It seems that the most recent employment report has convinced several* economists that there is a high risk that the Fed Open Market Committee (FOMC) will raise the target Federal Funds rate soon.

Paul Krugman

There will, predictably, be calls to respond to the good news by normalizing monetary policy, raising interest rates soon. And we will want to raise rates off zero at some point. But it’s important to say that (a) we are still highly uncertain about the underlying strength of the economy (b) the risks remain very asymmetric, with much more danger from tightening too soon than from tightening too late.

Brad DeLong

now is the time for the Federal Reserve to establish its credibility on the point that, if the economy enters a liquidity trap, the Fed is going to keep stimulating until the economy is out of the liquidity trap and interest rates can normalize. If the Fed does not do this now, future Fed Chairs will curse its name.

and G.I.

If unemployment does fall to 5% next year, that should have two beneficial effects for the labour market. First, it should push up wages. Hourly earnings rose 0.4% in November, an unexpectedly brisk and long overdue increase. But they are still up just 2.1% from a year earlier. Since profit margins are so wide, it will take several years of stronger wage growth to generate cost-push inflation. Second, some of the long-term unemployed who have quit the labour force should be drawn back in, reversing some of the loss of potential output brought about by the prolonged period the economy spent depressed.

To get inflation higher requires a negative output gap by allowing unemployment to fall below its natural rate for a time.

I’d just like to note that Krugman and DeLong complement each other as usual (and to compliment both as usualer). Brad notes a long term reputational advantage of inflation over 2% — I follow Brad who followed Woodward who followed Krugman in believing that, when the economy is in a liquidity trap, it is good for the monetary authority to credibly promise that it will allow inflation to rise above the normal target after the unemployment rate falls to the non accelerating inflation rate of unemployment (google “credibly promise to be irresponsible”). As Brad notes, a FOMC doing exactly that can only make it easier for future FOMCs to convince economic agents that it too will do exactly that.

Is this possible benefit which may or may not arrive in the distant future worth the costs of inflation slightly above 2% ? Of course it is. There is no jump in the marginal cost of a bit more inflation at 2%. 2% isn’t an especially important number**. If the 2% target was chosen rationally to maximize some reasonable social objective***, then a small benefit of higher inflation makes the optimal inflation rate higher.

The justification for choosing and inflation target, declaring it, and sticking to it is that it is possible for a clear simple rule which is followed mechanically to become credible. The risk that people will thing “the official target is 2% but next time we are in circumstances like these inflation will be allowed to get higher than 2%” is the reason to accept NAIRU unemployment when the unemployed wish they had jobs. In this case, it is a benefit.

It is possible to make an argument which isn’t internally logically inconsistent for raising the target Federal Funds rate — it is possible to make a logically consistent argument for anything if one is allowed to make any assumptions one pleases. But the argument actually made for higher rates soon is about as close as one can get to logical inconsistency if one is allowed to invoke confidence fairies, expected inflation imps and the whole pseudopsychological menagerie.

* Why did I link to Mark Thoma not to DeLong and whoever G.I. might be directly ? Well my original interest was in Mark Thoma and links not in policy and public welfare. I got to http://economistsview.typepad.com by clicking a link at www.sitemeter.com.

** I am referring to a vague memory (sorry no link) of Paul Krugman discussing US net capital income (GNP minus GDP) with Larry Summers in 1988 and saying “people who are smart enough to understand all that are smart enough to understand that zero isn’t an especially important number.” I thought that wasvery smart. I find it ironic that a few years later, he saw that the liquidity trap was baaack (pdf warning) and that, when it comes to nominal interest rates, zero is a particularly important number.

*** Note the if. I no more believe that the 2% target was chosen because it maximizes some social welfare function than I believe in unicorns.

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I am of the opinion that the economy is overshooting its natural sustainable level at the moment. There are problems that can occur from that. Below I give a warning from the field of Population Ecology.

Stocks are rising to records partly on the back of a lower labor share in 3rd quarter 2014, which today was adjusted down from 97.3 to 96.2 (non-farm business sector). That is a big adjustment. The profits seen in the stock market are partly based on a big hit to labor share.

Along with the hit to labor share, firms are stepping up hiring in an effort to support profit rates.

You see some talk that maybe the Fed will start to raise its base rate earlier in 2015. From Tim Duy…

“They (the Fed) may be less pleased that stocks keeps hitting record highs as it suggests that financial conditions are easing somewhat, thus perhaps necessitating a faster pace of rate hikes. Over the longer run, I remain wary of the flattening yield curve.”

So the economy is gaining great momentum with nominal rates still at the zero lower bound. Are we overshooting?

