Should Japan "reflate"?

In Japan, the term "rifure" stands for "reflation" or "reinflation", meaning a (hypothetical) Big Push by montary policymakers to end the decades of deflation in that country. The question of whether Japan should "reflate" is the biggest question in Japanese macroeconomic policy circles.

Now, I've gone on the record as a skeptic regarding the power of central banks to fine-tune the macroeconomy. In that post, I mentioned the idea of an inflation "snap-up", where expansionary monetary policy suddenly and unpredictably pushes inflation from very low to problematically high. Also, I've cast doubt on the idea that Shinzo Abe, the current hero of the Japanese "reflationist" camp, is really committed to following through on the radical changes he's proposed.

Still, I think that if Japanese politicians and policymakers were willing to try a big push for reflation, it would be a good idea. I explain why in an article (in Japanese) published on the Japanese econ blog site Agora. Here is an English translation of my main argument:

[T]he gains [of an attempt at reflation] seem disproportionate to the risks. Reflation has the potential to help Japan solve three of its biggest problems at once: 1) the slow economy, 2) deflation, and 3) the huge national debt. Monetary easing will probably lower Japan’s unemployment a bit, and will also cause the yen to weaken, helping exporters. It will also erode the real value of the national debt, which at over 140% is the highest in the developed world. 

The only risk, on the other hand, is hyperinflation. How much should we fear hyperinflation? In terms of its effect on the economy, it is very similar to a sovereign default, which Japan is headed for anyway if it does not get its deficit spending under control. Hyperinflation destroys savings and causes economic activity to grind to a temporary halt; it usually lasts for about a year, before the government is forced to implement harsh austerity. After the end of hyperinflation, economies often recover strongly as economic activity restarts. 

In other words, hyperinflation is bad, but it is not the end of the world. Furthermore, it seems like an unlikely event. Hyperinflations are rare in history, and usually seem to coincide with severe disruptions to the real economy, such as wars.  

So when contemplating reflation, we must balance the likely possibility of three very important gains against the unlikely possibility of one bad but not world-ending loss. To me, the risk seems to be one worth taking.

Nobuo Ikeda, the prominent Japanese econ blogger who runs Agora and graciously published my piece, offers a rebuttal (also in Japanese). Here is a (rough) translation of his main counterargument:

[Noah is espousing] the "burn it down and start over" theory I often hear these days; but would the damage [from hyperinflation] really be finished in just one year? The bad debt problem in the 90s lasted ten! And in 5 years, recovery from the American financial crisis has not yet been achieved; in fact, the effects have spread to Europe. A Japanese financial crisis would be even bigger, and I fear the Japanese economy would never be able to regain its footing. 

As I showed in the hypothetical scenarios outlined in my book, the real danger of hyperinflation is not an economic collapse, but a financial one. If [nominal] interest rates soar [as they would in a hyperinflation], the national debt bubble will burst and most local banks will collapse...the crisis would be even longer-lasting than the one now facing Europe... 

As Niall Ferguson (whom Noah dislikes) has pointed out, many civilizational collapses begin with a financial collapse.

Basically, Ikeda argues that even if hyperinflation is unlikely, it is so catastrophic that we should not countenance even the smallest possibility of it happening. 

Well, I have three thoughts about this:

1. Niall Ferguson shows that financial collapses precede civilizational declines. Precedence does not equal causation. Remember, financial markets are forward-looking, so if people see a civilizational collapse coming, of course they're going to sell their assets; that doesn't mean a hyperinflation or default would have caused civilizational collapses where none occurred. If civilizations collapsed every time there was a financial crisis, then America would have collapsed after 1929, Germany after 1920, and Sweden after 1992. In other words, financial crises have predicted 10 of the last 3 civilizational declines. 

2. Looking at the list of past hyperinflations, I don't see any instance of monetary policy experimentation causing a civilizational collapse. In many of the cases, hyperinflation was followed by a return to robust health (the Weimar hyperinflation, the end of Polish communism). In others, political upheaval followed hyperinflation, but these upheavals seem to have been related to wars or civil unrest (which in turn probably caused the hyperinflations). So I'm not denying the possibility that Japanese "reflation" could cause Japanese civilization to collapse; I'm merely saying it would be something new and unprecedented if it did.

3. Ikeda mentions the long stagnations that followed the Japanese "bubble burst" of 1990 and the American financial crisis of 2008. But it is important to remember that these involved deflation, not hyperinflation. The two are not the same; in fact, in one important way they are opposites. Deflation exacerbates debt; inflation destroys debt. A Japanese hyperinflation (or sovereign default) would eliminate Japan's government and corporate debt. That would act as a tax on the old people who own bonds. But it would remove the overhang of debt from Japan's economy, increasing the expected future income of workers and young people. That might be good for Japan's economy, not bad.

So it seems to me that the main risk of a Japanese hyperinflation is political. If hyperinflation caused a revolution and a collapse of the current regime, a much less effective Japanese regime (yes, you read that right!) might replace it; perhaps an autocracy. That, I agree, is a big risk.

So I'm left ambivalent about "reflation". I still think it's worth a try. I think hyperinflation seems unlikely (though I don't really know this for sure). Based on the historical evidence, I don't think the economic risks of hyperinflation are particularly huge. But the political risks might be big. And that might be reason enough to avoid "reflation". I can't say for certain, though I still definitely lean toward reflation.

In any case, as I said, Shinzo Abe is unlikely to actually carry through any sort of serious push for reflation. So the question is, in all likelihood, a moot one...

Trust not in Shinzo Abe, ye monetarists!

Monetarists are an innocent lot. American bloggers, op-ed writers, and economists seem quite taken in by Japanese Prime Minister Shinzo Abe's promise of a grand monetary experiment. Abe is threatening to revoke the Bank of Japan's independence, forcing those recalcitrant hard-money-loving inflation hawks to set a hard target of 2% inflation or higher. To an American monetarist, this is really Christmas. Finally, we get to actually test the hypothesis that a central bank can hit an inflation target if it really puts its mind to it! Finally, we get to see the ultimate two-men-enter, one-man-leaves doomsday showdown between the immovable object of Japan's implacable deflation and the irresistible force of Print Money And Buy Stuff!

But it is not to be. Shinzo Abe is not the Jesus of monetary policy. American monetarists, I feel for you - I would love to see the idea of monetary policy dominance put to a stark test - but I just don't think it's going to happen.

You see, unlike most Americans who weren't watching back in 2006-2007, I remember Shinzo Abe's first term as PM. So I know what a walking facepalm this man represents. A brief refresher course: Abe's agricultural minister killed himself after a corruption scandal, and another of his cabinet ministers resigned after another such scandal. His health minister, Hakuo Yanagisawa, managed to hang on despite a wave of negative publicity after he called women "baby-making machines".

Abe is mainly interested in social and cultural issues. He is the Japanese style of socio-cultural conservative, sort of a Newt Gingrich type . As prime minister in 2006-7, he enacted a law requiring public schools to teach "patriotism",  mounted a vigorous denial of Japan's WW2 "comfort women" sex-slavery, gave gifts to the nationalist Yasukuni Shrine (angering China), and pushed to de-emphasize Japan's WW2 war guilt in school textbooks. His lifelong quest has been the revision of Japan's "pacifist" constitution to allow Japan to have a normal military.

