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Tuesday, August 30, 2005


Edward Hugh

A lot of issues here Mark. I am, I suppose a lot more sympathetic to Greenspan than most, and especially on the 'rule' issues - new economist, our absent friend, is probably closer to you here. My guts tell me that central banking is more an art than a science, and that the most important thing is to keep them guessing. In that sense I would be most critical of the last phase of Gs stewardship, since I think he has boxed himself in too tightly with the measured rises, and the market is always trying to run ahead of him, so some freak adversity, or weakness in the eurozone (which I personally think very possible) could put pressure on him by driving up the dollar as he nudges up rates. This makes me nervous.

If you will permit me to go back to a post on your own blog, I couldn't disagree more strongly with Krugman when he says this:

"I think: the end of the housing bubble will automatically cure the trade deficit, too. Sorry, but no."

I almost think this argument verges on the dishonest, since Krugman knows better, but I don't like type M arguments so I'll put that aside. What K knows full well is that there are two principal policy options in reducing te deficit, change the value of the currency, or reduce the level of internal demand. (There is a third alternative which seems to be taboo, structural reforms to make the US enterprise more competitive and more able to face up to its German and Japanese rivals, but this would be longer term, improving the education level of the workforce eg).

Now..... we have a major structural problem with Bretton Woods (or if you like, bringing in the Chinese, Bretton Woods 2). For the dollar to go down, and adjust the deficit you need something else to go up, and the main candidate here is the euro. But the eurozone economies aren't strong enough (why is for another day) so we have the global imbalances, and the dollar is stuck at a higher level than the one needed to produce the correction.

So.... the only way to 'correct' is to turn the scew on domestic demand and stop it sucking in imports. Greenspan is trying to do this via the tightening, but a dramatic correction in house prices would have the same effet. At least this it appears to me is Gs argument, and I don't think i is so obviously false, at least I agree with it :).

"I believe much of the recent economic stability we observe comes from anchored inflationary expectations,"

The interesting thing here Mark is to ask the question just how anchored have the expectations been. My reading would be that many market participants have been surprised by the tame inflation we have had over the last couple of years (since their expectations were for more) and really what is striking is the low global inflation reading we are getting despite record annual global growth rates and high energy costs. I think there is something more going on here. What that more might be needs careful analysis, and calm discussion. The last annual report of the BIS might be a starting place.

Well that's enough on Greenspan, now for Trichet.

Edward Hugh

To try and put things in perspective, it is important to remember that many of these issues have a very different look depending on which side of the Atlantic you are based. Rather than the US and the eurozone, perhaps a better comparison would be between the non-Eurozone EU countries (like the UK and Sweden) where a more active approach is adopted and the ECB which seems esentially to go for a version of asymmetric risk based on the idea that doing something has more risks than doing nothing (and at least might attract more criticism since you have such divergent economies to cater for),so when in doubt, do nothing would seem to be the motto.The rest of the argument would seem to be post-hoc rationalisation. If BoJ policy is colloquially known as zirp, the ECBs is often reffered to as twirp (two % bla bla bla).

This impression is confirmed by a recent and relatively unprecedented assault on Trichet by LSE professor and former BoE MPC member Charles Goodhardt.He has written him an open-letter where he says, among other things, that the ECB demonstrates "conscious refusal" to be precise.

Eg "Is the medium term two years, three years, five years, n years, or what? By refusing to define the term, you can never be accused of missing your target. [It] is just an exercise in obfuscation,"


"It is hardly desirable, nor does it lead ultimately to credibility, to suggest that consensus existed when, in practice, it did not,"

Goodhardt is himself possibly better known for Goodhardt's Law, the economist's version of Murphy's Law, which states: any indicator you target soon becomes unreliable. Some indication of what he is getting at can be found in this papersummarising findings of his time on the MPC:


where he says among other things:

"Nevertheless we have attempted to establish that the MPC responded aggressively to any deviation of ex ante forecast inflation from its target, so much so, and so successfully, that there is no residual significant relationship between ex post inflation at any horizon, from current actual to t + 8, and nominal interest rates in this period. It would not have been possible for an observer to deduce what the MPC was really doing if she was to run a Taylor-type reaction function using current actual data during this short period. We hypothesize that the success of prior empirical tests of finding significant effects of current inflation on nominal interest rates has been because inflation targeting was either not being attempted so wholeheartedly, or just less successfully. Be that as it may, it does call into question the whole exercise of attempting to identify how Central Banks may react to a complete set of current and future variables by a simple regression using only current variables."

