Taylor rule.

    Having been there at the time, I’m confident that a cut to zero wouldn’t have made a lot of difference. Do you think it would?

  12. Zac
    August 28th, 2013 at 19:42 | #12

    @John Quiggin

    Surely there is no lower bound on how far the dollar can be depreciated? A low dollar boosts jobs and inflation.

    I suspect people need to be clearer about how they define inflation.

  13. Jordan
    August 29th, 2013 at 04:02 | #13

    Zac and TravisV

    Inflation is change in prices due to increased demand from increased buying power or animal spirits or succesfull advertising. Increased buying power comes from raising wages or easing borrowing terms. But prices can rise only in one or two sectors while other prices can be falling or rise much slower.

    Only rarely inflation can also come from energy price rise, like in 1970′s.
    Then you have core inflation and general inflation, core inflation is the steady one and followed by jumpy food and energy inflation, hence the reason for introducing core inflation measure. And even tough there is insurance for food and energy prices to reduce jumpiness and inflation transmission onto economy at large.

    Credit creation through banks causes inflation in housing prices against other segments in economy and with that increases wages in that sector.
    Credit manipulation (financial inovations/ derivatives) increased incomes in finacial sector against other wages in an economy. Enabling easier credit terms from financial inovations raised animal spirits in population at large (bubble).

    Inflation in a particular economic segment have positive feedback effect taking resources away from other lagging sectors.

    Central planing counters such effects with tax preference and subsidies improving positions of lagging segments. That would be a part of fiscal policy.

    Inflation comes from increased incomes, increasing debts or increasing world prices of energy (oil). Monetary policy works through influence of credit creation.

    This is the context of inflation that you need to consider when talking about fiscal and monetary policy. You did not consider such context and E. Gross and Ikonoclast were trying to point out to you, but you had no patience for highly professional lingue.

    All that is in normal times. If a bubble is allowed to last for too long, and gets inflation of one segment way out of whack, it disables monetary policy and monetary policy should then just create easier conditions for public debt to provide for fiscal policy to raise other segments of economy.
    Fiscal policy have to be pointed toward lagging sectors to catch up with resource grabbing inflated sector and put economy into balance.

    That explains inflation, sticky wages and prices using inflation language.

  14. Mark A. Sadowski
    August 29th, 2013 at 04:37 | #14

    @John Quiggin

    ““Tightening relative to a monetary rule” is another way of saying as “Not relaxing as much as the monetary rule prescribes”. It doesn’t matter which you use, as long as we are clear that we are using the world “expansionary” differently.”

    Obviously my last comment wasn’t clear enough. Expansionary monetary policy would be the equivalent of a real short term interest rate less than the real neutral rate of interest. All other things being equal, the short run neutral rate is lower than the long run neutral rate when the unemployment rate is above the natural rate. This is true completely independently of the Taylor Rule.

    There are simple econometric methods for estimating the short run neutral interest rate, but I take it that is beyond the scope of this conversation, and it should not be necessary in order for me to make my basic point. From 1969Q3 through 2013Q1 the real short run interest rate has averaged 2.20% in Australia, and I submit that is a reasonable proxy for the long run real neutral rate there. Thus when the unemployment rate is above the natural rate, any real short run interest rate above 2.20% should be contractionary.

    “I could quibble more about the numbers, but even on your own numbers, we see the real interest rate falling from 8.8 per cent to 4.2 per cent, while unemployment went up like a rocket. You say that this was 8 per cent too high, which implies that we would have hit the zero nominal lower bound on your Taylor rule.”

    They are not “my” numbers. They come from the Federal Reserve who in turn got them from the OECD, who in turn got them from the Australian Bureau of Statistics: Australian National Accounts: National Income, Expenditure and Product – Table 5. Expenditure on Gross Domestic Product (GDP), Implicit price deflators, Households; Final consumption expenditure; Seasonally Adjusted ; Series ID A2303940R. If you go and check you will see the values are identical among all three institutions.

    The fact that the real short run interest rate fell is less important than the fact that it was too high throughout. Whether it fell from 8.8% to 4.2%, or from 88% to 42% it was above the long run real neutral interest rate of 2.2%. Unemployment had risen to 7.9% by 1990Q4, and the OECD’s estimated NAIRU for Australia is 7.5% in 1990, so it was already above the natural rate by then, implying that the short run real neutral rate was below 2.2% fairly early on. And yet, real short run interest rates averaged 7.7% in 1990, 6.2% in 1991, 4.3% in 1992, 2.9% in 1993, 4.2% in 1994 etc. So monetary policy was contractionary throughout. Of course unemployment went “up like a rocket”.

    As for my Taylor Rule, it doesn’t prescribe a rate below zero until 1992Q2. That’s over two years of tight monetary policy before the zero lower bound was reached.

    “Having been there at the time, I’m confident that a cut to zero wouldn’t have made a lot of difference. Do you think it would?”

    Guess.

  15. Ikonoclast
    August 29th, 2013 at 08:17 | #15

    “… when the unemployment rate is above the natural rate.” – Mark A. Sadowski.

    Oh dear, is Mr. Sadowski invoking the NAIRU (non-accelerating inflation rate of unemployment) as a natural law? Does it demonstrate the reliability of Classical Mechanics or The Laws of Thermodynamics or the Special and General Theories of Relativity? No? Then it is useless.

    There is no natural rate of unemployment. There is always an artificial rate. “Artificial” of course means made by “artifice” ie. made by humans. Whatever the rate of unemployment is, it is always a rate made by the humans of a given society humans except perhaps for special cases involving force majeure or acts of nature.

    I am quite sure we can point to at least one era where it proved possible to run an economy with a low inflation rate and low unemployment rate of no more than the frictional unemployment rate. “Australia recorded a combination of low inflation and low unemployment in the 1960s.” – Budget paper No. 1 2004-2005. Whilst not necessarily endorsing the full analysis of the paper, I point to the facts it records about the 1960s. One disconforming piece of evidence is enough to refute an hypothesis. The era mentioned provides a string of disconfirming data if we want to use annual data points. The NAIRU and the Phillips curve as theories are easily refuted.

    http://www.budget.gov.au/2004-05/bp1/html/bst4-01.htm

    The fact that we run things differently now (from the 1960s) is matter of sectional public and social choices with undue weight and power being given to the wishes and choices of the rich, owning class.