I of course don't mean to imply that Abe's cultural conservatism makes him unlikely to experiment with monetary policy (unlike in America, in Japan "hard money" is less of a conservative sacred cow). Instead, what I mean is that Abe really just does not care very much at all about the economy. I mean, of course he wants Japan to be strong, and of course he doesn't want his party kicked out of power. But his overwhelming priority is erasing the legacy of World War 2, with the economy a distant, distant second.

This is why Abe allows himself to be surrounded by corrupt and incompetent people. He is entirely focused on his cultural conservative quest. The other day Abe called Obama "Bush". He just deeply, truly, does not care about stuff that does not involve boosting Japanese nationalism.

So why is Abe making all this noise about revoking central bank independence, setting hard inflation targets, etc.? I have a hypothesis: He is talking down the yen.

Since Abe was elected in a landslide a couple weeks ago, the yen, which had been at historically high levels, has plunged. (Update: from Matthew Boesler at Business Insider, here is a chart of the yen-dollar exchange rate since the LDP returned to power:


Wow!)

This is bound to give a (possibly temporary) boost to Japan's beleaguered exporters, who have been suffering quite dramatically under the strong yen. Remember, Abe's LDP, which ruled Japan for 55 years, has always been closely connected with export manufacturers in the so-called "iron triangle". The LDP, which thrived in the 60s, 70s, and 80s, has always been a mercantilist outfit, weakening the currency to pump up exports, using the surplus from exports to support Japan's corporatist social model in the so-called "two-tiered economy". In Japan's days as a high-quality low-cost export powerhouse, this worked marvelously and kept everyone happy, allowing the LDP to keep power for generations. The recent strength of the yen, however, has been looking like the final nail in that system's coffin.

By making lots of noise about revoking the BOJ's independence, Abe is trying to convince foreigners that inflation is on the way, thus sending the yen south. Basically, he is taking a page out of the LDP's old playbook - weaken the currency, pump up exports. Sure, it's not a sustainable strategy, but Abe doesn't need it to be sustainable; he just needs it to give the economy a fillip for long enough to let him complete his precious revision of the Japanese constitution. After that, he couldn't care less about what happens to the economy. It's a cursory, stopgap measure. To Abe, Japan's pride as a nation is infinitely more important than the fatness of its people's wallets.

Abe is not exactly trying to keep this strategy a secret, saying that counteracting the strong yen is a top priority.

So what does this mean for monetary policy? It means that Abe is targeting exchange rates, not inflation (or NGDP). He'll do what he has to do to tweak foreign expectations enough to keep the yen weak, but he won't actually follow through and revoke BOJ independence. And even if by some miracle he does revoke BOJ independence, he won't insist on a hard inflation target. A non-independent BOJ wouldn't be controlled by Shinzo Abe, it would be controlled by the Ministry of Finance, and those people are just as likely to fear the peril of hyperinflation.

Expect Abe to continue making noise at the BOJ, and expect to see some token BOJ response, i.e. a bit more quantitative easing. If the yen starts rising again, expect Abe to switch gears and start talking about (or actually carrying out) currency market intervention of the type carried out in 2004. Essentially, he will continue the current talk of radical monetary policy experimentation precisely as long as he thinks it's holding down the yen, and then abandon it for a different mercantilist stopgap. Do not expect any real action against the BOJ.

OK, maybe I'm wrong. I'm no expert in Japanese politics, just a guy who has been reading about the LDP for a long time. If Abe follows through on his radical monetary proposals, I'll gladly eat crow. But think of it this way. If a British guy came up to you six months ago, brimming with optimism that Vice President Paul Ryan would enact his famous Ryan Plan and save the U.S. from ballooning budget deficits, what would have been your response? That's how I feel when I see people put their trust in Shinzo Abe.

I hope I'm wrong. I'd love to see a bold monetary experiment. But I'm pretty sure I know these LDP jokers, and I'm pretty sure they're not going to deliver in the crunch.


Update: And now today, via the WSJ, I see that I'm completely right about the LDP's economic philosophy. Observe:

Japan's new finance minister upped the ante in the country's war of words against the strong yen, lashing out at the U.S. and Europe for letting their currencies weaken dramatically and calling on the U.S. to strengthen the dollar. 

The tirade from Taro Aso, Prime Minister Shinzo Abe's point person on currency strategy, underscores the increasingly pugnacious stance of the fledgling Abe government... 

"The U.S. ought to do its job and make the dollar strong. And what about the euro?" Mr. Aso said Friday... 

A procession of Japanese executives and politicians have bemoaned the yen's strength, blaming it for a loss of competitiveness, dwindling earnings, bankruptcies and the relocation of operations abroad... 

The dollar has recently staged a sharp recovery, as Mr. Abe's pledge to strong-arm the Bank of Japan into easing monetary policy to weaken the yen has driven investors to sell off the yen. (emphasis mine)

Oh yeah, they're really thinking a lot about inflation rates and money demand and the Zero Lower Bound. Sure.

Update 2: I think Reddit puts it very succinctly by saying: "Shinzo Abe isn't reading Scott Sumner, he just wants a return to Japanese mercantilism." That's exactly it. A mercantilist in monetarist's clothing.

Are voluntary contracts always mutually beneficial?

In a Crooked Timber post about cyborgs, Chris Bertram writes:

I expect someone will be along to explain how...contracts [requiring employees to get cyborg modifications] would be win-win.

Matt Yglesias drops by in the comments to write:

It seems pretty obvious how they would be win-win: They’d be agreed to voluntarily by two mentally competent adults.

Actually, this is a common misconception, so I thought I'd write a quick post to correct it. Basic Econ 101 does not imply that voluntary contracts are mutually beneficial to the people who enter into them.

The misconception springs from some solid intuition. In general, people who are free to do what they want, do do what they want. Maybe sometimes they don't realize what they want, or are subject to compulsions like addiction, but in general, free people only make deals that they want to make.

BUT, it doesn't follow that contracts are mutually beneficial. The reason is that there is uncertainty in the world.

Suppose that there's a deal that has a 60% chance of being to my benefit, and a 40% chance of being to my loss (assume equal benefit and loss here, just for simplicity). If I'm a rational person, and not too risk-averse, I would do that deal. But that still leaves a 40% chance that I'll lose out on the deal.

This is what's known as the difference between ex ante and ex post. Econ 101 says that people only make deals that are to their benefit ex ante. But that still leaves a lot of room for people to lose out ex post. And ex post is more important, since it's the real thing that actually happens to people, whereas ex ante is just what we guess will happen. (As a commenter points out, insurance contracts are a really good illustration of this principle. Would you buy health insurance if you knew you weren't going to have any health problems? Would your insurer sell you insurance if they knew you were going to get sick?)

