Restoring Prosperity

During the past two days, economists from around the world gathered at the Hoover Institution to focus on the crucial problem of how to restore prosperity. They took stock of lessons from past experiences in the US and Europe, and considered possibilities with a new Administration in Washington. It was a follow up to a conference and book that Lee Ohanian and I organized 5 years ago with Ian Wright. This year Jesus Fernandez-Villaverde joined with Lee and me in the planning, adding important economic and political perspectives as well as views from Europe.

Needless to say, the need to restore prosperity is still with us, as illustrated by the chart on this cover of 2012 book (Government Policies and the Delayed Recovery) along side the updated version today—the employment-to-population ratio is still barely above the level at the end of the recession in 2009. We have go a long way to go.two-covers

A huge amount of useful new facts and ideas were put forth at the conference so a book is again planned. The conference was also notable for topics that did not come up. No one suggested secular stagnation, as introduced by Larry Summers in a 2013 Hoover-Brookings conference, as a factor in the recent slow growth. Nor did anyone suggest demand-side fiscal stimulus packages as a means of restoring prosperity. Rather, people focused on structural or supply-side economic policy as reasons for the low growth and how to implement such policies.

Slides presented at the conference will soon be available on the conference web page, and there are some really amazing charts to look at. In meantime here are some of the highlights from my perspective.

George Shultz led off—as in the previous conference—with a note of optimism and words of encouragement reviewing how changes in policy—tax reform, monetary reform—led to greatly improved economic performance in the 1980s and could do so again.

Kevin Murphy then examined the key role for education and training in raising productivity growth. He showed that returns to education have increased, but that supply has not responded leaving a great deal of growth potential on the table with special harm to those at the bottom.  Rick Hanushek reported on the amazing economic growth gains that could come from simply weeding out the lowest 5% of teachers based on teaching effectiveness. Flavio Cunha examined underlying causes for poor educational performance delving into very early childhood experiences, where researchers can now monitor, for example, how many words children actually hear at home. There is no question that the US is not exceptional in K-12 education.

Bob Hall usefully decomposed empirically the recent slow growth of earnings per “member of the population,” showing that a decline in productivity growth and a drop in the share of labor in total income are the primary culprits.  John Haltiwanger examined the marked decline in young firms (5 years and less) as a share of US output, and examined how that decline in dynamism might be related to the decline in productivity; he found a suggestive association for some, but not all, industries.  Ed Prescott noted how technological change has created a wedge between output and real GDP citing examples of Bill Nordhaus’ work on “The Economics of New Goods.” However, Bob Hall and others noted that recent work by David Byrne, John Fernald and Marshall Reinsdorf shows that such developments are not new and do not explain changes in trends over time.

A full session concentrated on the role of government economic reforms in restoring prosperity.  Harald Uhlig focused on the role government in health care examining the recent ups and downs in the price of pharmaceutical firm stocks in response to statements coming from Washington. restoring-prosperty-conference-s-slides-taylorI assessed whether the US is having a much needed turning point in economic policy by applying the ideas in my book First Principles.  This chart shows the potential gain in productivity growth if reforms such as regulatory reform and tax reform are implemented; in my view the response to such supply side reforms can be large.  Steve Davis then discussed recent trends in regulation, intervention and policy uncertainty, provided new data and making new reform proposal to contain the costs. He provided a chart—which I replicate below—which shows some correlation between the swings in policy uncertainty and historical swings in productivity growth from my chart.

A good part of the conference was about the slow growth in Europe. regulatory-complexity-and-policy-uncertainty-davisMuch of this fascinating discussion focused on how poor policy has pulled down growth. Fortunately, the discussion will be broadcast by Russ Roberts on his famous Econtalk Podcast and includes Nicholas Crafts, Luis Garicano, and Luigi Zingales—so watch for that.  Joel Mokyr talked about his new book: A Culture of Growth, and examined whether the development of a “market for ideas,” which he argues led to the Industrial Revolution, has lessons for the future.  Jesus Fernandez-Villaverde spoke at lunch on European lessons for the US.  To paraphrase the key lesson, coming from joint work with Lee Ohanian, is: “If the US does not get its policy act together it will surely follow Europe to stagnation.”  He reminded everyone how unemployment rates in Europe used be less than in the US, and they are now of course much greater.  He was not optimistic about reforms in Europe given the demographic situation in there.

