This is a sort of follow-up to my previous post.  One can think of demand stimulus as policies that boost NGDP.  (There are of course other policies that boost RGDP, such as supply side reforms, which work even if NGDP doesn’t rise.  But demand stimulus boosts NGDP.)

We know from long run money neutrality that the long run trend rate of growth doesn’t matter, except for second order effects like hysteresis and menu costs and taxation of capital income—and these second order effects might be positive or negative.  If someone argues that a certain policy may be able to significantly raise the trend line for RGDP, they may be right, but they are almost certainly NOT talking about demand-side stimulus.

The upshot of all of this is that there is only one coherent way to think about demand-side policies.  When should AD be more expansionary than average and when should it be less expansionary than average? It’s incoherent to say, “I think demand side polices should always be stimulative.”  That doesn’t even mean anything.  It’s like saying, “I believe all Americans should earn above average incomes.”  Any demand-side strategy should either call for stable AD growth, or else specify when aggregate demand should be more expansionary than average and when it should be more contractionary than average.

If you are advocating demand stimulus during a period of low unemployment, then (whether you know this or not) you are implicitly suggesting that demand-side policy should be more contractionary than average during a recession.  Not good.

A corollary of this is that terms like ‘hawks’ and ‘doves’ don’t have the meaning that almost everyone thinks they have.  If you have a 2% inflation target, exactly how do you implement a “dovish” policy?  A “hawkish” policy?

What if we turn to fiscal policy; does that change things?  Not at all.  The government’s national debt is constrained by the fact that the debt must be serviced in the long run.  This budget constraint means that budget deficits that are larger than average during certain periods must be offset by deficits that are smaller than average during other periods–to keep the debt manageable.  It makes no sense for someone to say, “I generally favor a more expansionary fiscal policy than what is favored by Sumner.”  It’s not even a coherent statement.  If you say that you favor a more expansionary fiscal policy that what I currently favor, you are implicitly saying, “and at some future date I prefer a more contractionary fiscal policy than what Sumner will favor at that point in time.”  I worry that the insights of Robert Lucas are being forgotten.

I don’t have strong views on who’s going to win the election.  Clinton seems more likely to win, but by how much?  Earlier today I defended 538, which gives Trump a (fairly good) 35% chance.  That’s more than the betting markets.  Now I’ll present the opposite argument, and then try to tie it in to monetary policy, which is what this stupid blog is supposed be about—right?

To see the argument for Trump having a good chance, check out this map, from RealClearPolitics.  It shows all states colored, based on poll averages, no matter how narrow the margin:

That seems like a pretty decent margin for Hillary–so why do I say it’s good news for Trump.  Because (blue) Florida is really close, has 29 electoral votes, and would put Trump up to 270 if it flipped.  That brings back memories of 2000, when a very close Florida put Bush up to 271.  And just as in that case, if Trump narrowly wins with 270 electoral votes, he’ll likely lose the popular vote—too many wasted Hillary votes in California and New York.  My hypothetical is identical to 2000, except Iowa, Virginia and Colorado flip.

I think this path to victory is semi-plausible, which is why Nate Silver’s 538 gives Trump a 35% chance.  But if he loses any of these states, no matter how small, then he falls short unless he can pick up another state.  And that’s where things get tougher. He’d need Pennsylvania, Colorado, Michigan or some place like that.  Those are tougher than Florida.  (I’m from Wisconsin, and have confidence in my fellow cheeseheads.)

To me, the most interesting event in the past 24 hours is the sharp fall in Trump contracts in the betting markets, to 22%.  AFAIK, that’s 10 points down from a couple days ago.  What’s going on?  The polls have not changed dramatically.  I’m not sure, but I suspect Nevada:

And now that Nevada early voting has come to a close, Ralston isn’t mincing words about how he sees Trump’s prospects. “Trump is dead,” Ralston tweeted Saturday. He elaborated on his blog that from the early voting numbers so far, the GOP nominee would need a “miracle” to win Nevada at this point.

The polls have tended to put Nevada as a pure toss-up state, and a few recent ones have even shown Trump ahead there. Accordingly, it hasn’t generally been considered part of Clinton’s swing state “firewall.”

But Nevada is a famously difficult state for national pollsters to get right. Its population is transient and many work at night. Furthermore, its population is over one-quarter Hispanic, and it’s often challenging for English-language polls to sample Hispanic voters accurately.

Does anyone know where Nevada was two days ago in the betting markets?

In the past, polls in Nevada have been less accurate than in other states:

So in previous years, analysts like Ralston have found success in reading tea leaves from Nevada’s early voting numbers instead. And all week, Ralston has been warning of danger signs for Trump. The partisan and geographic breakdown of early voting turnout has looked similar to 2012, when Barack Obama won the state by 6 and a half points. But the final day of early voting Friday was, Ralston writes, “cataclysmic” for Republicans.

.  .  .

Though the statewide early voting numbers aren’t yet finalized, Ralston estimates that registered Democrats will have a 6 point lead on registered Republicans among early voters. Since registered partisans tend to overwhelmingly vote for their own party, Trump probably either needs to dominate among early voters associated with neither party or else make up the gap on election day.

But how important is the early turnout?  This important:

But ballots equivalent to well over two-thirds of the total 2012 turnout in Nevada have already been cast. So if Trump has indeed fallen significantly behind in the early vote, it will be very challenging for him to catch up.

Experts warn that early vote totals can be misleading.  But they are not meaningless.  At a minimum, we actually have some HARD DATA.  We know that Dems in Nevada are turning out in large numbers.  That doesn’t mean Hillary will win the state; I could image Trump doing well among working class Dems.  But it tells us something–maybe that GOTV is working.  It’s no longer just polls.  My hunch is that 538 is ignoring this data, because early voting isn’t always reliable, but the betting markets are concluding that Hillary is very likely to win Nevada. Indeed while RCP (i.e. polls) give Nevada narrowly to Trump, the betting markets show a very strong 77% for Hillary.  I know of no other state with such a huge gap.

Rational expectations say that investors look at everything when making a forecast, including decisions on asset valuation.  Thus while experts might have said (in the weeks after Brexit) that “it’s too soon to say how it will impact the UK economy” the markets sniffed out that the UK was holding up better than expected, and UK stocks rallied quite a while ago.  Economists wait for data like GDP and employment, which comes out with a lag.  As another example, I think the markets sniffed out that slow RGDP growth and “lower for longer” interest rates were the new normal long before the Fed figured that out.  The Fed relies on models where 3% trend RGDP growth and 5% T-bill yields are “normal”, and it took them a long time before they downgraded those forecasts.

So while 538 is a great site, and I love their thoughtful statistical analysis, you could argue that it’s more driven by “models” than a pure rational expectations forecast would imply.  That is, it might not put enough weight on tea leaves like the Nevada early vote, because of its unreliability in other contexts.

I don’t want to make too much of this difference, as 22% isn’t that different from 35%.  Even after the election we won’t know for sure which approach was “right”, especially if Hillary wins.  I suppose if Trump wins then 538 will look good, as its numbers for Trump have been higher than elsewhere.  But even then it won’t be a crowning victory, after all, 538 is predicting a Hillary victory.  Michael Moore won’t be impressed.  You’d need lots of repeated tests to establish whether rational expectations beats really good models.

I believe it does, which is why I prefer NGDP futures markets to Lars Svensson’s suggestion that the Fed target its own internal forecast, based on structural models.  So there, a Trump Derangement Post that actually had implications for monetary policy!

PS.  Here is the betting market map:

Notice that they have Hillary winning New Hampshire and North Carolina too.

PPS.  Not enough derangement in this post?  I love this Matt Yglesias post on that disgusting illegal immigrant Melania:

So there’s really nothing so surprising about the Melania story. Trump doesn’t like immigrants who change the American cultural and ethnic mix in a way he finds threatening and neither do his fans. Europeans like Melania (or before her, Ivana) are fine. I get it, David Duke gets it, the frog meme people get it, everyone gets it.

But it does raise the question of why mainstream press coverage has spent so much time pretending not to get it. Why have we been treated to so many lectures about the “populist appeal” of a man running on regressive tax cuts and financial deregulation and the “economic anxiety” of his fans?