Of course, all this doesn't mean the government needs to step in and stop people from taking risks. It just means that you can't infer outcomes from people's decisions.

Now just for fun, and because I don't like writing short blog posts, let's move out of the Econ 101 world, and introduce two advanced concepts: 1) asymmetric information, and 2) Knightian Uncertainty.

In a world of asymmetric information, one party to a deal may know something that the other party doesn't. For example, suppose you and I are considering making the deal in the above example. You think that the deal gives you a 60% chance of benefiting and a 40% chance of losing out. So, by your best guess, this deal is worth it ex ante. And so you're willing to do the deal.

But suppose I have information you don't (of which you are entirely unaware). Suppose I know that in reality, you have only a 30% chance of benefiting from the deal and a 70% chance of losing out. If you know what I knew, you'd never agree to the deal.

Now, if we could do 100 such deals, you'd eventually realize that I systematically had better information than you, and you'd become wary and stop making deals with me (as in George Akerlof's "lemons" model of asymmetric information). But in the real world, conditions are changing all the time - today I might have information you don't, and you might have information I don't. Thus, not only is there asymmetric information, but there's uncertainty (called "Knightian Uncertainty" after Frank Knight) about how likely it is that there's asymmetric information.

This allows people to be swindled again and again, as new kinds of asymmetric info keep popping up and falling into different hands. The swindlers may change, but the swindling will never stop, no matter how rational people are or how much experience they get. This is the basis of what George Akerlof calls "Phishing for Phools".

This is why we might want the government to step in and force people to divulge their private information. Econ 101 does say that better information all around can't possibly worsen the outcome of deals. I know of no "economic efficiency" argument for allowing people to try to swindle other people.

Anyway, bottom line: Even in a perfectly rational, perfectly free world, voluntary contracts are not always  mutually beneficial to the people who enter the contracts. And in a realistic, ever-changing, uncertain world, some kinds of contracts might be mutually beneficial less than 50% of the time. (Of course, if you allow for people to be irrational and unfree, things get even worse. And this post doesn't even mention things like externalities, which throw a further wrench into the system.)

Rise of the cyborgs

People have been requesting that I do more futurist posts, so here's a bit of holiday optimism.

A lot of recent futurist discussion in the media and blogosphere has revolved around either the technological stagnation thesis, or the question of whether robots will replace humans. Elsewhere, people are toying with the implications of more far-out technologies like brain emulation and desire modification, or following the ongoing mini-booms in natural gas fracking and 3-D printing.

But it occurs to me that people may be overlooking something big: another technological revolution that is right under our noses, about to change our world in a big way. I'm talking about the rise of biomechanical engineering...or, to use a more catchy term, cyborg technology. The cyborg revolution is not a far-future sci-fi conjecture; it is upon us even as I write these words.

For a taste of how cyborg technology may soon change our world, check out this BBC article. The key technology is the integration of human brains with computers. Here are some extrapolations of technologies that currently exist:

1. Direct mental control of machines (also called Mind-Machine Interface, or MMI). Non-invasive ways of controlling machines with one's mind have already been developed and will soon be commercialized. The biggest benefit of this, of course, will be for physically impaired people, but it will also probably allow us to write a lot faster; just think words, and they appear on the page. Writing speed is probably a significant constraint on productivity, so MMI may have the potential to raise service-industry productivity, which has been lagging in recent decades. Of course, MMI may also be a much easier and more fun way to play video games, control your mobile devices, etc., than punching buttons.

Another aspect of this is mind-internet interface. Obviously, this is scary, since you don't want your brain getting hacked by jerky teenagers halfway around the globe. So I'm not sure if this will ever be done, especially because sight is already a very fast way to assimilate information from the net.

2. Augmented intelligence. Artificial intelligence is one of the most-talked-about technologies, but if you think about it, it's probably easier and more natural to begin with the intelligence we already have, and simply augment it with computers. The BBC article I cited discusses experiments in which artificial devices have already served as functioning brain structures in rats, in particular as artificial memory centers; expect this technology to improve rapidly.

If we can store human memories in artificial brain structures, the implications are enormous. First of all, it would vastly expand the knowledge base and expertise of a human knowledge worker; if we could store vastly expanded amounts of knowledge, we would no longer be constrained to specialize in one incredibly narrow field. This might unlock huge innovative potential, as individual humans could do the kind of creative work that now require teams of humans.

If these artificial brain structures can be exchanged between people (a nontrivial task, obviously!), then we get human memory transfer, and the possibilities are even more enormous. Instant education, as expertise is copied and transferred from human to human. Functional immortality, as full sets of memories are transferred to cloned brains (Note: This is an idea I got from Miles Kimball; he explains it in this post). Etc.

Artificial brain structures might also allow boosted cognitive ability. Imagine humans with the processing power of computers at their beck and call. This, of course, is a more speculative technology...but maybe not so speculative, to wit:

3. Augmented learning. This sounds very pie-in-the-sky, until you read the BBC article and find that it is already real and may even be available over the counter:

Transcranial direct-current stimulation (tDCS) is a way of running electrical current through the brain with electrodes attached to the outside of the skull. The US Defence Advanced Research Agency (Darpa) currently uses tDCS to improve the learning speed of snipers, claiming it cuts the learning curve by a factor of 2.5. There are issues, though. "They learn more quickly but they don't have a good intuitive or introspective sense about why,” says Vincent Clark, neuroscientist at the University of New Mexico. 

Such devices were initially expensive, but now GoFlow sells a DIY kit for $99, which consists of two electrodes, cables and a 9-volt battery. So, in theory, everybody can try and tune his or her own brain at home. But if it is not applied correctly, anything could happen – from enhancing intelligence (intended), rewiring our brains (who knows?) through to electrocuting ourselves (not intended). Neuroscientist Roi Cohen Kadosh from Oxford University says he wouldn’t buy the DIY kit, because he thinks it is premature to distribute it to non-experts. “People might feel like they should stimulate their brain as much as they want, but just as buying a medicine on the counter, you need to know when to use it, how often, in what conditions and in what cases you should not take it.”

There is no word to describe this except for "amazing". I fully expect other bloggers to buy the kit, try it out, and tell me how it goes...

Of course, another possible application of this exact same type of technology is:

4. Mood modification. We already know how to stimulate certain emotions with direct brain stimulation; noninvasive methods, of the type currently being developed for artificial learning, would revolutionize the applications of this technology. For example, cognitive behavioral therapy currently relies on human attention and vigilance to replace negative thoughts with positive ones (thus alleviating depression and anxiety); if this process could be automated, it could help cure some of the great psychological scourges of modern society.

But why stop there? People with phobias could get rid of the phobias by counteracting fear responses at high speed; as soon as you see the thing you fear (a dog, or an enclosed space), a computer will see your fear response spiking and stimulate feelings of safety and security instead. Poof, phobia gone! Not to mention social anxiety; imagine how easy it would be to talk to cute girls at parties if your mobile device could zap you with artificial self-confidence every time you started to get scared.

Of course, at this point, mood modification becomes a rudimentary form of my "holy grail" technology of Desire Modification. The thing to understand is that non-invasive external stimulation of emotional responses is not very far away; we're talking a few years, not a few decades.

