the making of an economist: Stephanie Schmitt-Grohe

Economics has lost two of its greatest female economists in the past month. Elinor Ostrom was a brilliant economist who published some of her best works on one of the most difficult subjects of our times: water. Common resources such as water are always challenges to individuals, and these challenges are often met by furthering private property rights. However, aspects of water make it very difficult to differentiate and privatize. Of all the people that have written on this subject, hers might be the best solution. She has written on it extensively throughout her career, but my favorite article is "Legal and Political Conditions of Water Resource Development" with her husband, Vincent Ostrom.

(photo: Embassy of Sweden in the United States)

Her most cited book is Governing the Commons. Her last article was published the day that she died, "Green from the Grass Roots." She is an important person within the Institutional school of economics. She won the Nobel Prize in economics in 2009, and was the first and so far only woman to be honored.

If you were to ask ten economists to recommend ten books to undergraduate economics students, A Monetary History of the United States, 1867-1960 might appear on all ten lists. It is one of the most important books ever published in the subject. Anna Jacobson Schwartz wrote that book along with Milton Friedman, who went on to become a Nobel laureate and famous, but said that Dr. Schwartz actually did much of the empirical heavy lifting. That is also easy to infer by her other major works. She also notably co-wrote Growth and Fluctuations in the British Economy, 1790-1850, and Monetary Statistics of the United States. She has been associated with the National Bureau of Economic Research since 1941 (!). Her last article was published days before her death earlier this week, "Foreign-Exchange Intervention and the Fundamental Trilemma of International Finance: Notes for Currency Wars" on current monetary problems. She is clearly one of the greatest monetary economists of all time.

Every economics department that I've ever seen has many more male professors and students than female. This is not a terrible outcome, but it is not ideal. Although we have just lost Ostrom and Schwartz there are currently more notable female economists than ever before. Claudia Goldin is one of the best economists on the subject of inequality. Stephanie Schmitt-Grohe is a terrific monetary economist. Esther Duflo is a groundbreaking economist on development and microeconomic techniques. Christina Romer is one of the best economic historians of all time. Her contribution to our understanding of the Great Depression is as important as Friedman/Schwartz and Benjamin Bernanke. Carmen Reinhart wrote the best popular economics book last year, This Time is Different: Eight Centuries of Financial Folly along with Kenneth Rogoff. There are so many great female economists now that I can't list them all, but it still hurts to lose these two.

The Federal Reserve just announced its first formal inflation target. They set a target of 2% interest as a long term target for inflation. This is in step with Bernanke's academic work on monetary policy and with the recent Fed moves towards transparency and their attempts to create expectations rather than simply respond to them. Many central banks have already practiced this for some time.

Brief Case Study: Sweden

Sweden Consumer Price Index

Sweden has been targeting inflation since recovering from a currency crisis in 1993. This gives us a long period of time to examine inflation targeting's effectiveness. The first graph (above) shows the monthly inflation rate of Sweden since their online data begins in 1980. Their maximum inflation rate during the period has been 5.2%, and the minimum -1.9% with the average being 1.56%. The standard deviation has been 1.42%, but while it has had a lot of variation, it has been pretty centered around 1.5% as shown by the histogram below.

The histogram shows the number of times that Sweden has hit a given percentage of inflation since they introduced inflation targeting in 1993. I added a box from 1% to 3%, with a line down the middle at 2% showing the target and the acceptable range. This shows that Sweden has been conservative in their approach to their intention, which has been a static 2% inflation target ±1%. It looks more like that they've targeted 0-3% inflation rather than 1-3%, which ended up with a median 1.5%. This policy has been largely successful in creating relatively stable growth for their economy, as shown in the graph below which begins in 1993.

Target Too Low?

Almost immediately after releasing the target, it was criticized. This is probably to be expected, but not in the way that I expected it to be. One of the first critics of the policy was Paul Krugman, who argued that 2% is too low. Two percent is a pretty standard number in inflation targeting central bank circles. It would be more shocking if they chose to formally inflation target and didn't choose 2%.

