Greg Ip—The Fed's Choice: Overheat the Economy or Give Up Its 2% Per Year Inflation Target

My post "When the Output Gap is Zero, But Inflation is Below Target" appeared on August 17, 2017. On September 13, 2017, I was pleased to see Greg Ip pick up much of the argument in my post in his Wall Street Journal article "The Fed’s Bad Options for Addressing Too-Low Inflation: The central bank’s choice: overheat the economy or give up its 2% target." 

In "When the Output Gap is Zero, But Inflation is Below Target" I write:

Sometimes journalists discuss a zero output gap combined with too-low inflation as if such a situation were strange, but a range of different macroeconomic theories all have the property that a zero output gap is consistent with any constant inflation rate. (This is an aspect of "monetary superneutrality.")

 27 days later, Greg Ip writes:

Ms. Yellen’s worldview assumes that when unemployment is this low—4.4% in August—inflation should move up to the Fed’s target of 2%. Instead, it may have stabilized around 1.5%. That presents the Fed with some unpalatable options: deliberately overheat the economy for years to get inflation back up, then potentially induce a recession to stop it from overshooting; or give up on the 2% target, which could hobble its ability to combat future recessions.

This isn’t scaremongering: It’s the logical consequence of how central banks believe inflation operates. At the center of their model is the Phillips curve, according to which inflation edges lower when unemployment is above its natural, equilibrium level and putting downward pressure on prices and wages. Below that natural rate, also known as full employment, inflation crawls higher.

Later on in his article, Greg Ip argues that trend inflation has indeed fallen:

Since the current expansion began in 2009, inflation has persistently fallen short of 2%. ...

That leaves the third explanation: Trend inflation has fallen. ...

He uses this graph to help make that argument,

Screen Shot 2017-09-15 at 10.18.35 AM.png

and backs it up by referencing the Fed's own internal deliberations:

In 2014, Fed staff slightly revised down its own assessment of trend inflation, according to minutes to the central bank’s June meeting that year. ...

Greg Ip sees a dilemma:

Raising inflation half a point could require letting unemployment drop to around 3.5% and keeping it there for five years. Then, to prevent inflation from overshooting, the Fed would have to slow the economy and guide unemployment back over 4%. In theory it could do this gradually enough to avoid a recession; in practice, the number of times since 1948 when unemployment has gone up that much without a recession is zero, according to Goldman Sachs.

The alternative is to ditch the 2% target and accept 1.5% as the new inflation trend. 

I see much less of a dilemma. Here from my post: "When the Output Gap is Zero, But Inflation is Below Target":

To bring inflation back up to target would require a period of time with a positive output gap. 

Since positive output gaps are pleasant given all the distortions that make the natural level of output lower than the level at which (other than the effects on inflation) the marginal benefit of output equals the marginal cost, why don't central banks shoot for a positive output gap until inflation returns to the target of 2% per year? I think the answer is:

1. Central bankers are not used to trying to have positive output gaps. The low unemployment rates associated with positive output gaps seem dangerous.

2. Central bankers don't really like having an inflation target above zero. They feel in their bones that their job is to keep inflation down, close to zero, not to push it up. 

I then go on to point out that it is OK to have a lower inflation target when one is prepared to use negative interest rates, as I discussed at length in  "The Costs and Benefits of Repealing the Zero Lower Bound...and Then Lowering the Long-Run Inflation Target." What a central bank thinks about negative interest rate policy matters even when the central bank is not currently using negative interest rates. 


On the Virtue of Self-Distraction

There are downsides to being distracted. (See above.) But here I want to talk about the upside to being able to distract oneself when appropriate. A good example is the famous Stanford marshmallow experiment. Here is the current opening paragraph of the Wikipedia article on the Stanford marshmallow experiment:

The Stanford marshmallow experiment[1] was a series of studies on delayed gratification in the late 1960s and early 1970s led by psychologist Walter Mischel, then a professor at Stanford University. In these studies, a child was offered a choice between one small reward provided immediately or two small rewards (i.e., a larger later reward) if they waited for a short period, approximately 15 minutes, during which the tester left the room and then returned. (The reward was sometimes a marshmallow, but often a cookie or a pretzel.) In follow-up studies, the researchers found that children who were able to wait longer for the preferred rewards tended to have better life outcomes, as measured by SAT scores,[2] educational attainment,[3] body mass index (BMI),[4] and other life measures.[5]

One detail not mentioned in the Wikipedia article that I remember reading somewhere is that many of the children who didn't eat the marshmallow managed this feat by distracting themselves somehow (despite the lack of outer distractions in the room).  