    It is interesting and revealing that rising wages are considered inflationary but rising profits are not considered inflationary (by the ideological right). It is interesting that asset price inflation is ignored in the main now. It is also interesting and revealing that the basket of goods chosen and the hedonic regression methods employed are both used to rig the measured inflation rate. Were inflation measured more objectively and less politically I predict we would correctly determine that we now live in a high unemployment / high inflation era. This, if true, would amount to another piece of evidence that the NAIRU and Phillips curve hypothesis are refuted by the empirical facts.

  16. Mark A. Sadowski
    August 29th, 2013 at 08:46 | #16

    @Ikonoclast

    I’m arguing that the conduct of monetary policy was contractionary in the early to mid-1990s. I’m using the OECD’s estimate of NAIRU because its available, and precisely because it is so high, it’s actually a concession to John Quiggin’s argument that monetary policy was expansionary.

    But if you want to strengthen my argument, by showing the gap between the unemployment rate and the full employment unemployment rate is even greater than what I am suggesting, be my guest.

  17. JamesH
    August 29th, 2013 at 10:15 | #17

    Sinclair Davidson (I know, I know) has an interesting article up at The Conversation which has a link to a study showing the consumption effects on households of the stimulus handouts at the time of the GFC time were very small – about a 1% increase in consumption. Anyone else come across this? I had the impression that the stimulus was rather more effective than that.

  18. August 29th, 2013 at 10:36 | #18

    @Ernestine Gross

    I agree, that price changes in some segments of the market are faster than other segments of the market (e.g. financial market versus the goods market). While CPI does not measure all the change in prices (e.g. asset prices), the reason why I use the CPI is that it is not a bad measure of consumer goods price change.

    The point of my comment is counter points such as “If they were fully flexible, then they would of dropped wages instead of firing people. Falling wages wouldn’t of been problematic as prices were also falling and you have assumed away money illusion.”

    Even if nominal wages are flexible downwards (as in the case of Japan which is much more flexible relative to other countries in the OECD), the nominal prices of consumer goods takes a much longer time to adjust downwards due mainly to debt and the time lag between R&D, production and point of sales. If this is true, then downward flexible nominal wages changes does not lead to the same degree of change in downward nominal price change of consumer goods. This suggests that downward flexible nominal wage is not the answer to stabilising employment because aggregate demand would still be falling.

    My definition of inflation is an increase in nominal price of consumer goods and services and vice versa for deflation. I admit this is a very limited definition as it does not include asset prices, but I believe it is better to use another term such as asset price inflation to describe price change in assets.

  19. Ernestine Gross
    August 29th, 2013 at 11:44 | #19

    On ‘bounds’ (and market monetarism).

    1. A finite date economy(competitive and private ownership) without financial securities (no money of any kind) has a natural lower bound for a world with a finite life (ultimate resource constraint). This corresponds to the edges of an Edgworth-Box diagram (elementary) and Arrow Debreu (advanced)

    2. A finite date economy (competitive and private ownership) with a sequence of commodity and financial securities (at least private contracts) does not have a natural lower bound because negative quantities of security holdings are possible (short selling). An arbitrary lower bound (to get a solution to the model) results in a “pseudo-equilibrium” (excess supply is possible) Radner, 1973

    (A major result, which deals with removing the essentially arbitrary lower bound in an exchange economy – easier than one with production – is that by O. Hart mid-1970s. The crucial additional assumptions are: a) price expectations must not be too different (in a closed cone) and, b) each and every market participant must have strictly convex preferences. (1 proverbial A. Bond is too much).

    3. To the best of my knowledge the best brains in math econ have not produced as yet conditions under which a ‘price system’ includes negative values. Hence ‘market prices’ are non-negative.

    4. In a monetary economy, the interest rate on ‘the unit of account’ is zero. (Where the interest rate is defined as (1/1)-1) for each period (two dates). (This raises interesting questions about monetary policy, I would suggest, starting with what is money!)

    5. In a monetary economy, which we observe (ie one where there are legal traditions, too), the lower bound of the interest rate (cash rate in the case of Australia) is zero.

    6. In a monetary economy, which we observe, every pair of exchange rates relates to one date. The greatest lower bound for currency unit x in terms of currency unit y is zero.

    (One observes as the value of the proverbial pesos in terms of say the proverbial Swiss franc approaches zero asymptotically (while the value of the Swiss franc in terms of all other currency units is positive), someone gets the idea of introducing a new unit of account, say the austral to replace the said pesos, We call this a monetary reform. Similarly, when the US dollar was no longer convertible into gold, the remnant of the Bretton Wood system collapsed – another critical point) leading to a monetary reform.)

    Comment. The idea of a ‘real interest rate’ makes no sense to me because there are as many ‘real interest rates’ as there are commodity pairs defined for each period: p(x)[2] -p(x)[1]/p(x)[1] is the real one-period interest rate for commodity x., x = 1…., n commodities, and dates 1, 2, …..m (Bliss, 1975).

    Note: All of the authors I’ve mentioned here had published before the great leap forward to the 19th century, which, I understand, started in the late 1970s in the US.

    It seems to me many monetary authorities are doing much better than what could be achieved under ‘market monetarism’. They have, so to speak, ignored the mental bounds imposed by the reincarnation of 19th century thought, now labelled ‘market monetarism’.

  20. Ernestine Gross
    August 29th, 2013 at 13:35 | #20

    Tom, I understood what you said in your first post. I can assure you I am not alone. Indeed, if one takes out the inflexibility introduced by debt (and hence the risk of system instability due to mass bankruptcies – a huge simplification of the real world we now have ) one ends up examining the relative speed of the change in prices and wages (your point)and things don’t work the way the reincarnated 19th century models predict. This is why I referred to some authors who had analysed more complex but also more realistic dynamics back in the 1970s and 1980s.