Olivier Blanchard was an early major economist to write of raising the inflation target in his paper (along with Giovanni Dell'Ariccia and Paolo Mauro) "Rethinking Macroeconomic Policy" which considered more than monetary policy, but also fiscal and tax policies as well. Blanchard mainly asks if there would be substantially higher costs and benefits to targeting 4% compared to 2% inflation.

Stephanie Schmitt-Grohe and Martin Uribe wrote an interesting paper in 2010 titled, "The Optimal Rate of Inflation" where they attempt to formalize some aspects of the debate on inflation targeting. "For a realistic model of the monetary transmission mechanism must incorporate both major sources of monetary nonneutrality, price stickiness and a transactional demand for fiat money. Indeed, in such a model the optimal rate of inflation falls in between the one called for by the money demand friction—deflation at the real rate of interest—and the one called for by the sticky price friction—zero inflation. The intuition behind this result is straightforward. The benevolent government faces a tradeoff between minimizing price adjustment costs and minimizing the opportunity cost of holding money. Quantitative analysis of this tradeoff, however, suggests that under plausible model parameterizations, this tradeoff is resolved in favor of price stability."

They bring up an incredible amount of ideas that I hadn't considered. They examine ways in which the Friedman rule, or the optimal monetary policy that focuses on zero opportunity cost to holding money, could break down. All three of these ways are related to taxation, whose relation to monetary policy I had not considered.

While I'm not sure if I agree with them, all of these are important concepts to consider, especially when current monetary policy is constrained by the Zero Lower Bound due to our current liquidity trap. Formally announcing a target seems to be a way of creating expectations both for better and for worse. The better is that it signals to the market that the central bank is taking steps to create inflation, and the market can often help by making the claim a self-fulfilling prophecy. Similarly for worse, inflation hawks can be cooled by the setting of a reasonable level of inflation target.

The latter of the two is important as the Federal Reserve will eventually have to perform a tricky dismount of these current monetary policies. They have undoubtedly increased the monetary base in shocking amounts. Much of this has been done with relatively normal operations using Treasury security repo's, but much of it has been done with alternative monetary policies. This has been done to combat liquidity trap conditions, but as those conditions ease, longer term inflation problems will start. The Fed has a large amount of sub-prime mortgages and it is unclear whether, even now, that there is a market for those assets. The point being that many of the assets that the Fed purchased might not be incredibly easy to sell.

John B. Taylor has talked about crisis policies of the Fed being unprecedented and that there is a need for a clear exit strategy. This is due to the fact that if or when inflation does creep above the target, all of the old devilish aspects of relatively high inflation will creep back into society. The chief of those being: increases in the cost of capital to the user. I recently wrote an article in praise of Chairman Bernanke, and I stand by that post, but to be clear... the most tricky part for Bernanke's Fed is still to come.

References:

Blanchard, Olivier and Giovanni Dell'Ariccia and Paolo Mauro. "Rethinking Macroeconomic Policy." Washington DC: IMF. 2010.

Working Paper.

Cohen, Darrel, Kevin Hassett, and R. Glenn Hubbard. ED: Martin Feldstein. The Costs and Benefits of Price Stability. "Inflation

and the User Cost of Capital: Does Inflation Still Matter?" Chicago: University of Chicago Press. NBER Conference Report.

1999. Print.

Krugman, Paul. "Two Percent is Not Enough." The New York Times. New York: New York Times Publishing. 1/26/12. Web.

http://krugman.blogs.nytimes.com/2012/01/26/two-percent-is-not-enough/

McCallum, Bennett. "Should Central Banks Raise Their Inflation Targets? Some Relevant Issues." Economic Quarterly.

Richmond: Federal Reserve Bank of Richmond. Vol. 97, No. 2. 2011. Journal.

Schmitt-Grohe, Stephanie and Martin Uribe. "The Optimal Rate of Inflation." 2010. Working Paper.

Taylor, John B. ED: John B. Taylor. The Road Ahead for the Fed. "The Need for a Clear and Credible Exit Strategy." Stanford: