Monday, February 13, 2017

Balance Sheet Blues

We're starting to hear some public discussion about Fed balance sheet reduction. For example, Jim Bullard has spoken about it, and Ben Bernanke has written about it.

Balance sheet reduction is part of the FOMC's "Policy Normalization Principles and Plans. Quoting from scripture:
The Committee intends to reduce the Federal Reserve's securities holdings in a gradual and predictable manner primarily by ceasing to reinvest repayments of principal on securities held in the SOMA.
The normalization plan also states that balance sheet reduction will occur after interest rate increases happen, and that no outright sales of assets in the Fed's portfolio are anticipated. Thus, since we have now seen two increases in the target range for the fed funds rate - in December 2015 and December 2016 - it would be understandable if people were anticipating some consideration of the issue by the Fed in the near future.

What's at stake here? The Fed engaged in several rounds of large scale asset purchases, beginning in late 2008, and continuing through late 2014, which served to more than quadruple the size of the Fed's balance sheet:
But the Fed's assets, which now consist primarily of long-maturity Treasury securities and mortgage-backed securities, mature over time. As the assets mature, the size of the Fed's asset portfolio will fall naturally, and Fed liabilities will be retired. But that isn't happening, because the FOMC instituted a "reinvestment" policy in August 2010, and that policy has continued to the present day. Under reinvestment, assets are replaced as they mature, the result being that the size of the portfolio stays roughly constant, in nominal terms. The Fed's normalization plans state that revinvestment will stop eventually, but there are different ways to phase it out. For example, revinvestment could stop abruptly, or the Fed could somehow smooth the transition.

But, if Ben Bernanke were still Fed Chair, he would be postponing balance sheet reduction. Why? As stated in his post, Bernanke thinks that:

1. There is uncertainty about the effects of ending reinvestment, so the Fed should wait until the fed funds rate is higher, giving it a larger margin to make corrections if something goes wrong with balance sheet reduction.
2. Because the demand for currency is growing over time, this reduces the amount of balance sheet reduction that would be required to return to the pre-financial crisis state of affairs in which reserves are close to zero.
3. There may be good reasons to continue operating a floor system, under which the interest rate on reserves determines overnight interest rates. But, according to Bernanke, it takes a heap of reserves to operate a floor system, giving us another reason to think that the ultimate balance sheet reduction required for normalization isn't so large.

Perhaps the most curious aspect of Bernanke's piece is the absence of any explanation of how quantitative easing (QE) is supposed to work. However, it's easy to find a stated rationale for QE in Bernanke's earlier public statements as Fed Chair, for example in his 2012 Jackson Hole speech. Basically, Bernanke argues that QE affects asset prices because of imperfect substitution among assets. Thus, for example, swaps of reserves for long-maturity Treasuries will increase the prices of long-maturity Treasuries, reduce long bond yields, and flatten the yield curve, according to Bernanke. He also claims there is solid empirical evidence supporting this theory. In Bernanke's mind, then, QE is just another form of "monetary accommodation," which substitutes for reductions in the policy interest rate when such interest rate reductions are not on the table. The reductions in long bond yields should, in Bernanke's view, increase real economic activity and increase inflation.

Actually, the evidence that QE works as intended is pretty sketchy. For the most part, the empirical work consists of event studies - isolate an announcement window for a policy change, then look for movements in asset prices in response. There's also some regression evidence, but essentially nothing (as far as I know) in terms of structural econometric work, i.e. work that is explicit about the theory in a way that allows us to quantify the effects. But surely, since QE has been in use for so long a time, it should have found a place in models that are widely used for policy analysis. Indeed, a paper by David Reifschneider at the Board of Governors uses the Board's large scale macroeconometric FRB/US model to conduct a policy exercise that, in part, evaluates the efficacy of QE. The conclusion is:
...model simulations of a severe recession suggest that policymakers would be able to use a combination of federal funds rate cuts, forward guidance, and asset purchases to replicate (and even improve upon) the economic performance that hypothetically would occur were it possible to ignore the zero lower bound on interest rates and cut short-term interest rates as much as would be prescribed by a fairly aggressive policy rule.
So, that's consistent with Bernanke's post. Bernanke argues that it was necessary to use QE in 2008 and after because the Fed was constrained by the zero lower bound on nominal interest rates. More accommodation was needed, according to Bernanke, and QE provided that accommodation. Reifschneider says that's exactly what the FRB/US model tells us. QE (along with forward guidance) effectively relaxes the zero lower bound constraint. That is, QE is just like a decrease in the target for the policy interest rate.