Distracting oneself can be a good way to resist temptation. For example, if tempted to eat something with sugar in it (see Sugar as a Slow Poison, turning one's attention to a good TV show out of immediate reach of anything sugary can reduce the strength of that temptation. At a bigger level, constructing an interesting life for oneself in other ways can provide distraction sufficient to reduce the strength of the temptation to lie, cheat and steal. 

For moments of temptation when one is caught otherwise unprepared, it is good to have ready a powerful, innocent mental distraction. For some, a good math problem would work; for others, a memorized poem or song might work. One way or another, figure out a way to distract yourself from temptation. 

If there is no way to distract yourself from a temptation, chances are the temptation has an element of addiction or obsession to it. Assuming it is a bad addiction or obsession, it is then good to get help when one runs up against a temptation not amenable to the power of self distraction. 

If the temptation is the temptation to get distracted, that is not the subject of this post. But the image at the top may be helpful. 

Hilary Putnam on the Philosophy of Science

Thanks to C. Trombley for pointing me to this video.

One of my best memories from graduate school (while getting a PhD in Economics at Harvard) was sitting in on a Philosophy of Science class by Hilary Putnam. Hilary Putnam argued that each discipline has its own wisdom that is much deeper than attempts to legislate methodology from on high. 

Indeed, when academic disciplines display a lack of wisdom, it is often because someone has tried with some success to enforce a methodology. 

The Economist on Minimum Wages Versus Wage Subsidies

I am glad to have the Economist reinforce the arguments against minimum wages that I made in "Inequality Is About the Poor, Not About the Rich." Here is the Economist's view:

Yet however well people are taught, their abilities will remain unequal, and in a world which is increasingly polarised economically, many will find their job prospects dimmed and wages squeezed. The best way of helping them is not, as many on the left seem to think, to push up minimum wages. Jacking up the floor too far would accelerate the shift from human workers to computers. Better to top up low wages with public money so that anyone who works has a reasonable income, through a bold expansion of the tax credits that countries such as America and Britain use.

On John Locke's Labor Theory of Property

John Locke enunciates an intriguing principle to govern property rights in section 27 of his 2d Treatise on Government: “Of Civil Government” (Chapter V "Of Property"):

Though the earth, and all inferior creatures, be common to all men, yet every man has a property in his own person: this no body has any right to but himself. The labour of his body, and the work of his hands, we may say, are properly his. Whatsoever then he removes out of the state that nature hath provided, and left it in, he hath mixed his labour with, and joined to it something that is his own, and thereby makes it his property. It being by him removed from the common state nature hath placed it in, it hath by this labour something annexed to it, that excludes the common right of other men: for this labour being the unquestionable property of the labourer, no man but he can have a right to what that is once joined to, at least where there is enough, and as good, left in common for others.

The starting place for John Locke's argument seems sound: 

  1. People have a property right in their own bodies.
  2. To the extent possible, people should have a property right in their own labor.

The difficulty that John Locke does his best to minimize is this: what if my labor modifies something to which I did not have a property right? Then

  • if the modified thing is made mine, I have arrogated to myself something that was not mine by "mixing it with my labor";
  • if the modified thing is not made mine, then the labor I have put into modifying it has been taken away from me. 