"An even more complex problem arises because these results indicate that the MPC did not intend to build gradualism into its own behaviour, and yet gradualism in the shape of consecutive series of similarly signed small steps in interest rates occurred nonetheless. Our attempts to explain this conundrum are mostly to be found in two separate, but connected, papers (Goodhart 2004 b and c). Even so, we suggest that such (largely unintended) gradualism arose through two main routes, first - and probably less important - as a quasi-automatic effect of using the constant-interest-rate conditioning assumption for the forecast, and second as a result of strong auto-correlation in forecasting errors."


"There was absolutely no indication of gradualism, of short run response being much less than long-run responses, in these results. Yet simple observation of the time path of interest rates.... reveals that the actual auto-correlation of interest rate changes, with a high ratio of continuations of small steps of the same sign relative to reversals has been just as high during the MPC years as before."

"How come? This is a complicated and complex story, which is the subject of a separate paper. But let me give the gist of those findings here. Given the above econometric results, we dismiss those arguments ... that claim that gradualism may, of itself, be desirable, since this was *not* what the MPC was aiming to achieve. This auto-correlation of interest rates was not intended. Instead it came about primarily through two routes. One such mechanism, though from my analysis somewhat the less important, occurred as a direct consequence of using a constant interest rate (CIR) conditioning assumption in making the forecast. As it well known, holding nominal interest rates constant soon results in Wicksellian instability. So any trend developing at the horizon t + 8 is likely to persist, and perhaps to become more extreme, beyond the horizon........ Then rolling the forecast quarter by quarter could easily result in a series of small, similarly signed step changes. Since the Bank does not publish forecasts beyond the t + 8 horizon, we cannot test this directly."

There is more:

"The UK experience in the years of our sample, 1997-2003, was, however, remarkable for its success in stabilising inflation around its target level. The variance of actual inflation, as measured by RPIX, around the target of 2.5% was minuscule as measured either by historical standards, (see Benati, 2003), or compared to most other countries. Although there has been some systematic correlation in the deviation of actual inflation from target, it has been small enough to disregard. Outcomes have been less successful in previous periods, and perhaps in other countries. In so far as actual inflation deviates to a significant and worrying extent from target, pressures will build up on the authorities to respond, irrespective of the belief that only future inflation reacts to current interest rates. Moreover, given the autocorrelation in economies, current deviations of inflation from target may well indicate forecast, future deviations of inflation from target. Indeed, as noted in the Introduction, this is an argument for the use of such reaction functions. Thus, one seems to reach the rather odd conclusion that such reaction functions, using actual contemporaneous data, are effectively identified by their comparative failure to achieve their supposed objective."


"To give a taste of the results, the coefficients in this function change markedly (and highly significantly) as the (forecast) horizon alters, and, on the basis of this, admittedly very short data set, it would simply not have been possible to work out what the MPC was trying to do by running a conventional Taylor-type function using contemporaneous values alone."

A lot of puzzles for people to think about here.

Edward Hugh

Bloombergs Caroline Baum has a piece on this debate here. I don't really agree with her, but its's worth a read.

Mark Thoma

Great follow-up commentary. Thank you.

My next post will be another comparison that is a bit more speculative. I am anxious to hear what you will have to say!

Dave Iverson

Krugman's comments, Aug 29 "Greenspan and the Bubble":

"And here's where Mr. Greenspan is still saying foolish things. In his closing remarks he suggested that "an end to the housing boom could induce a significant rise in the personal saving rate, a decline in imports and a corresponding improvement in the current account deficit." Translation, I think: the end of the housing bubble will automatically cure the trade deficit, too.

"Sorry, but no. A housing slowdown will lead to the loss of many jobs in construction and service industries but won't have much direct effect on the trade deficit. So those jobs won't be replaced by new jobs elsewhere until and unless something else, like a plunge in the value of the dollar, makes U.S. goods more competitive on world markets, leading to higher exports and lower imports."

So Edward, exactly where do you feel Krugman "borders on the dishonest"? Just curious.. d.

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