The Principle of Overshoot

In the field of Population Ecology, there is a principle for overshooting the carrying capacity of an environment. Population can be sustained at the carrying capacity of an environment. The idea of overshoot is that if the carrying capacity is exceeded too much, the environment will be damaged and carrying capacity will collapse. What does overshooting look like? (source 1, source 2)

The carrying capacity would be like the natural level of output for an economy. If the economy is pushed too far beyond it, we could actually do damage to the economy, such that potential output would drop even further afterwards. The next recession would be that much more grueling.

I know Krugman and others push for overshooting saying that the risks of tightening monetary policy too soon outweigh the benefits. But overshooting has a great risk too. And Krugman acknowledges that we do not know where the natural level of potential output is.

Is secular stagnation the result of overshooting sustainability with years of bubbles before the crisis? Maybe, but I think the drop in labor share is more to blame. However, we still need to be careful that policies are not causing a tremendous overshoot.

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Update: Incredibly embarrassing and rude misspelling corrected all credit due to Robert in comments who sure is different from Robert who is now typing.

Noah Smith writes better than I can and in particular that

Nobel-winning economist Paul Krugman recently claimed that John Maynard Keynes — or the general idea of Keynesianism — is winning the battle of opinion in the public sphere. George Mason University economist and blogger Tyler Cowen responded, playing devil’s advocate, and listed a bunch of points that he thinks indicate that Keynesian ideas (liquidity traps are important, austerity during recessions is destructive, fiscal stimulus is useful) might be losing the substantive battle.

Econ blog arguments are fun, so I’ll play devil’s advocate squared — angel’s advocate? — and go through some of Cowen’s points.

Sure sounds like fun. Also Tyler Cowen is on my very short list of reasonable and reasonably honest conservatives (in fact, as not very far as my memory serves me, it is entirely possible that “Tyler Cowen” *is* my list of reasonable and reasonably honest conservatives).

Acting as devil^2 advocate, Smith concedes two points to Cowen

Here is Cowen:

Keynesians predicted disaster following the American fiscal sequester, and the pace of the recovery accelerated.

This is intriguing especially in light of the fact that everyone blames a 3 percent sales-tax hike in April for crashing the Japanese economy. If that small tax increase sent the Japanese economy into a tailspin, why didn’t the across-the-board spending cuts of the sequester inflict similar damage on the U.S. economy This does make me doubt the standard Keynesian story.

I wonder which Keynesians predicted disaster. I certainly didn’t and I don’t recall Paul Krugman doing so. I thought the policy was obviously bad and the opposite of what should be done, but I certainly didn’t expect it to cause a recession. Here (and elsewhere) Cowen appears to use constant growth as a baseline. But the recovery has consistently disappointed (except for the “morning in America” surpassingly rapid turnaround when ARRA spending started).

Doing better than amazingly bad isn’t enough to make me doubt the standard Keynesian story. To be intrigued I would have to see economic growth higher than that predicted by a Keynesian model.

Cowen seems to consistently use constant growth as a benchmark. This is odd. To argue by analogy, I note that Krugman predicted a u shaped recovery and a u curves up, that is, accelerates. More seriously, there are a number of factors which should imply accelerating growth. One is the declining stock of housing per adult. The very low rates of house construction mean this falls over time. That should cause pent up demand for housing and accelerating construction. Another is deleveraging — debtors who are no longer considered credit worthy and can’t roll over their debt have been gradually paying it back (or having it cancelled by foreclosure or bankruptcy). This means that the demand depressing effect of their very binding liquidity constraint is weakening. The recovery improves state and local government budget balances and this affects their spending with a lag due to the annual budget cycle.

Now sequestration might not have had a dramatic effect on US real GDP. It also didn’t have a dramatic effect on US real government consumption plus investment (G). If you didn’t know when sequestration occured, could you figure it out from this graph ?

What I see is declining G during the long consistently disappointing recovery (until 2014q2 see below). I mean I also see the ARRA which started just before the recovery started.

Oh and finally, growth didn’t accelerate after sequestration which started March 2013, 2013q2 growth was lower than 2013q1 growth. Growth since sequestration has averaged 2.7%/yr which is very low given the output gap. Cowen is using the whatever lag I please operator.

On Smith “small” ??? 3% of consumption is 2% of GDP even in Japan. The ARRA was less than 2% of US GDP over the 2 years it lasted. The consumption tax increase was a huge shift in fiscal policy which dwarfs sequestration. That might explain the difference in the effects.

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In this rather long post Brad (who writes faster than most people can read causing potentially inefficient fixed pixel formation) Brad spends an odd amount of time critiquing some neo-Austrian and Singer the inflation truther.

But then he discusses the thoughts Bernanke and Summers, which are well worth discussing.