Is the FRB/US model the right laboratory for an assessment of the efficacy of QE? Reifschneider says:
For several reasons, FRB/US is well-suited for studying this issue. For one, it provides a good empirical description of the current dynamics of the economy, including the low sensitivity of inflation to movements in real activity. In addition, the model has a detailed treatment of the ways in which monetary policy affects spending and production through changes in financial conditions, including movements in various longer-term interest rates, equity prices, and the foreign exchange value of the dollar.
So, Reifschneider hasn't really told us why using this model is the right thing to do in this circumstance, but he's told us something about how the FRB/US model works. You can read about the FRB/US model here, and even figure out how to run it yourself if you have the inclination. The FRB/US model is a descendant of the FRB/MIT/Penn model, which existed circa 1970. In fact, if we could resurrect Lawrence Klein and show him the FRB/US model, I'm sure he would recognize it. In spite of the words in the FRB/US documentation that make it appear as if the model builders took to heart the lessons of post-1970s macroeconomics, FRB/US is basically an extended IS/LM/Phillips curve model - without the LM. Monetary policy is transmitted, as Reifschneider tells us in the above quote, through asset prices. So how would one use such a model to capture the effects of QE?
... the model’s asset pricing formulas provide a way for long-term interest rates and other financial factors to respond to shifts in term premiums induced by the Federal Reserve’s large-scale asset purchases.
So, in the simulation, QE is assumed to work through a "term premium" effect on asset prices - a flattening of the yield curve. But how large a change in the term premium results from a purchase of $x in assets by the Fed? That's in footnote 8:
The effects of asset purchases on term premiums used in this study are calibrated to be consistent with the estimates reported in Ihrig et al (2012) and Engen, Laubach and Reifschneider (2015) for the second and third phases of the Federal Reserve’s large-scale asset purchase programs, both of which involved buying assets of a longer average maturity (and thus a larger term premium effect) than the original phase. Specifically, the simulations reported here assume that announcing the purchase of an additional $500 billion in longer-term Treasury securities causes an immediate 20 basis point drop in the term premium embedded in the yield on the 10-year Treasury note; for yields on the 5-year Treasury note and the 30-year Treasury bond, the initial decline is assumed to be 17 basis points and 7 basis points, respectively. Thereafter, the downward pressure on term premiums is assumed to decline geometrically at 5 percent per quarter; this rate would be consistent with the Federal Reserve using reinvestments to maintain the size of its portfolio at its new, higher level for several years, and then allowing it to shrink passively by suspending reinvestment.
So, that's quite indirect. In the FRB/US model there are no central bank balance sheet variables. There are equations that capture the relationships among interest rates and asset prices, but there are no asset quantities. Thus, it's impossible to use the model to address directly the question: "What happens if the Fed purchases $600 billion in 10-year Treasury bonds?" To answer the question we have to do it indirectly. What Reifschneider has done is to work with what he's got, which is event studies and regression evidence. This gives him an estimate of the effect of Fed asset purchases on term premia, and he plugs that into the asset pricing relationships in the model. Maybe you're OK with that, but I don't trust it.

What makes me skeptical of Reifschneider's results? One approach to uncovering the effects of QE is to look for natural experiments. This is simple, which is ideal for a simpleton such as yours truly. For example, in April 2013, the Bank of Japan embarked on a QE project, which continues to this day. One objective of the project was to get inflation up to 2%. So, that policy has now had almost 4 years to work. What's happened? First, the magnitude of the BOJ's asset purchases is reflected in the monetary base:
The monetary base has about quadrupled over a period of less than four years. If QE works to increase inflation, surely we would be seeing a lot of it by now, right? Here's the CPI for Japan:
The price level went up alright, but part of that was due to an increase of three percentage points in the consumption tax in April 2014, which feeds directly into the CPI. Even including that, average inflation has been about 0.7% since April 2013, and about zero for the last two years. So, is QE effective in increasing inflation? Japanese experience says no.

