Saturday, November 7, 2009

Does Macro Need a Paradigm Shift?

Bob Murphy emailed me about a recent Scott Sumner post:
Before I forget, I think you would like this Sumner piece. It's a bit long so don't read it in the back of a cab; you need to ponder it. But you will love at least 3 or 4 of his points I think.
I have finally stopped lecturing my cabbie. And I have had a chance to ponder the Sumner piece. Murphy was right, I think it contains some of the most important observations and calls for clarifications that I have seen from a mainstream economist in some time.

He writes:

Economists talk about “monetary policy” without having a coherent idea of what they mean by the term.

Recall that a standard model should have an agreed upon set of terms, so that communication between scientists is possible. OK, what do we mean by the “stance of monetary policy?” What do we mean by “easy money?” How about “tight money?” Surely if we claim to be a science it’s not good enough to say “it depends” or “I know it when I see it.” We must have some metric in mind, something in the real world we can point to, beyond our gut instinct. So let me throw out this challenge: I say it is impossible to come up with any sort of coherent meaning for terms like ‘easy money’ and ‘tight money’ in the context of the standard model. Economists use these terms all the time, and yet are really just spouting nonsense.
Amen, in a period when the Fed is not printing an money, economist after economist continues to discuss when the Fed will tighten monetary policy, as though it is not now occuring.

Sumner again:
To make things simpler I’ll offer 6 options, which conform to all of the ways in which I have heard people try to give meaning to the term:

1. The Joan Robinson interpretation:

As you may recall, I like to mock Joan Robinson’s statement that the German hyperinflation could not possibly have been caused by easy money; after all, nominal interest rates were not low in Germany during the early 1920s. I think it is fair to say that Joan’s views are no longer part of the standard model. It is now widely believed that the German hyperinflation was caused by easy money, and hence nominal interest rates cannot be the right indicator for the stance of monetary policy. When economists say “easy money” they can’t possibly be referring to low nominal interest rates, otherwise they’d have to accept Joan rather eccentric views.
Sumner has an important point here. One shouldn't look at nominal rates to determine whether the Fed is maintaining an easy or tight money policy. Many see the current near zero nominal rates and conclude the Fed is easing. This we can now call the Robinson error.

Sumner again:

2. How about real interest rates?

When I make the preceding argument to economists, the quick retort is usually “of course what I really meant was that easy money means low real interest rates, and tight money means high real interest rates.” Fair enough. So let’s look at the record. Real interest rates on five year TIPS rose from 0.57% in mid-July 2008 to 4.24% in late November 2008. If real interest rates are the appropriate indicator of the stance of monetary policy, then this 4 month period was one of the most sudden and aggressive examples of monetary policy tightening in all of recorded history.

So maybe we do have a coherent view of the stance of monetary policy. It refers to the level of real interest rates. Except there is just one problem. When I tell other economists that money became ultra-tight in the second half of 2008, I am met with stares on incomprehension, as if I had just escaped from a lunatic asylum. So whether or not real interest rates are the “right” indicator (and for what it’s worth I don’t think they are) one thing is perfectly clear—this is not the standard model. If only a tiny handful of economists think money was tight last fall, most economists obviously are defining “tight” as in terms of much higher real interest rates.
Sumner makes a very good point here. The summer of 2008 was a very tight money period as measured by M2 nsa money supply growth. Thus, real rates would have gone up. By observing the real rate on TIPS, Sumner is using a very good proxy for what real rates probably were in the summer of 2008. Sumner is very accurate in pointing out most economists were not aware this occured in the summer of 2008.

Next Sumner correctly disses the monetary base as an indicator of Fed tight and loose monetary policy:
3. The monetary base:

I used to like this one. It seems to conform best to what the Fed actually does. They print money. And the money they print isn’t M1 or M2, it’s base money. But again, whether or not this is the best indicator (and I no longer think it is) it’s clear that it hasn’t been the standard view for decades, if ever. As Friedman and Schwartz showed the base was extremely misleading in the Great Depression, as M1 and M2 fell sharply at the same time as the base was rising rapidly. Most of the profession now accepts their view that Fed policy was very tight in the early 1930s. During that period the sharply falling M1 and M2 seemed to be better indicators as we also experienced extreme deflation, not what you’d expect from easy money. Now of course there are other ways to look at this picture. Krugman has argued that one could think of money as being easy, but that because we were in a liquidity trap the easy money did no good. However, the fact that Krugman might make this argument doesn’t mean that he thinks the monetary base is the right indicator of the stance of monetary policy. I rarely see him (or other Keynesians) pay any attention to the base. I suppose one could still argue that the base is the right indicator of monetary policy, but that view is certainly not the standard view. I’ll bet 90% of the economists who claim Greenspan ran an easy money policy in 2003 have never once examined the base data from that year
Sumner than reaches the correct conclusion about M2. Although, I would add it should be non-seasonnaly adjusted M2. I have no idea how seasonaly adjusted M2 is a valuable concept. Either money is out there bidding up prices or not, seasonally adjusted money is a number that distorts the understanding of how actual money is available for bidding up goods and services:
4. How about the broader aggregates?

In some ways M2 is better than the other three. It certainly gave a more useful indication of monetary policy than either the base or nominal interest rates during the Great Depression. (And my hunch is that even real rates were misleading, although there is some debate about whether the deflation was anticipated.) But once again, it is certainly not the standard view that M1 or M2 are the right indicator of the stance of monetary policy. Indeed, after the early 1980s most economists lost any interest in these variables. Mike Belongia argues that we can and should come up with much more informative aggregates. He may be right, but that’s not the issue I am examining here.

This week’s Economist mentioned how M2 has recently been flat, and then a few sentences later asked “whether all this fiscal and monetary stimulus will work.” Obviously they are assuming that nobody would view M2 as the right indicator of monetary policy
It is stunning, but Sumner is correct, few economists actually look at M2 when discussing monetary policy.

This failure by most economists to recognise what I see as reality, Sumner believes may be a Thomas Kuhn like paradigm shift. Sumner writes:

I’ve been giving some thought to how my views of macro are different from those of other economists. Until this crisis hit, I assumed that I was doing “normal economics,” to use Thomas Kuhn’s terminology. NGDP targets are different from the Taylor Rule, but they aren’t all that different. Even Ben Bernanke has talked about targeting the forecast. You’ve seen me endlessly recite Mishkin’s 4 key concepts from his monetary textbook. They are a virtual blueprint for my current critique of monetary policy. So I’ve never thought of my views as being particularly heterodox.

And yet . . . . You could count on one hand the number of economists who think money was tight last fall. And you could count on one hand the number of right-wing economists who think that the economy currently needs much more stimulus. So although my views are not completely unique, there is apparently something rather unusual about my approach to macro.

Kuhn is famous for arguing that scientific revolutions were preceded by a buildup of “anomalies,” or things that were difficult to explain within the standard model. I’d like to discuss two possible anomalies, although in this case I don’t think that either are currently recognized as such. I hope to change that. The discussion will actually be more of a challenge to my fellow economists. Can you explain these anomalies in a way that is consistent with the standard model?
I don't see it that way. I just see it as confusion on the part of most economists. It isn't that they have a different paradigm for what nominal interest rates are, what real rates are or what the money supply is. They simply uses these terms in a sloppy manner when discussing monetary policy. Pushing nominal interest rates lower under most, but not all situations, will mean increasing money supply. Most economists have thus slipped into looking at lower nominal rates as assuming things that aren't really happening, namely growing money supply. In fact, the disassociation has become so great that most bizarrely don't even look at money supply, itself, any more.

No these guys don't have a different paradigm. They are so confused they don't even know the basic elements of the paradigm they are using.

UPDATE: I do want to add that in regard to a paradigm shift, I am specifically referring to a shift based upon the points Sumner raises and with regard to money growth. In other areas, such as methodology, believe a paradigm shift away from econometric forecasting and testing is long overdue.


  1. "As Friedman and Schwartz showed the base was extremely misleading in the Great Depression, as M1 and M2 fell sharply at the same time as the base was rising rapidly. Most of the profession now accepts their view that Fed policy was very tight in the early 1930s."

    Wouldn't it be more accurate to say Fed policy was loose (as shown by the base), but the shrinking in bank credit, which they have less influence over compared to the base, outweighed the Fed's printing. Which would mean that the Fed intended for a loose monetary policy, but was unsuccessful.

  2. What do you think about using the True Money Supply (TMS) as formulated by Murray Rothbard?

  3. If economic students were required to read an introductory text on deductive/inductive logic and then Rothbard's "MES," or better yet, Reisman's "Capitalism," the paradigm problem would go away.

  4. Funny seeing a guy (Sumner) who lives and dies by not defining his terms sensibly, scolding others for this.

    What a crank