Ben Bernanke says that there is a:

risk… that rates will remain low…. [For] in an environment of persistently low returns, incentives may grow for some investors to engage in an unsafe ‘reach for yield’…. [The alternative risk that] rates will rise sharply…. The two risks may very well be mutually reinforcing…

Here I think it is important (in the context of the rest of the post) that when Bernanke writes “investors” he is thinking of financiers not people who engage in Physical investment as defined in the national income and product accounts. Basically he is worried about bankers and pension fund managers. I agree with Brad that

It seems to be very clear that prudential regulation rather than interest-rate manipulation is overwhelmingly the proper tool to deal with Ponzi finance, irrational or near-rational, and with systemic risk created by too much “reaching for yield”.

But fools and agents with incentive contracts written by fools reaching for yield by picking up pennies in front of a steam roller have created problems. The incentives created by fools can include that it isn’t good enough to maximize this years profits if the maximum is less than zero, so if the expected value of profits must be zero, gamble because its the only way to have a chance to keep your job.

So Bernanke (and Jeremy Stein et al) have a bit of a point.

Then we move to “Larry Summers” who is paraphrased.

And Larry Summers will say that if the problem is the collapse of the credit channel–the inability of a market in which participants have impaired balance sheets to properly mobilize the risk-bearing capacity of society in order to finance enterprise–the first-best answer cannot be pushing down the long-run rate of interest and so providing extraordinary incentives to invest in long-duration projects. That would produce an economy with (a) too-few risky short- and medium-term enterprises, (b) a too-high duration capital stock, and (c) too-much near-rational Ponzi finance. Much better to either (a) fix the balance-sheet problems and restore the risk-bearing capacity mobilizing power of the credit channel, or (b) failing that using the government as a financial intermediary to mobilize the taxpayers’ risk-bearing capacity when private finance cannot mobilize investors’.

Huh ?

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Dan here…Thomas Palley is Senior Economic Policy Advisor, AFL-CIO Washington DC. Here he addresses the issues of trade imbalances in a paper worth considering.

by Thomas Palley

The theory of global imbalances: mainstream economics vs. structural Keynesianism

Prior to the 2008 financial crisis there was much debate about global trade imbalances. Prima facie, the imbalances seem a significant problem. However, acknowledging that would question mainstream economics’ celebratory stance toward globalization. That tension prompted an array of explanations which explained the imbalances while retaining the claim that globalization is economically beneficial. This paper surveys those new theories. It contrasts them with the structural Keynesian explanation that views the imbalances as an inevitable consequence of neoliberal globalization. The paper also describes how globalization created a political economy that supported the system despite its proclivity to generate trade imbalances. [READ MORE]

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Dan here… Gail is an actuary interested in finite world issues – oil depletion, natural gas depletion, water shortages, and climate change. Oil limits look very different from what most expect, with high prices leading to recession, and low prices leading to inadequate supply.  Her blog Our Finite World offers an extensive look at these issues.  Originally published at Our Finite World and re-posted with permission from the author.

by Gail Tverberg

Oil Price Slide – No Good Way Out

The world is in a dangerous place now. A large share of oil sellers need the revenue from oil sales. They have to continue producing, regardless of how low oil prices go unless they are stopped by bankruptcy, revolution, or something else that gives them a very clear signal to stop. Producers of oil from US shale are in this category, as are most oil exporters, including many of the OPEC countries and Russia.

Some large oil companies, such as Shell and ExxonMobil, decided even before the recent drop in prices that they couldn’t make money by developing available producible resources at then-available prices, likely around $100 barrel. See my post, Beginning of the End? Oil Companies Cut Back on Spending. These large companies are in the process of trying to sell off acreage, if they can find someone to buy it. Their actions will eventually lead to a drop in oil production, but not very quickly–maybe in a couple of years.

So there is a definite time lag in slowing production–even with very low prices. In fact, if US shale production keeps rising, and Libya and Iraq keep work at getting oil production on line, we may even see an increase in world oil production, at a time when world oil production needs to decline.

A Decrease in Oil Prices May Not Fix Oil Demand

At the same time, demand doesn’t pick up quickly as prices drop. We are dealing with a world that has a huge amount of debt. China in particular has been on a debt binge that cannot continue at the same pace. A reduction in China’s debt, or even slower growth in its debt, reduces growth in the demand for oil, and thus its price. The same situation holds for other countries that are now saturated with debt, and trying to come closer to balancing their budgets.

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Hospitals are just not producing at the same rate they used to. In particular, they are not producing as many avoidable deaths.

Wide-ranging efforts to make hospital care safer have resulted in an estimated 50,000 fewer patients dying because of avoidable errors in the past three years, according to a new report presented by government and industry officials.

I do think that Obamacare is responsible for a significant part of this change.