John Locke supposes that there are plenty of things available that have not been mixed with anyone's labor, so I might as well be given that thing that was not mine if I mix my labor with it. Yes it was not mine and now it is mine, but anyone else can get one if they want, John Locke argues. But this is too optimistic. In the world of 2017, there is a shortage of attractive land that is unowned by anyone, and an even greater shortage of land over which no nation claims political dominion. Even when it comes to ideas, I might pluck an idea out of the Platonic realm and claim ownership of it by thinking about it a little bit, when given another week or another year you might have figured that idea out. 

The marginalist theory has another proposed principle: whoever owns the thing to begin with, they should be willing to pay me the improvement in value from modifying it. The marginalist theory then has no theory at all for the ownership of things that are not themselves the results of someone's labor.

The Coasian principle is that if there were no frictions, it there would be Pareto efficiency regardless of how the property rights are assigned, but in practice, various frictions suggest who should own something in order to minimize the efficiency costs of those frictions. For example, it might be convenient, other things equal, to assign ownership of something to someone who is mixing labor with it in order to reduce transactions costs and any problems from imperfect competition. This is only one possibility when coming from a Coasian point of view, but it is a possibility in the direction of what John Locke is suggesting. 

For an initial allocation of property when there really is an abundance of items that no-one has labored over, Locke's labor theory of property seems fine if one does not carefully think through what happens over time. But when items no-one has labored over will become scarce later on, that future scarcity cannot be ignored. Overall, Locke's labor theory of property seems like an excellent early attempt at a theory of property, but it is far from being a fully acceptable theory of property. It is well worth considering what other alternatives there are. I hope to return to this issue in future John Locke posts. 


Don't miss other John Locke posts. Links at "John Locke's State of Nature and State of War."

Greg Ip Defends the Dismal Science

Going forward, in principle, economists have the knowledge and tools to avert another financial crisis and to pull the economy quickly out of another potential Great Recession, or failing that to provide clear enough warnings and admonitions that the blame falls on those who don't heed economists. But the failure to avert the last financial crisis in 2008 and the long-drawn-out aftermath of that financial crisis and the Great Recession have hurt the reputation of economists. 

However, some of the negative views of economists predate economists' failure in 2008 and after. In his August 25, 2017 Wall Street Journal article "In Defense of the Dismal Science," (All the quotations here are from that article.) Greg Ip explains negative views of economics and economists and defends economics and its practitioners. These two paragraphs best sum up his discussion:  

Thus, when economists preach the virtues of globalization, market solutions or cost-benefit analysis, they sound to critics on the left like corporate shills lacking any moral anchor. To critics on the right, they sound like globalist elites who despise patriotism.

Yet it is precisely their love of numbers that makes economists invaluable. By stripping the emotions from pressing problems, economists can often illuminate the most practical ways to tackle them—but only if ordinary people and their representatives are prepared to listen.

On the first charge against economics, some economists no doubt are corporate shills lacking any moral anchor, but that is mostly limited to a subset of those on the payroll of corporations or wealthy patrons. (Incentives affect economists, too.)

Something I hope will tug the overall worldview of economists away from too much of a corporate worldview is the increasing amount of work on measuring nonmarket goods with subjective well-being data I am involved in (1, 2). 

As to the second charge, I view caring about the welfare of all human beings as consistent with patriotism. The United States is still the indispensable nation, and needs to strengthen itself by welcoming more people as citizens rather than discouraging people from joining in the historic mission of the United States. 

I love Greg's line "it is precisely their love of numbers that makes economists invaluable." In addition to the obvious meaning, it is their love of numbers—and in some cases their interpersonal cluelessness—that makes many economists more likely to tell the truth than others who are more sensitive to the political ramifications of any statement. 

Today, the greatest strength of economics as a discipline is its devotion to statistics:

In 1963, roughly half the papers published in the top three American economics journals were theoretical, according to a tally by Daniel Hamermesh, now at Royal Holloway, University of London. By 2011, that figure had shrunk to 28%; the remainder were empirical papers based on public data, on data gathered by the authors or on experiments. Economic debates these days are won not by the best theory but by the best data: Statistics are more important than calculus. Economists are far more obsessed with measurement than with math. When public discourse is plagued by innumeracy, this capacity to count is no small thing.

