Blogger smackdown: Robert Waldmann vs. David Glasner

Somehow I missed the first few salvos in this little police action, but I'm on it now! In this corner, we have Robert Waldmann, one of the pioneers of "noise trader" finance theory. In the other corner we have David Glasner of the FTC. Today's ingredient is wild mushrooms question is whether monetary policy works.

(I have to say, it's pretty fun to see these two guys debate, since Waldmann is one of the most terse bloggers out there, and Glasner one of the most verbose.)

Waldmann starts with a potshot at Matt Yglesias' rosy predictions for Shinzo Abe's monetary policy:

Ben Bernanke too has declared a policy of unlimited quantitative easing and increased inflation (new target only 2.5% but that's higher than current inflation).  The declaration (which was a surprise) had essentially no effect on prices for medium term treasuries, TIPS or the breakeven....[Y]ou have confidently asserted again and again that if only the FOMC did what it just did, expected inflation would jump and then GDP growth would increase. However, instead of noting the utter total failure of your past predictions (and the perfect confirmation of mine) you just boldly make new predictions. Face fact,  like conventional monetary policy (in the US the Federal Funds rate) forward guidance is pedal to the metal. It's long past time for you to start climbing down. 

Basically: "QE-infinity didn't budge inflation expectations, so monetary policy doesn't look like it works the way monetarists say it should work."

Glasner then jumps in to say, well, the Fed hasn't really done very much in terms of changing policy:

I mention this, because just yesterday I happened across another blog post about what Bernanke said after the FOMC meeting.  [That] post by David Altig, executive VP and research director of the Atlanta Fed, was on the macroblog. Altig points out that, despite the increase in the Fed’s inflation threshold from 2 to 2.5%, the Fed increased neither its inflation target (still 2%) nor its inflation forecast (still under 2%). All that the Fed did was to say that it won’t immediately slam on the brakes if inflation rises above 2% provided that unemployment is greater than 6.5% and inflation is less than 2.5%. That seems like a pretty marginal change in policy to me.

Waldmann then responds with two points. First, he criticizes Glasner for failing to mention the Zero Lower Bound: 

Your analysis of monetary expansion does not distinguish between the cases when the ZLB holds and when it doesn't...I think it is clear that the association between the money supply and domestic demand has been different in the USA since oh September 2008 than it was before...

Second, he says that the data show no indication of Fed policy announcements having any effect:

I claim that the null that nothing special happened the day QEIV was announced or any of the 4 plausible dates of announcement of QE2 (starting with a FOMC meeting, then Bernanke's Jackson Hole speech then 2 more) can't be rejected by the data. This is based on analysis by two SF FED economists who look at the sum of changes over three of the days (not including the Jackson Hole day when the sign was wrong) and get a change (of the sign they want) whose square is less than 6 times the variance of daily changes (of the 10 year rate IIRC).  IIRC 4.5 times.  Cherry picking and not rejecting the null one wants to reject is a sign that one's favored (alternative) hypothesis is not strongly supported by the data.

Basically: "We shouldn't assume that monetary policy works at the ZLB. We should assume it doesn't work at the ZLB, unless we have clear evidence that it does. We haven't seen any clear evidence that monetary policy works at the ZLB, so we should continue to assume it doesn't."

Glasner responds first by throwing out some of his own ideas about how monetary policy should work:

I agree that the zero lower bound is relevant to the analysis of the current situation. I prefer to couch the analysis in terms of the Fisher equation making use of the equilibrium condition that the nominal rate of interest must equal the real rate plus expected inflation. If the expected rate of deflation is greater than the real rate, equilibrium is impossible and the result is a crash of asset prices, which is what happened in 2008. But as long as the real rate of interest is negative (presumably because of pessimistic entrepreneurial expectations), the rate of inflation has to be sufficiently above real rate of interest for nominal rates to be comfortably above zero. As long as nominal rates are close to zero and real rates are negative, the economy cannot be operating in the neighborhood of full-employment equilibrium. I developed the basic theory in my paper “The Fisher Effect Under Deflationary Expectations...and provided some empirical evidence (which I am hoping to update soon) that asset prices (as reflected in the S&P 500) since 2008 have been strongly correlated with expected inflation (as approximated by the TIPS spread) even though there is no strong theoretical reason for asset prices to be correlated with expected inflation, and no evidence of correlation before 2008. Although I think that this is a better way than the Keynesian model to think about why the US economy has been underperforming so badly since 2008, I don’t think that the models are contradictory or inconsistent[.]

(Got that? There will be a quiz afterward.)