  21. John Quiggin
    August 29th, 2013 at 16:07 | #21

    OK then, I’ll make some points on the data. First, the starting point for the cash rate was 17.5 per cent, as I said in my post, not 15.8 per cent. So, to restate, the cut was about 12 percentage points. If you can call this a contraction, I think you are in Humpty Dumpty territory.

    Also, the most relevant inflation variable is expected inflation, which was about 4 per cent as measured by the difference between nominal and inflation-adjusted bond rates, or 5 per cent, as measured by consumer surveys. Expectations adjusted more slowly than actual inflation rates, because most people expected a bigger resurgence of inflation than actually took place.

  22. Ikonoclast
    August 29th, 2013 at 17:08 | #22

    @Ernestine Gross

    You have severely criticised classical economics calling it “19th C economics” (sans Marx obviously) and severely criticised neo-classical economics and monetarists from the 1970s on. This shows me that I am much closer to your economic position than I thought. Phew, that’s a relief to me. I don’t like to be disagreeing with more edcuated people than me in their field of expertise. It gives me a horrible nagging feeling I am a crank after all. Apart from my possibly excessive leanings part way to MMT and apart from Marx on whose work we might have different views, I suspect we are economically simpatico for the most part in broad terms. I don’t understand your more technical arguments. My autodidact education is economics is very inadequate for that.

  23. Grim23
    August 29th, 2013 at 20:14 | #23

    @John Quiggin

    If the Wicksellian interest rate was lower than 5.5%, then yes that would be a contraction. Low interest rates can be a sign that monetary policy has been too tight.

    That’s why interest rates can be misleading. Better to look at nominal GDP. And by that measure I agree with you (sort of). Monetary policy can’t have been too tight, but it wasn’t “pushing on a string” either. Going by FRED data, NGDP growth was about 5% by 1993 and 6% by 1994.

    http://m.research.stlouisfed.org/fred/series.php?sid=AUSGDPNADSMEI&show=chart&range=max&units=pc1

    That’s a much slower NGDP trend line than pre 1990, so in that sense monetary policy was tight and the labour market would have taken some time to adjust to the new trend growth. But NGDP continued growing at about the same rate from then on until 2000, which is clearly what the RBA wanted, so gowing by that definition monetary policy was neutral.

  24. Mark A. Sadowski
    August 30th, 2013 at 04:11 | #24

    @John Quiggin

    “OK then, I’ll make some points on the data. First, the starting point for the cash rate was 17.5 per cent, as I said in my post, not 15.8 per cent. So, to restate, the cut was about 12 percentage points. If you can call this a contraction, I think you are in Humpty Dumpty territory.”

    The value of 15.8% represents a quarterly average of nominal short term interest rates. And, to be technical, the cash rate target was in a range from 17.0% to 17.5% from January 23, 1990 through February 14, 1990.

    To reiterate, nominal interest rates are a terrible measure of monetary policy stance, real interest rates are somewhat better. Furthermore even changes in real interest rates are a terrible measure of monetary policy stance. To be clear, it is the level of real interest rates that matters, not the change. And if the rate to which it is changed is still higher than the real neutral interest rate, then monetary policy is still contractionary in the sense that it is conducive to a reduction in real output.

    “Also, the most relevant inflation variable is expected inflation, which was about 4 per cent as measured by the difference between nominal and inflation-adjusted bond rates, or 5 per cent, as measured by consumer surveys. Expectations adjusted more slowly than actual inflation rates, because most people expected a bigger resurgence of inflation than actually took place.”

    This is may be a good point but it presents some problems. The main consumer survey of inflation expectations is the Westpac/Melbourne Institute survey, and it does not appear that I have access to such historical data. As for inflation adjusted bond rates, the RBA records seem to indicate that none were issued from 1988Q2 through 1992Q4. However we know that the indexed bond yield was 4.74% in 1988Q1 and 4.62% in 1993Q1. Since 10-year bond yields averaged 12.20% in 1988Q1 and 8.13% in 1993Q1 this means inflation expectations were 7.46% in 1988Q1 and 3.51% in 1993Q1.

    Note that real rates barely changed, so almost all of the reduction in 10-year bond rates reflected a change in inflation expectations. Thus it is possible to approximate inflation expectations from April 1988 through December 1992 by subtracting 4.68 (the average of 4.74 and 4.62) from the 10-year bond yield. This proxy has the additional advantage that FRED has Australian 10-year bond yields in monthly frequency.

    Ten year bond yields averaged 12.2% in January 1990 and 8.94% in December 1992. Thus this estimate of inflation expectations declines from 7.52% in January 1990 to 4.26% in December 1992. The real call rate target thus declined from 9.48%-9.98% in late January 1990 to 1.49% in December 1992 by this measure. However, assuming Australia’s long run real neutral rate is 2.2%, then the real call rate target did not fall low enough to be economically expansionary until January 1992 by which point unemployment had already risen to 10.1%. I’ll link to a graph of relevant data in a subsequent comment since it will be held for moderation.

    Inflation expectations calculated from indexed bond yields indicate that real call rates by this measure never dropped below 1.5% except in May through August 1994. Interestingly, it was in fact the summer of 1994 when unemployment first started to rapidly drop. But by 1994Q4 the real call rate target was again above the long run real neutral rate of 2.2%. So even by this measure monetary policy was only expansionary in 1992Q1 through 1994Q3, and only significantly expansionary in the summer of 1994.

    As a bonus, I’m including a revised Taylor Rule for 1988Q2 through 1992Q4. I’ve made the following changes; I’ve raised the real neutral rate to 2.2%; I replaced inflation with the aforementioned proxy for inflation expectations; I replaced the Okun’s Law coefficient with a more precise value of 1.81; I replaced the natural unemployment rate with a value of 7.73%, which happens to be the weighted average of the OECD’s NAIRU estimates for 1988Q2 through 1992Q4. I’ll include the link to the graph in the subsequent comment.

    The Taylor Rule residual rises from (-0.3) points in January 1990 to 4.5 points in December 1992. Almost all of the increase occurs between April 1990 and April 1991 when it rises from (-2.7) to 4.3 points. The Taylor Rule residual is positive from November 1990 on forward during this period. The only time the Taylor Rule prescribes a rate below 1.3% is in July 1992 when it falls to 0.5%.