5. Artificial sensory input. This already exists and is on the market, in the form of cochlear impants (artificial ears) and visual prostheses (artificial eyes). The technology is improving very rapidly. At the point where artificial senses become as good as (or better than!) natural ones, whole new worlds of possibility open up.

For example: artificial eyes and ears would replace all input devices. You would never need a television screen, a phone, Google Goggles, or a speaker of any kind. All you would need would be your own artificial eyes. You could play video games in perfect, pure augmented reality. Imagine the possibilities for video-conferencing, or hanging out with friends half a world away!

And why stop there? If you wanted, you could perceive the buildings around you as castles, or the inside of a spaceship. The whole world could look and sound however you wanted.

(Of course, brain chips that could feed artificial input to the sensory perception centers of the brain - the technology of The Matrix - could accomplish this task even better. But this might be farther away.)


OK, time to stop. Of course, I haven't come close to encompassing the full set of possibilities available from brain-computer interface, but I think I've shown that many cyborg technologies that currently exist have the potential to quickly and dramatically reshape human life. I leave it to you to fill out the list.

What will this mean for the economy? Well, unlike media and information technologies (which can usually be copied without cost), biomechanical technologies are good old manufactured goods; their inclusion into the economy will show up in the GDP statistics, unlike Facebook or Craigslist. And because these technologies have the potential to vastly improve the human experience, we can expect them to become near-universal consumer goods, provided our legal institutions allow it.

Also, cyborg technologies have the potential to improve human productivity quite a bit, as my examples above have hopefully shown. Humans who can store vast amounts of knowledge and expertise, who can directly interface with machines, and who can make themselves more well-adjusted and motivated at the touch of a (mental) button will be valuable employees indeed, and will prove useful complements to the much-discussed army of robots.

All this means that cyborg technologies, if they become widespread, will do much to quiet the fears of the stagnationists. But this, of course, requires institutions that allow these technologies to become universal. Currently, I feel that institutions like the FDA and the health care system are biased toward treating the "sick", and place way too little value on technologies to improve the average human experience above its baseline (witness how we push antidepressants on everyone, but ban even weak recreational pleasure drugs like marijuana). I fear that our society will collectively decide that anything that improves on "natural" humanity is unsafe for public consumption. This would sacrifice huge amounts of growth potential on the altar of what is essentially a pointless, semantic distinction (Isn't it "natural" for old men to become impotent? But we still allow Viagra...).

In any case, the cyborg revolution is upon us. Pay attention, futurists. This could be very, very big.


Update: Just to clarify, I think that: A) cyborg technologies that affect the mind are going to be far, far more important than ones that affect mainly the body, and B) Noninvasive methods of brain-computer interface definitely count as "cyborg" technology; you don't have to have robot parts in your head to be a cyborg.

Update 2: In this must-read piece, io9's George Dvorsky lists 16 science fiction predictions that actually came true just in 2012. Cyborg technology dominates the list; see items 1, 3, 10, 13, and 15. The cyborg revolution is upon us!

Update 3: A TED talk on cyborgs just came out. Like I said, this is bigger than anyone realizes, and is right now in the process of exploding into the public consciousness.

Update 4: Futurist Ramez Naam has an article in Forbes summarizing a lot of the new cyborg tech and speculating about where it might take us.

Waiver of Subrogation, What is it?

If after an insurance claim is paid out by your insurance company, it is deemed that another party was actually the negligent one, then your insurance company (via the insurance policy contract) has the right to go after the negligent party. This right is usually found in the "Conditions" section of your insurance policy. This conditional right can, however, be waived. This means that your insurance company would then not be allowed to go after the negligent party. The term for this waiving of rights is called Wavier of Subrogation.

Often you will see the Waiver of Subrogation in commercial leases. Landlords will require that tenants have this verbiage in their insurance policy so that if a claim occurs at the leased location that the tenant's insurance company cannot come back after them for damages. The landlord, however, would be less inclined to have this wording on their policy since it would mean they and their insurance company would not be allowed to go after their tenant after a claim. A building owner and their insurance company usually have more to lose (the building and its rental income) than the tenant does so they would be very interested in being able to go back after a negligent party.

There are two example of where a landlord may want the Waiver of Subrogation wording on their own insurance policy. The first is if they are renting to a family member or friend who they know doesn't either have enough assets or money to be able to cover them in case of a claim, they may not want their insurance company to be able to go after them to collect for damages. The second is if the landlord and tenant are owned by the same person or organization. In some cases, usually for legal or tax reasons, a person may have one company that owns the building and another company that owns the business that is the tenant. In those cases you would probably want both the landlord and tenant policy to have a Waiver of Subrogation clause in their policies so that you don't have your two insurance companies fighting over payout.

Another place where you will see Wavier of Subrogation is in situations where companies or organizations will subcontract work to other companies or organizations. Often, if a business is going to hire another business to do work on their behalf they will request that the subcontractor have Wavier of Subrogation on their policy. Similar to the Landlord/Tenant relationship, if the contractor requires the subcontractor to have Waiver of Subrogation on their policy it means the subcontractor, if a claim arises, is not able to go back after the contractor for money.

When entering into a lease or a business contract it is important to know if you are going to be required to have Waiver of Subrogation and if you have it or not in your insurance policy. It is best to have both your legal team and your insurance professionals review contracts to make sure you are adequately protected.

New Atlantic column: Gun control is good, but ending the War on Drugs is even better

I have a new column up at the Atlantic, in which I try to give some perspective to the gun control debate that has exploded since the Newtown massacre. Some excerpts:

This is not a column against gun control. Gun control is a good idea. The assault-weapons ban is a good idea. So are background checks, stricter licensing agreements, and greater efforts to keep guns out of the hands of minors. A prohibitive tax on ammunition? There's another good idea finally getting attention it deserves... 

Stringent gun-control measures are unlikely to turn the United States into a peaceful gun-free society like Japan...[T]o become like Japan, banning gun sales wouldn't be enough...if the U.S. banned gun ownership, and confiscated all the guns that people currently own, it would probably be very effective. But this is almost certainly politically infeasible... 

[I]f we really care about those 9,000 souls who are shot to death each year, there is an extremely effective policy that we could enact right now that would probably save many of them.  

I'm talking about ending the drug war... 

[F]ew would argue that the illegal drug trade is a significant cause of murders. This is a straightforward result of America's three-decade-long "drug war." Legal bans on drug sales lead to a vacuum in legal regulation; instead of going to court, drug suppliers settle their disputes by shooting each other. Meanwhile, interdiction efforts raise the price of drugs by curbing supply, making local drug supply monopolies (i.e., gang turf) a rich prize to be fought over. And stuffing our overcrowded prisons full of harmless, hapless drug addicts forces us to give accelerated parole to hardened killers... 

[D]on't expect [gun control] to be a panacea...[W]e need to end the self-destructive, failed drug policies that have turned us into a prison state and turned many of our cities into war zones.

Read the whole thing here!