Another natural experiment is the US and Canada. Since the financial crisis, the difference in interest rate policy between the Bank of Canada and the Fed has been minimal. For example, the Bank of Canada's current target for the overnight policy rate is 0.50%, while the ON-RRP rate (the comparable secured overnight rate in the US) is also 0.50%. From one of my papers, here's a chart showing what was going on with monetary policy in Canada, post-financial crisis:
We will return to this chart later, but for now just focus on the blue dotted line, which is overnight reserves at the Bank of Canada. For most of this period, except Spring 2009 to Spring 2010, the Bank of Canada operated under a channel system, under which it targets overnight reserves at zero. There is some slippage, with a quantity of overnight reserves typically less than $500 million. That's a very small amount relative to the quantity of interest-bearing Fed liabilities (currently close to $3 trillion). So, the Bank of Canada has not been indulging in QE, but the Fed has been doing it in a big way. Surely, if we believe Ben Bernanke, that would have resulted in observable differences in the behavior of real economic activity and inflation in the two countries. Here's real GDP, and the consumer price index for the US and Canada:
So, since the beginning of 2008, average real GDP growth and average inflation has been about the same in Canada and the US. As an econometrician once told me, if I can't see it, it's probably not there. Sure, since Canada is small and is highly integrated with the US economically, Fed policy will matter for Canadian economic performance. But, if QE were so important, the fact that the US did it and Canada did not should make some observable difference for relative performance.

What else do we know about QE? I thought about it a bit, and wrote a couple of papers - this one and this one. Basically, the idea is to think about QE for what it is - financial intermediation by the central bank. If QE is to work, and for the better, the reason has to be that the central bank can do a better job of turning long-maturity assets into short-maturity assets than either the private sector, or the fiscal authority. So, for example, QE could work because the fiscal authority is not doing its job - there is too much long-maturity government debt outstanding. So, if the central bank swaps reserves for long-maturity government debt, that could bring about an improvement, by improving the stock of collateral that supports intermediated credit. Basically, short-maturity assets are better collateral. But maybe reserves are worse assets than short-maturity government debt. Reserves can be held only by a limited set of financial institutions, while Treasury bills are widely-traded, and very useful, for example in the market for repurchase agreements. So, it's not clear that there is an improvement if, for example, the Fed purchases 10-year Treasuries, thus converting highly-useful 10-year Treasuries into not-so-useful reserves. Some of those concerns could be mitigated by an expansion in the Fed's reverse repurchase agreement (ON-RRP) program, but so far that has been operated on a small scale.
The chart shows outstanding ON-RRPs, which are a relatively small fraction of interest bearing Fed liabilities (approaching $3 trillion).

So, what of Bernanke's first point, that the Fed should postpone the termination of reinvestment, because of uncertainty? My conclusion is that it is hard to make a case that QE does anything at all, and one could make a case that it gums up the financial plumbing. But here's an interesting detail. If we break down the Fed's holdings of Treasury securities by maturity, we get this:
The chart shows the percentage of Treasury securities held by the Fed that will mature within one year, in 1-5 years, in 5-10 years, and in more than 10 years. Before the financial crisis, these percentages did not vary much, with about 80% of the portfolio maturing in less than 5 years - average maturity was relatively short. In early 2013, average maturity reached its peak, with about 75% of the total portoflio maturing in more than five years, and the remainder maturing in 1-5 years. But, since early 2013, the fraction of the portfolio maturing in more than five years has declined to about 40%, with about 10% maturing in less than one year.

So, if one thought that the degree of monetary accommodation was related not only to the size of the Fed's portfolio but to average maturity, then there is considerably less accommodation than was the case three years ago (at least in terms of the Fed's Treasury holdings). Further, if the reinvestment program were halted, the assets will run off more quickly than would have been the case if reinvestment had ceased three years ago.

What of Bernanke's two other points? The first is that the stock of currency is growing, which increases the size of the balance sheet at which interest-bearing Fed liabilities disappear. The next chart shows the stock of currency as a percentage of nominal GDP:
That's remarkable. In 1990, US currency outstanding in the world was about 4.4% of US GDP, and today it is almost 8%. To get some idea what implications this has for the Fed's balance sheet, we'll calculate the interest-bearing portion of Fed liabilities (that's total liabilities minus currency) and express that as a percentage of GDP:
So, you can see that the size of the balance sheet has actually been declining, measured as interest-bearing Fed liabilities relative to GDP. Again, if we took what is in the chart as a measure of accommodation, there is less of it than was the case late in 2014. But how long would it take for this ratio to decline to where it was (0.5%) prior to the financial crisis, if the reinvestment policy stays in place indefinitely. If my arithmetic is correct, about 55 years. Within 55 years, all kinds of things could happen, of course. Ken Rogoff could get his way and 80% of the currency stock could disappear, government currency could be replaced by private digital currencies, etc. So projecting that far into the future is pure speculation.

