August 29, 2003

Comment on Stock and Watson

Comment on James Stock and Mark Watson (2003), "Has the Business Cycle Changed?"

(Forthcoming in the 2004 Monetary Policy and Uncertainty: Adapting to a Changing Economy (Kansas City: Federal Reserve Bank of Kansas City).

James Stock and Mark Watson's paper challenges things that I thought I knew, and tells me that I am going to have to rethink a bunch of issues--going to have to mark my beliefs to market once again.

To the extent that there has been a conventional wisdom among economic historians, the extraordinary moderation of the business cycle--the reduction in the size of swings in the unemployment rate, and in the variance of annual output growth--has been due to very important learning about how to better conduct monetary policy. Christina Romer has been the most powerful advocate of this line of narrative. And this has been what I have taught my students over the past several years.

The founding of the Federal Reserve brought the possibility of an elastic currency, and of avoiding the great liquidity catastrophes that afflicted the U.S. in the late nineteenth century. The silver-agitation crises of the 1890s, the great crash of 1873 when British investors grew nervous about the "crony capitalism" of America (a crisis with remarkable similarities to the 1997-1998 East Asian crisis), the Panic of 1907 (mitigated by J.P. Morgan's getting the New York Clearing House to expand the effective money supply via printing Clearing House Loan Certificates, and then cramming them down the throats by telling banks that they would incur his permanent displeasure if they did not accept them as valid and liquid instruments).

But the Fed's performance in its first two decades was not impressive. The disaster of the Great Depression brought further institutional changes. The coming of deposit insurance to avoid the radical instability of the money multiplier that was such a powerful features of the Great Depression in America. Keen awareness of the dangers of, as Milton Friedman's teachers put it, "unbalanced deflation." The role of fiscal policy when short-term safe interest rates are near their zero nominal bound floor and yet risk, default, and term premiums remain high. Before World War II an economic disaster of the magnitude of the Great Depression was always a live possibility. With the institutional and organizational changes, since World War II a macroeconomic disaster of the magnitude of the Great Depression is--well, before the recent Japanese experience, I would have said impossible.

Nevertheless, when you compare the pre-Great Depression to the post-World War II period there is less of a reduction in the size of the business cycle than economists hoped or, in the case of Arthur Burns and many others, confidently expected. Improved credit markets allowed households to smooth their spending. Automatic stabilizers meant that incomes varied less than production. In his 1959 presidential address to the American Economic Association, Arthur Burns went as far as to say that deep recession--large spikes in the unemployment rate--were no longer a problem.

He was wrong. Look at 1975. Look at 1982-1983. In Christina Romer's interpretation, Arthur Burns was wrong because he did not recognize the developing stop-go nature of Federal Reserve policy. Most of the time the Fed worried about achieving maximum purchasing power. Some of the time the Fed worried about achieving price stability. While it was worried about achieving maximum purchasing power it successfully stabilized production, but at too high a level that allowed inflation to rise. As the late Rudi Dornbusch used to say, expansions in the U.S. before 1985 did not die of natural causes: they were killed by a Federal Reserve that had shifted to a mindset in which reducing inflation was job #1. Thus the first four post-World War II decades saw longer expansions, fewer recessions, but still substantial output variance driven by large inflation-control recessions. And the conventional wisdom has been that the remarkably good performance of the last two decades has been due to the Federal Reserve's greater success at maintaining its balance: at acting pre-emptively and maintaining an appropriate balance between price stability and maximum purchasing power, rather than careening from one objective to the other.

Now come James Stock and Mark Watson to challenge this belief. The reduction in output volatility is there, is real, is very large. (Although, as Larry Summers was saying in the shadow of Mt. Moran an hour ago, the fact that Stock and Watson's index of the size of the business cycle has fallen by 3/4 over a time period in which the average German unemployment rate rose from 2% to 8% makes one wonder whether the variance of output is what belongs on the left-hand side.)

But Mark Watson and Jim Stock look hard and find little sign that reduction in output volatility is due to changes in how the Federal Reserve reacts to economic circumstances. By process of elimination, they conclude that the reduction in the output business cycle is primarily due to luck and not to skill: primarily to smaller shocks hitting the American (and the other OECD economies) and only secondarily to better monetary policy.

