From the Money Illusion by Scott Sumner:
It was announced today that Christopher Sims and Thomas Sargent will be awarded the Nobel Prize in economics. A number of bloggers have discussed their contributions, with MarginalRevolution leading the pack. I don’t keep up with the field enough to provide a comprehensive overview, but I thought I’d provide a few remarks:
1. I was shocked to hear that Sargent won, because I’d assumed he must have already won the award years ago. Sargent and Wallace did a lot of important work integrating rational expectations into monetary economics back in the 1970s and early 1980s. This work may have contributed to Krugman’s paper on expectations traps. I often argue that if we do eventually get high inflation, the cause will most likely be tight money over the past few years. That argument comes directly from this paper by Sargent and Wallace.
2. The Swedish academy provided a short paper explaining some of the contributions of each winner, and I thought I’d make a few comments on impulse response functions and VARs, since those innovations (due mostly to Sims) are being singled out as particularly important:
The difference between forecast and outcome – the forecasting error – for a specific variable may be regarded as a type of shock, but Sims showed that such forecasting errors do not have an unambiguous economic interpretation. For instance, either an unexpected change in the interest rate could be a reaction to other simultaneous shocks to, say, unemployment or inflation, or the interest-rate change might have taken place independently of other shocks. This kind of independent change is called a fundamental shock.
The second step involves extracting the fundamental shocks to which the economy has been exposed. This is a prerequisite for studying the effects of, for example, an independent interest-rate change on the economy. Indeed, one of Sims’s major contributions was to clarify how identification of fundamental shocks can be carried out on the basis of a comprehensive understanding of how the economy works. Sims and subsequent researchers have developed different methods of identifying fundamental shocks in VAR models.
This certainly sounds like a promising approach, and yet I’ve always been skeptical about its practical applicability. To be honest, I don’t know if my objections hold water, perhaps some commenters can let me know.
When impulse response functions are estimated for monetary shocks, they typically show tight money leading to a near term reduction in output, lasting for several years. They also show no near term impact on prices, with a slight decline after about 18 months (although it’s not clear if the results are statistically significant.)
I have several problems with this approach. Researchers often use changes in the monetary base or (more often) interest rates as indicators of monetary shocks. I don’t find these to be reliable indicators. They also use macro data such as the Consumer Price Index, which I view as not only highly inaccurate, but systematically biased over the business cycle. If monetary shocks are misidentified, then you have big problems. For instance, are higher interest rates tight money, or a reaction to higher NGDP growth expectations?
I’ve noticed that when we do have massive and easily identifiable monetary shocks, as in 1920-21, 1929-30, and 1933, output seems to respond almost immediately to the shock, as does prices. This makes me wonder about those impulse response functions. Why would severe monetary shocks immediately impact prices, whereas mild monetary shocks only impact prices after 18 months or more. That doesn’t seem intuitively plausible, but perhaps I’m missing something here.
Perhaps VAR models are misidentifying monetary shocks. I’d argue we saw a severe negative monetary shock in the second half of 2008, and that this caused both prices and output to decline significantly between mid-2008 and mid-2009. What do VAR models show? Do they correctly identify this contractionary monetary shock? If not, is there any way of telling why not? What variables might have given off a misleading reading?
3. Paul Krugman recently made this argument:
Most spectacularly, IS-LM turns out to be very useful for thinking about extreme conditions like the present, in which private demand has fallen so far that the economy remains depressed even at a zero interest rate. In that case the picture looks like this:
Why is the LM curve flat at zero? Because if the interest rate fell below zero, people would just hold cash instead of bonds. At the margin, then, money is just being held as a store of value, and changes in the money supply have no effect. This is, of course, the liquidity trap.
And IS-LM makes some predictions about what happens in the liquidity trap. Budget deficits shift IS to the right; in the liquidity trap that has no effect on the interest rate. Increases in the money supply do nothing at all.
That’s why in early 2009, when the WSJ, the Austrians, and the other usual suspects were screaming about soaring rates and runaway inflation, those who understood IS-LM were predicting that interest rates would stay low and that even a tripling of the monetary base would not be inflationary. Events since then have, as I see it, been a huge vindication for the IS-LM types
I certainly agree about the lack of inflation resulting from the tripling of the base, which I also predicted, but I don’t see it as having much to do with the shape of the LM curve. Indeed Sargent and Wallace (1973) provide a much clearer explanation; the Fed publicly announced that the monetary injections would be temporary (although you could also view the IOR program as an explanation.)
Here’s why I don’t like IS-LM. Suppose the Fed had instead announced that the tripling of the base would be permanent. What does the IS-LM model predict? Notice the LM curve is flat, which means the variable on the vertical axis is the nominal interest rate. But saving and investment depend on real interest rates. A tripling of the base that was expected to be permanent, would lead to a large increase in inflation expectations—probably to double digit levels. This would shift the IS curve far to the right, to where it intersected the LM curve at a positive interest rate. Easy money would make interest rates rise.
So there is no liquidity “trap,” just a promise by the Fed not to allow significant inflation, which they have kept. From the Fed’s perspective, and even more so from the ECB’s perspective, it’s mission accomplished—inflation has stayed low. So IS-LM doesn’t show that monetary policy “doesn’t work,” because it has worked out exactly as the Fed hoped; no breakout in inflation expectations. Some people are under the illusion that the Fed tried to create higher inflation and failed. But Bernanke explicitly indicated that he was very opposed to a 3% inflation target. People need to pay more attention to the Fed’s announced objectives, as those objectives are a major cause of the Great Recession. And Sargent and Wallace help us to understand why.
PS. I do not favor having the Fed announce that monetary injections will be permanent. Rather I favor an announced target trajectory for NGDP (or prices), with level targeting. This would implicitly mean that the Fed was promising enough of the injections would be permanent to hit the nominal target in the future.