Must-Read: Tim Duy: Kevin Warsh, Very Serious Person

October 12, 2017

Must-Read: Yes, I know that every serious Republican interested in monetary policy is whispering that Kevin Warsh would be a disastrous Fed Chair appointment unless the technostructure could rein him in. And I even know that some non-serious Republicans interested in monetary policy are adding to the whispers—John Taylor, for example (but he may want it for himself). But more strong, open, public opposition from Republicans and bipartisans would be very welcome now.

Tim Duy breadth the lesson:

Tim Duy: Kevin Warsh, Very Serious Person: “Scott Sumner is perplexed by… Kevin Warsh[‘s in 2010]…

…The path that you’re leading us to, Mr. Chairman, is not my preferred path forward. I think we are removing much of the burden from those that could actually help reach these objectives… and we are putting that onus strangely on ourselves rather than letting it rest where it should…. We are too accepting of dangerous policies from others that have been long in the making, and we should put the burden on them…. Trichet did not take action until very late that Sunday night, until the fiscal authorities did their part…. I would still encourage you to put the burden where it rightly belongs, which is on other policymakers here in Washington…

Sumner is understandably scratching his head, trying to figure out what Warsh is getting at:

His reasoning process is poor and he lacks good communication skills.  He has very poor judgment when interpreting data.  I really don’t know what he’s trying to say here, but the reference to Trichet is interesting…. I find it odd that Warsh would be advocating fiscal stimulus, as Brannon suggests.  But again, the passage is so garbled that I could easily be wrong.

I don’t think Warsh was advocating for more fiscal stimulus at this meeting. Warsh is a Very Serious Person, and all Very Serious People know that deficits are bad. I believe that Warsh was at this juncture advocating a Trichet-style approach to the crisis, using the independence of the central bank to force the fiscal authorities to rein in those bad deficits…. Of course, Trichet’s approach proved to be disastrous, which is why Sumner is rightfully puzzled when hearing a Fed governor suggest the same.

Sadly, Warsh was not the only Fed official who advocated such an approach. Warsh is apparently cut from the same cloth as [Richard Fisher,] the person I believe was the worst regional bank president in recent memory. Recall when the FOMC statement contained this sort of reference:

Household spending and business fixed investment advanced, and the housing sector has strengthened further, but fiscal policy is restraining economic growth.

Of course, if you bothered to know what the FOMC was saying, you knew the complaint was that they believed monetary policy had reached its limits to stimulate the economy, and that faster growth required a more stimulative monetary policy. Then Dallas Federal Reserve President Richard Fisher either didn’t understand what the FOMC said, or deliberately misinterpreted the FOMC. In a 2013 speech, Fisher says:

Even if we at the Dallas Fed are right and the overall outlook for the economy is better than the current dashboard or the conventional prognostications of economists, there exists a formidable brake on growth. It was referred to point-blank in the last statement issued by the FOMC: “…fiscal policy is restraining economic growth.” Fiscal policy is inhibiting the transmission of monetary policy into robust job creation…. The propensity of members of Congress has been to spend in excess of revenues to give pleasure to their constituents and garner their affection…. Until the Congress and the president provide a clear road map as to how fiscal rectitude will be implemented, this lack of credible details for limiting the debt-to-GDP ratio and reengineering fiscal policy to stimulate rather than constrain growth is creating undue uncertainty about future tax rates, future government purchases, future retiree benefits and all manner of factors that impact employment and economic growth. Meanwhile, the divisive nature and petty posturing of those who must determine the fiscal path of the nation is further undermining confidence and limiting the effectiveness of monetary policy…. I argue that the Fed has no hope of moving the economy to full employment unless our fiscal authorities get their act together…Until then, I argue that the Fed is, at best, pushing on a string and, at worst, building up kindling for a massive shipboard fire of eventual inflation.

These aren’t the kind of people you want in charge of monetary policy. We need policymakers that understand their role is not to withhold monetary stimulus to force fiscal authorities to pursue countercyclical policy simply because Very Serious People know that deficit spending is always bad and cutting deficits is the solution to every problem. Monetary policy is about independently assessing the economy and enacting the policy necessary to maintain full employment and price stability. And oftentimes that means taking fiscal policy as an exogenous factor.

What is particularly discouraging is that neither Warsh nor Fisher appears to understand that during a recession, at a minimum automatic stabilizers themselves will swell the deficit. Taking aim at the deficit in such times is naive at best, deliberately spiteful at worst.