Macro, what have you done for me lately?

Paul Krugman says the state of macroeconomics is rotten. Steve Williamson disagrees. With apologies, I'll cut-and-paste most of Steve's post:

This is actually a relatively tranquil time in the field of macroeconomics. Most of us now speak the same language, and communication is good. I don't see the kind of animosity in the profession that existed, for example, between James Tobin and Milton Friedman in the 1960s, or between the Minnesota school and everyone else in the 1970s and early 1980s. People disagree about issues and science, of course, and they spend their time in seminar rooms and at conferences getting pretty heated about economics. But I think the level of mutual respect is actually relatively high... 

Since the 1970s, it is hard to identify a field called macroeconomics. People who call themselves macroeconomists have adopted ideas from game theory, mechanism design, general equilibrium theory, finance, information economics, etc. to study problems of interest to policymakers and the public at large. Sometimes it's hard to tell a macroeconomist from a labor economist, from someone working on industrial organization problems. What are "freshwater" and "saltwater" macro? No idea...

The truth is that we have all moved on from the macro world of the 1970s. Methods that seemed revolutionary in 1972 are the methods everyone in the profession uses now. The nerds who had trouble getting their papers published in 1972 went on to run journals and professional organizations, and to win Nobel prizes. This isn't some "cult that has taken over half the field," it's the whole ball of wax... (emphasis mine)

Economic science does an excellent job of displacing bad ideas with good ones. It's happening every day. For every person who places obstacles in the way of good science to protect his or her turf, there are five more who are willing to publish innovative papers in good journals, and to promote revolutionary ideas that might be destructive for the powers-that-be. The state of macro is sound - not that we have solved all the problems in the world, or don't need a good revolution.

On the question of whether macro is divided into warring "schools", I'd say Williamson is 85% right, and Krugman only 15%. Yes, there are some systematic disagreements, but they're not very bitter or rancorous, and everyone uses mostly the same "language". The old "freshwater"/"saltwater" distinction is still there to a limited degree among older faculty, but younger faculty don't seem to see much of a dividing line. (Krugman even hints at this when he mentions the fact that "saltwater" and "freshwater" models now look very much alike.) In the blog world you see lots of name-calling and rhetorical fireworks and serious consideration of "fringe" ideas, but in the academic world of conferences and seminars and journals, there seems to be almost none of that.

So if collegiality and similarity of technique are measures of a field's health, then macro is doing quite well. But I feel like there's a larger question: What has macro done for the human race in the last 40 years? How are we better off as a result of all this macro research effort?

(This is the more general version of the question asked by the Queen of England, when she asked why (macro)economists didn't see the financial crisis coming. Sure, some people argue that "financial crises" are inherently unpredictable because of the EMH. But there's no obvious reason why recessions shouldn't be predictable in advance.)

Today, in 2012, do we know much more about the "shocks" that cause recessions than we knew in 1972? I'm not sure we do. The question of whether these shocks are mainly "real" or mainly "monetary" is not settled within the field (as Bob Lucas mentioned in a recent interview). Nor do we seem to know much about how the shocks actually work - usually, macroeconomists just assume the shocks follow a simple random process like an AR(1).

What this means is that the actual cause of recessions is basically still one huge mystery.

What about the question of how the economy responds to the shocks? Even if we don't know much about the cause(s) of recessions, do we understand how recessions play out? I'm not sure we do. We have some empirical observations, of course - we know how much investment tends to vary with swings in GDP, etc. But in terms of impulse responses - i.e. the way the economy would move if all the noise were cleared out of the data - we have as many different guesses as we have macro theory papers. And macro theory papers are as numberless as the stars in the night sky. 

What about the question of policy? Do we know how governments can damp out the swings in the business cycle? Here there seems to be very little agreement. Even if macro isn't divided into warring camps shouting at each other, there is nevertheless a huge diversity of opinion on both the efficacy and the proper conduct of monetary policy, fiscal policy, and other recession-fighting measures. That there is no consensus means that the question is still unanswered. Useful technology has not been delivered. It doesn't take an expert to realize that fact. (Update: Well, actually not quite. Constantine Alexandrakis comes up with a couple of important counterexamples; see below.)

So macro has not yet discovered what causes recessions, nor come anywhere close to reaching a consensus on how (or even if) we should fight them.

(As an aside, modern macro models - at least, the DSGE variety - are basically not regarded as useful by private industry, although time-series methods developed for macro, such as vector autoregressions, have seen wide application.)

Given this state of affairs, can we conclude that the state of macro is good? Is a field successful as long as its members aren't divided into warring camps? Or should we require a science to give us actual answers? And if we conclude that a science isn't giving us actual answers, what do we, the people outside the field, do? Do we demand that the people currently working in the field start producing results pronto, threatening to replace them with people who are currently relegated to the fringe? Do we keep supporting the field with money and acclaim, in the hope that we're currently only in an interim stage, and that real answers will emerge soon enough? Do we simply conclude that the field isn't as fruitful an area of inquiry as we thought, and quietly defund it?

And who do we call in to evaluate the health of a science? If we only rely on insiders to evaluate their own field, we are certain to run afoul of vested interest (If someone asked you "How valuable is the work you do", what would you say?). But outsiders often lack the relevant expertise to judge someone else's field.

It's a thorny problem. And (warning: ominous, vague brooding ahead!) it seems to be cropping up in a number of fields these days, from string theory in physics to "critical theory" in literature departments. Are we hitting the limits of Big Science? Dum dum DUMMMM...But no, this question leads us too far afield...


Update: Mark Thoma and Simon Wren-Lewis weigh in on the original Krugman-Williamson debate.

Update 2: Simon Wren-Lewis drops by in the comments to say that yes, macro did produce a policy consensus (basically interest rate targeting by the Fed, with a Taylor Rule type objective function balancing growth stability and price stability), and yes, that policy consensus did help the world, by giving us the Great Moderation, which wasn't perfect but was better than what came before. I guess that's a fair point. But I'd point out that:

A) the New Keynesian models to which Simon is referring were made after the 70s inflation and early-80s Volcker disinflations, and the Great Moderation policies might have been mostly inspired by the Volcker episode rather than by the models that came after it;

B) the New Keynesian "consensus" was always rather fragile, accepted by central banks but pooh-poohed by the academics that Krugman calls "freshwater" macroeconomists; and

C) Taylor-type rules were originally estimated as Fed reaction functions, describing Fed behavior rather than prescribing it (later they became prescriptive when added to Woodford's New Keynesian models), so it seems that the Fed may have been behaving in the way it did in the Great Moderation well before New Keynesian models emerged to endorse the policy.

So I am still very skeptical of the notion that modern macro models motivated the Great Moderation policies rather than just describing them after the fact...But I guess I could be convinced.

