Minsky, the Lucas Critique, & the Great Moderation

Last week, I noted that the post-2008 world had provided an astonishingly good test for Milton Friedman’s notion that stabilising M2 growth was an effective antidote for economic depressions. Bernanke stabilised M2 growth, yet the depressive effects such as elevated unemployment, elevated long-term unemployment, and depressed growth still appeared, although not to such a great extent as was experienced in the 1930s. Friedman-style macro-stabilisation may have succeeded in reducing the damage, but in terms of preventing the onset of a depression Friedman’s ideas failed.

Of course, the onset of the post-2008 era was in many ways also a failure of the previous regime, and its so-called Great Moderation. Ben Bernanke in 2004 famously noted that “one of the most striking features of the economic landscape over the past twenty years or so has been a substantial decline in macroeconomic volatility”.  Bernanke saw successful monetary policy as a significant reason for this stabilisation:

The historical pattern of changes in the volatilities of output growth and inflation gives some credence to the idea that better monetary policy may have been a major contributor to increased economic stability. As Blanchard and Simon (2001) show, output volatility and inflation volatility have had a strong tendency to move together, both in the United States and other industrial countries. In particular, output volatility in the United States, at a high level in the immediate postwar era, declined significantly between 1955 and 1970, a period in which inflation volatility was low. Both output volatility and inflation volatility rose significantly in the 1970s and early 1980s and, as I have noted, both fell sharply after about 1984. Economists generally agree that the 1970s, the period of highest volatility in both output and inflation, was also a period in which monetary policy performed quite poorly, relative to both earlier and later periods (Romer and Romer, 2002). Few disagree that monetary policy has played a large part in stabilizing inflation, and so the fact that output volatility has declined in parallel with inflation volatility, both in the United States and abroad, suggests that monetary policy may have helped moderate the variability of output as well.

Bernanke’s presumptive successor, Janet Yellen explained in 2009 that from a Minskian perspective, this drop in visible volatility was itself symptomatic of underlying troubles beneath the surface:

One of the critical features of Minsky’s world view is that borrowers, lenders, and regulators are lulled into complacency as asset prices rise.It was not so long ago — though it seems like a lifetime — that many of us were trying to figure out why investors were demanding so little compensation for risk. For example, long-term interest rates were well below what appeared consistent with the expected future path of short-term rates. This phenomenon, which ended abruptly in mid-2007, was famously characterized by then-Chairman Greenspan as a “conundrum.” Credit spreads too were razor thin. But for Minsky, this behavior of interest rates and loan pricing might not have been so puzzling. He might have pointed out that such a sense of safety on the part of investors is characteristic of financial booms. The incaution that reigned by the middle of this decade had been fed by roughly twenty years of the so-called “great moderation,” when most industrialized economies experienced steady growth and low and stable inflation.

Minsky’s financial instability hypothesis can be thought of as an instance of the Lucas Critique applied to macro-stabilisation. Lucas’ contribution — earlier stated by Keynes — is that agents alter their behaviour and expectations in response to policy.  By enacting stabilisation policies, policy makers change the expectations and behaviour of economic agents. In the Minskian world, the promise and application of macro-stabilisation policies can lead to economic agents engaging in increasingly risky behaviour. A moderation is calm on the surface — strong growth, low inflation — but turbulent in the ocean deep where economic agents believing the hype of the moderation take risks they would otherwise not. In a Minskian world, these two things are not separate facts but deeply and intimately interconnected. Whichever way monetary policy swings, there will still be a business cycle. Only fiscal policy — direct spending on job creation that is not dependent on market mood swings — can bring down unemployment in such a context while the market recovers its lost panache.

The march of monetarists — following the lead of Scott Sumner — toward nominal GDP targeting, under which the central bank would target a level of nominal GDP, is a symptom of Friedman’s and the Great Moderation’s failure. If stabilising M2 growth had worked, nobody would be calling for stabilising other monetary aggregates like M4 growth, or stabilising the nominal level of economic activity in the economy. Sumner believes by definition, I think, that the policies enacted by Bernanke following 2008 were “too tight”, and that much more was needed.

Of course, what the NGDP targeters seem to believe is that they can have their Great Moderation after all if only they are targeting the right variable. This view is shared by other groups, with varying clinical pathways. Followers of von Mises’ business cycle theory believe that an uninhibited market will not exhibit a business cycle, as they believe that the business cycle is a product of government artificially suppressing interest rates. Minsky’s financial instability hypothesis and its notion that stability is destabilising is a slap in the face to all such moderation hypotheses. The more successful the moderation, the more economic agents will gradually change their behaviour to engage in increasingly risky activities, and the more bubbles will form, eventually destabilising the system once again. Markets are inherently tempestuous.

Or at least that is the theory. It would be nice to see empirical confirmation that the moderation produced by Sumnerian NGDP targeting is just as fragile and breakable as the Great Moderation. Which, of course, requires some monetary regimes somewhere to practice NGDP targeting.

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A Visual Representation of the Zero Bound

I’ve been trying to understand the relationship between savings and interest rates in the economy. There are many theoretical models and constructs that purport to represent the relationship between savings and interest rates, but it is interesting to look at it from an empirical standpoint. This graph shows savings at depository institutions as a percentage of GDP against the Federal Funds Rate:

Mises

The actual cause of the desire to save rather than consume or invest is uncertain. Perhaps this is a demographic trend — with more people closing in on the retirement age, they seek to save more of their income for retirement. Perhaps it is a psychological trend — fear of investment in stock markets and bond markets, due to fear of corruption, or market crashes or a general distrust of corporations. Perhaps it is a shortage of “safe” assets — by engaging in quantitative easing, central banks are removing assets from markets and replacing them with base money, and deleveraging corporations are paying down rather than issuing new debt. Perhaps it is anticipation of deflation — people expecting that saved money will increase its purchasing power in future. Perhaps it is a combination of all these things and more. But whatever it is, we know that there is an extraordinary savings glut.

There have been a lot of assertions that interest rates at present are unnaturally or artificially low. Well, what can we expect in the context of such a glut of savings? Higher interest rates? Based on what?

There was a clear negative association between savings and interest rates up until interest rates fell to zero, while the savings rate continued to soar. Theoretically, lower interest rates ceteris paribus should inhibit the desire to save, by lowering the reward for doing so. But interest rates cannot fall below zero at least not within our current monetary system — there exist some theoretical proposals to break the zero bound using negative nominal interest rates, but these remain untested and controversial. Even tripling the monetary base — an act that Bernanke at least believes simulates an interest rate cut at the zero bound — has not discouraged the saving of greater and greater levels of the national income.

In the long run, the desire to save increasingly massive percentages of the national income will cool down. Sooner or later some externality will jolt the idle resources in the economy into action. But that is the long run. In the short run saving keeps soaring. Investors are not finding better investment opportunities for their savings and the structure of production does not appear to be adjusting very fast to open up new opportunities for all of that idle cash.