This surprises me. This is a shock. I would have bet serious money that Stock and Watson's calculations would have come out the other way. I need to mark my beliefs about this to market. Clearly I have some serious rethinking to do before I give my "macroeconomic stability" lecture to my graduate students at the end of the semester.

But humans are, as cognitive psychology teaches us, really bad at changing their minds. We are really good at finding ways to explain away and ignore new information.

So let me now try to explain away and ignore Stock and Watson's results:

First, their idea of "policy" is limited to "systematic reactions by the Fed that change interest rates in response to changes in inflation and in economic growth rates." This is a very limited definition of "policy." For one thing, it leaves out much of what Christina Romer sees as harmful in pre-1984 policy: the fact that the Fed reacted in one way when it was worried about price stability, and reacted in another very different way to a similar economic situation when it was worried about maximum purchasing power. Stock and Watson's Taylor Rule framework can't see this at all. (Now it is true when Stock looks for evidence that such stop-go policy he fails to find it, but our econometric techniques are not very good at picking up such non-linearities.)

Second, it is not at all clear that the actual shocks to the economy have been smaller since 1984. Before 1984 we have the Vietnam War, the oil shocks of 1973 and 1979, et cetera. Since 1984 we have the stock market crash of 1987, the dot-com bubble and then the NASDAQ crash, the extraordinary near-panic of 1998 (which one low-ranking LTCM employee is supposed to have characterized as a nine-sigma shock: the universe will not last long enough for there to be an even chance of even one nine-sigma shock happening ever), 911, presidential warnings that all Americans are at risk of attack by Iraqi drone aircraft carrying weapons of mass destruction. These shocks are smaller than the earlier shocks in Stock and Watson's framework, but are they really smaller in reality?

Doesn't the swift reaction of the Fed to 1987, to 1998, to 2001--swift reactions that find no place in Stock and Watson's measures of "policy"--play a role in reducing the size of the business cycle? Doesn't the emergence of more private-sector willingness to speculate on stability as a result of confidence in the Fed reduce the magnitude of what Stock and Watson call "shocks"?

So my rationalization is that a lot of what Stock and Watson's framework calls "shock" is actually "policy". This is not a criticism, really: they have done a very good job. But it is a product of the limitations of our analytical tools.

Responses to Comments:

First, let me thank everyone--Alice Rivlin and Anne Krueger, Bill Poole and Allen Sinai, Marty Feldstein and Larry Summers, John Berry and Chairman Greenspan--who has tried in the discussion to stiffen my backbone and restore my full and unblemished confidence in the conventional wisdom. But it is worth remembering that ex ante I would have bet serious money that Stock and Watson's calculations would have come out the other way. And it is still a shock to me that it did not.

Second, let me underscore Antonio Fraga's point. Any interpretation of recent events that points to a smaller magnitude of shocks to the world economy has to explain why things have looked so different--look like the shocks are bigger--from a developing-country standpoint.

Looking back at my career, I see many local analytical low points. But my personal global analytical nadir came in early 1994, when I wrote a memo for my Treasury boss saying that yes, the Bank of Mexico's policy was inappropriate and overstimulative, but that the magnitude of the policy mistake was small and there was no reason to expect it to generate a serious problem. Now I still think the Bank of Mexico's sins against the Gods of Monetarism in 1994 were small, were venial, not mortal. But the punishment was swift and awful. And that is hard to reconcile with the view of a placid, low-shock world economy.

Posted by DeLong at August 29, 2003 05:55 PM | TrackBack


Honor to your search for truth!

May our shocks remain small and Greenspan's fear of deflation remain unncessary.

Posted by: David on August 29, 2003 10:08 PM

Honor to your search for truth!

May our shocks remain small and Greenspan's fear of deflation remain unncessary.

Posted by: David on August 29, 2003 10:09 PM

Honor to your search for truth!

May our shocks remain small and Greenspan's fear of deflation remain unncessary.

Posted by: David on August 29, 2003 10:09 PM

Honor to your search for truth!

May the shocks we experience be small and may Greenspan's fear of deflation go unneeded.

Posted by: David on August 29, 2003 10:18 PM

"presidential warnings that all Americans are at risk of attack by Iraqi drone aircraft carrying weapons of mass destruction."

When did Bush say that? In particular the word "all."