Update 3: In the comments, Costas Alexandrakis (CA) points out that the development of the ideas of adaptive expectations (Friedman) and rational expectations (Lucas) helped put an end to the mistaken idea that the Phillips Curve represented a stable, usable policy tradeoff between inflation and unemployment. This is a good point. Exposing the flaws in bad economic policy is just as important as suggesting good economic policy. So this is definitely an exception to my sweeping statement that macro hasn't given us much in the way of policy advice. Also, Costas points out that Lucas' idea of rational expectations helped motivate the Fed's practice of "forward guidance". This I'm not so sure has been effective, but it is definitely another interesting counterexample.

Update 4: Brad DeLong thinks I am using the phrase "techniques of modern macroeconomics" too loosely, and lists a number of questionable Steve Williamson quotes that he thinks should be inconsistent with the true "techniques" of macro. But I think that that doesn't negate the ubiquity of DSGE modeling in modern macro journals and conferences. Steve Williamson certainly does use DSGE in his theory papers, and he certainly does get published...

Update 5: Paul Krugman also says that just because everyone in (mainstream) academia uses DSGE doesn't mean that they're really using the same "techniques"; the content of the models makes all the difference.

Update 6: Scott Sumner comments. He disagrees with my observation that the freshwater/saltwater conflict has waned. His answer to the question of "what causes recessions" is "aggregate demand shocks", but this doesn't really answer the question of what is causing those shocks (of course, Scott Sumner thinks NGDP targeting can perfectly cancel out any aggregate demand shocks, so maybe he doesn't even care where the shocks come from). He agrees that modern macro methods (DSGE models) have given us no useful technology of any kind. And he endorses replacing the current mainstream macro profession with "Market Monetarists" like himself and David Beckworth.

Update 7: Brad DeLong weighs in. He agrees that academic macro hasn't produced useful models (actually I myself wouldn't go quite that far; I think academic macro simply hasn't produced models that we can know are useful in time to use them). He says that economists in the public sphere have been less than helpful since 2008 primarily because of political pressure from the conservative movement.

New article in the Huffington Post: Why conservatives shouldn't fear the fiscal cliff

I have a new article up at the Huffington Post. Basic idea: Conservatives tend to believe in the power of forward-looking expectations. That will tend to reduce the impact of the fiscal cliff - yes, even the distortionary part - because if people are forward-looking, they will have been expecting taxes to go up ever since Reagan raised deficits in the 80s, and this will dramatically reduce the impact of the cliff. Excerpt:

[A]ccording to a central tenet of conservative economics, the fiscal cliff is not going to be a big deal. I'm talking about the principle known as "Ricardian equivalence."... 

Ricardian equivalence has become a pillar of conservative thinking about economic policy. When President Obama was preparing the 2009 "stimulus" bill, a number of economists -- including Robert Barro himself -- took to the editorial pages to vigorously protest. Deficit spending, they argued, couldn't boost the economy, because people would expect future taxes to pay for today's spending, and would cut back accordingly, exactly canceling out the "stimulus." 

By the same logic, conservatives shouldn't be worrying about the fiscal cliff. Yes, taxes will go up if we go over the cliff. But according to Ricardian equivalence, people have known all along that this would have to happen at some point, and they have been planning accordingly... 

In other words, the fight over the fiscal cliff might just be an elaborate form of political kabuki theater. Conservatives, if they believe their own economic doctrine, are probably not actually losing any sleep.

Read the whole thing here!

The Omnipotent Fed idea

Since the Fed started its new policy of "QE infinity" (which it stepped up on Wednesday), acclaim has been heaped upon the economists who have promoted a policy of NGDP targeting (or "NGDP level path targeting"), which bears some resemblance to "QE infinity". Chief among these economists is Scott Sumner, who promotes his ideas mainly through his blog; Sumner was recently named one of Foreign Policy Magazine's top 100 global thinkers, and economics pundits from Tyler Cowen to Matt Yglesias have credited Sumner as being the intellectual force behind the Fed's new policy. However, Scott is far from a solitary crusader; he has been assisted by David Beckworth, Ryan Avent, Andy Harless, Steve Randy Waldman, Joe Weisenthal, Evan Soltas, and a number of other bloggers and pundits. Additionally, my own graduate advisor, Miles Kimball, has promoted similar ideas on his blog and in his academic work.

I generally support the idea of an activist Fed, unconventional monetary policy, etc. However, I do have a misgiving about a key element of the case made by the aforementioned crop of monetarists. This is the notion of an "Omnipotent Fed"...by which I mean not that the Fed can create stars and galaxies, but that the Fed can set NGDP to be whatever it wants. If this assumption is wrong, NGDP targeting (or similar policies) may simply not work.

To some, the proposition that the Fed can hit any NGDP target seems self-evident. NGDP is just real GDP multiplied by the price level; if the Fed perfectly controls the price level, and either A) knows the relationship between the price level and output, or B) can change the price level faster than real output changes, then it immediately follows that the Fed sets NGDP. You often hear this stated as the idea that "the Fed can always choose to inflate".

But what if the Fed can't set the price level? There are several ways this could be the case. For example, the price level might be discontinuous in certain regions. For example, suppose the Fed attempts to set inflation at exactly 176.73%. But it might be the case that any monetary policy that pushes inflation above 175% will automatically cause inflation to jump to 190% (and vice versa). In other words, suppose that in some region, NGDP is a step function with respect to monetary policy. That's just one example, though; in general, any time NGDP is an unstable, stochastic, or undetermined function of monetary policy, the "omnipotent Fed" proposition fails. One special case of this is Milton Friedman's idea that monetary policy acts with "long and variable lags", a notion that has been pooh-poohed by the new monetarists.

Anyway, OK, so is the Fed "omnipotent" or not? Well, how on Earth could we know? My big problem with the "Omnipotent Fed" idea is that it seems non-falsifiable. By which I mean, it doesn't seem like the evidence will ever be able to tell us whether the Fed is omnipotent or not.

Why not? Two reasons: A) Because the Fed's thought process is unobservable, and B) Because the Fed's policy toolkit is unobservable. To know what the Fed can do, we have to know what the Fed tries to do. For example, suppose we see the Fed do $1 trillion of quantitative easing, and NGDP doesn't seem to budge much.

Interpretation 1: The Fed knew that its actions would lead to a non-budging NGDP level, which is why it did what it did. In other words, the Fed chose to keep NGDP where it was, and if it had wanted to, it could have raised NGDP instead of just keeping it static.

Interpretation 2: The Fed tried to raise NGDP and failed. It failed because the people at the Fed made a mistake. They did the wrong kind of easing, or didn't manage expectations correctly, or in some other way used the wrong tools. If the Fed had used the right tools, it could have raised NGDP.

Interpretation 3: The Fed tried to raise NGDP and failed. It failed because the only way to raise NGDP would have been to cause a hyperinflation, which would raise NGDP by much, much more than it wanted.

There are more interpretations. I just highlighted these three to demonstrate a point.

How can you know what the Fed wants? You can make some guesses, but not scientific ones. The Fed keeps its decision-making process secret. And suppose you somehow could figure out what the Fed wants (say, by applying a mind-reading device to the Fed chairman during a policy announcement). That would tell you precious little about what the Fed is actually capable of. For example, suppose that expectations are very important in the determination of NGDP. Do we know what determines expectations? Not really, no. Or suppose money demand is unstable, or contains hysteresis, in certain regions. How would we know that?