    Extending the Taylor Rule calculations forward using indexed bond yields to estimate inflation expectations, and the OECD’s annual NAIRU estimates, reveals that the only month that the Taylor Rule residual drops below zero is August 1994. So this largely confirms what the real call rates already revealed.

  25. Mark A. Sadowski
  26. Ikonoclast
    August 30th, 2013 at 07:25 | #26

    Applying arbitrary monetary or fiscal rules while ignoring the real economy, real unemployment and real people is just about the most foolish and callous thing you can do in terms of economic management.

  27. John Quiggin
    August 30th, 2013 at 10:04 | #27

    @Mark A. Sadowski

    I think we are getting close enough to engage now. One final adjustment is that the neutral real rate of interest here is generally assumed to be 3 per cent. I agree that is high, but it’s consistent with an inflation target of 2.5 per cent and a cash rate centred on 5.5 per cent, which is what we had for the Great Moderation period, which was very much based on Taylor rules.

    Next, to avoid terminological disputes about what “expansionary” means, I’ll discuss where monetary policy stood relative to neutrality (expected inflation + 3 per cent) on my view, and relative to a Taylor rule prescription (I’ll use yours for the moment),

    To restate the original post in these terms, interest rates went from broadly neutral to well above neutral (about 7 percentage points above neutral on my measure) during 1989 and were held there until January 1990. This produced a massive credit squeeze and widespread bankruptcies, ensuring that unemployment would rise, as it did. Interest rates were then cut drastically, but since inflation and inflation expectations were also falling, they were above the neutral level until early 1992. Rates were below the neutral level thereafter until the tightening in 1994 (more on this in a later post).

    If I can restate your point, even though rates were below neutral by the end of 1992, they were well above the level prescribed by a Taylor rule, because unemployment was so high. I agree with this as a factual statement, but not with the implications you draw.

    Our disagreement, as I understand it, is as follows. I don’t think cutting another 5 percentage points would have made much difference. Rather, I infer that monetary policy is more effective in contraction than in expansion, so that raising interest rates and then lowering them to below the previous level produces a net contraction

  28. Ernestine Gross
    August 30th, 2013 at 10:59 | #28

    @Mark A. Sadowski

    I understand a lot of empirical work in economics examines the workings of ‘an economy’ in bits and pieces. I understand you are interested in whether or not the monetary policy was expansionary in Australia during a period of time. Fine. However, I suggest the empirical method must at least be logically consistent with whatever we know about the rest of ‘the economy’, both theoretically and empirically. One thing not only economists know but everybody is that people make decisions in calendar time.

    Monetary policy, in whichever form, can have an effect on ‘an economy’ if and only if at least one agent (person) in the economy in question is making a decision based on the information contained in a policy measure. The timing of the impact is directly related to the time of the policy event, the time of receiving the information and the time it takes to make a decision.

    We know empirically that traders in financial markets (money market, bond markets, share markets, some bank transactions) act very fast. Their trading time horizon ranges from seconds to a day or two.

    ‘Everybody’ in economic theory, knows that there are conditions under which continuous trading during a calendar time interval can achieve an end of period value. (This may not hold for all financial markets nor all of the time, but the result gives comfort to those who use end-of period data.)

    This is where I see a major problem with your approach. You use quarterly averages of short term interest rates.

    I do not know of any theoretical result which establishes conditions under which any trader or any other agent (not allowing insider trading) could make any decision during a period, based on the ex-post quarterly averages.

    I do not know any real life person who makes decisions on the basis of data you use.

    Your argument about real interest rates makes no sense to me either, except under either one of the two following conditions, both of which are empirically not true in Australia during the relevant time interval:

    a) There is a gold standard and the one period real rate of interest is p(gold)[2]-p(gold)[1]/p(gold)[1], where p(gold) denotes the price of 1 unit of gold (specified in detail) in terms of the currency unit p.
    b) There is only one good in ‘the economy’, for which there is a monetary price.

    (See Bliss, Capital Theory and the Distribution of Income, North Holland/American Elsevier,1975, regarding the number of real interest rates in general).

  29. Melbourne Dan
    August 30th, 2013 at 14:56 | #29

    Just a few points to clarify my understanding

    I wish to leave Fiscal Policy aside for the moment but just note my concern that 8 days away from an election it is very unclear whether Abbott has taken aboard the lessons of austerity failure in Europe.

    Moving onto Monetary Policy and the issue of ZLB:

    1. What I personally have learnt most whilst reading blogs since the GFC began was that Expectations played a key role in monetary policy. However earlier this week you described MP at the ZLB “like pushing on a string”. I went back and read the Woodford paper linked to earlier (via Krugman), my laymen understanding was expectations was very important:

    “an expectation of an unchanged nominal interest rate for several quarters, that will be largely insensitive to the precise evolution of aggregate conditions over that time, creates a situation in which expectations of aggregate conditions after the interval over which the nominal rate is expected to be fixed have a particularly large effect on the current economy.” – Michael Woodford
    http://www.columbia.edu/~mw2230/JHole2012final.pdf

    Also in May when Bernanke changed his signalling regarding QE, interest rates rose quite a bit (~1%), I interpreted this movement as him having an effect at the ZLB. Am I reading too much into this?

    2. I am having trouble grasping why you “don’t think cutting another 5 percentage points would have made much difference”. Living through that time my main concern was trying to be like Andrew Gaze, but also I remember my dad being a builder of spec houses unable to cope with 18% interest rates on borrowings and no one buying his houses. Using this as an example, any relief through lower interest rates would have been welcome, payments to the bank would have been lower, but more people would have been able to purchase housing..etc..etc…Victoria would have been better off.
    “if only rates had been cut even more, we wouldn’t have had the recession, or would have recovered quickly. Having been around at the time, I disagree.” Your first sentence describes what is going on in my head. Using my example above of housing, why in the 1990 recession would this mechanism not work? Or a diff example? (I only ever did first year econ, so maybe I am missing something!) BTW my hopes and dreams for life from this period were broken…..I never came close to being as good as Gaze. :)

    3. You mentioned last year that using Nominal GDP targeting would be useful. With mining investment dropping sharply and interest rates at very low levels would it not be useful to implement such a tool before we may reach the ZLB? US waited 4 years after GFC (and millions unemployed) and Japan almost two decades before using atypical policies. I have only ever come across NGDPLT at Institutional Economics blog and a Senate hearing where NGDP targeting is brushed off by the RBA governor. Why is this not discussed? Is this just the pace of change in government? Or for a change like this must we wait for things to get really bad?