I wonder how Fox News will spin this (not really — I am sure the study won’t be mentioned at all).

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I have often wondered whether the very low level of Private Residential Investment (also known as building houses) in the USA is due to unusually low expectations of long term increases in home prices. Here, I add that I would guess that the change was and end of the belief that the relative prices of houses has a strong upward trend (so houses are good investments) which belief is not supported by Robert Shiller’s data in Irrational Exuberance.

Of course I knew that, to find out, I should google something like ( Shiller house price expectations ). I forget what I told google but google sent me to this pdf.

Which you must read, but from which I will steal data on expectated house price increases over the next 10 years and this graph

yes indeed, expected appreciation of house prices has dropped dramatically as one would expect given the bursting of the bubble. The question is does this explain the low level of residential investment ?

Note that Shiller thinks the relevant variable is the expected growth of home prices minus the mortgage interest rate. Unfortunately even he only has 10 observations of the expected growth of home prices over 10 years. It is easy to fit the ratio of private residential investment to GDP with this variable, but this may just be because it is easy to fit 10 observations.

It is mildly interesting that the difference alone seems to explain the huge change in residential investment without any need to appeal to financial frictions.

The more interesting question would be whether the relationship between the variables in recent years is the same as it was before the great recession. Alternatively, it is possible that some factor other than low home price increases is needed to explain low US residential investment. The natural candidate would be unusually tight lending standards as an over-reaction to the disasters caused by the extraordinarly loose lending standards of the early 00s.

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I keep telling people that the German euro is undervalued, but some folks seem not to believe me. (See the comments section from this post last year for an example.) But this is a really big deal. The dominant narrative about the eurozone crisis is that fiscally irresponsible countries like Greece were bringing the once-proud currency to its knees, and weakening the European project to boot. Meanwhile, the virtuous Germans keep on cranking out trade surpluses and have to bail out Greece, Ireland, Portugal, and Spain. And it’s pretty clear that the Germans believe this version of events.

Never mind that Spain and Ireland, for two, had budget surpluses prior to the crisis, or that Spain’s economy is five times as large as Greece’s. What’s going on in Greece is supposedly the true explanation for the eurozone’s problems.

Let me challenge that narrative that with a simple thought experiment. Instead of one euro, let us reason as if each of the 18 eurozone members had its “own” “euro.” Let’s begin by thinking about what creates the value of the current 18-country euro. We might include interest rates, inflation rates, growth rates, and trade balance, among other things, and of course expectations for all these variables. What we need to remember is that the value of today’s euro represents the averaged effect of all these variables in all 18 countries, rather than reflecting the economic conditions of any one of them.

So the euro is currently worth about $1.25. It used to be higher; what is dragging it down? The simple answer is that conditions in Greece, Spain, Ireland, Portugal, and at time Italy have pulled its value down. As has often been noted, if Greece pulled out of the euro it would then devalue the drachma, becoming internationally competitive again without the need for the brutal austerity that has pushed its unemployment rate over 25%. The same is true for the other peripheral countries. By looking at what would happen to the drachma/punt/peseta/escudo, we can see that, for these countries, the euro is overvalued. Another way to say it is that the “Greek euro,” for example is overvalued.

So why isn’t the value of the euro lower than $1.25? The answer, of course, is that Germany, the Netherlands, Austria, Luxembourg, and so forth, are performing well and pushing the value of the euro upwards. These countries, by contrast, would see their currency values rise if the euro were suddenly abolished. For Germany, for instance, the euro is undervalued; an equivalent DM would rise in value.

U.S. officials constantly rail about the undervalued Chinese yuan and the huge bilateral trade deficit it creates for this country. But officials could (and to some extent do) say the same thing about Germany, which now has a larger trade surplus than the vastly larger Chinese economy. In fact, last year Morgan Stanley estimated that a stand-alone German euro would be worth $1.53, compared to the actual euro exchange rate then of $1.33.

With an undervalued currency, Germany gets a much larger trade surplus than it would have had otherwise, magnifying trade deficits in the United States and elsewhere. At the same time, it gets to pretend that this surplus is simply due to German thrift and virtue, rather than currency misalignment. It then points to its virtue as justification for doing nothing to increase domestic consumption, wages, or inflation, and for demanding austerity from the countries to which Paul Krugman rightly says Germany is exporting deflation.

Let me leave you with Krugman’s chart. You can see at a glance that Germany has throttled nominal wage growth and has inflation far below the European Central Bank’s announced target of just under 2%. When you combine its low inflation with an undervalued exchange rate (remember, low inflation should tend to raise the currency’s value), you come to realize that Germany is a huge part of the world economy’s problems today.

Source: Paul Krugman

Cross-posted from Middle Class Political Economist.

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