Some people have claimed that an "NGDP futures market" would allow us to test the proposition of Fed omnipotence. If NGDP futures were stable, they say, that would show that the Fed can hit any NGDP target it likes. But this is just flat-out false. Low NGDP futures volatility could mean that the Fed is utterly powerless, and that investors simply expect few shocks to NGDP.

So it seems to me that the proposition of Fed omnipotence is something that we can only believe by making a leap of faith. It is functionally equivalent to the notion that an invisible God controls everything we see in the world. Thus, believers in the Omnipotent Fed will always be able to claim, without scientific or logical refutation, that every jump and juggle of NGDP was the deliberate choice of the Fed.

Does this mean that every question about monetary policy is fundamentally unanswerable? No, it doesn't. We can't observe the Fed's desires, and we definitely can't observe the Fed's total choice set. But we can observe the Fed's actual choices. If you tell me "Inflation always rises 1 for 1 with the monetary base," well, that is an easy proposition to falsify.

So what is the implication for monetary policy? I am not claiming that NGDP targeting is a bad idea, or that it definitely will not work, or even that it is unlikely to work. What I'm claiming is that, in the presence of true Knightian uncertainty about the power of the Fed, it is certain that at some point, if NGDP targeting doesn't seem to work, we will inevitably abandon the policy. And the point where we decide it has failed will depend not on scientific fact, but on intuition and heuristics. In other words, if the Fed keeps printing money and NGDP doesn't return to its pre-crisis path, at some point we will simply start to entertain the notion that the Fed is incapable of doing what we want it to do. And then we will try to think of something else. And of course the true believers will say: "No, the Fed could have done it, they just didn't really want to." And we won't be able to prove them wrong.


Update: On Twitter I asked Miles Kimball what he thought of this post, to which he responded:

It is certainly a logical possibility that the Fed can't get inflation up without overshooting...The difference is that I don't think the US is actually in that situation of having to overshoot. Japan may be.

Did risky mortgage lending cause the financial crisis?

No.

Or, at least, not by itself, it did not.

The financial crisis consisted of two things:

1. A liquidity crunch or bank run, in which financial institutions all wanted to sell their long-term assets in order to pay off short-term liabilities at the same time, but couldn't.

2. A solvency crisis, in which so many systemically important financial institutions had made bad bets that their simultaneous failure threatened the health of the financial sector itself.

Both of these things involved risky mortgage lending. But risky mortgage lending, by itself, was not sufficient to cause either one of these. That's why I say that risky mortgage lending didn't cause the crisis.

Why not? Because in an efficient financial market, risk is fine. Risk is OK. In an efficient financial market, risk is priced. In an efficient financial market, if I buy a risky asset from you, I pay you less money because of the fact that I agree to take on more risk. (Paying less money up front means a higher expected return. So higher returns are my compensation for taking on more risk.)

What happened in the financial crisis was that risk was mispriced. People underestimated the risk of mortgages, mortgage-backed bonds, derivatives of mortgage-backed bonds (CDOs), insurance on mortgage backed bonds (CDS), commercial paper of banks that owned a bunch of mortgage-backed bonds, repurchase agreements with banks that owned a bunch of mortgage-backed bonds etc. Because they underestimated the risk of these things, they paid too much for them. This caused crisis (2), the solvency crisis, which hobbled our banks for years. And realization of crisis (2) caused crisis (1).

If there had been less risky lending, would people have underestimated these risks as much as they did? Maybe, maybe not. But whether or not they would have, we know that if the financial system had worked like it should, then there would not have been such a systematic underpricing of risk.

So risky mortgage lending didn't cause the crisis. What (partially) caused the crisis was risky mortgage lending being mistaken for non-risky mortgage lending, by people who ought to have known better.

Which brings me to the Community Reinvestment Act. Via Tyler Cowen, here is an NBER working paper that shows that the CRA made banks take on riskier portfolios of mortgage loans than they otherwise would have.

Does this mean that the CRA contributed to the financial crisis? No. Because the CRA existed since 1977, and the U.S. housing bubble only began in the 2000s. If three decades was not enough for the financial market to figure out that CRA mortgages are riskier than other mortgages, then the market is grossly inefficient, and crises will tend to form even with no CRA. And if in those three decades the market did figure out that CRA mortgages were riskier, then the CRA risk described in the paper was properly priced into all the MBS, CDOs, CDS, asset-backed commercial paper, etc.

In other words, the CRA made have caused more risky mortgages to be born, but the banks should have known that and hedged their bets accordingly. Either they did, and the root cause of the financial crisis was the mispricing of non-CRA risks (I suspect this is the case), or else they didn't, and thus the financial system was broken for a long, long time.

Either way, we shouldn't blame the CRA.


Update: Yes, I know there are reasons to doubt this study, and to think that the CRA didn't even cause much of the increase in risky lending. But the point of this post is: Even if it did, that doesn't mean it contributed to the financial crisis!

Is a bailout a tax?

I'm sure that by now, a bunch of people have piled on to this instantly notorious Casey Mulligan blog post. But let me add my voice to the chorus.

Mulligan's thesis is that because poverty rates didn't rise in the Great Recession (once you factor in government transfers), poor people now face an effective 100% marginal tax rate on their income; make one dollar more, if you're a poor person, and your government benefits go down $1. Here's Mulligan:

When measured to include taxes and government benefits, poverty did not rise between 2007 and 2011, and that shows why government policy is seriously off track... 

[W]hen someone loses $10,000 by not working, he should get some help from the government or from others in the forms of reduced taxes and enhanced benefits but still should bear a portion of that loss himself... 

If people with declining incomes found them entirely replaced by government help, that amounts to 100 percent taxation (providing more benefits as income falls is sometimes called “implicit taxation”)... 

Erasing incentives is not the way to a civilized society but rather to an impoverished one.

Casey Mulligan's general point - that the expiration of government benefits is a form of implicit taxation - is a good one. But I don't agree with his conclusion about the Great Recession. Just because poverty rates didn't rise doesn't mean that the government imposed a 100% implicit tax rate.

Why not? Because individual incentives don't (necessarily) depend on aggregate outcomes.

Suppose that the government gave out cash to poor people in order to keep the poverty rate at or below 15%.  Would that make it impossible to become poor? No. Because you'd still have a chance of becoming one of the 15%. If you work less than the poor guy next door, it's possible that you'll fall into the 15% and he'll rise out of it. The aggregate poverty rate will stay the same, but now you'll be poor. In other words, there is still an individual incentive for people to work, even if the aggregate poverty level is held fixed.

Or take another, even simpler example. Suppose the poverty level is $10,000 per year. Suppose the government decided to hand every citizen exactly $10,000 per year (raised with an income tax on people making above the median income). The poverty rate would then be permanently fixed (at 0%), and yet for everyone in the lower part of the income distribution, the implicit marginal income tax rate would be unchanged from whatever it was before the policy.