Economics has the most unity where economists have done good statistical work: 

A study by Gordon Dahl and Roger Gordon of the University of California, San Diego, found that disagreement among economists was greatest where the empirical research was most sparse ...

The second great strength of economics is the understanding of endogeneity that comes from learning economic theory: 

Economists are also instinctively skeptical of simple explanations. They are trained to look for equilibrium, which is another way of saying, “When you change one thing, how do other things respond? Where do things settle once all interactions have occurred?”

These two strengths of economics make it important for economists to pursue a wide range of research topics that go far beyond the traditional domain of economics. On that points, see:

Circling back to the financial crisis of 2008, Ricardo Reis describes well both the limitations and value of economics:

But such misjudgments don’t justify the charges leveled at economists. Take, for example, their inability to predict financial meltdowns. Crises almost by definition are unpredictable. In a recent essay, Ricardo Reis, an economist at the London School of Economics, argues that failing to foretell a financial crash is no more an indictment of economics than failing to predict when a patient will die is an indictment of medicine. Economists didn’t predict the financial crisis, Prof. Reis notes, but they did help to arrest it by applying theory and experience: “The economy did not die, and a Great Depression was avoided, in no small part due to the advances of economics over many decades.”

Economics can say that high capital requirements will lessen the chance of a financial crisis but if that advice to have high capital requirements is not heeded it can't easily predict when the financial crisis will happen. Economic can't always predict when a recession will strike, but it can say that negative interest rates will shorten the length and reduce the severity of a recession. And economics can give insight into a thousand other issues. But it can't keep us from being surprised by events. 

The Only Military Action the US Should Take Against North Korea Is to Shoot Down Every North Korean Missile in Boost Phase

Note: I learned a lot from writing this post and getting reactions along the way. Take a look and learn along with me. 

North Korea claims, fairly credibly, to have detonated an H-bomb. It has been testing and improving missiles with the goal of being able to make a nuclear attack against the continental United States. It has a history of violating any diplomatic agreement it makes. North Korea has a patron, China, protecting it, but seemingly unable to control it. And 25 million South Koreans, along with a large share of South Korea's economy, are within easy artillery range in the Seoul metropolitan area. What can the US do to protect itself?

First, let me stipulate that we should be willing to let China have whatever it wants in relation to the Korean peninsula on three conditions: 

  1. What China asks for is acceptable to South Korea
  2. China is willing to enforce a complete blockade of North Korea unless North Korea verifiably gives up nuclear weapons
  3. China is willing to acquiesce in the military actions against North Korea spelled out below.   

The rise of China is something I worry about quite a bit (1, 2), but that challenge has to be faced regardless of what happens on the Korean peninsula. If China wants to keep North Korea in business as an increasingly powerful rogue state in order to get what it wants even beyond the Korean peninsula, it might not agree to the deal above; in that case, we have to go ahead trusting that despite bitter complaints from China, it will in the end acquiesce to the military actions spelled out below. 

Although diplomacy with China seems fruitful, diplomacy with North Korea does not. So the approach to North Korea consists of declaring unilateral actions the US will take. 

The immediate military action the US needs to take is to begin shooting down every North Korean missile launched, not with the Thaad system that is so much in the news, but with boost-phase interception. This requires explanation. Arthur Herman writes in the March 12, 2017 Wall Street Journal op-ed shown at the top of this post: 

To its credit, the Obama administration agreed to install land-based and sea-based missile technology like Thaad and Aegis to protect South Korea and Japan. The problem with these systems is that they can shoot down an incoming ballistic missile only toward the end of its flight, as it re-enters the atmosphere. That narrows the margin for error. ...

There’s a better alternative. Technology exists now for stopping a North Korean missile launch much earlier, in its boost phase. It’s called boost-phase intercept, or BPI, and the U.S. and Japan have the means to deploy it.

All large multistage rockets require high-thrust booster engines to push them out of the atmosphere, which then drop away when the missile achieves orbit. Destroying a missile at this early boost phase has many advantages. Since it’s the hottest stage of a ballistic-missile launch, it’s the easiest for infrared sensors to detect and identify. It’s also the slowest phase of the launch, so the missile loses any advantage it might have in speed in its later descent.