The final issue Bernanke raises is related to possible benefits for monetary policy implementation from a large Fed balance sheet. A case can be made that, in the U.S. institutional context, it is easier to implement monetary policy under a "floor" system than a "channel" or "corridor" system. There are some complications in the US case but, roughly, under a floor system the interest rate on reserves (IOER) should determine the overnight interest rate. To make the floor system work requires that there be adequate reserves in the financial system, so that a typical financial institution is indifferent between lending to the Fed (at IOER) and lending overnight to another financial institution. But once it's working, a floor system is easy for the Fed, as overnight interest rates are effectively set administratively, rather than through the hit-and-miss approach the Fed followed pre-financial crisis. But the key question is: How much reserves need to be in the system to make the floor system work? Here's what Bernanke says:
To ensure that the floor rate set by the central bank is always effective, the banking system must be saturated with reserves (that is, in the absence of the interest rate set and paid by the central bank, the market-determined return to reserves would be zero). In December 2008, when the federal funds rate first fell to zero and the Fed began to use the interest rate on bank reserves as a tool of monetary policy, bank reserves were about $800 billion. Taking into account growth in nominal GDP and bank liabilities, the critical level of bank reserves needed to implement monetary policy through a floor system seems likely to be well over $1 trillion today, and growing.
If you look at the very first chart, you can see what he's thinking. In October 2008 the Fed began paying interest on reserves in the midst of turmoil in financial markets. By the end of the year, overnight rates were essentially zero, and the size of the balance sheet had increased by a very large amount with reserves increasing about $800 billion. So, Bernanke is assuming that, at the end of 2008, it took $800 billion to make the overnight interest rate go to the floor - the IOER. If the balance sheet increase had occurred gradually in a relatively calm financial market, we might take that seriously, but I'm not buying it.

To see this, go back to the fourth chart, which shows what the Bank of Canada was up to. The chart shows three interest rates: (i) the rate at which the central bank lends to private financial institutions (green); (ii) the overnight interest rate the Bank of Canada targets (blue); (iii) the interest rate on deposits at the Bank of Canada - the interest rate on reserves (orange). Normally, the Bank operates a channel system, under which the overnight rate falls between the other two rates. But, for about one year, from Spring 2009 to Spring 2010, the Bank operated a floor system. As you can see, the policy rate goes to the floor for this period of time. How much reserves did it take to make the floor system work? The Bank targeted overnight reserves to $3 billion (Canadian) over this period. To get an idea of the order of magnitude, a rule of thumb is that the Canadian economy is roughly a multiple of 10 of the US economy, so this quantity of reserves is roughly comparable to $30 billion in the US. We need to account for the fact that there are reserve requirements in the US, and none in Canada, and that the US institutional setup is very different (many more banks for example). But, I think it's hard to look at the Canadian experience and think that it takes as much as $1 trillion in interest bearing Fed liabilities to make a floor system work in the US, as Bernanke is suggesting. I would be surprised if we needed as much as $100 billion.

So, in conclusion, I think Bernanke's arguments are weak. It's hard to make a case that QE is a big deal, or that stopping the Fed's reinvestment policy is risky or harmful - indeed it might improve economic welfare. Further, if one thinks that QE is accommodative, and that we can measure accommodation by the average maturity of the Fed's asset portfolio, or by the ratio of interest-bearing Fed liabilities to GDP, then withdrawal of accommodation has been underway for some time.

Addendum: This pertains to JP's comment below. Here's real GDP for Japan:
I don't see any break in the recovery from the recession associated with Abenomics. Do you? Just for good measure, we can look at the GDP price deflator for Japan:
So, you can see that it's the price behavior that's giving the nominal GDP increase. But, most of the price deflator increase is in 2014 - the price level increased by about 4% in a year's time. But, again, some of this is due to the direct effect of the consumption tax increase of three percentage points in April 2014. Note that inflation, measured by the increase in the GDP price deflator, has been about zero for the last two years.

Friday, February 3, 2017

Going North

I've accepted a new job, beginning in the 2017-18 academic year, as the Stephen A. Jarislowsky Chair in Central Banking in the Economics Department at Western University (a.k.a. the University of Western Ontario), London, Ontario. This is an exciting opportunity for me, but it comes with regrets, as I have to leave a lot behind here in St. Louis. The St. Louis Fed has treated me very well. Some of the best economists anywhere work at the St. Louis Fed, and the institution is run by first-rate people. I'll miss the advice, the economics, and the always-interesting policy work. But I'm very much looking forward to working with my new (and old) colleagues at Western. Special thanks go to Stephen Jarislowsky and the Jarislowsky Foundation for their generous support.