Joel Peterson, Chair of JetBlue and a leader in venture capital funding, gave the dinner talk explaining how government policy actually affects business formation and growth with many examples from his own experience. He thereby provided a much needed connection—and I would say confirmation—between the empirical/theoretical work of the economists and what actually goes on in individual firms.  Some of Joel’s examples came from his fascinating new book, The Ten Laws of Trust.

Conferences like this are useful if they help bring ideas into practice. Let’s hope that when we have the next conference on economic growth and prosperity–say in another 5 years–that many of the ideas from this conference will have been applied in practice and that we might be able to title the conference “Prosperity Restored.”

Posted in Regulatory Policy, Slow Recovery

Benefits of Comparing Policy with Reference Rules

In a recent VOX article, Henrike Michaelis and Volker Wieland write favorably about the approach taken by Fed Chair Janet Yellen in a recent speech where she compares recent Fed policy actions with several monetary policy rules—including the Taylor rule—much as would be required by recent legislation in the U.S. Congress. They argue that these kinds of “comparisons of Fed policy to simple reference rules show how such legislation would serve to bolster the Federal Reserve’s independence…. By referring to such legislation and appropriate reference rules, the Fed would be able to better stand up to … [political] pressure and more effectively communicate its reasons to the public.”  The article also refers to this statement by economists supporting the legislation.

As an illustration of the kind of constructive criticism that would likely be the healthy outcome of such comparisons, Michaelis and Wieland also take issue with one aspect of the Fed Chair’s comparison. They show that the comparison is incomplete, and thereby potentially misleading, because it uses only part of recent research by Holston, Laubach, and Williams (HLW).  The comparison applies the shift in the equilibrium interest rate r* from HLW, but not the associated shift in potential GDP that is an integral part of that study.  Janet Yellen shows that if you insert the HLW r* estimates into a Taylor rule, you get a lower policy interest rate than if you assume a 2 percent real rate as in the original version of that rule. However, Michaelis and Wieland show that plugging in the associated real output gap estimated with the HLW methodology, along with the HLW r*, moves the implied rate in the opposite direction.

Posted in Monetary Policy

Monetary Policy Strategy Statements Should Have a Strategy

At its meeting this week the Fed decided not to post changes in its “Longer-Run Goals and Monetary Policy Strategy” as might have been expected as part of its annual organizational meeting actions as it did last year at this time. The January 2016 statement is still on the Fed’s web page.  Maybe they will make changes at the next meeting, and, in particular, add some words about the Fed’s strategy for the policy instruments.  Despite the use of the phrase “Monetary Policy Strategy” in the title, a strategy for the policy instruments does not now appear in the statement. If you read the statement you will find nice clear sentences about goals, but little in the way of a strategy for the policy instruments to achieve the goals. As former Fed Staff member Andy Levin explains in a chapter in a recent book “the FOMC’s Statement on Longer Run Goals and Policy Strategy is almost exclusively aimed at clarifying its longer-run goals…what’s still missing—and what’s desired by the general public as well as academic economists, market investors, and members of Congress—is for the FOMC to explain its policy strategy more clearly.”

In a Wall Street Journal op-ed this week former Fed Governor Kevin Warsh made the very sensible suggestion that the Fed “announce a practicable long-term strategy” and add it to the “document—purporting to state the Fed’s strategy…”  In a paper published in the Swedish Riksbank Economic Review I also urged that consideration be given to including the strategy to achieve the existing goals, giving details about the strategy for the policy instruments.  In a blog post on Janet Yellen’s West Coast speeches I suggested a possible way forward.

The Fed is not the only central bank that could be clearer about its strategy. The European Central Bank also has a statement about monetary policy, which it simply calls “Strategy”. It has a good explanation about goals including a “quantitative definition of price stability”, but it too says little about a strategy for the instruments of policy other than reference to its “two-pillar approach” which provides for some cross-checking with the monetary aggregates. The time is ripe for change at a number of central banks. As ECB President Mario Draghi said in a speech last summer in Portugal: “…we would all clearly benefit from enhanced understanding among central banks on the relative paths of monetary policy. That comes down, above all, to improving communication over our reaction functions and policy frameworks.” If there is a first mover problem, the Fed would be a natural first mover.

Posted in Monetary Policy

Good Progress on Describing and Comparing Monetary Strategies

Janet Yellen visited San Francisco and Stanford last week. She gave two interesting talks about monetary policy, which together, in my view, break new ground, and are worthy of more discussion.

