The problem with "shocks"
By Scott Sumner
I recently presented a paper discussing how economists think about the “stance” of monetary policy. That is, what do economists mean by terms like “easy money” and “tight money”? It turns out that the entire subject is just a big muddle. My paper quoted a number of big names like Friedman, Mishkin and Bernanke, all saying that changes in the monetary base (QE) and interest rates are not reliable indicators, and then suggesting all sorts of alternatives. In other words, there was absolutely no agreement. My views were closest to those of Bernanke, who recommended looking at NGDP growth or inflation (I prefer NGDP growth.)
I’ll return to this issue in a moment, but first I’d like to digress and discuss how economists think about economic “shocks.” A shock is some sort of exogenous event (not explained by the model), which impacts the macroeconomy. It might be a shift in monetary or fiscal policy, or some sort of supply-side disturbance like political instability, war, natural disaster, or imposition of 90% marginal tax rates. The shock affects other macro variables over a period of time.
Macroeconomists have developed a technique called “Vector Auto Regression” (VAR) for estimating the impact of shocks. Thus you could collect lots of data and then try to statistically estimate the impact of a change in government spending, or a change in monetary policy, on variables like inflation and RGDP. In general, I haven’t kept up with this field, but unless I’m mistaken there is good reason to be skeptical of this entire line of research. To see why, we need to return to the initial discussion of the stance of monetary policy. How can economists be expected to measure the impact of monetary policy, if they don’t even know what monetary policy is?
Even worse, the same problem affects fiscal policy, even if we can agree as to what fiscal policy is. For instance, suppose we can agree that the cyclically-adjusted budget deficit is a reasonably objective measure of the stance of fiscal policy. So we go out and do a VAR study of the effect of fiscal shocks, holding monetary policy constant. But wait, didn’t we just decide that we don’t even know what monetary policy is? In that case, how can we hold it constant? Is it real interest rates, nominal rates, the base, M2, trade-weighted exchange rates, NGDP growth, or something else? And if we use the Bernanke/Sumner criterion (say expected NGDP growth) then it’s pretty likely that VAR studies of fiscal policy will show almost no effect on NGDP due to monetary offset.
In the past I’ve played the devil’s advocate and suggested that the concept of inflation is not well-defined and not very useful. This might seem to be a similar exercise in nihilism. In fact it’s far worse. Even I accept that if inflation during 1980 is measured at 22% in Britain, 13% in the US, and 5% in Germany, then it’s reasonable to assume the actual rates of inflation (if we could measure it accurately), would line up in roughly the same way. Here I’m making a much more radical claim. It’s not just that I think interest rates are an imperfect measure of the stance of monetary policy, I think they are downright perverse, that is, over any substantial period of time a tight money policy leads to low interest rates, and vice versa.
Would there be any way to save the study of macroeconomic shocks? I think so, but to do so we’d have to radically re-think what we mean by monetary shocks. In a better world we’d have highly liquid and subsidized prediction markets for NGDP, RGDP, inflation and unemployment. These would give us investor expectations in real time. Instead of monetary, fiscal, and various real shocks, we’d just have nominal and various real shocks. After all, in economics the term ‘nominal’ basically means measured in money terms. Instead of VAR studies we’d look at market reactions to policy shocks in real time.
For instance, suppose the Fed stuns the markets today by hinting that rates will rise in June. Stocks and other asset prices fall sharply within minutes of the announcement. A study could examine the impact of the surprise announcement on the various macro futures prices. Suppose his comment led to an immediate 0.3% fall in 2 year NGDP growth expectations, and a 0.2% fall in 2 year RGDP growth expectations (implying a 0.1% fall in inflation expectations.) That study would show the size of the monetary shock, and how its effects were likely to be partitioned between real GDP and inflation. It would replace VAR tests with a market test. Likewise, we could look at the impact of a fiscal policy surprise on NGDP growth expectations, which would provide a fairly direct measure of central bank incompetence (where zero effect is “competence.”)
As I indicated, I am not well informed on the modern VAR literature. Perhaps the problems I’ve discussed have been fixed. But the papers I have looked at recently don’t give me much confidence. Nor does the existence of a “price puzzle.” (Early VAR studies seemed to show that tight money raised inflation.) Nor am I reassured when I talk to other economists about how they would measure the stance of monetary policy. And you can’t solve these problems by looking at interest rate movements not predicted by the model, for instance.
I’d appreciate any thoughts from people with more expertise in this area than I have.