Sunday, January 15, 2017

What's a Macro Model Good For?

What's a macro model? It's a question, and an answer. If it's a good model, the question is well-defined, and the model gives a good answer. Olivier Blanchard has been pondering how we ask questions of models, and the answers we're getting, and he thinks it's useful to divide our models into two classes, each for answering different questions.

First, there are "theory models,"
...aimed at clarifying theoretical issues within a general equilibrium setting. Models in this class should build on a core analytical frame and have a tight theoretical structure. They should be used to think, for example, about the effects of higher required capital ratios for banks, or the effects of public debt management, or the effects of particular forms of unconventional monetary policy. The core frame should be one that is widely accepted as a starting point and that can accommodate additional distortions. In short, it should facilitate the debate among macro theorists.
At the extreme, "theory models" are purist exercises that, for example, Neil Wallace would approve of. Neil has spent his career working with tight, simple, economic models. These are models that are amenable to pencil-and-paper methods. Results are easily replicable, and the models are many steps removed from actual data - though to be at all interesting, they are designed to capture real economic phenomena. Neil has worked with fundamental models of monetary exchange - Sameulson's overlapping generations model, and the Kiyotaki-Wright (JPE 1989) model. He also approves of the Diamond-Dybvig (1983) model of banking. These models give us some insight into why and how we use money, what banks do, and (perhaps) why we have financial crises, but no one is going to estimate the parameters in such models, use them in calibration exercises, or use them at an FOMC meeting to argue why a 25 basis point increase in the fed funds rate target is better than a 50 basis point increase.

But Neil's tastes - as is well-known - are extreme. In general, what I think Blanchard means by "theory model" is something we can write up and publish in a good, mainstream, economics journal. In modern macro, that's a very broad class of work, including pure theory (no quantitative work), models with estimation (either classical or Bayesian), calibrated models, or some mix. These models are fit to increasingly sophisticated data.

Where I would depart from Blanchard is in asking that theory models have a "core frame...that is widely accepted..." It's of course useful that economists speak a common language that is easily translatable for lay people, but pathbreaking research is by definition not widely accepted. We want to make plenty of allowances for rule-breaking. That said, there are many people who break rules and write crap.

The second class of macro models, according to Blanchard, is the set of "policy models,"
...aimed at analyzing actual macroeconomic policy issues. Models in this class should fit the main characteristics of the data, including dynamics, and allow for policy analysis and counterfactuals. They should be used to think, for example, about the quantitative effects of a slowdown in China on the United States, or the effects of a US fiscal expansion on emerging markets.
This is the class of models that we would use to evaluate a particular policy option, write a memo, and present it at the FOMC meeting. Such models are not what PhD students in economics work on, and that was the case 36 years ago, when Chris Sims wrote "Macroeconomics and Reality."
...though large-scale statistical macroeconomic models exist and are by some criteria successful, a deep vein of skepticism about the value of these models runs through that part of the economics profession not actively engaged in constructing or using them. It is still rare for empirical research in macroeconomics to be planned and executed within the framework of one of the large models.
The "large models" Sims had in mind are the macroeconometric models constructed by Lawrence Klein and others, beginning primarily in the 1960s. The prime example of such models is the FRB/MIT/Penn model, which reflected in part the work of Klein, Ando, and Modigliani, among others, including (I'm sure) many PhD students. There was indeed a time when a satisfactory PhD dissertation in economics could be an estimation of the consumption sector of the FRB/MIT/Penn model.

Old-fashioned large-scale macroeconometric models borrowed their basic structure from static IS/LM models. There were equations for the consumption, investment, government, and foreign sectors. There was money demand and money supply. There were prices and wages. Typically, such models included hundreds of equations, so the job of estimating and running the model was subdivided into manageable tasks, by sector. There was a consumption person, an investment person, a wage person, etc., with further subdivision depending on the degree of disaggregation. My job in 1979-80 at the Bank of Canada was to look after residential investment in the RDXF model of the Canadian economy. No one seemed worried that I didn't spend much time talking to the price people or the mortgage people (who worked on another floor). I looked after 6 equations, and entered add factors when we had to make a forecast.