A BPI would be launched ... from an unmanned aerial vehicle waiting at 55,000 feet and equipped with infrared sensors that will detect missile launches from 350 miles outside North Korean airspace. ...

The aerial vehicle would be equipped with a conventional antimissile missile of 225 kilograms ...

There are already American-built unmanned aerial vehicles capable of carrying up to four interceptor missiles of this size, while conventional aircraft have successfully done BPI tests using missiles of this type. 

Boost-phase interception is not a mature technology, but neither is North Korean missile technology. We can get every bit as much practice in shooting down North Korean missiles as they get in launching missiles and countermeasures to boost phase interception. US resources are enough greater than North Korea's, we can win an arms race of missile vs. antimissile.

Initially, antimissiles will need a manned platform. That means US aircraft patrolling off the North Korean coast for quite some time until the unmanned aerial antimissile platforms are ready.

Crucially, if all or most North Korean missiles are shot down in boost phase, North Korea will get very little practice in dealing with the tough technical challenge of having a missile and its payload survive atmospheric reentry intact. Also, devoting technical resources to evading antimissiles may distract from other technical challenges like dealing with atmospheric reentry. 

Is shooting down all North Korean missiles soon after launch overly provocative? I don't think so. North Korea is loudly proclaiming that these missiles are intended as a threat to the United States. Shooting them down is simple self-defense. Not shooting down North Korean missiles practicing for an attack on the United States is appeasement. 

Shooting down North Korean missiles does not require attacking North Korean territory. And it is likely to be much more effective in hindering North Korea in sharpening its missile threat than attacking hardened North Korean missile sites or hardened nuclear development sites. Shooting down missiles is proportional to the threat. It is not escalation. 

China will hate the idea of the US further developing antimissile technology. China's distaste for our justifiably using North Korean missiles as target practice must not be allowed to stop us from doing so. If China wants to stop us from developing our antimissile technology further, it can work harder to stop North Korea from launching missiles. And if it does do everything it can, as laid out above, to restrain North Korea, it can have whatever it wants in relation to the Korean peninsula that is acceptable to South Korea, too. (South Korea is under enough threat itself, it is likely to be amenable to many things.)  

In addition to being valuable in its own right, shooting down every North Korean missile soon after launch will make other warning the US must make credible. In particular, the US must be able to deter North Korean development of a nuclear missile submarine threat. The ability to shoot down submarine-launched missiles in boost phase will help, but depending on technological developments, it may be necessary at some point in the future for the US to destroy North Korea's submarine capability. Fortunately, other countries can probably be dissuaded from providing North Korea with submarine bases, so North Korea's submarine bases will be on the North Korean coast. Because of the nature of ports, it is a lot harder to harden a submarine base than it is to harden a missile site or nuclear development facility. So if needed five or ten years from now, the US should be able to carry out an effective attack on a North Korean submarine base before North Korea gets a fully operational submarine-launched nuclear-missile capability. We need to announce our intention to destroy North Korean submarine bases in the event North Korea gets close to a submarine-launched nuclear-missile capability long in advance so that China gets used to the idea. (There might be some effect on more protective measures for the submarine base, but there is only so much that can be done to protect a submarine base against US firepower.) Obviously, we don't want to be put in the position of having to attack a North Korean submarine base, so it is crucial to build up our credibility that we would if necessary, precisely so that we don't have to. Making every effort to shoot down all North Korean missiles soon after launch is one of the best ways to build up that credibility.  

It may be reasonable to pursue Chinese economic sanctions for about two more months (long enough to get past the October 18, 2017 Party Congress in China) before beginning to shoot down North Korean missiles. But it would be folly to wait much longer than that if the situation then is similar to the situation now, but with several more North Korean missile launches having taken place. Those two months should be devoted to putting US boost-phase interception technology development into high gear.   