Posted by: A. Zarkov on August 29, 2003 10:23 PM

a few years back, while browsing Fed working papers, I read a paper that argued that business cycle moderation since ca. 1984 was tied to modernization of business practices, most especially to inventories. as has been repeated in other papers since, large changes in inventories became comparatively rare after 1984.

it made sense to me at the time, so I discarded the conventional wisdom that the Fed had gotten smarter (for which I found, not to offend, little confirming evidence) and adopted this explanation.

it may yet prove to be wrong, but it's worth exploring for at least one reason: the mid-'80s do, in fact, coincide with a sea change in inventory management practices. there is (afaik) no similar qualitative revolution in monetary policy at that time.

Posted by: wcw on August 30, 2003 12:02 AM

August 24, 2003

Analysts Doubt U.S. Claim on Iraqi Drones
By DAFNA LINZER and JOHN J. LUMPKIN, Associated Press Writers

Huddled over a fleet of abandoned Iraqi drones, U.S. weapons experts in Baghdad came to one conclusion: Despite the Bush administration's public assertions, these unmanned aerial vehicles weren't designed to dispense biological or chemical weapons.

The evidence gathered this summer matched the dissenting views of Air Force intelligence analysts who argued in a national intelligence assessment of Iraq (news - web sites) before the war that the remotely piloted planes were unarmed reconnaissance drones.

In building its case for war, senior Bush administration officials had said Iraq's drones were intended to deliver unconventional weapons. Secretary of State Colin Powell even raised the alarming prospect that the pilotless aircraft could sneak into the United States to carry out poisonous attacks on American cities....

Posted by: Ari on August 30, 2003 02:33 AM

Joachim Fels of Morgan Stanley has been arguing that our central bank has increasingly become a destabilizing force by not focusing on asset prices as well as goods prices in making monetary policy decisions. I raise this issue for argument, not because I am in any way convinced. Did the Fed allow a stock market bubble, then correct for the decline of stock prices and the recession by creating a housing and bond market bubble? Indeed, are stock prices dangerously high once again?

Also, I am convinced the world bank accentuated the crises in Asia and Latin America during the 90's. Austerity was the wrong policy for an Argentina in recession, a Mexico in recession, as for a Korea in recession.

Posted by: anne on August 30, 2003 06:59 AM

I would have thought that the nice long-term trend of a moderating business cycle was mainly due to factors that make aggregate demand less sensitive to macroeconomic movements, factors like: (1) the shift to services from manufacturing, (2) a higher proportion of employment income coming from government, (3) expanded social security, pensions and other forms of household income not dependent on private employment. Compared to the impact of such big-scale changes as these, the quality of Federal Reserve policy strikes me as a minor point. Could the economists unconsciously be exaggerating their own importance?

Posted by: Marc on August 30, 2003 08:56 AM

IMVHO, The Tequila crisis, and to a large extent Bahtulism, can be explained by this immortal sentence of Paul Krugman:

"We all know that in the days before the FDIC a run by depositors could break even a fundamentally sound bank; Why can't it happen to countries?"

Posted by: roublen vesseau on August 30, 2003 12:14 PM

I'm just an old time securities lawyer but is it policy when the Fed encourages exponential financial expansionism (options, futures, junk bonds, program trading, indexes, arbitrage, blank check IPOs aka, mortgage-backed securities, derivatives, hedges, QQQs, single stock options etc.)& their companion brethern (mutual funds, money market funds,retirement accounts, etc) knowing bubbles are inevitable and even welcomed (employment up, spending up etc) and then is able to smoothly manage the anticipated "shock" because it is perceived as a "securities" crisis not a monetary/fed banking one? Maybe it's my perspective, but financial instruments & available cash pools define the business cycle and Greenspan understands that with deft adaptation, when one instrument/cash pool comes under duress, it's important that another is available. This new system diverts fed bank panics because faith in dollars remains stable (only the popped instrument suffers bad publicity). But if everyone figures out what's going on, then faith in the fed will wane & perhaps this is what now concerns Mr. Fels.

Posted by: D Dohm on August 30, 2003 05:35 PM

Alan Greenspan will in time have to come to grips with supporting tax law changes that turned us from a surplus to massive deficit economy, and turned a mildy progressive federal tax system to a regressive system. This Fed chief has not been kind to our middle class!

Posted by: lise on August 30, 2003 05:57 PM

D Dohm

"I'm just an old time securities lawyer but is it policy when the Fed encourages exponential financial...?"