    Thanks. Long time lurker.

  30. Clint
    August 30th, 2013 at 20:21 | #30

    Wow, this thread is fun. It reminds me of a western in which the locals pick on a stranger to town sitting in the corner sipping his rye.
    They pick a fight only to find themselves disarmed by a man with a lightening draw.
    Stupid image? Yeh, but when Quiggins, nursing a bruised ego quips, “I think we are getting close enough to engage now,” he’s bang on the money and about to be gunned down.
    Can’t wait for the next installment of “A Fist Full of Dollars”
    “You hicks, don’t mess with Market Monetarists. Got it?”

  31. John Quiggin
    August 31st, 2013 at 05:10 | #31

    @Clint I had in mind something more like Last Man Standing. I’m just waiting for the MMT gang to show up.

    AFAICT, MMT is the idea that the economy is always in a liquidity trap (hence unlimited scope for fiscal policy) while MM is the idea that the Great Moderation is forever (hence, omnipotence of monetary policy). Right now, MMT is closer to the truth.

  32. Grim23
    August 31st, 2013 at 07:34 | #32

    @John Quiggin

    Really don’t see how MMT is closer to the truth if it is the idea that the economy is permanently stuck in the liquidity trap.
    Inflation in the UK has been above the BoE’s target rate for most of the time since the GFC, despite “austerity”.
    US nominal GDP has been growing despite the sequester.
    Even Japan has generated higher inflation expectations and devalued the yen.
    ALL of these countries could use more aggressive monetary stimulus and monetary policy is far from adequate in any of them. But NONE of these countries supports the MMT or Keynesian view of the liquidity trap.

  33. Mark A. Sadowski
    August 31st, 2013 at 09:40 | #33

    @John Quiggin

    “One final adjustment is that the neutral real rate of interest here is generally assumed to be 3 per cent. I agree that is high, but it’s consistent with an inflation target of 2.5 per cent and a cash rate centred on 5.5 per cent, which is what we had for the Great Moderation period, which was very much based on Taylor rules.”

    Actually this all sounds perfectly reasonable to me as it matches what I have been reading. (Incidentally the real call rate has averaged 3.2% since 1990Q3.) I largely agree with your policy analysis but I have incorporated these changes into my Taylor Rule and in light of these values let me add the following.

    Assuming Australia’s long run real neutral rate is 3.0%, and using 10-year bond yields to estimate inflation expectations, then by this measure the real call rate target did not fall low enough to be expansionary until December 1991, by which point unemployment had already risen to 9.9%. Inflation expectations calculated from indexed bond yields indicate that real call rates remained below 3.0% through March 1995. The sustained period of below 1.4% (not 1.5% as I said previously) real call rate target interest rates actually lasted from May through September 1994.

    The revised Taylor Rule residual rises from (-0.9) points in January 1990 to 3.9 points in December 1992. Almost all of the increase occurs between April 1990 and April 1991 when it rises from (-3.3) to 3.9 points. The Taylor Rule residual is positive from January 1991 on forward during this period. The only time the Taylor Rule prescribes a rate below 1.9% is in July 1992 when it falls to 1.1%.

    Extending the Taylor Rule calculations forward using indexed bond yields to estimate inflation expectations, and the OECD’s annual NAIRU estimates, reveals that the revised Taylor Rule residual drops below zero from 1994Q2 through 1995Q3 with the exception of 1995Q1. One might very well wonder why by Taylor Rule standards policy was loose in 1995Q2/1995Q3 but contractionary by the standards of real call rates. Inflation expectations were 4.3% and 4.2% in 1995Q2 and 1995Q3 respectively which is well above the target inflation rate of 2.5%.

    I’ll include a link to the revised Taylor Rule graph in a subsequent comment as that is the only thing that has changed.

    “Our disagreement, as I understand it, is as follows. I don’t think cutting another 5 percentage points would have made much difference. Rather, I infer that monetary policy is more effective in contraction than in expansion, so that raising interest rates and then lowering them to below the previous level produces a net contraction.”

    Yes, I believe this is all that remains of our disagreement. But if your intent was to provide an example of monetary policy being more effective in contraction than expansion, then surely the 1990 Australia recession is still not a very good example. The real call rate target was 7.0 to 7.5 points higher than the real neutral rate in January 1990 by this standard, and the lowest it fell in the early to mid 1990s, on a monthly basis, was 2.4 points below the real neutral interest rate in September 1994. Thus there is a tremendous amount of asymmetry in terms of monetary policy stance during this episode.

  34. Mark A. Sadowski
    August 31st, 2013 at 09:42 | #34
  35. Nathan
    August 31st, 2013 at 10:13 | #35

    @Grim23
    Your claims, some of them factually incorrect, were responded to earlier. Do you plan to simply keep repeating yourself?

  36. Zac
    August 31st, 2013 at 10:23 | #36

    Sumner weighs in

    http://feedproxy.google.com/~r/Themoneyillusion/~3/uMglefCbKwA/

    I thinking in terms on interest rates is confusing. Because nobody ever knows what the natural rate is. But the fact remains that rates weren’t at zero, and even if they were there are plenty of other avenues for increasing the money supply via QE or better through the exchange rate.

  37. Mark A. Sadowski
    August 31st, 2013 at 10:38 | #37

    @Ernestine Gross

    “This is where I see a major problem with your approach. You use quarterly averages of short term interest rates.

    I do not know of any theoretical result which establishes conditions under which any trader or any other agent (not allowing insider trading) could make any decision during a period, based on the ex-post quarterly averages.

    I do not know any real life person who makes decisions on the basis of data you use.”

    One must use the data that is available.