Technical Issues. If Arthur Herman (the op-ed writer above) is overoptimistic about the state of boost-phase interception technology, it will make sense to pursue the economic sanctions route for longer before trying to shoot down North Korean missiles. Jason Smith raises technical issues about the readiness of boost-phase interception technology in this storified Twitter exchange. One issue raised is that North Korea and our other enemies will learn more about our antimissile technology if we use it. To me this does not seem a strong argument. Surely we learn as much by getting experience with our antimissile technology as they (and other potential adversaries) do by seeing where we are so far. In order to avoid losing face, the US needs to avoid overpromising how well its antimissile technology will work in the short run. We don't need to be able to connect with a North Korean missile every time at first; shooting down a North Korean missile at a rate far below 100% can still help the US as long as the expectations are set low.  

Jason emphasizes the difficulties created by North Korea's mountains. The highest mountain is Mount Paektu (or Baekdu), 2744 meters high. At 10 Gs, 98 meters per second squared straight up, a missile would reach an altitude of 3136 meters after 8 seconds. So after 10 seconds or so, even at some angle, a missile will be above all the North Korean mountains and the mountainous terrain can no longer hide the missile. (However the problem of seeing around the curve of the Earth is now relative to the tops of the mountains, so it would require the detection systems to be that much higher.) Since it will only be traveling at a speed of about one kilometer per second at that point, it needs a longer boost phase than that. (Even straight up, 1 kilometer per second can be counteracted by Earth's gravity in just 102 seconds.) Arthur Herman claims:

Once the launch is detected, operators of the BPI system would have nearly a minute to decide whether a launch is genuine or not, and then to initiate the intercept—more than enough time to prevent a mistake.

If Arthur is even in the right ballpark, shaving 10 seconds off of that minute because of mountainous terrain still leaves 50 seconds. 

Jason also raises the issue of false alarms. Given its threats, North Korea has no right to a space program, which in North Korea's case would be little more than an advertisement of its missile prowess in any case. Being willing to risk shooting down a space launch may be essential in order to respond quickly enough to a North Korean missile. Alternatively, in the quite unlikely event that they want to pursue a space program for entirely peaceful reasons, the North Koreans can arrange for a pre-inspection of their satellite-launch rocket and monitoring its time of launch so that it can be distinguished from a missile. 

It is important to distinguish between missiles and supersonic jets. That should be feasible. To the extent it is difficult, North Korea can be warned about the types of extreme behavior of supersonic jets that would cause them to be targeted as if they were missiles.

A key principle we need to insist on to the international community is that given the provocations of the North Korean regime, shooting down a North Korean missile is not an act of war, it is antiwar. If one asks as a technical matter of international law why North Korean can be treated differently than other countries in this regard, its repeated violation of UN sanctions is salient. The UN is not good at managing all the details of international affairs, nor should we expect it to do so, but sometimes it is able to identify a rogue state. 

I am old enough to remember the ridicule heaped on Ronald Reagan's interest in antimissile technology—so called "Star Wars." (The Soviets took it much more seriously than most American journalists did.) Thirty years have passed. Antimissile technology is not in the same place now it was back then. If it is not as good as it should be, that may owe something to partisan opposition to antimissile technology at times during those 30 years, and overoptimism that economic sanctions would take care of the North Korean threat. (I confess that I thought the North Korean nuclear threat would have been dealt with by now, so I understand this miscalculation.) If boost-phase interception technology is not ready to do what I am positing it should do, someone should be held to account for not getting it to the point we can use it by now when we desperately need it. And we need to rectify any deficiency in our antimissile technology as soon as possible. 

One final objection to antimissile technology is that it might destabilize strategic deterrence between the US and Russia or between the US and China. But this is an argument that antimissile technology is too good, quite inconsistent with the argument that antimissile technology is not good enough to use against North Korea. There is no time in the foreseeable future when antimissile technology will be good enough to stop Russia or China from wreaking massive nuclear destruction on the US should they choose to do so. It is quite possible for antimissile technology to be good enough to help greatly in dealing with North Korea without disturbing the doctrine of "mutually assured destruction" between the US and Russia or between the US and China.