By Karl Smith
John Cochrane is giving New Keynesianism a chance:
From this one [Euler] equation and graph [of consumption], you can make sense of lots and lots of new-Keynesian analysis and policy advice.
The level of today’s consumption depends on the whole string of future interest rates, not just today’s interest rate. So, if people expect the interest rate in 2014 to be lower, that is every bit as effective in raising today’s consumption as would be lowering today’s rate. Hence, 'open mouth operations,' 'forward guidance,' and 'managing expectations.' If the Fed by just talking can persuade people it will hold interest rates low for a longer periods, when they are expecting rates to rise above zero, that expectation will 'stimulate' today’s consumption. If promises don’t help, perhaps announcing a new 'rule,' which if followed would lead to lower rates for longer will help to change expectations.
I’m not sold on this story, as you probably guessed, for a variety of reasons.
New Keynesian models are a bit fuzzy on just why interest rates have to be so low -- why the 'natural rate' is sharply negative and why zero interest rates aren't enough. Many of the formal models assume that consumer’s discount rate ((rho)) has declined sharply, beyond the capacity of the interest rate to follow it. If rho goes to, say -5%, with our 2% inflation, then even a zero nominal interest rate is like a 3% real interest rate. (These are deviations from trend, so one might not need actually negative discount rates to hit the zero bound. But even adding growth, it’s hard to avoid the need for a negative natural rate to cause a problem of this size.)
Now, a spontaneous outbreak of thrift, to the point of valuing the future a lot more than the present, seems a bit of a strained diagnosis for the fundamental trouble of the U.S. economy.
So, let's run through the reasons John might reconsider his skepticism. First, a spontaneous outbreak of thrift caused by the financial crisis is not really that crazy for a couple of reasons.
1. It more or less happened:
That's in dollars, not fraction of income and not adjusted for inflation or inflation expectations, all of which collapsed just as savings was rising.
2. The financial crisis is not simply a convenient post-hoc rationalization for a very low natural rate. For many of us, it was an overriding concern in real time:
Friday, March 14, 2008
Lots of people have said to me both on and off line that we don't have to worry about the Japan Scenario because we have a solid inflation buffer in the U.S.
While the inflation buffer gives us more room in a sense, it is important to remember that it is not deflation per se that causes a liquidity trap. It is that the equilibrium interest rate is below zero.
It is possible that the equilibrium risk free interest rate is a real negative 3% in this crisis, which implies that we still won’t be able to get there with 2.7% inflation.
Exploding risk premiums could drive the equilibrium real rate that low because what matters is credit availability to firms and consumers.
So we are not in a position were we can ignore the liquidity trap possibility. On top of that is the issue that there are increasing deflation pressures in the decline collateral values, falling consumption and the potential for dramatically slower global growth. While ultimately they might not override inflationary effects of recent Fed policy, they are not to be ignored.
In short deflation cannot be ruled out and the liquidity trap remains a threat even in a moderately inflationary environment.
Second, the most obvious alternative explanation has even more issues than John seems to realize off the cuff. He acknowledges:
The [alternative] permanent income model does suggest that we look for changes in permanent income to explain the fall, rather than (only) a rise in discount rates or real interest rates -- i.e., the desired intertemporal allocation of consumption. From this perspective, consumers realized in fall 2008, that this recession was going to last forever rather than bounce back quickly, and they adjusted consumption downward accordingly. They were right. Just how they knew, when all the Government's forecasters thought we would quickly bounce back, is an interesting question. Surely, my litany of free-marketer's complaints did not obviously get suddenly worse in October 2008, just coincident with a run in the shadow banking system. Well, maybe not so surely. Maybe consumers thought, we're in a horrible banking crisis, and our government is likely to prolong this one with ham-handed policies just like they did in the 1930s. But that's pretty speculative. And I do think (just as speculatively) there was a run in the shadow banking system, effective risk aversion spiked, and the financial crisis was more than just a signal of bad policy to come.
This is a really tough needle to thread. First, because the policies most obvious at the time -- bailouts, government equity stakes, etc. turned out to both run a profit for the taxpayer as well as allow for record profits by the financial sector. Indeed, financial corporate profits -- unlike consumption -- returned almost immediately to trend.
No, perhaps the worst is yet to come or the second order effects of "ham-handed" policy are what folks really feared. However, that's a really tough story given that we are not even clear what those effects are supposed to be.
Third, why is the correlation between inflation expectations and stock market performance so tight? If anything, we might expect higher inflation expectations to erode stock values through their effect on capital gains taxation.
Yet, this relationship is perfectly consistent with the notion that higher inflation expectations are "stimulative."
Fourth, why are inflation expectations so low, given that the Fed has radically increased the money supply? If supply side factors were tightening, then we would expect that less money would be needed in the future, not more. Hence, even maintaining the same rate of money printing should be inflationary and rapid increases should be highly inflationary.
Fifth, there is the "unemployment" problem. We can see why folks might want to consume less and save more if they though the government was causing a supply crunch. We can also see how they could find it less worthwhile to work.
However, why would fewer of the remaining workers be able to find work? And why would job turnover collapse? In particular, why would voluntary separations falls so much?
These facts are consistent with a story in which prices -- in particular, the interest rate -- is failing to clear markets and disequilibrium is created where more people (given the prevailing price) want to push consumption into the future than (given the prevailing price) are willing to accept more consumption in the future.