(Now, if poor people could somehow coordinate - if they could get together and say "Hey guys, let's all not work, and then the government will give us all bigger checks!" - then the government policy would indeed produce a 100% tax rate. But poor people can't coordinate like that in real life. And if somehow they did, the government could probably see them doing it, and change the policy to avoid getting ripped off.)

Note that in my example, the antipoverty programs are permanent. They are not temporary recession-fighting measures. My argument does not depend on the temporary nature of the incentive structure.

But in real life, the programs that Mulligan is talking about are temporary, and that actually makes my argument even stronger. Programs to keep the poverty rate constant during a recession are like bank bailouts - they are only likely to be used in a time of systemic crisis. If the overall economy is doing well, the government will be much more likely to allow the poverty rate to grow (this is basically what happened in the Bush years). And poor people know this. Since incentives depend on the future as well as the present, this means that we can't just look at what happened during the Great Recession in order to make conclusions about incentives.

In other words, I think Casey Mulligan makes two mistakes here: 1) He confuses individual incentives with aggregate outcomes, and 2) He assumes that poor people are not forward-looking.

Now, remember, Mulligan's more general point is still correct: The phase-out of antipoverty programs as income rises acts as an implicit marginal tax. But there is little we can deduce about the strength of this incentive just by looking at aggregate incomes during the Great Recession.

David Beckworth might be very wrong about the multiplier

Via Tyler Cowen, I see that David Beckworth is claiming that recent events prove that the "fiscal multiplier" is very low. In a post entitled "Paul Krugman will not like these figures", Beckworth writes:

See if you can figure out why [Krugman will not like these figures]:

This first figure shows that aggregate demand growth has not been affected by a tightening of fiscal policy since 2010.  Specifically, it shows that nominal GDP (NGDP) growth has been remarkably stable since about mid-2010 despite a contraction in federal government expenditures. The same story emerges if we look at the budget deficit relative to NGDP growth: 

 

Both figures seriously undermine the argument for coutercyclical fiscal policy and suggest a very a low fiscal multiplier.  They also indicate that the Fed has been doing a remarkable job keeping NGDP growth stable around 4.5%. Monetary policy, in other words, appears to be dominating fiscal policy in terms of stabilizing aggregate demand growth.

Beckworth's conclusion is not necessarily valid, and illustrates the danger in drawing conclusions about structural variables from looking at correlations between macroeconomic aggregates. Here's why the conclusion might not be valid:

Suppose that Keynesian demand management policy works perfectly: in other words, fiscal stimulus perfectly smooths fluctuations in aggregate demand. In that case, you will observe substantial swings in fiscal policy, but no swings whatsoever in aggregate demand. When external shocks push AD up, fiscal tightening will push it back down; when external shocks push AD down, fiscal policy will push it back up.

Beckworth's graphs give no measure of external shocks; hence, they are perfectly consistent with the idea that fiscal stimulus was allowed to wind down as the economy naturally recovered. (Tyler points this out.)

Check out Nick Rowe for an exploration of this idea in much greater depth. Using these graphs to conclude that fiscal policy is ineffective is like saying "Hey, no matter how much power my neighbor's heating system puts out from day to day, his room stays the same temperature; his heater must be useless!" It might be true. Or it might be the exact opposite of true.

Also, note that if fiscal policy is effective (i.e. if the multiplier is high), then aggregate demand will depend not just on current deficits but on expectations of the response of deficits to future external AD shocks. This is a central tenet of the "market monetarism" that Beckworth espouses, but there's no reason that forward-looking expectations can't be applied to fiscal policy as well as monetary policy.

To conclude: The graphs Beckworth shows are perfectly consistent with a large fiscal multiplier. In fact, they are perfectly consistent with the hypothesis that monetary policy is essentially ineffective, that the Fed is basically powerless, and that fiscal policy is capable of doing a perfect job of smoothing NGDP growth all on its own.

Now, I'm not saying Beckworth is wrong, and that the multiplier is big. I'm saying that the graphs he shows do not tell us much about the size of the multiplier. We should always beware of drawing conclusions about structural variables from looking at correlations between macroeconomic aggregates.

Update: David Beckworth responds (in the comments, and in an update to his post):

Noah, the thermostat assumes policy can respond in real time to the shocks. Do you really think fiscal policy is nimble enough to do this? It is reasonable to claim monetary policy can given its flexibility, but it's a stretch with fiscal policy (unless there are large automatic stabilizers built into place). 

Well, it's possible that there just weren't any big shocks in recent years...stimulus might have just calmly would down as planned, while the economy slowly recovered as expected. Also, remember expectations. Expectations are certainly nimble enough to respond quickly to any shock.

A bigger problem with your alternative story is that it doesn't fit the facts. Fiscal policy has been tightening despite the spate of negative economic shocks over the past few years: Eurozone crisis, debt cliff talks 2011, China slowdown which have kept U.S. economy from having a robust recovery.

Well, these are certainly putative negative shocks. They seem like things that might have been shocks. But do we know that they really were shocks? The Eurozone crisis was resolved, the debt cliff talks resulted in compromise, and China's slowdown was not really that big of a deal. Maybe in reality this was small potatoes compared to the basic restorative forces, pushing us to a slow but steady recovery after the Great Recession.

Paul Krugman has made this abundantly clear in many pieces where he repeatedly laments the lack of adequate fiscal policy. Surely he wouldn't be saying this is he thought along the lines of your thermostat example?

Ah, but what does Krugman consider a satisfactory outcome? The "recovery" from the Great Recession has seen pre-crisis RGDP (and NGDP) growth rates restored, but at a lower level than the pre-crisis trend; Krugman might just be dissatisfied with this outcome, even if it was the outcome produced by fiscal policy. Remember, Krugman doesn't set fiscal policy, he just talks about it a lot.

I continue to conclude that the notion that fiscal policy is ineffective is not supported by these graphs.


Update 2: Scott Sumner weighs in:

I was asked to comment on Noah Smith’s recent critique of David Beckworth’s post on the fiscal multiplier.  I basically agree with Noah, and would simply add that his arguments also suggests that the standard arguments in favor of the effectiveness of fiscal stimulus are also mostly flawed, in basically the same way that he claims Beckworth’s arguments are flawed (ignoring expectations channels, etc.)  When it comes to fiscal stimulus it’s all about faith—the data tell us almost nothing.

The whole world seems to be converging on the idea that macro data doesn't really reveal the true workings of the macroeconomy...I personally think we can do much better, data-wise, than some simple graphs of macroeconomic aggregates, but it is true that any empirical study of the fiscal multiplier (or the money multiplier, or any such policy effect) is going to have to rely on a theoretical model which itself can't easily be verified with data...


Update 3: This blogger put up some similar graphs comparing monetary aggregates and NGDP. Guess what? Monetary aggregates jump all over the place, NGDP just sails along. Exactly like deficits and NGDP in Beckworth's graphs. There's a lesson here...


Update 4: Paul Krugman weighs in, agreeing about the graphs in question, but saying that I'm too "nihilistic" about how much we can learn from macro data. But this, dear readers, is a topic for another post...