Slovenian models include anorexics, prima donnas, former porn stars, and some, I assume, are good people.

I’m no fan of Austrian macroeconomics, but even I think Noah Smith is way too hard on Austrian economics in this post. Although he does distinguish between Internet Austrianism and academic Austrianism, he doesn’t really do so very clearly in the portions of the post that mocks the Austrian school of thought–leaving the impression that his ridicule applies to both varieties.  (Maybe it does.) Then suddenly, Smith is way too kind to Austrianism and too mean to ratex:

But at least Austrianism embraces the possibility that businesses might make big, systematic mistakes. That possibility is essentially ruled out by most modern mainstream models, which use “rational expectations” as their jumping-off point. It also requires that productive capital come in multiple forms, while mainstream macro usually assumes that all forms of capital are interchangeable. Over in China, it seems clear that there has been a lot wasted resources —ghost cities and overcapacity in various manufacturing industries. That in turn seems to have led to a bubble in Chinese real estate prices, whose slow decline may in turn have caused the recent spectacular stock bubble and crash.

There are lots of problems here:

1.  Why would overbuilding of homes “have led to a bubble in Chinese real estate prices”?  Wouldn’t it depress prices?

2.  What does it mean to suggest that rational expectations doesn’t allow for systemic systematic mistakes?  I always thought that meant it ruled out repeated mistakes in the same direction, predictable mistakes.  Here he seems to apply it to economy wide mistakes.  In fact, ratex does not rule out 99% of the population holding expectations at a point in time that, ex ante, are too optimistic. I’m sure that 99.99% of New Yorkers did not expect the Twin Towers to collapse on 9/11, and yet ex post their expectations that the Twin Towers would not collapse were too optimistic.  Was that a systematic mistake? I don’t think so.

3.  The ghost city phenomenon is a creation of the Chinese Communist government.  There is nothing in ratex theory that I know of that rules out the possibility of communist governments doing a poor job of allocating resources.

HT:  Gordon

Noah Smith has a new post discussing the current fad of looking for alternatives to the rational expectations model.  The motivation seems to be that we need to explain the collapse of bubble expectations and the rise in the propensity to save (although not actual saving?) during the 2008 recession.  I understand why people want to do this, but it would be a very big mistake.

I’ve always thought that it was patently obvious that the Fed caused the Great Recession with a tight money policy that allowed NGDP expectations to collapse in late 2008. But other people apparently don’t see it as being at all obvious.  They look for alternative explanations.  And yet when you ask them why, they tend to give these really lame “concrete steppes” explanations, such as, “The Fed didn’t raise interest rates on the eve of the Great Recession, so how can you claim that tight money caused the recession?”  Or they show themselves to be completely ignorant of actual Fed policy, and claim that the fed funds target was at zero when NGDP expectations collapsed in 2008.  It wasn’t.

Fortunately, neither of those apply to the ECB, which had positive target interest rates throughout 2007-2012, and which took “concrete steppes” in both 2008 and 2011, tightening money and triggering not one but two plunges in NGDP growth, which led to two recessions.  If there has ever been a more perfect example of the monetary policy/AS/AD model that we teach in our textbooks, I’d like to see it. (OK, maybe 1929-32.) And yet last time I did one of these rants almost no economists were blaming the ECB’s tight money policy for the double dip recession.

Now, I’m seeing progress.  I’m seeing more and more mainstream economists accept the MM claim that the monetary tightening of 2011 caused the second dip in Europe.  In a few more years economists will realize that the ECB tightening of 2008 (which was also “concrete”) caused the 2008 recession as well.

Then economists may begin to notice that the 2008-09 recession in the US was oddly similar to the eurozone recession, which was clearly caused by tight money. The only (minor) difference was that in the US it was “passive tightening”, if the fed funds rate is your preferred policy indicator.