    I was trying to move the discussion away from nominal interest rates, which are a terrible measure of monetary policy stance, towards real interest rates, which, although flawed, are a considerable improvement. FRED, which is convenient for sharing data, graphs and equations for discussion, for some reason does not have Australian CPI in monthly frequency.

    When John Quiggin correctly pointed out that Australian CPI from this period is flawed for this purpose, I shifted to using HCEPI, which again FRED only has in quarterly frequency. (In fact I believe it may only be produced in quarterly frequency, unlike the equivalent U.S. measure PCEPI.) However, when John Quiggin pointed out that inflation expectations would be a better measure for this period, I discovered that there is no indexed bond data available for the period in question. But since virtually the entire decline in 10-year bond yields during 1988Q1 to 1993Q1 consisted of a decline in inflation expectations, this permitted me to come up with a proxy for inflation expectations for April 1988 through December 1992 based on 10-year bond yields, which FRED does have in monthly frequency.

    Thus, if you check the links that I have provided, the most recent data is all in a monthly frequency.

    “Your argument about real interest rates makes no sense to me either, except under either one of the two following conditions, both of which are empirically not true in Australia during the relevant time interval:

    a) There is a gold standard and the one period real rate of interest is p(gold)[2]-p(gold)[1]/p(gold)[1], where p(gold) denotes the price of 1 unit of gold (specified in detail) in terms of the currency unit p.
    b) There is only one good in ‘the economy’, for which there is a monetary price.

    (See Bliss, Capital Theory and the Distribution of Income, North Holland/American Elsevier,1975, regarding the number of real interest rates in general).”

    I have not read “Capital Theory and the Distribution of Income.” Nor do I have a copy.

    But if I understand Christopher Bliss’ views correctly, simple models of the real rate of interest seem to be inadequate, although they may throw light on important issues, and it may be that simple models, although they may not satisfy a theoretical purist, deliver more effective insight than more complicated models can ever do. True, to be really insightful a model should be disaggregated, but no model can be as disaggregated as realism would dictate.

    Or, to put it more plainly, all models are wrong, some are useful.

  38. Mark A. Sadowski
    August 31st, 2013 at 11:29 | #38

    @John Quiggin

    “The real call rate target was 7.0 to 7.5 points higher than the real neutral rate in January 1990 by this standard, and the lowest it fell in the early to mid 1990s, on a monthly basis, was 2.4 points below the real neutral interest rate in September 1994.”

    should read

    “The real call rate target was 6.5 to 7.0 points higher than the real neutral rate in January 1990 by this standard, and the lowest it fell in the early to mid 1990s, on a monthly basis, was 2.4 points below the real neutral interest rate in September 1994.”

  39. John Quiggin
    August 31st, 2013 at 11:57 | #39

    @Mark I agree that there’s a lot of asymmetry here. The monetary squeeze was ferocious, and the relaxation was reluctant and incomplete.

    In part, I’m still reacting against the policymakers of the time, who thought that if they simply shifted back to neutral, the economy would bounce back rapidly.

    Obviously, we can’t tell what would have happened if they had cut rates further, as they should have. Do you have any good examples of successful escape from recession relying solely on monetary policy?

  40. Zac
    August 31st, 2013 at 12:09 | #40

    @John Quiggin

    Australia over the past 18 months? Lots of consolidation/falls in public demand, coupled with big wobbles in the US/Europe financially plus a double dip in UK & Euro – but still good growth in Australia probably due to 200 basis points reduction in the cash rate?

  41. Grim23
    August 31st, 2013 at 17:58 | #41
  42. Ernestine Gross
    August 31st, 2013 at 19:50 | #42

    @Mark A. Sadowski

    I assume you replied because you are interested in fair and honest discourse in the spirit of this blog-site. I am responding in this spirit.

    I cannot agree that: “One must use the data that is available”. I would say one first has to ask whether the data available is suitable for the question one wants to answer and if the answer is No, then the available data is plainly useless. Ignoring methodological problems in quantitative research results in false objectivity. [FN1]

    I did understand you wanted to shift the focus to ‘real interest rates’, which, as JQ noted and you accepted, involves price expectations. That is, the relevant underlying theoretical concept is the Fisher equation.

    Irving Fisher is now said to be a founder of Monetarism. I don’t know what I. Fisher had intended. I would say Irving Fisher did thorough and path breaking work before WWII, for which he still deserves great respect in a historical context. However, since then great advances have been made in both Walrasian and non-Walrasian general equilibrium theory, introducing increasingly more realistic characterisations of ‘the market’. So my critique is not of I. Fisher but of the great leap forward (back) to the 19th century (including the pre Great Depression time), of the so-called ‘Market Monetarism’, in which you seem to be participating.

    I have looked at your updated graphs. They tell me it is yet another example the possibility to construct just about any graph one wants by suitable data transformations, including averaging, unconstrained by known theoretical and empirical conditions. There is only one graph which corresponds to empirical data points in chronological time, namely that of nominal interest rates.

    The ‘theoretical purist argument’ is not appropriate here because, while it is the case that theoretical variables are often approximated (eg indices with the known difficulties), it does not follow that therefore theoretical variables can be chosen when one wants to (eg Fisher equation) but ignored if one wants to (namely the condition about the institutional environment of ‘the economy’, which matches the Fisher equation, (the gold standard, for obviously the number of goods and services is much greater than 1).

    I wouldn’t describe the content of Bliss’ book as containing his “views” (FN2). Since you haven’t got access to the book, you can’t tell. Fair enough. But Milton Friedman’s view (‘dictum’?) on models, which you present, isn’t going to change anything.

    Having said all this, I respect your honesty regarding choice of data. I hope you take my comments as an attempt to contribute a little bit by trying to reach out across barriers of specialisations.

    FN1: The plethora of papers that claimed to have tested the semi-strong form EMH in the 1970s and 1980s are useless because they didn’t test the hypothesis they claimed to have tested. At best they tested whether on average for a particular time, at a particlar place, a hypothetical average trader could make a profit above the ‘market’. Of course this does not test whether ‘the market’ is efficient in any sense (because there was no test whether ‘the market’ reflects the information at all)), nor does it test whether there is an actual person that corresponds to the hypothetical average. Incidentally, my students with a science backgroud picked this crucial flaw without me having to point it out.)

