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

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.

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

  1. 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.

  2. @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

  3. @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).

  4. 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.

  5. 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?”

  6. @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.

  7. @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.

  8. @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.

  9. @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.

  10. @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.”

  11. @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?

  12. @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?

  13. @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.

  14. “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.

  15. @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.

  16. @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.

  17. @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.”

  18. @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.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

w

Connecting to %s