A few economists don’t buy the “nominal shocks have real effects due to sticky wages and prices” model of demand side business cycles.  I don’t agree with them, but it’s fine if people like John Cochrane don’t accept my claim that the ECB didn’t caused the eurozone depression. But as for the rest, the overwhelming majority who think nominal shocks do matter, I’m mystified.  Take the AS/AD model that you see in McConnell, Mankiw, Krugman, Cowen and Tabarrok, Hubbard, or any of the other textbooks.  Why do we even teach this model if confronted with an almost perfect example of a depression caused by tight money, we simply don’t believe it?

Update: John Cochrane informed me that I mischaracterized his views.  He does believe that nominal shocks have real effects, and that wage and price stickiness do exist.  Mea culpa.

I was inspired to do this post by an excellent recent paper on the eurozone depression, by David Beckworth.

HT: Gordon

It’s generally assumed that Milton Friedman’s Natural Rate Hypothesis led to Robert Lucas applying rational expectations to macroeconomics.  But is it possible that we’ve reversed causality?  I’m probably reading too much into this Holman Jenkins interview of Lucas, but it offers a tantalizing hint that Robert Lucas might have planted the seed that blossomed into Friedman’s greatest theoretical innovation:

He also cites Milton Friedman, with whom Mr. Lucas took a first-year graduate course.

“He was just an incredibly inspiring teacher. He really was a life-changing experience.” Friedman, he recalls, was a skeptic of the Phillips curve””the Keynesian idea that when businesses see prices rising, they assume demand for their products is rising and hire more workers””even if the real reason for higher prices is inflation.

“Milton brought this [Phillips curve] up in class and said it’s gotta be wrong. But he wasn’t clear on why he thought it was wrong.” In his paper for Friedman’s class, Mr. Lucas remembers reaching for a very rudimentary notion of expectations to try to explain why the curve could not operate as predicted.

I was a student at Chicago during the late 1970s.  At the time I read a lot of supply-side stuff in the Wall Street Journal.  I recall one class where Lucas “disproved” the Laffer Curve argument that tax cuts could lead to more revenue.  Unfortunately, Lucas evaluated the hypothesis with a standard Keynesian multiplier model (where incentives played no role.)  I imagine that he hadn’t followed supply-side econ very closely, other than hearing from his fellow economists that Laffer was a bit of a nut.  I raised my hand and suggested that Laffer’s argument was based on incentives to produce, and couldn’t be addressed with a demand-side model.

In the exam for the class Lucas asked a question on this topic, and I answered the way he taught it, not based on my class comment.  When the tests were returned I saw it was market wrong–Lucas had wanted the answer I gave in class.  I gained a lot of respect for the University of Chicago that day.

On another occasion I was talking to Lucas about growth (he was shifting to growth theory about that time).  He suggested we don’t know much about what causes growth.  I suggested that it might be free market policies.  He pointed out that communist Romania had had the fastest RGDP growth rate in recent years.  I said I didn’t believe their numbers, but fumbled around when he asked what evidence I had that they were wrong.  I learned then that there’s a big difference between knowing you are right, and being able to offer persuasive evidence that you are right.  (Or maybe there isn’t—it’s an interesting philosophical question.)

Later Lucas seems to have become something of a supply-sider himself:

For the best explanation of what happened in Europe and Japan, he points to research by fellow Nobelist Ed Prescott. In Europe, governments typically commandeer 50% of GDP. The burden to pay for all this largess falls on workers in the form of high marginal tax rates, and in particular on married women who might otherwise think of going to work as second earners in their households. “The welfare state is so expensive, it just breaks the link between work effort and what you get out of it, your living standard,” says Mr. Lucas. “And it’s really hurting them.”

I suppose you know where I’m going with this.  For a fleeting moment I wondered whether I could have planted the seed of Lucas’ interest in supply-side economics.  But then I read this:

Mr. Lucas launches into a brisk dissertation on the work of colleagues””Martin Feldstein, Michael Boskin, others””whom he credits with disabusing him and fellow economists of a youthful assumption that taxes have little effect on the overall amount of capital in society.

You mean to say he was more influenced by the empirical studies of leading economists, then by a few off the cuff remarks by an annoying first year grad student?  I’m very disappointed in Mr. Lucas.

PS.  That’s two posts within a month named after Harold Bloom books.