    FN2. A view is what you get when looking out the window; 2 people looking out 2 windows, which point in different directions, get different views. But this doesn’t change the landscape.

  43. Mark A. Sadowski
    September 1st, 2013 at 07:27 | #43

    “Over the same period, unemployment rose from 6 per cent to nearly 11 per cent, a record for the period since the Depression, and stayed around that level well into 1994, until the adoption of the Working Nation package of fiscal stimuuls .”

    This is new content. It’s none of my business but in the interests of fairness blog owners usually label new content as “updates”.

    I’m deeply skeptical that the Working Nation package made much of a difference in terms of aggregate demand stimulus for two reasons:

    1) It’s my understanding that the original committment under Working Nation was for $6.5 billion to be spent over four years. This was at a time when Australian nominal GDP ranged from $480 to $600 billion a year. Thus it comes to about 0.24% of GDP per year on average.
    2) The IMF’s estimates of Australia’s cyclically adjusted general government budget balance (i.e. corrected for the business cycle) shows it decreasing in calendar years 1991, 1992 and 1993 and increasing in 1994, 1995, 1996 and 1997. In other words the period of fiscal stimulus by this measure precedes the implementation of Working Nation, and the period of fiscal consolidation largely overlaps its implementation.

    http://www.imf.org/external/pubs/ft/weo/2013/01/weodata/weorept.aspx?sy=1989&ey=1998&scsm=1&ssd=1&sort=country&ds=.&br=1&c=193&s=NGDP%2CGGSB_NPGDP&grp=0&a=&pr.x=54&pr.y=15

    None of this should be construed as questioning the value or effectiveness of Working Nation. I’m merely pointing out the fact that fiscal policy stance was contractionary during the time that the unemployment rate dropped.

  44. Mark A. Sadowski
    September 1st, 2013 at 09:36 | #44

    @John Quiggin

    “Obviously, we can’t tell what would have happened if they had cut rates further, as they should have. Do you have any good examples of successful escape from recession relying solely on monetary policy.”

    You want me to come up with a counterexample? Then it might be subject to the same critique as your example and I would not have the recognition of posting it on a blog (I don’t have one). One of the pleasures of commenting on blogs is the luxury of criticizing without putting forth one’s own claims or examples.

    However, this presents an interesting challenge. I’m used to thinking about examples of monetary policy effectiveness in liquidity trap type situations and the problem here as I understand it is to come up with an example of relatively swift recovery from a serious recession away from the zero lower bound without the aid of fiscal policy. I also think this would be more convincing if we restricted our attention to relatively large closed currency areas. One might think this is easy but the problem is that since the 1970s central banks have generally followed a policy of disinflation and this has led to a pattern of jobless or “jobloss” recoveries.

    The US is the logical place to start since there is an abundance of easily shared data and it satisfies the requirement of being relatively large and closed to trade. The CBO has estimates of cyclically adjusted Federal government budget balances (termed “without automatic stabilizers” since 2011) going back to fiscal year 1960:

    http://www.cbo.gov/sites/default/files/cbofiles/attachments/43977_AutomaticStablilizers3-2013.pdf

    An inspection of the data reveals the only decade without a great deal of fiscal policy volatility is the 1970s. The cyclically adjusted Federal government budget balance stayed within the relatively narrow range of (-2.7%) to (-1.3%) from fiscal years 1971 through 1982. The US had one relatively serious recession with a complete and relatively swift recovery during that time span: the 1974-75 recession. Unemployment peaked at 9.0% in May 1975 which was 2.8 points above the natural rate of unemployment (NROU). It fell to 5.6% by May 1979 which was 0.7 points below NROU:

    http://research.stlouisfed.org/fred2/graph/?graph_id=135089&category_id=0

    US Federal government fiscal years ran from July 1 through June 30 until 1976 when they shifted to October 1 through September 30 (there was a transitional quarter in 1976). The cyclically adjusted Federal budget balance was (-2.1%), (2.7%), (1.9%), (2.6%) and (1.9%) of potential GDP in fiscal years 1975 through 1979 respectively. So fiscal policy was mildly expansionary in fiscal years 1976 and 1978, and was mildly contractionary in fiscal years 1977 and 1979. And the cyclically adjusted budget balance was actually incrementally higher at the conclusion of this recovery than at the beginning.

    The real federal funds rate (adjusted by the core PCEPI inflation rate) rose from a low of (-4.4%) in March 1975 to a high of 8.7% in April 1980. It remained below 2% through October 1978 and rose above 3% by December 1978. The real neutral interest rate was probably more than 2% in those days so monetary policy was expansionary until just a few months before the unemployment rate reached its trough:

    http://research.stlouisfed.org/fred2/graph/?graph_id=135086&category_id=0

    The 1970s were subject to energy price shocks so a legitimate question is what roles these might have played during the period. One way of check for this is to look at the Robert Gordon “food-energy effect” which is simply the difference between the year on year change in headline PCEPI and core PCEPI:

    http://research.stlouisfed.org/fred2/graph/?graph_id=135106&category_id=0

    The food-energy effect suggests that the US economy was subject to a severe negative aggregate supply shock (AS) in 1973-74. This was followed by a mild positive shock in 1975-76 which in turn was followed by a mild negative shock in 1977-78. A second severe AS shock started in 1979. But on the whole AS shocks played a relatively minor role during the recovery and relative food and energy prices actually ended up higher in May 1979 than they were in May 1975.

  45. Mark A. Sadowski
    September 1st, 2013 at 11:31 | #45

    @Ernestine Gross

    “I assume you replied because you are interested in fair and honest discourse in the spirit of this blog-site. I am responding in this spirit.”

    I generally try to respond to comments addressed to me.

    “I cannot agree that: “One must use the data that is available”. I would say one first has to ask whether the data available is suitable for the question one wants to answer and if the answer is No, then the available data is plainly useless. Ignoring methodological problems in quantitative research results in false objectivity.”

    Since the data resulted in an update to this blog post, I think that it has already proven its usefulness. Since this is merely a conversation taking place within a blog, evidently no research is involved.