What happened to such models? Well, they are alive and well, and one of them lives at the Board of Governors in Washington D.C. - the FRB/US model. FRB/US is used as an explicit input to policy, as we can see in this speech by Janet Yellen at the last Jackson Hole conference:
A recent paper takes a different approach to assessing the FOMC's ability to respond to future recessions by using simulations of the FRB/US model. This analysis begins by asking how the economy would respond to a set of highly adverse shocks if policymakers followed a fairly aggressive policy rule, hypothetically assuming that they can cut the federal funds rate without limit. It then imposes the zero lower bound and asks whether some combination of forward guidance and asset purchases would be sufficient to generate economic conditions at least as good as those that occur under the hypothetical unconstrained policy. In general, the study concludes that, even if the average level of the federal funds rate in the future is only 3 percent, these new tools should be sufficient unless the recession were to be unusually severe and persistent.
So, that's an exercise that looks like what Blanchard has in mind, though he discusses "unconventional monetary policy" as an application of the "theory models."

It's no secret what's in the FRB/US model. The documentation is posted on the Board's web site, so you can look at the equations, and even run it, if you want to. There's some lip service to "optimization" and "expectations" in the documentation for the model, but the basic equations would be recognizable to Lawrence Klein. It's basically a kind of expanded IS/LM/Phillips curve model. And Blanchard seems to have a problem with it. He mentions FRB/US explicitly:
For example, in the main model used by the Federal Reserve, the FRB/US model, the dynamic equations are constrained to be solutions to optimization problems under high order adjustment cost structures. This strikes me as wrongheaded. Actual dynamics probably reflect many factors other than costs of adjustment. And the constraints that are imposed (for example, on the way the past and the expected future enter the equations) have little justification, theoretical or empirical.
Opinions seem to differ on how damning this is. The watershed in macroeconomists' views on large scale macreconometric models was of course Lucas's critique paper, which was aimed directly at the failures of such models. In the "Macroeconomics and Reality" paper, Sims sees Lucas's point, but he still thinks large-scale models could be useful, in spite of misidentification.

But, it's not clear that large-scale macroeconometric models are taken that seriously these days, even in policy circles, Janet Yellen aside. While simulation results are presented in policy discussions, it's not clear whether those results are changing any minds. Blanchard recognizes that we need different models to answer different questions, and one danger of the one-size-fits-all large-scale model is its use in applications for which it was not designed. Those who constructed FRB/US certainly did not envision the elements of modern unconventional monetary policy.

A modern macroeconometric approach is to scale down the models, and incorporate more theory - structure. The most well-known such models, often called "DSGE" are the Smets-Wouters model, and the Christiano/Eichenbaum/Evans model. Blanchard isn't so happy with these constructs either.
DSGE modelers, confronted with complex dynamics and the desire to fit the data, have extended the original structure to add, for example, external habit persistence (not just regular, old habit persistence), costs of changing investment (not just costs of changing capital), and indexing of prices (which we do not observe in reality), etc. These changes are entirely ad hoc, do not correspond to any micro evidence, and have made the theoretical structure of the models heavier and more opaque.
Indeed, in attempts to fit DSGE to disaggregated data, the models tend to suffer increasingly from the same problems as the original large-scale macroeconometric models. Chari, Kehoe, and McGrattan, for example, make a convincing case that DSGE models in current use are misidentified and not structural, rendering them useless for policy analysis. This has nothing to do with one's views on intervention vs. non-intervention - it's a question of how best to do policy intervention, once we've decided we're going to do it.

Are there other types of models on the horizon that might represent an improvement? One approach is the HANK model, constructed by Kaplan, Moll, and Violante. This is basically a heterogeneous-agent incomplete-markets model in the style of Aiyagari 1994, with sticky prices and monetary policy as in a Woodford model. That's interesting, but it's not doing much to help us understand how monetary policy works. It's assumed the central bank can dictate interest rates (as in a Woodford model), with no attention to the structure of central bank assets and liabilities, the intermediation done by the central bank, and the nature of central bank asset swaps. Like everyone, I'm a fan of my own work, which is more in the Blanchard "theory model" vein. For recent work on heterogeneous agent models of banking, secured credit, and monetary policy, see my web site.

Blanchard seems pessimistic about the future of policy modeling. In particular, he thinks the theory modelers and the policy modelers should go their own ways. I'd say that's bad advice. If quantitative models have any hope of being taken seriously by policymakers, this would have to come from integrating better theory in such models. Maybe the models should be small. Maybe they should be more specialized. But I don't think setting the policy modelers loose without guidance would be a good idea.

Review of "The Curse of Cash"

This is a review of Ken Rogoff's "The Curse of Cash," forthoming in Business Economics.