My concern remains that a Fed with someone like Kevin Warsh at the helm would prove to be disastrous for Wall Street and Main Street alike when the next recession hits. Neither group needs a central banker that believes a recession is an opportunity to inflict more pain.

The older I get, the more I am gobsmacked by the difference in reaction between Keynesians and Democrats on the one hand—we were wrong here; how can we do better in the future?—and Chicago-its and Republicans on the other—we were not wrong; it did not happen. And this difference is absolutely poisonous for dialogue and discussion.

The example of this in the forefront of my mind right now is the example of Chicago economist Robert Lucas and the Volcker disinflation. At the end of the 1970s the question at issue between rational expectations and adaptive expectations versions of macroeconomics was whether a sharp, sustained, credible shift to a lower inflation-target policy by the Federal Reserve could produce a sustained reduction in inflation without requiring the large and very painful hike in unemployment that adaptive expectations models suggested. Paul Volcker undertook such a sharp, sustained, and credible shift in policy at the end of the 1970s. The rise in unemployment was in line with that predicted by the adaptive expectations school. Both the power and limits of monetary policy were thus displayed for all to see. As Paul Romer summarizes:

Paul Romer: The Trouble with Macroeconomics: “Facts: If you want a clean test of the claim that monetary policy does not matter…

…the Volcker deflation is the episode to consider. Recall that the Federal Reserve has direct control over the monetary base…. Figure 1 plots annual data on the monetary base and the consumer price index (CPI) for roughly 20 years on either side of the Volcker deflation. The solid line in the top panel (blue if you read this online) plots the base. The dashed (red) line just below is the CPI. They are both defined to start at 1 in 1960 and plotted on a ratio scale so that moving up one grid line means an increase by a factor of 2. Because of the ratio scale, the rate of inflation is the slope of the CPI curve.

The Volcker Disinflation

The bottom panel allows a more detailed year-by-year look at the inflation rate, which is plotted using long dashes. The straight dashed lines show the fit of a linear trend to the rate of inflation before and after the Volcker deflation. Both panels use shaded regions to show the NBER dates for business cycle contractions. I highlighted the two recessions of the Volcker deflation with darker shading. In both the upper and lower panels, it is obvious that the level and trend of inflation changed abruptly around the time of these two recessions….

The best indicator of monetary policy is the real federal funds rate – the nominal rate minus the inflation rate. This real rate was higher during Volcker’s term as Chairman of the Fed than at any other time in the post-war era. Two months into his term, Volcker took the unusual step of holding a press conference to announce changes that the Fed would adopt in its operating procedures. Romer and Romer (1989) summarize the internal discussion at the Fed that led up to this change. Fed officials expected that the change would cause a “prompt increase in the Fed Funds rate” and would “dampen inflationary forces in the economy”….

If the Fed can cause a 500 basis point change in interest rates, it is absurd to wonder if monetary policy is important…. The only way to remain faithful to dogma that monetary policy is not important is to argue that despite what people at the Fed thought, they did not change the Fed funds rate; it was an imaginary shock that increased it at just the right time and by just the right amount to fool people at the Fed into thinking they were the ones who were the ones moving it around. To my knowledge, no economist will state as fact that it was an imaginary shock that raised real rates during Volcker’s term, but many endorse models that will say this for them…

Yet it was during this Volcker disinflation that Robert Lucas not only clung to rational expectations but doubled-down and began to assert that not even unanticipated monetary shocks had significant real effects on the U.S. economy:

Robert Lucas: Professional Memoir: In October, 1978—leaf season—the Federal Reserve Bank of Boston sponsored a conference at the Bald Peak Colony Club in New Hampshire…

…Ed Prescott and I rented a car at Logan Airport and drove up together. Night fell before we reached the conference center and we got lost on country roads. We stopped for directions at a crossroads store, but after a few minutes of laconic “Nope, yep” New England conversation we realized that the two old men in the store were amusing themselves at our expense, conveying no information. We left in disgust and anger. The incident heightened my sense of entering foreign territory….

Though I did not see it at the time, the Bald Peak conference also marked the beginning of the end for my attempts to account for the business cycle in terms of monetary shocks…. Through numerical simulations of their Bald Peak model, Kydland and Prescott found that the monetary shocks were just not pulling their weight: By removing all monetary aspects of the theory, they obtained a far simpler and more comprehensible structure that fit postwar U.S. time series data just as well as the original version. Besides introducing an important substantive refocusing of business cycle research, Kydland and Prescott introduced a new style of comparing theory to evidence that has had an enormous, beneficial effect on empirical work in the field…

Go figure…

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