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. Jordan
    August 26th, 2013 at 19:34 | #1

    It would be easier to think of monetary policy as forcing bankrupcies on debtors.

    Rising interest rates increase bankrupcy rates by raising costs of debt above profit rates.
    Decreasing interest rates provide no help for debtors that can not get refinancing on cheaper terms that others with good standing credit rating can.
    No matter that interest rates went down so much in 1990′ since companies were bankrupt and could not get refinancing of debilitating debts which created unemployment. You could argue that monetary easing came too late for already overdebted businesses.

    In any case, monetary policy trough bankrupcy of private sector by deminishing their profits can only prevent overconfidence but not return it.

    That is the reason that monetary policy can only destroy, not improve. And if taken that “independence” of a Central Banks means that CB is supposed to counter Congress’ fiscal policy by bankrupting stimulated companies.

  2. Jim Rose
    August 26th, 2013 at 21:11 | #2

    NZ and australia had rapid recoveries from their great depressions. Both had fiscal consolidations and monetary expansions.

  3. Jordan
    August 26th, 2013 at 22:05 | #3

    There is another way to think of inefectivness of monetary policy, by John Kenneth Galbriath’s book, The Good Society: The Humane Agenda:

    “The serious flaw in monetary policy is that it may have little or no effect on the flow of aggregate demand. As noted, the lowered interest rates are assumed to work against depressive conditions by encouraging consumer borrowing and expenditure and business investment. The latter responds to the lower cost of borrowing and therewith the improved possibility for profit. But when times are poor and unemployment is high, lower interest rates do not reliably inspire consumer expenditure; depressive attitudes, including those which are the product of unemployment or uncertain employment, are in control. And at such times, excess business capacity being evident, business firms, old and new, may not be encouraged by low interest rates to borrow and invest and so contribute to the income flow; the larger prospect is too uncertain. There is also the adverse effect of low rates on those whose income comes from interest — a reduction in their contribution to aggregate demand. None of this, however, discourages faith in monetary action as a decisive economic instrument. Quasi-religious conviction here triumphs over conflicting experience.”

  4. TravisV
    August 26th, 2013 at 22:25 | #4

    How do you define easy vs. tight monetary policy?

    Imagine that increased government spending increases aggregate demand and inflation. And the central bank allows inflation to increase to, say, 6%.

    Is that an example of monetary policy staying constant? Heck no, that was a hugely aggressive easing!

  5. rog
    August 26th, 2013 at 22:36 | #5

    It might be better to look at both monetary and fiscal policy; if they act against each other they could cancel each other out. The UK is one example, where austerity policy weakens the effects of QE. Japan is another, with tax hikes during the Asian crisis eating into dwindling revenue.

  6. Danyzn
    August 26th, 2013 at 22:42 | #6

    17.5% to 5.25% over 2 years. Since 1) 5.25>0 and 2) 2>0, monetary policy wasn’t as easy as it could have been even assuming that it becomes totally ineffective at the zero lower bound.

  7. August 26th, 2013 at 22:56 | #7

    What model do you use to justify the pushing on a string theory? Most macroeconomists reject the hypothesis (Mishkin etc)…

  8. Ernestine Gross
    August 27th, 2013 at 00:08 | #8

    Zac, no knowledge of “string theory” is required. (String theory is a math theory.)

    JQ’s ‘ pushing the string’ argument relies on the assumption that monetary policy (cash rate, QE) works via the financial sector and not via the budget sets of individuals and non-financial businesses. This assumption corresponds to observables (is a fact). Therefore effective demand is not influenced for a long time. (Effective demand shows up under ‘revenue’ in the accounts of businesses and it shows up as ‘expense’ in the accounts of customers.)

    May I suggest you read up on where the QE money went and how it was ‘invested’ by those who had access to the QE money of the Fed and then ask the question, why did it take so long for anything to happen in the US in response to QE and then ask, why did security market (share market to be precise) prices increase (could it be financial asset price inflation – another bubble in the making?)

    Simpler still, did you get any QE money in your letter box?

    You guys should read J.M. Keynes rather than being second hand dealers in ideas.

  9. August 27th, 2013 at 02:13 | #9

    This could be a good way to think about monetary expansion. If you think of fiat currency instead as flash drives holding information and productive work as creating information, then up to a point building flash drives increases data output (because there is a place to store data that would be produced –i.e. potential AD), but eventually the benefit goes away (“pushing on a string”) and you start building flash drives that sit in a vault somewhere.

    http://informationtransfereconomics.blogspot.com/2013/08/visualizing-diminishing-marginal.html

  10. rog
    August 27th, 2013 at 05:23 | #10

    @Ernestine Gross In retrospect the Ken Henry advice to “go early, go hard and go households” was right on the money.

    I was in the US a bit later and people were (pleasantly) amazed and astounded at the Australian stimulus package.

  11. Ikonoclast
    August 27th, 2013 at 06:18 | #11

    @Zac

    I think Prof. J.Q. is not relying on a model (theory) to justify the “pushing on a string” critique. He is relying on empirical evidence.

    Do you remember the very amusing Seinfeld epsiode characterised by this didactic statement? “First you TAKE the reservation then you KEEP the reservation.”

    In the same spirit I would say; “First you take the evidence THEN you make the theory.”

  12. Greg vP
    August 27th, 2013 at 07:27 | #12

    Thanks for putting a shoulder to the Sisyphean rock, JQ.

  13. Ikonoclast
    August 27th, 2013 at 07:49 | #13

    @Jim Rose

    That’s an interesting claim and one I was tempted to ridicule, However, on checking the facts (at least according to Wikipedia) it appears that Australia and the Premiers did respond to the Great Depression by fiscal consolidation (austerity) and monetary expansion.

    Whether Australia’s recovery from the Great Depression was “rapid” is open to debate. It still took a long time to recover but recovered faster than the US whose depression was much deeper and longer.

    This begs the question of what other factors, other than fiscal and monetary policy might affect depression recovery? Obviously, how deep it is in the first place is one of the issues. I would be particularly interested in the opinions of John Quiggin and Ernestine Gross on this matter. It also indicates to me that I should employ a bit more caution about being a total Keynesian or worse still, as the more orthodox might see it, an MMT pro-deficit warrior.

    There you go! A red letter day! Not often do I back down even a bit. :)

  14. Ernestine Gross
    August 27th, 2013 at 08:18 | #14

    @rog .IMHO Ken Henry’s advice for Australia was right at the time, not only with the benefit of hindsight, and so was the Government in acting on the advice on time.

    It was right for Australia because a) the banking sector was in relatively good shape b) the government debt was relatively low, c) household debt in 2008 was relatively high. By contrast, in Germany conditions a) and b) were similar but household debt was relatively low. In Germany, which also survived the GFS reasonaby well, the government reacted with public works programs – many small scale but spread geographically. There are many other differences but above may suffice to illustrate the importance of ‘initial conditions’.

    Economics isn’t all mystry if one ignores the macro-economic ‘schools of thought’. (I feel save to say this on this blog-site because JQ is not a schools of thought economist by his own statement.)

  15. Ernestine Gross
    August 27th, 2013 at 08:22 | #15

    GFS should read GFC
    “but above” should read “but the above”
    “mystry” should read “mystery”

  16. August 27th, 2013 at 08:39 | #16

    But John isn’t relying on evidence. He is relying on one data point (the 1990s recession) with no counterfactual!

    A proper atheortical evaluation of the evidence would look at multiple countries over multiple time periods. For example there is strong evidence that easing monetary policy (going off the gold standard) ended the great depression. Not too mention current evidence from Japan and the US on the effectiveness of monetary policy – even at the zero lower bound.

    If Australia hadn’t lowered interest rates in the early 1990s then the recession would of been even worse – that’s why you need a counterfactual. And in macro with its highly limited data its why you probably need a model too.

    Models, even obviously wrong models, are good for clarifying your thinking. Why does fiscal policy work when monetary doesn’t for example? There are a lot of unstated assumptions in that sentence.

    As for the mechanisms of monetary policy there are far more then just the financial system – house prices, wealth effects, the exchange rate, expectations of future monetary policy. All of those effect the economy, and yes even QE works to increase agreegate demand. I see little reason why this mechanisms are impaired in a downturn.

    I’ve read Keynes, but he is not the solution to all the worlds problems (he is after all 70+ years out of date!) An appeal to authority is a terrible way to debate public policy.

  17. John Quiggin
    August 27th, 2013 at 11:04 | #17

    Zac :
    What model do you use to justify the pushing on a string theory? Most macroeconomists reject the hypothesis (Mishkin etc)…

    @Zac

    An appeal to authority is a terrible way to debate public policy.

  18. John Quiggin
    August 27th, 2013 at 11:08 | #18

    To expand a bit on that gotcha, I wouldn’t appeal to Mishkin’s authority given his record eg on Iceland

    As regards evidence, the 1990 episode was particularly striking. But the “pushing on string” metaphor, which I learned well before 1990, reflected the whole experience of the postwar period.

    Everyone knew it at the time. The policymakers of 1990 knew it too, but assumed, falsely, that the micro reform of the 1980s had made the economy so resilient that past experience could be disregarded

  19. August 27th, 2013 at 11:32 | #19

    I am alas a raging hypocrite. And I completely concede that point.

    If you would allow me to rudely recharactertise my point, I would expand by saying when I mentioned Mishkin I meant not so much the economist specifically, but the author of the top selling monetary textbook, which of course cribs heavily from the foremost ‘conventional’ monetary economists around the world. Ideas like sticky wages, sticky prices, Euler equations etc. the basic building blocks of the main stream consensus.

    I agree I probably wouldn’t trust Mishkin’s assesment of a financial system/stability, but I think his record as a monetary economist is much stronger. One does not nessacarily tarnish the other.

    I find the Japanense evidence today, and the evidence from the Great Depression, as particuarly good (atleast good relative to other macro evidence) examples of monetary inflation at the zero lower bound/recession. Even the fact that the US has continued to produce jobs at the same rate as last year, despite the tax increases and the sequester seems to indicate that there is somesort of monetary offset at work.

    Are you refering to the post-war (70s) stagflation? I, and think quite of few others, would characterise that as a supply side shock (oil) which I agree the monetary policy (or any demand side tool) can’t do much about.

  20. Tim Peterson
    August 27th, 2013 at 12:30 | #20

    The age old adage about pushing on a string is based on an equally old misnomer about monetary policy: that it works without lags. The peak effect of (real) interest rate movements on nominal GDP is 4 or more quarters; people who are looking for contemporanious movements are barking up the wrong tree.

  21. Ernestine Gross
    August 27th, 2013 at 12:51 | #21

    The 1990-1992 increasingly severe recession (in terms of unemployment, bankruptcies…) belongs to the entrepreneurial 1980s debt bubble – the time when some famous entrepreneurs didn’t seem to know the difference between Assets and Owners’ Equity in terms of financial accounting. Some of these then heroes were indeed giving support to the weakest conceivable notion of ‘market efficiency’ (defined here as markets aggregate the expectations of many people) by being slower than the share market participants in recognising that their ‘asset growth’ couldn’t last because debt was growing faster. Stock exchanges crashed in October 1987 all over the place (except in Cairo – reportedly a stockbroker hadn’t even heard about the NY crash a day or two after the event).

    About 20 years after the height of the 1992 recession, bankers involved with the Bond Corporation’s debt induced asset bubble now have to learn their lesson in the only language they understand: money.

    http://www.watoday.com.au/business/court-appeal-backfires-as-banks-ordered-to-pay-more-in-bond-case-20120817-24cvv.html

    Those who argue that welfare effects linger on long after macro-aggregates have recovered have a point, I would suggest.

    Every major crisis is different in detail but with one common factor: Debt, in its various forms.

    The monetarists know only one form of debt: government debt. Hence they keep on ignoring the elephant in the room (they are not alone in this respect). Nobody forced the then entrepreneurs to go on a spending spree with bank money, denominated in local currency units; they did it ‘freely’.

    There is a fundamental problem with the mental model of ‘market monetarists’. They are correct in saying ‘it’ is the governments’ fault, but they are wrong as to the reason. The government allows various forms of debt (private money, denominated in fiat currency units) to be generated (‘deregulation’ to get conditions similar to those before the 1930s Great Depression). This is the correct bit of the argument. But they want a market economy at the same time, with a government sector so small that any ‘crowding out’ through fiscal policy or regulation of financial markets or both would be empirically undetectable, but big enough to get ‘monetary policy right’. But surely, if the ‘market’ bit of monetarism would be credible, then the market participants would not act like Alan Bond in the 1980s and the proverbial Wall Street bankers in the first decade of the 21st century. It seems to me the ‘market monetarists’ are implicitly asking for a strictly supervised kindergarten with monopoly money.

  22. John Quiggin
    August 27th, 2013 at 14:56 | #22

    @Tim Peterson

    Most of the case for using monetary rather than fiscal policy rests on shorter decision lags – say a month between RBA meetings as opposed to six-months between Budget and mid-year review. But if you think the impact lag for monetary policy is more than four quarters, and you have a functional Treasury, you should be relying mainly on fiscal policy, at least for anything big.

    Like most of the arguments for relying on monetary policy, a four-quarter lag is no problem if you are just tweaking a Taylor rule with 25bp nudges.

  23. Declan
    August 27th, 2013 at 16:30 | #23

    A small quibble – the cash rate wasn’t cut to 5.25% until March ’93.

    What is your implied counterfactual in the early 90s – in particular, why wouldn’t any fiscal expansion have resulted in slower rate cuts, given the RBA was still worried about inflation, and actually raised rates as soon as 1994?* Do you think fiscal policy has significantly shorter lags (not clear if your reply to Tim reflects your views or his), a better short-run tradeoff with inflation, more precision, or what?

    *”We did not set out to have a recession in order to reduce inflation. … But once it was apparent that it was going to happen, it was reasonably quickly realised that there was an opportunity to achieve something of lasting value out of the unfortunate events.” – Ian McFarlane

  24. John Quiggin
    August 27th, 2013 at 18:16 | #24

    @Declan

    In 1993, we didn’t have central bank independence in the modern sense, so the idea of the RBA offsetting fiscal policy doesn’t apply. We should have had the same monetary policy and an earlier switch to fiscal expansion.

    More generally, as Noah Smith has pointed out, it’s unclear whether the MM fiscal policy ineffectiveness claim is that central banks do in fact perfectly offset fiscal policy (clearly false) or that their control of the economy is so precise that they can do so if they want to (false in general, though probably true while the Great Moderation lasted).

    On your quote, while I generally admire McFarlane this is an ex post rationalisation of failure.

  25. August 27th, 2013 at 19:03 | #25

    Pr Q said:


    tight monetary policy can reliably cause recessions, but expansionary monetary policy in a deep recession is “pushing on a string”.

    Reckless monetary policy can cause much mischief, but good monetary policy is not much of a quick fix. Even its most enthusiastic proponent conceded that “long and variable lags” were the best it could do.

    Generally speaking, loose monetary policy can reliably cause price inflation in either goods markets (seventies) or asset markets (noughties). Quantitative easing being the latest case in point, see the run up of the Dow.

    Tight monetary policy can of course restrain inflation. But goods price inflation is not a pressing problem these days.

    Loose fiscal policy gets a lot of bad press but is rarely as bad as it seems. Chronic deficits are not inherently inflationary. They simply cause a run-up in debt. How that debt is serviced may be inflationary (printing money) or deflationary (higher taxes/lower benefits) or neutralised (through higher productivity growth).

    Chronic deficits only seem to be a real problem when there is a risk of default due to dwindling tax base. Combined with a home currency is pegged to an over-valued specie. This is the Greek problem.

    Its passingly strange how many of our modern woes in economic policy are simply the result of ignoring the wisdom accumulated by our elders: “pushing on a string”, “casino capitalism”, “taking away the punch bowl just as the party gets going” were all proverbial wisdom when I arrived as an economics undergraduate in the early eighties.

    Much the same can be said for the way we ignore the wisdom of our elders on matters of national culture. Interestingly, Keynes was decisively un-liberal in macro-economics, macro-ethnic and macro-eugenic policy. I guess he was just a silly old fool so we dont need to pay attention to him at all ever again.

    When the history of this era is written future students will wonder at the ability of liberal triumphalists to be oblivious to the obvious.

  26. August 27th, 2013 at 19:04 | #26

    Pr Q said:


    tight monetary policy can reliably cause recessions, but expansionary monetary policy in a deep recession is “pushing on a string”.

    Reckless monetary policy can cause much mischief, but good monetary policy is not much of a quick fix. Even its most enthusiastic proponent conceded that “long and variable lags” were the best it could do.

    Generally speaking, loose monetary policy can reliably cause price inflation in either goods markets (seventies) or asset markets (noughties). Quantitative easing being the latest case in point, see the run up of the Dow.

    Tight monetary policy can of course restrain inflation. But goods price inflation is not a pressing problem these days.

    Loose fiscal policy gets a lot of bad press but is rarely as bad as it seems. Chronic deficits are not inherently inflationary. They simply cause a run-up in debt. How that debt is serviced may be inflationary (printing money) or deflationary (higher taxes/lower benefits) or neutralised (through higher productivity growth).

    Chronic deficits only seem to be a real problem when there is a risk of default due to dwindling tax base. Combined with a home currency is pegged to an over-valued specie. This is the Greek problem.

    Its passingly strange how many of our modern woes in economic policy are simply the result of ignoring the wisdom accumulated by our elders: “pushing on a string”, “casino capitalism”, “taking away the punch bowl just as the party gets going” were all proverbial wisdom when I arrived as an economics undergraduate in the early eighties.

    Much the same can be said for the way we ignore the wisdom of our elders on matters of national culture. Interestingly, Keynes was decisively un-liberal in macro-economics, macro-ethnic and macro-eugenic policy. I guess he was just a silly old fool so we dont need to pay attention to him at all ever again.

    When the history of this era is written future students will wonder at the ability of liberal triumphalists to be oblivious to the obvious.

  27. Zac
    August 27th, 2013 at 19:34 | #27

    @John Quiggin

    CBs don’t need to be independent for monetary offset to occur. In fact you can tell a very plusiable story where governments consolidate, to reduce debt say, and work with the central bank to ease monetary policy such that overall aggregate demand is maintained.

    I think the claim of MM is that central banks *can* offset fiscal contractions but in a imprecise manner. So when the sequester happened, which was an anticipated shock, the fed was able to keep job growth roughly stable with easier money. If the government slashed spending over night then it would be much harder to offset and output would probably dip for 6-12 months.

  28. Jim Rose
    August 27th, 2013 at 19:43 | #28

    Ikonoclast, Australia came out of the Great Depression earlier than most because of the fiscal discipline of the Premiers’ Plan.
    • The premiers’ plan required federal and state governments to cut spending by 20%, including pensions. It was accompanied by tax increases, and reductions in interest on bank deposits and government internal loans.
    • The plan was complementary to a 10 per cent wage cut of January 1931 and the devaluation of the Australian pound.

    The New Zealand government also cut everything that could be cut by 20%. NZ had the most rapid recovery of all western countries from the 1930s depression.

    By the mid-1930s, the unemployment rates in Oz and NZ were in mid-to-high single digits similar to the pre-1929 rates.

    MacLaurin (1936) dated the Australian economic recovery from the last months of 1932. It was to take another three years before the unemployment rate fell below 10 per cent — the rate during the 1920s.

    the data published in the 2001 yearbook of the Australian Bureau of Statistics graphed iat http://www.abs.gov.au/AUSSTATS/abs@.nsf/Previousproducts/1301.0Feature%20Article142001?opendocument&tabname=Summary&prodno=1301.0&issue=2001&num=&view= shows a rapid fall in the high twenties unemployment rate in 1932 to be below 10 per cent by 1937.

    Australian unemployment was 7.5 per cent in 1938, which is the long-term average for the period 1906 to 1929. The USA had an unemployment rate twice that in 1938 and was just coming out of a double dip depression caued by the new deal

  29. John Quiggin
    August 27th, 2013 at 20:28 | #29

    @Zac

    Sure, under some circumstances it makes sense for contractionary fiscal policy to be combined with expansionary monetary policy – a fiscal consolidation under normal cyclical conditions is one such case, as you say.

    But, in the context of a deep recession, expansionary monetary policy alone won’t work fast – you need to use fiscal policy as well

    In the Depression, Sweden recovered faster than Australia & NZ, using both fiscal and monetary policy – almost the only country to do so.

  30. August 27th, 2013 at 20:41 | #30

    Jim Rose said:


    Australian unemployment was 7.5 per cent in 1938, which is the long-term average for the period 1906 to 1929. The USA had an unemployment rate twice that in 1938 and was just coming out of a double dip depression caued by the new deal…Australia came out of the Great Depression earlier than most because of the fiscal discipline of the Premiers’ Plan.

    Dear Jim,

    Your reference to Australian Great Depression, both in dimensions and cure, is wildly misleading. Australian Unemployment was at catastrophically high levels for the first half of the thirties. And the Premiers Plan, far from alleviating unemployment, greatly exacerbated the problem, prioritizing the servicing of loans to British banks over the care of Australias workers and war widows.

    The core of the Great Depression was the first half of the thirties, thats when most of the (in)action occurred. During that period Australia’s labour market suffered insults and injuries comparable to those of other countries in the Anglosphere, with the unemployment rate going from just over 10% in 1929, peaking at nearly 30% in 1932 before settling back closer to 10% by 1935. Here is the ABS summary:


    In 1906, unemployment stood at 6.7%, and fluctuated at around this rate (though it rose briefly to a little over 9% in 1915, and just over 11% in 1921) until 1929 when unemployment stood at 11.1%. The unemployment rate then increased rapidly to 19.3% in 1930, before reaching a peak of 29.0% in 1932, in response to the economic conditions of the Great Depression. This unprecedented high rate of unemployment persisted for two years, before the unemployment rate fell rapidly to below 10% by 1937. During World War II, unemployment in Australia reached a new low of 1.1%. This marked the beginning of a sustained period of low unemployment, with the unemployment rate generally remaining below 3% until the early 1970s.

    The Australian unemployment profile broadly fit the pattern of the UK, mainly because we followed the same disastrous policies of the orthodox Treasury View.

    And the “discipline” of the Premiers Plan was a pointless exercise in masochism designed to “please the markets” (in this case the Bank of England headed by the sinister figure of Sir Otto Niemeyer). Shades of ratings agency, c’est plus ca change.

    There is no evidence at all that Niemeyers program of leeching and cold showers did any good at all to the economic patient. Its true that Australian economy did recover during the second half of the thirties – some five years after the Premiers Plan. But this seems to have been a resource export-led recovery coming on the heels of a sustained devaluation of the currency. Together with some manafacturing protectionism and a steadily increasing rearmament program.

    That is hardly what one would call an orthodox scheme of measures.

    Of course the policy that really cured the Great Depression was the Second World War, which entailed a massive increase in government expenditure and control. All of which restored the labour market to full health for another 30 years. Nothing like an Arms Race to give an adrenaline hit to economic activity.

    In fact it was Hitler who, for all his faults, gets the prize for first successful Keynesian economic program. He stumbled onto the economic benefits of budget deficits through his rearmament program which caused Germany to climb out of Depression quicker than the Anglo powers. Keynes in the second edition of the General Theory goes out of his way to praise the Nazis for their robust economic policies.

    But then Hitler had to spoil it all by declaring war on everyone everywhere. Why cant people leave well enough alone?

  31. August 27th, 2013 at 21:39 | #31

    @John Quiggin

    Sure, and in the event of a ‘deep’ recession in all likelihood you would try both policies as a method of insurance. Model uncertainty (which is always high in macro) demands it.

    But ‘in the event of deep recessions try everything’ is a long way from monetary policy is ‘just pushing on a string’. Monetary policy may not be omnipotent, but it is far from powerless.

  32. TerjeP
    August 27th, 2013 at 22:09 | #32

    Interest rates are the price of credit. I don’t think the price of credit should be manipulated. The goal of monetary policy ought to be to define the national unit of account in reference to a suitable stable proxy for value and then leave prices (including interest rates) to be determined through market dynamics.

  33. SJ
    August 27th, 2013 at 22:20 | #33

    Yeah, yeah, gold standard. Heard it before, Terje.

  34. Declan
    August 27th, 2013 at 22:51 | #34

    @John Quiggin

    I’m not sure lack of formal independence = no ability to act independently (the board structure was pretty similar to now, AFAIK, and how pleased was the govt with the rate hikes of ’94?), but I was pretty young at the time. But even if they were acting in perfect harmony, that surely means interest rates were being set given the fiscal stance so there is still a tradeoff.

    Regardless, it seems pretty arbitrary to pick the historical path of interest rates + more fiscal expansion as your preferred policy. If monetary policy is so ineffective (and arguably overshot, given the cash rate was back to 7.5% by the end of ’94), why not smaller rate cuts and even more fiscal expansion, or conversely why not bigger and earlier rate cuts? Again, do you prefer fiscal policy because of shorter lags, greater precision, or what, and can you defend it with anything more than “everyone knew it at the time” and a couple of Depression anecdotes (which is the mirror image of “The US and Japan ran huge deficits and still remained depressed” and “everyone [at Chicago] knows fiscal stimulus is useless”)?

    My understanding of the MM position is “multipliers are just estimates of central bank incompetence” i.e. unpredictable under bad policy and zero under good policy. (Although they might become predictable under predictable bad policy e.g. at the zero lower bound absent further action, or a general reluctance to move interest rates.)

    The success of inflation targeting in stabilising inflation makes me somewhat optimistic that a nominal income target, say, would be successful in stabilising nominal income (without thinking that either of them are actually good targets for Australia).

  35. Declan
    August 27th, 2013 at 22:56 | #35

    As a general observation, a lot of people here seem to have a very mechanical view of demand management: figure out a multiplier m so if we are hit with a shock of size X we pull the fiscal or monetary lever by X/m to offset the shock, rather than shaping expectations (of future income, mainly) so that demand is more stable in the face of shocks in the first place.

  36. Mark A. Sadowski
    August 28th, 2013 at 01:16 | #36

    http://www.petermartin.com.au/2006/12/truths-about-australias-recession.html

    December 1, 2006

    Truths about Australia’s recession
    By Peter Martin

    “Australia’s Reserve Bank deliberately dragged its feet in moving to end the early 1990’s recession, according to its recently retired Governor Ian Macfarlane.

    In the latest of his Boyer Lectures, to be broadcast on Sunday, the former Governor says that the Bank decided to move slowly in ending the recession in order to grab a once-in-a-generation opportunity to turn Australia into a low-inflation economy.

    At the time Mr Macfarlane was an Assistant Governor under Governor Bernie Fraser.

    In the lecture he says that “in earlier recessions, all the policies and all the government rhetoric were pointed towards re-expanding the economy as quickly as possible and reassuring the public that all efforts were being made to cushion the blow”.

    But that in 1990, once it became apparent that Australia was going to have a recession “it was reasonably quickly realised that there was an opportunity to achieve something of lasting value out of the unfortunate events”…

    He says that while the bank did cut interest rates from 1990 it did it “in a measured fashion” in order to ensure that inflation did not rekindle.

    It was a new approach that the former Governor says had the support of the Government led by Prime Minister Bob Hawke and Treasurer Paul Keating.

    “It is significant that in March 1991, in the middle of the recession, the Government was prepared to announce a further phased reduction in tariffs, a move that would reduce inflation but do nothing to support the economy,” he said.

    In his lecture Mr Macfarlane is at pains to point out that the bank did not set out to create a recession in order to reduce the inflation rate. It merely took advantage of the opportunity that the recession presented it with.

    “The experience throughout the developed world… demonstrates an unfortunate but inescapable fact – no country with an entrenched inflation problem has significantly reduced inflation without it occurring in the context of a recession. While everyone would like to find a softer way of doing so, without incurring the unemployment costs of a recession, no-one has found such a way.”

    The former Governor says he finds it odd that in the United States the success of the Fed Chairman Paul Volcker in destroying inflation in early 1980’s is viewed positively while in Australia “the equivalent disinflation of the early 1990s tends to be viewed as a monetary policy mistake.”…”

  37. August 28th, 2013 at 01:42 | #37

    I don’t agree with market monetarists who don’t like fiscal policy, but I don’t agree with the “pushing on a string” meme either. This best approach is monetary and fiscal policy working in concert. See Abenomics and Japan.

  38. Mark A. Sadowski
    August 28th, 2013 at 03:26 | #38

    “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 December 1992, 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 10.9 per cent, a record for the period since the Depression. 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”.”

    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 CPI 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 CPI inflation fell from 8.7% in 1990Q1 to 0.3% 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 7.1% to 5.4%.

    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 5.4% 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 2.3% in the second half of 1995.

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

    One way of thinking about this is the Taylor Rule, which is simple rule for the appropriate level of the policy interest rate given the gap between inflation and the target inflation rate (say 2%) and the gap between unemployment and the natural rate of unemployment. 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=134410&category_id=0

    In constructing this Taylor Rule I’ve assumed the long run real neutral interest rate is 2% and that Australia’s natural rate of unemployment was 8% throughout this period. The OECD’s estimate of Australia’s NAIRU varies from 7.4% to 8.5% during this period, increasing from it’s low prior to the recession and peaking at its high when the unemployment rate peaked. Furthermore I’ve assumed an Okun’s Law coefficient of 1.8 based on Lawrence Ball’s recent estimates for Australia for 1980-1995 (“Okun’s Law: Fit at Fifty?”).

    Note that the residual increased from (-1.5%) in 1990Q1 to 9.8% in 1992Q4 and would not get close to 0% until mid-1995. 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.

    And the policy rate never fell below 4.75% in the early to mid-1990s, so Australia didn’t have the excuse of the zero lower bound. Based on Ian Macfarlane’s recollections above, monetary policy was intentionally tight during this period as a means of reducing the inflation rate.

  39. TravisV
    August 28th, 2013 at 03:33 | #39

    Mark Sadowski,

    You da ma!!!

    Peter K.,

    See my comment above.

  40. Mark A. Sadowski
    August 28th, 2013 at 04:07 | #40

    @TravisV

    There’s a lot more when it’s released from moderation. In the meantime you can read it all in the comments on the most recent post on The Money Illusion (“Why would tapering hurt Indonesia?”) or in the comments on today’s links of Economist’s View (“Links for 08-27-2013″).

  41. TerjeP
    August 28th, 2013 at 04:43 | #41

    @SJ

    Long term perhaps. However I’d be looking to setup a proxy for value similar in many ways to the bancor as proposed by Keynes. Perhaps an ECU style basket weighed with USD, EUR, CNY and Gold.

  42. Ikonoclast
    August 28th, 2013 at 04:51 | #42

    I am rapidly losing interest in economics. The notion that you can do economics, especially mathematical economics, in a vacuum without considering class, government, law and force is a nonsense. Political economy is a different matter. Now that is a real subject. Economics as current bourgeois economics is piffle.

  43. TravisV
    August 28th, 2013 at 04:58 | #43

    Ikonoclast,

    I think you’re wrong. I think we can simplify macroeconomics to “Wages are sticky. Therefore, money matters. The central bank has to print enough money to ensure moderate NGDP growth. If it doesn’t, then people will resist nominal wage cuts and there will be mass unemployment.”

    No additional analysis involving class, government, law or force is necessary.

  44. Zac
    August 28th, 2013 at 08:16 | #44

    @TravisV

    I agree. Although arguably the sticky wages themselves are caused by culture, notions of fairness and psychology.

  45. urban legend
    August 28th, 2013 at 08:29 | #45

    Seems pretty self-evident, doesn’t it? I certainly do not remember as devastating a hit to “animal spirits” as we saw in 2008-2009, especially coming on top of the erosion of confidence in an economy already suffering from serious issues — the rapid loss of manufacturing, the outsourcing trend, erosion of labor influence, wage stagnation, health insurance cost explosion, college cost explosion, abandonment of defined-benefit pensions and employer sponsored health insurance — that was fairly obviously being propped up by the real estate bubble. On top of it all, despite the alleged positions of one of the parties as more populist in economics, both parties have been beholden to the money-providing elite that created the mess and, therefore, bereft of solutions.

  46. urban legend
    August 28th, 2013 at 08:38 | #46

    @TravisV

    Who cares whether wages are sticky in this situation (since 2008)? Suppose they were not sticky and employers were free to drop nominal wages as far as they wanted? What good would that have done when demand for what they can produce had plummeted — and promised to decline even more with everyone making still less income? If employers only needed so many workers to produce what was being demanded, they wouldn’t hire more just because they didn’t cost as much.

  47. John Quiggin
    August 28th, 2013 at 10:49 | #47

    @Mark A. Sadowski

    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.

    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.

  48. Ernestine Gross
    August 28th, 2013 at 11:05 | #48

    ZAC (namesake)

    “A proper atheortical evaluation of the evidence would look at multiple countries over multiple time periods”

    What would you be evaluating in an ‘atheoretical’ evaluation at ‘multiple countries’ over multiple time periods?

    Your statement seems to me to be a spurious assertion about a methodological problem because, if someone talks about ‘a recession’ or a ‘deep recession’ or ‘fiscal’ and ‘monetary policy’, it is quite obvious to me the author is talking in the context of macro-economic theoretical frameworks.

    “For example there is strong evidence that easing monetary policy (going off the gold standard) ended the great depression. Not too mention current evidence from Japan and the US on the effectiveness of monetary policy – even at the zero lower bound.”

    Really? Not all ‘countries’ (as defined by the local populations, rather than imposed by the legal notions of imperial powers) were members of the ‘gold standard’ club. Ignoring a large segment of the world’s population hardly seems to be an improvement on methodological grounds you suggest.

    Furthermore, if you look into details of the functioning of the ‘gold standard’ you will find it hardly ever worked exactly. Moreover, the ‘gold standard’ should not be confused with the ‘gold exchange standard’. And, while we are at it, the subsequent Bretton-Wood system with the US-dollar being convertible into gold, collapsed because DeGaulle called the US bluff. (The US effectively defaulted.) And the ‘Great Moderation’ collapsed on itself because the financial system (proverbial Wall Street Bankers and their associates, the rating agencies) built a huge delusion of ‘values’.

    My second question to you is: Are the financial contracts underlying these ‘great moderation values’ money or not?

    These financial contracts did affect quantities and prices, including relative prices, denominated in currency units.

    “I’ve read Keynes, but he is not the solution to all the worlds problems (he is after all 70+ years out of date!)”

    Quite right, there were major developments in both Walrasian and non-Walrasian equilibrium (solution concept) theory.

    My third question to you is: Why do you ignore these advances. In particular, why do you ignore ‘critical points’ in the time series, by focusing on “the current evidence” ?

    The only points in time of interest for questions about the stability of a system are ‘critical points’. (See for example the work by authors including, M.C. Blad, , M.C. Blad and C. Zeeman, M.C. Blad and A. Kirman, Malinvaud and Benassy and Malinvaud , V. Boehm – in no particular order, from the 1970s and 1980s).

    Empirically, you might not easily observe the critical points, unless you work with daily data.

    “Why does fiscal policy work when monetary doesn’t for example?”

    Fiscal policy can be directed to individuals and individual non-financial businesses. To the best of my knowledge, monetary policy has never been implemented via a helicopter from which notes and coins can be dropped into the corresponding locations.

    If one focuses only on aggregates of interest to the private and public financial managers, nominal GDP, then the selectivity advantage of fiscal policy over monetary policy (taking out critical points) is of no interest, because it doesn’t matter whether most of the people in a society are homeless or destitute in some other way as long as the ‘aggregate’ doesn’t drop in numerical value for two (or three? I can’t remember) consecutive quarters. (Why any economist wants to chase ever increasing real numbers – an abstract object – is a mystery to me. But I can understand very well why financial managers want to chase such numbers if their personal income and non-monetary welfare depends on it)

    I suppose the answer to your question “Why does fiscal policy work when monetary doesn’t for example?” ultimately depends on your notion of ‘deep recession’.

  49. Ikonoclast
    August 28th, 2013 at 11:05 | #49

    @TravisV

    You want to talk about sticky wages and not talk about the systems and relations of ownership, production and labour in our society. An idea like sticky wages is empty of content without that context.

    You want to ignore the issue of force when force clearly determines who drills for oil where, who owns the fields and who gets the benefits. As an example there is the news headline;

    “Israel has given permission for an American based energy company to drill for oil in the Golan Heights, a plateau it captured from Syria in 1967. ”

    Now, I don’t want to start an Israel debate at all. That would be very derailing. This is merely to illustrate that force (one of the parameters of anlysis you rejected) conditions when, where and how markets, production and benefits all operate… and indeed who gets the work and wages… and who gets the profits.

    As I said, economics taken alone is all but meaningless. Political economy is the real subject perhaps twinned with biophysical economics to link it to the real physical world. All of this talk about economics that occurs as if the economy was free standing from both the biophysical world and from the world of politics, administration, law, custom, class, force, persuasion, exploitation and so on is just so much bumpf. There is no such thing as a value free “economic desision” or a value free “economic judgement”.

    The mere fact you are talking about wages without pondering why wage labour and capital ownership exist and what their existence might mean illustrates the paucity of all such analysis in economics which is blind to its own ideological premises and mistakes particular constructed historical and social conditions for universal, unchanging conditions.

  50. Troy Prideaux
    August 28th, 2013 at 11:39 | #50

    @Ikonoclast
    [chuckle] what’s that saying again? “Economics was created to give credibility to astrologers”?

    [tongue firmly implanted in cheek]

  51. August 28th, 2013 at 11:56 | #51

    @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.

  52. Mark A. Sadowski
    August 28th, 2013 at 13:02 | #52

    @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.

  53. Mark A. Sadowski
  54. Mark A. Sadowski
    August 28th, 2013 at 14:08 | #54

    @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.

  55. August 28th, 2013 at 16:46 | #55

    @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.

  56. August 28th, 2013 at 17:00 | #56

    @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.

  57. crocodile
    August 28th, 2013 at 17:27 | #57

    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.

  58. Ernestine Gross
    August 28th, 2013 at 18:35 | #58

    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.

  59. Zac
    August 28th, 2013 at 18:35 | #59

    @crocodile

    Two words for the same thing.

  60. sdfc
    August 28th, 2013 at 19:21 | #60

    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.

  61. John Quiggin
    August 28th, 2013 at 19:27 | #61

    @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?

  62. Zac
    August 28th, 2013 at 19:42 | #62

    @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.

  63. Jordan
    August 29th, 2013 at 04:02 | #63

    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.

  64. Mark A. Sadowski
    August 29th, 2013 at 04:37 | #64

    @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.

  65. Ikonoclast
    August 29th, 2013 at 08:17 | #65

    “… 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.

  66. Mark A. Sadowski
    August 29th, 2013 at 08:46 | #66

    @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.

  67. JamesH
    August 29th, 2013 at 10:15 | #67

    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.

  68. August 29th, 2013 at 10:36 | #68

    @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.

  69. Ernestine Gross
    August 29th, 2013 at 11:44 | #69

    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’.

  70. Ernestine Gross
    August 29th, 2013 at 13:35 | #70

    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.

  71. John Quiggin
    August 29th, 2013 at 16:07 | #71

    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.

  72. Ikonoclast
    August 29th, 2013 at 17:08 | #72

    @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.

  73. Grim23
    August 29th, 2013 at 20:14 | #73

    @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.

  74. Mark A. Sadowski
    August 30th, 2013 at 04:11 | #74

    @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.

  75. Mark A. Sadowski
  76. Ikonoclast
    August 30th, 2013 at 07:25 | #76

    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.

  77. John Quiggin
    August 30th, 2013 at 10:04 | #77

    @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

  78. Ernestine Gross
    August 30th, 2013 at 10:59 | #78

    @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).

  79. Melbourne Dan
    August 30th, 2013 at 14:56 | #79

    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.

  80. Clint
    August 30th, 2013 at 20:21 | #80

    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?”

  81. John Quiggin
    August 31st, 2013 at 05:10 | #81

    @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.

  82. Grim23
    August 31st, 2013 at 07:34 | #82

    @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.

  83. Mark A. Sadowski
    August 31st, 2013 at 09:40 | #83

    @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.

  84. Mark A. Sadowski
    August 31st, 2013 at 09:42 | #84
  85. Nathan
    August 31st, 2013 at 10:13 | #85

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

  86. Zac
    August 31st, 2013 at 10:23 | #86

    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.

  87. Mark A. Sadowski
    August 31st, 2013 at 10:38 | #87

    @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.

  88. Mark A. Sadowski
    August 31st, 2013 at 11:29 | #88

    @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.”

  89. John Quiggin
    August 31st, 2013 at 11:57 | #89

    @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?

  90. Zac
    August 31st, 2013 at 12:09 | #90

    @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?

  91. Grim23
    August 31st, 2013 at 17:58 | #91
  92. Ernestine Gross
    August 31st, 2013 at 19:50 | #92

    @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.

  93. Mark A. Sadowski
    September 1st, 2013 at 07:27 | #93

    “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.

  94. Mark A. Sadowski
    September 1st, 2013 at 09:36 | #94

    @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.

  95. Mark A. Sadowski
    September 1st, 2013 at 11:31 | #95

    @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.

  96. Mark A. Sadowski
    September 1st, 2013 at 13:38 | #96

    @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.”

  97. John Quiggin
    September 1st, 2013 at 14:11 | #97

    @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.

  98. Clint
    September 2nd, 2013 at 19:51 | #98

    @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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