Kenneth Rogoff has written an accessible and informative book on the role of currency in modern economies, and its importance for monetary policy. Rogoff makes some recommendations that would radically change the nature of retail payments and banking in the United States, were policymakers to take them to heart. In particular, Rogoff proposes that, at a minimum, large-denomination Federal Reserve notes be eliminated. If he could have everything his way, currency issue would be reduced to small-denomination coins, and these coins might at times be subjected to an implicit tax so as to support monetary policy regimes with negative interest rates on central bank reserves.

The ideas in “The Curse of Cash” are not new to economists, but Rogoff has done a nice job of articulating these ideas in straightforward terms that non-economists should be able to understand. The book is long enough to cover the territory, but short enough to be interesting.

Why is cash a “curse?” As Rogoff explains, one of currency’s advantages for the user is privacy. But people who want privacy include those who distribute illegal drugs, evade taxation, bribe government officials, and promote terrorism, among other nefarious activities. Currency – and particularly currency in large denominations – is thus an aid to criminals. Indeed, as Rogoff points out, the quantity of U.S. currency in existence is currently about $4,200 per U.S. resident. But Greene et al. (2016) find in surveys that the typical law-abiding consumer holds $207 in cash, on average. This, and the fact that about 80% of the value of U.S. currency outstanding is in $100 notes, suggest that the majority of cash in the U.S. is not used for anything we would characterize as legitimate. Rogoff makes a convincing case that eliminating large-denomination currency would significantly reduce crime, and increase tax revenues. One of the nice features of Rogoff’s book is his marshalling of the available evidence to provide ballpark estimates of the effects of the policies he is recommending. The gains from reforming currency issue for the United States appear to be significant – certainly not small potatoes.

But, what about the costs from making radical changes in our currency supply? There are two primary factors that, as economists, we should be concerned with. The first is implications for government finance. In general, part of the government’s debt takes the form of currency – the government issues interest-bearing debt, which is purchased by the central bank with outside money (currency plus reserves), and then the demand for currency determines how much of the government debt purchased by the central bank is financed with currency. Currency of course has a zero interest rate, so the quantity of currency held by the public represents an interest saving for the government. This interest saving is the difference between the interest rate on the government debt in the central bank’s portfolio and the zero interest rate on currency. This interest saving reverts to the government as a transfer from the central bank. Therefore, if steps are taken (such as the elimination of large-denomination currency) to make currency less desirable, the quantity in circulation will fall, and it will cost the government more to service its debt.

The second key cost of partial or complete elimination of currency would be the harm done to the poor, who use currency intensively. Rogoff discusses the possibility of government intervention to ameliorate these costs, including the subsidization of alternative means of payment for the poor (debit cards or stored value cards) or central bank innovation in supplying electronic alternatives to cash. Costs to the poor of withdrawing currency should be taken seriously, particularly given recent experience in India and Venezuela. In both countries, announcements were made that there would be a brief window in which large-denomination currency would remain convertible (to other denominations or reserves) at the central bank, after which convertibility would cease. The old large-denomination notes would then be replaced by new ones. In India and Venezuela, this led to long lines at banks to convert notes, and a partial shutdown of cash-intensive sectors of the economy. Though these currency reforms differed from what Rogoff is suggesting, in that neither reform involved a permanent withdrawal of large-denomination currency, these experiments demonstrate the serious disruption that can result if currency reforms are mismanaged.

Rogoff makes a strong case that the net social benefits from a partial reduction in the use of currency could be large, considering only the positive and negative effects discussed above. I agree with that conclusion. However, a significant portion of Rogoff’s book makes the case that the partial or complete elimination of currency would also have large benefits in terms of monetary policy. In that case, I think, his conclusions are questionable.

Rogoff’s argument as to why currency impedes monetary policy is, for the most part, consistent with conventional New Keynesian (NK) thinking. In NK macroeconomic models (see Woodford 2003, for example) policy acts to mitigate or eliminate the distorting effects of sticky prices, and the zero lower bound (ZLB) on the nominal interest rate is a constraint for monetary policy. Typically, in NK models, the central bank conducts policy according to a Taylor rule, whereby the nominal interest rate increases when the “output gap” (the difference between efficient output and actual output) goes down, and the nominal interest rate increases when inflation goes up. But, if we accept the NK framework, there are good reasons to think that the ZLB will be a frequently binding constraint on monetary policy for some time. In particular, the well-documented secular decline in the real rate of return on government debt implies that the average level of nominal interest rates consistent with 2% inflation is much lower than in the past. This then leaves much less latitude for countercyclical interest rate cuts in future recessions.