Glasner then says that no, since we have plausible theories about how monetary policy should work, we should assume that it does work until we have convincing evidence otherwise:

I think that the way to pick out changes in monetary policy is to look at changes in inflation expectations, and I think that you can find some correlation between changes in monetary policy, so identified, and employment, though it is probably not nearly as striking as the relationship between asset prices and inflation expectations. I also don’t think that operation twist had any positive effect, but QE3 does seem to have had some...[E]ven if Waldmann is correct about the relationship between monetary policy and employment since 2008, there are all kinds of good reasons for not rushing to reject a null hypothesis on the basis of a handful of ambiguous observations. That wouldn’t necessarily be the calm and reasonable thing to do.

Basically: "No, my hypothesis is the null!"

Waldmann fires back. First, he says, "No, your hypothesis should not be the null, mine should":

1) Get the null on your side is my motto (I admit it).  You follow this.  You suggest that your hypothesis is the hull hypothesis then abuse Neyman and Person by implying that we can draw interesting conclusions from failure to reject the null.  Basically the sentence which includes the word "null" is the assertion that we should assume you are right and I am wrong until I offer solid proof.  To be briefer, since we are working in social science, you are asking that I assume you are right.  This is not an ideal approach to debate. 

I ask you to review your sentence which contains the word "null" and reconsider if you really believe it.  The choice of the null should be harmless (it is an a priori choice without a prior).  How about we make the usual null hypothesis that an effect is zero.  Can you reject the null that monetary policy since 2009 has had no effect ? At what confidence level is the null rejected ?  Did you use a t-test ? an f-test ?  "null" is a technical term and I ask again if you would be willing to retract the sentence including the word "null".

In other words: "Macro data sucks, so whoever has the burden of proof will always lose. By putting the burden of proof on me, you want me to hand you an automatic win. But no, the burden of proof is on the people who think monetary policy does work at the ZLB."

(Update: Waldmann shows up in the comments and says: Your translation of my statement about QE# isn't exactly what I meant...The evidence that the true effect of FOMC announcements on expected inflation is small is solid, clear, and strong.")

Waldmann also continues the discussion about what the data tell us with regards to whether our monetary policy is working:

[U]sing expected inflation to identify monetary policy is only a valid statistical procedure if one is willing to assume that nothing else affects expected inflation.  If you think that say OPEC ever had any influence on expected inflation, then you can't use your identifying assumption.  In particular TIPS breakevens can be fairly well fit (not predicted because not out of sample) using lagged data other than data on what the FOMC did...I think we can detect the effect of recent monetary policy on TIPS breakevens if we agree that it (including QE) is working principally through forward guidance.  There should be quick effects on asset prices when surprising shifts are announced.  QE 4 (December 2012) was definitely a surprise.  The TIPS spread barely moved (within the range of normal fluctuations).  I think the question is settled.

Glasner retorts that all this talk of "null hypotheses" and "alternative hypotheses" is bad:

What I meant to say was that even if the evidence is not sufficient to reject the null hypothesis that monetary policy is ineffective, there may still be good reason not to reject the alternative or maintained hypothesis that monetary policy is effective. In the real world, there is ambiguity. Evidence is not necessarily conclusive, so we accept for the most part that there really are alternative ways of looking at the world and that, as a practical matter, we don’t have sufficient evidence to reject conclusively either the null or the maintained hypothesis. With the relatively small numbers of observations that we are working with, statistical tests aren’t powerful enough to reject the null with a high level of confidence, so I have trouble accepting the standard statistical model of hypothesis testing in this context.

In other words, macro data sucks, so we'll never have any firm conclusions. In the absence of good data we must rely on plausibility of theory, tempered with a little bit of data.

Glasner follows this with some musings on Copernicus, Galileo, Ptolemy, etc. He basically says "Don't toss out monetarist theory just because the data isn't solidly in its favor. Someday we may get better data." He then goes on to discuss whether QE-infinity really was a surprise and which factors we should assume are more important in driving inflation expectations.

Anyway, you probably get the point by now. As I see it, the take-away from this debate should be the following:

1. Macro data is really uninformative.

2. Because macro data is really uninformative, whoever gets stuck with the burden of proof in a macro debate is usually going to lose. Hence, the way not to lose a macro debate is to play "hot potato" with the burden of proof.

3. If Fed intentions and the expectation formation process are both unobservable, we'll never be able to tell how well monetary policy really works. This is a point I've made before.

At least until we are better able to understand the intentions of the Fed and how inflation expectations are formed, monetarism will involve a big leap of faith. But the pooh-poohing of monetarism will also require a big leap of faith.

(P.S. - "WADR" means "With all due respect", IIRC. AFAIK, Waldmann was asking JOOC, but IMHO that's OK, FWIW. LOL)