    “Irving Fisher is now said to be a founder of Monetarism.”

    He’s also claimed by the Post Keynesians for his work on the Debt-Deflation theory of depressions, and he made the point that there are different own-rates of interest long (1896) before Piero Sraffa ever did.

    “So my critique is not of I. Fisher but of the great leap forward (back) to the 19th century (including the pre Great Depression time), of the so-called ‘Market Monetarism’, in which you seem to be participating.”

    I don’t call myself a Market Monetarist. I dislike the label and generally don’t find such labels to be useful. However the principle characteristic which all Market Monetarists share is the belief that central banks should target nominal incomes, and I enthusiastically endorse this idea. I have been extensively quoted on Market Monetarist blogs and have written a few guest posts on an MM blog on related topics.

    To my knowledge the earliest that anyone suggested nominal income targeting was James Meade in 1978. I fail to see anything about nominal income targeting that could be construed as a step “backwards” to the 19th century. It also seems to me that nominal income targeting, if successful, by definition would lead to an end to economic depressions, so I find the idea it could cause a depression to be an absurdity

    “There is only one graph which corresponds to empirical data points in chronological time, namely that of nominal interest rates.”

    Empirical evidence consists of more than data which can be directly observed without mathematical transformation, and even monthly averages of nominal interest rates are the product of mathematical transformations.

    “The ‘theoretical purist argument’ is not appropriate here because, while it is the case that theoretical variables are often approximated (eg indices with the known difficulties), it does not follow that therefore theoretical variables can be chosen when one wants to (eg Fisher equation) but ignored if one wants to (namely the condition about the institutional environment of ‘the economy’, which matches the Fisher equation, (the gold standard, for obviously the number of goods and services is much greater than 1).”

    There are many ways of judging monetary policy stance. John Quiggin chose to judge monetary policy stance via a single interest rate. I merely suggested that if one is going to judge monetary policy stance by a single interest rate, that a real interest rate is preferable to a nominal one, which he has seemingly acknowledged. I submit that your beef concerning the choice of judging monetary policy stance via a single interest rate is really with him and not with me.

    “I wouldn’t describe the content of Bliss’ book as containing his “views”.”

    Then I take it that Bliss discusses things in the book which he does not necessarily agree with.

    “But Milton Friedman’s view (‘dictum’?) on models, which you present, isn’t going to change anything.”

    I paraphrased a rather famous quote attributable to George E. P. Box. It may be found in “Empirical Model-Building and Response Surfaces”, a book he coauthored with Norman R. Draper in 1987. To my knowledge, Milton Friedman never said anything remotely similar.

    “I hope you take my comments as an attempt to contribute a little bit by trying to reach out across barriers of specialisations.”

    I don’t know what your specializations are. For whatever it may be worth I have degrees in mathematics and economics.

    “The plethora of papers that claimed to have tested the semi-strong form EMH in the 1970s and 1980s are useless because they didn’t test the hypothesis they claimed to have tested. At best they tested whether on average for a particular time, at a particlar place, a hypothetical average trader could make a profit above the ‘market’. Of course this does not test whether ‘the market’ is efficient in any sense (because there was no test whether ‘the market’ reflects the information at all)), nor does it test whether there is an actual person that corresponds to the hypothetical average. Incidentally, my students with a science backgroud picked this crucial flaw without me having to point it out.)”

    EMH is misnamed. It’s not really a hypothesis, it’s not about “efficiency” in the economic sense of the word, and it’s not unique so it shouldn’t have a “the” in front of it. Some of this is just semantic clumsiness on the part of the people who came up with the theory, and some of it is just sloppy science.

    The “efficient” part of “EMH” doesn’t mean that financial markets lead to a Pareto-efficient outcome. There could be externalities and the market could still be “efficient” in the way that financial economists use the term. Similarly, a vastly “inefficient” financial market might be Pareto efficient. The “efficient” actually just refers to information processing efficiency.

    More importantly, it’s not really a hypothesis. How prices reflect information will always depend on people’s preferences. In finance, preferences include preferences about risk. So without a measure of risk, it’s impossible to scientifically test whether or not prices incorporate information. To be a real hypothesis, the EMH needs to be paired with a specification of risk. And since there are many possible such specifications, there isn’t just “one” EMH. (And to further complicate things, EMH says nothing about how long it takes for a market to process information.)

    So I like to call EMH the Random Markets Idea, or RMI. The simplest form of the RMI was stated by Paul Samuelson in 1965: “Properly anticipated prices fluctuate randomly.”

    That’s all it really means.

  46. Mark A. Sadowski
    September 1st, 2013 at 13:38 | #46

    @John Quiggin

    “The cyclically adjusted Federal budget balance was (-2.1%), (2.7%), (1.9%), (2.6%) and (1.9%) of potential GDP in fiscal years 1975 through 1979 respectively.”

    should read

    “The cyclically adjusted Federal budget balance was (-2.1%), (-2.7%), (-1.9%), (-2.6%) and (-1.9%) of potential GDP in fiscal years 1975 through 1979 respectively.”

  47. John Quiggin
    September 1st, 2013 at 14:11 | #47

    @Mark A. Sadowski
    The update was primarily correcting timing errors that had been pointed out in earlier comments. I didn’t think it needed noting. I agree that Working Nation is better described as a labour market program than a fiscal stimulus and have adjusted accordingly.

    Nevertheless, my recollection of the discretionary changes in fiscal policy is significantly different from the IMF estimates of the structural deficits, which are supposed to measure discretionary policy changes rather than autonomous effects arising from the macroeconomy. In particular, while there was some discretionary stimulus in 1991, it wasn’t nearly as much as is suggested here. Conversely, the consolidation didn’t really start until the 1995-96 budget. It was greatly accelerated after the 1996 change of government – in this respect my memory is consistent with the IMF estimates.

    I see that Scott Sumner has weighed in, and I will try to respond to him when I get some free time.

  48. Clint
    September 2nd, 2013 at 19:51 | #48

    @John Quiggin
    JQ, see that jail door? It’s open. It never was locked. Just walk through. You’re a free man. Use your freedom wisely.

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