At the Commonwealth Club in San Francisco she briefly described the Fed’s monetary strategy for the policy instruments.  At the Stanford Institute for Economic Policy Research she compared the Fed’s recent monetary policy with the Taylor rule and closely related monetary policy rules.

If you view these two talks together, I think they resemble what would be required under the Requirements for Policy Rules of the Federal Open Market Committee, Section 2 of the Fed Oversight Reform and Modernization (FORM) Act which has passed the House of Representatives. That legislation requires that the Fed (1) “describe the strategy or rule of the Federal Open Market Committee for the systematic quantitative adjustment” of its policy instruments and (2) compare its strategy or rule with a reference rule. More detail here.

Let me explain why the two talks represent progress in both directions. In the San Francisco talk, Janet Yellen summarized the Fed’s strategy for the policy instruments, saying that

“When the economy is weak and unemployment is on the rise, we encourage spending and investing by pushing short-term interest rates lower. As you may know, the interest rate that we target is the federal funds rate, the rate banks charge each other for overnight loans…. Similarly, when the economy is threatening to push inflation too high down the road, we increase interest rates to keep the economy on a sustainable path and lean against its tendency to boom and then bust.” She then described “price stability” as a level of inflation of “2 percent a year,” the maximum level of employment that can be sustained in the longer run as an unemployment rate of around 4-3/4 percent, and a “longer-run neutral rate” of the federal funds as a rate of “3 percent.”

One could certainly add more detail, but the statement includes the signs of the responses by the policy instruments, though not the magnitudes; it mentions key factors driving the responses; and it gives numerical values for three key parameters.  It could be usefully added, as is, to the Fed’s Statement on Longer-Run Goals and Monetary Policy Strategy, which, despite its name, now has no strategy for the instruments, only goals.

Next consider the Stanford talk which was loaded with charts and references to the Taylor rule and other policy rules. The purpose was to compare actual Fed policy with the Taylor rule, which she states, “embodies key principles of good monetary policy,” and then explain any differences. People found that useful, and it was good to see clarification of how the FOMC uses such policy rules in a constructive manner. That’s the kind of comparison that is required in the legislation that passed the House.  My question to her at the talk (see here) was meant to explore the possibility that such a presentation could satisfy the legislation, but in her answer she still expressed opposition to the legislation. Nevertheless, I think further discussion of the issue would be useful. There are more similarities than differences between the type of presentation given by Janet Yellen in California last week and the type of presentation required by the FORM Act, suggesting that a compromise might be feasible.

To be sure, the description of the policy strategy and the comparison of policy with the reference rule took place in two different talks.  If presented in the same talk the analogy with the requirement under the legislation would be easier to make. Janet Yellen frequently uses footnotes for algebraic descriptions in her talks. If she added another footnote, an algebraic way to summarize the words used in San Francisco might be:

r = p + ay + b(p – 2) + 1

with a > 0 and b > 0, where r is the federal funds rate, p is the rate of inflation, and y = 2.3(4.75-u) where u is the unemployment rate. (The 2.3 comes from Janet Yellen, Remarks, April 11, 2012)

In contrast the reference rule (Taylor rule) is:

r = p + .5y + .5(p – 2) + 2

So the comparison is pretty obvious.

In listening to Janet Yellen’s talk I was reminded that I invited Alan Greenspan to give a talk to the same research group at Stanford 20 years ago in 1997 when I was the director. He came, and he chose as the topic, Rules vs. Discretionary Monetary Policy. He discussed the Taylor rule, about which he listed “a number of attractive features” and commented on the usefulness of monetary policy rules in general. The experience with monetary policy, both when it is rules-based and when it is not rules-based, in the United States and other countries during the past 20 years provides much useful information about how to improve monetary policy going forward. Talks such as Janet Yellen’s and further discussion about them will further this important goal.

Posted in Monetary Policy

The Room Where It Happens

I enjoy the nexus between the world of ideas and the world of action, probably because I have gone back and forth between those two worlds several times as described here. There is nothing more rewarding then developing ideas and then having the opportunity to bring them into action. The song “The Room Where It Happens” in the musical Hamilton is a wonderful rendition of this nexus where Alexander Hamilton gets his debt ideas into action.

When asked by the Wall Street Journal and Bloomberg News about by favorite books for 2016, I chose books that fell into this nexus.  For the Wall Street Journal list, I chose The Man Who Knew, Sebastian Mallaby’s excellent biography of Alan Greenspan, and War by Other Means by Robert Blackwill and Jennifer Harris. Here are the reasons that I gave and that the Journal published:


For Bloomberg News I chose The Euro and the Battle of Ideas by Markus Brunnermeier, Harold James and Jean-Pierre Landau (I also wrote a longer review here) and The Curse of Cash by Ken Rogoff.  Again here are the reasons as published by Bloomberg News:



Posted in Teaching Economics

Show Us Your Model and Your Method

In a Wall Street Journal op-ed today I addressed claims made by Neel Kashkari in an earlier op-ed about rules-based monetary reforms, showing that his claims that the reforms were mechanical or computer-run were simply false and misleading.

Kashkari mentioned the Taylor rule a lot in his op-ed. For example, he reported that “my staff at the Minneapolis Fed,” found that unemployment after the 2008 financial crisis would have been higher with a Taylor rule. However, he gave no reference to the study, its methodology, or even its authors, unlike many other Fed officials who write or speak on policy. In my response I cited research that got opposite results to those reported by Kashkari. That research is published and publicly available.

So many people have asked me:  What model did Kashkari use, and how did he use it?  I hope that someday the Minneapolis Fed study will see the light of day, but in the meantime we do not know the answers. From the op-ed it sounds like the staff did an old fashioned “alternative path” simulation with some model rather than a more realistic “alternative rule” simulation. (For an historical review of the old and new models and methods, see my recent paper for the Bank of Canada.) Thus the calculation did not take account of expectations or other systems effects normally considered essential when evaluating policy. Rather than evaluating a monetary rule over time they looked as a one-time change in the policy instrument.

If so, this is pretty bad economics. Nearly all of the hundreds of studies of monetary policy rules over the past 30 years have taken this systematic approach. Kashkari is welcome to weigh in on this debate, but to do so he needs to report the model and the methodology that form the basis of the results.

Posted in Monetary Policy

Unconventional Monetary Policy, Normalization, and Reform

This week the Monetary Policy Subcommittee of the House Financial Services Committee held a hearing on “Unconventional Monetary Policy.”  Charles Plosser, Mickey Levy, Simon Johnson and I testified. It was a good hearing with pertinent questions by Members of Congress, led by Chairman Bill Huizenga, and candid answers from the witnesses.chair-huizenga In my view the hearing was good because it focused on monetary reform in a practical context where reform is now seen as a real possibility. Here’s a link to a video and written testimonies.

I led off by reviewing how the Fed’s move toward unconventional monetary policy can be traced back to the “too low for too long” period of 2003-2005, and much research shows that the results were not good. (References to research are in my testimony.) Along with a breakdown in the regulatory process, these policies were a cause of the financial crisis and the Great Recession. While the Fed did a good job during the panic in 2008 as lender of last resort, it then moved sharply in an unconventional direction starting in 2009 with large scale asset purchases, erratic forward guidance, and near zero interest rates long after the recession was over. Again the results were not good.  My research and that of others shows that these policies were not effective, and may have been counterproductive.

The policy implication of this experience is clear. Monetary policy should be normalized. The Fed should transition to a rules-based monetary policy like the one that worked in the past while recognizing that the economy and markets have evolved. This appears to be the intent of the Fed, but normalization, or transition, is difficult in practice, and the pace has been slow and uncertain.taylor-dec-7-mpt-hfsc

Normalization is easier if there is an understanding of the basic monetary strategy. This points to monetary reform where the Fed would describe the strategy or rule for the systematic adjustment of its policy instruments.  Recent empirical research by Alex Nikolsko-Rzhevskyy, David Papell, Ruxandra Prodan shows that if this reform had been in place in recent years, the Fed would have had to explain the deviations, and this would have likely reduced their size. Additional research by Carl Walsh shows that economic performance would improve if the Fed were accountable about the rule for achieving goals as well as about the goals.

Monetary normalization and reform have important implications for the international monetary system. Unconventional monetary policies with near zero policy rates have spread internationally, as the Bank of Japan, the European Central Bank, and other central banks adopted similar policies. Thus the international monetary system has deviated from a sound rules-based system. This has increased the volatility of the dollar and other exchange rates. Because a key foundation of a rules-based international monetary system is rules-based policy in each country, normalization and reform by the Fed would contribute to international monetary stability, which will in turn benefit the United States economy.

The opportunity for monetary reform is now better than it has been in years. Remember that tax reform, regulatory reform, budget reform and monetary reform go together. They reinforce each other. All are crucial to a prosperous economy.

Posted in Monetary Policy