This is a fine question. My sense is that Warren Buffett and Charles Munger have been asking the question just this way. In 1994 and 1998 and this July we saw the effects of derivative based bond market reversals. Imagine trying to properly gauge the risk merely in JP Morgan Chase derivates.


Again, a fair worry. Alan Greenspan's 2001 concern about the surplus that would eat Cleveland, struck me as bizarre and sad. Was the point not to properly provide for Social Security and Medicare for an aging America?

Posted by: anne on August 30, 2003 06:25 PM

The US shocks are smaller. Financial shocks like LTCM, various panics, booms & busts in market indices have a smaller effect on the goods & services economy.

The key rate should be the unemployment rate, and its rates of change, those spikes. I'd guess that Quarter by quarter variability has been lower in the last 2 decades than other times after WW II.

The oil shocks were more pervasive.

Is it possible that financial shocks are GREATER when there are less severe output shocks? The idea balloon being that financial trends, like a boom, would get corrected along with significant output adjustments, if there was a real output shock. W/o the output shock, the financial expansion continues until there is a purely financial bubble-popping.

Posted by: Tom on August 30, 2003 07:08 PM

Are we experiencing a gasoline shock just now? What will a quarter of gasoline prices in the $1.70 to $1.75 cents a gallon do to GDP? We are paying $2. Why should a pipeline break in Arizona create such a problem? Infrastructure? Well, what about American infrastructure?

Posted by: anne on August 31, 2003 03:39 AM

Along the lines of Tom's comment, I have to wonder whether there's something significant to be learned in the natures of the shocks you refer to and the Fed's better or worse performance in responding to different kinds. Speaking very broadly, the pre-1980 shocks were physical, the post-1980 ones political. The earlier shocks had their initial impact on a different slice of the economy than the later ones. And thanks (ahem) to the changing structure of whose decisions count in driving consumption and investment, the economy hit by the later shocks should have been expected to react differently both to shock and to Fed manipulations.

Obviously this is pure speculation until there's a new shock that a) the current Fed regime isn't suited to handle and b) whose mishandling shows up in the statistics that economists have settled on for measuring such things.

Posted by: paul on August 31, 2003 08:44 AM

"The key rate should be the unemployment rate, and its rates of change, those spikes. I'd guess that Quarter by quarter variability has been lower in the last 2 decades than other times after WW II."

Well yes, but mainly on the upside. Stirling Newberry calls it the stall speed economy, and he's got something there.

Posted by: Ian Welsh on August 31, 2003 01:42 PM

What if the shocks from 1987 to pre-9/11 2001 were all anticipated financial instrument deflations and the Fed knowing the inevitable bubble transition eased the pops through monetary policy much as it is currently adjusting the anticipated mortgage backed securities/housing bubble/Fannie-Freddie reorganization through low interest rates despite deficits? Would not the monetary policy ease the output shocks ie unemployment and even disguise the pre-adjustments as non-measurable events? Again, I'm just a lawyer, but I know how easily calculations can be distorted and what appears to be luck might be well calculated by disguisable manipulation. (You know volume manipulations can look an awful lot like luck and with the right equations its hard to argue that a manipulation was at work instead of blind coincidence.)

Posted by: D Dohm on August 31, 2003 11:24 PM

Lets get back to the basics. The market cycle goes up, then crashes. The reason for the crash is "The inability or the supposed inablility to servise the DEBT." The total national debt. What happens in between eather softens or increases the sevierety of the crash. Recession, in laymans terms is caused by over supply, 1962-1964. Recession after the crash ie. 1991, (followed a crash,1987, DEBT,) most of the cash was spent durning the crash years, Those who had cash or could borrow money got good deals. The only thing left to do was pay down the DEBT and save up some money. Then a few years later, low debt and some savings, the bubble started to form again. This is the cycle, weather it's 9, 13,or 60 years (Hint 60 year cycle). What is the single common factor in all crashes? DEBT!!! The total National DEBT. Look at England now. Very, very low government Debt, but the impact of the crash of 2000 has been less sever than on other countries. PS. Deflation is the final factor that brings all the imbalances back into balance. Think about it. Devaluation of the curency is a cheap form of deflation.

Posted by: Jim Coomes on September 1, 2003 05:19 PM
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