Given the NK framework, one proposed solution to the ZLB problem is to simply relax the ZLB constraint. How? Miles Kimball of the University of Colorado-Boulder is currently the most prominent proponent of negative nominal interest rate policy as a solution to the ZLB problem. This problem, according to Kimball, exists only because asset-holders can always flee to currency, which bears a nominal interest rate of zero. But, if the government eliminates currency, or devises schemes to make currency sufficiently unattractive, then there is an effective lower bound (ELB) on the nominal interest rate that is lower than zero. Rogoff appears to be on board with this idea, and thinks that reducing the role for currency in the economy could produce large welfare benefits, because of a relaxation in the ZLB constraint.

Rogoff thinks that negative nominal interest rates are an extreme measure that will increase inflation when it is deemed to be too low. In this respect, I think Rogoff is wrong, but he’s in good company. A typical central banking misconception is that a reduction in the nominal interest rate will increase inflation. But every macroeconomist knows about the Fisher effect, whereby a reduction in the nominal interest rate reduces inflation – in the long run. What about the short run? In fact, mainstream macroeconomic models, including NK models, have the property that a reduction in the nominal interest rate reduces inflation, even in the short run (see Rupert and Sustek 2016 and Williamson 2016). This is the basis for neo-Fisherism – the idea that central bankers have the sign wrong, i.e. reducing inflation is accomplished with central bank interest rate cuts. This is consistent with empirical evidence. For example, the central banks that have experimented with negative nominal interest rates – the Swedish Riksbank, the European Central Bank, the Swiss National Bank, and the central bank of Denmark – appear to have produced very low (and sometimes negative) inflation.

So, I think Rogoff is correct that currency reform would be beneficial on net, and that the gains in terms of economic welfare could be significant. But those gains are unlikely to come from unconventional monetary policy in the form of negative nominal interest rates.

In summary, Ken Rogoff’s The Curse of Cash is an accessible and provocative book – one of the best I have read on economic policy. I do not agree with all of his recommendations, but this is a good start for the policy debate.

Greene, C., Schuh, S., and Stavins, J. 2016. “The 2014 Survey of Consumer Payment Choice: Summary Results,” Research Data Report 16-3, Federal Reserve Bank of Boston.
Rupert, P. and Sustek, R. 2016. “On the Mechanics of New Keynesian Models,” working paper.
Williamson, S. 2016. “Neo-Fisherism: A Radical Idea, or the Most Obvious Solution to the Low-Inflation Problem?” The Regional Economist 24, no. 3, 5-9, Federal Reserve Bank of St. Louis.

Tuesday, January 10, 2017

The Trouble with Paul Romer

Please bear with me, as I'm out of practice. My last blog post was September 8 (seems like yesterday). As a warmup, we're going to get into Paul Romer's "The Trouble with Macroeconomics." This is somewhat old hat (in more ways than one), but this paper got a lot of attention in various media outlets, and still comes up occasionally. The titles of the articles are entertaining in themselves. For example:

"The Rebel Economist Who Blew Up Macroeconomics"
"It's Time to Junk the Flawed Economic Models That Make the World a Dangerous Place"

And who can forget:

"Famous Economist Paul Romer Says Macroeconomics is All Bullshit"

Paul has some rules for bloggers writing about his stuff. These are:
1. If you are interested in a paper, read it.
2. If you want to blog about what is in a paper, read it.
I've taken these to heart, and have indeed read the paper thoroughly. Comprehension, of course, is another matter altogether.

Paul's conclusions are pretty clear. From his abstract:
For more than three decades, macroeconomics has gone backwards...A parallel with string theory from physics hints at a general failure mode of science that is triggered when respect for highly regarded leaders evolves into a deference to authority that displaces objective fact from its position as the ultimate determinant of scientific truth.
So, those are strong charges:

1. The current stock of macroeconomists knows less than did the stock of macroeconomists practicing in 1986 or earlier.
2. A primary reason for this retrogression is that junior macroeconomists are unabashed butt-kissers. They can't bear to criticize their senior colleagues.

If you are a macroeconomist, one question that might occur to you at this point is how Romer views his role in all this macro bullshit. As we know, Romer's early work was highly influential. It's hard to say where the endogenous growth research program would be without him. This paper and this one have more than 22,000 Google scholar citations each. That's enormous. In order to collect that many citations, those papers had to be on many PhD macro reading lists, had to be read carefully, and had to form the basis for much subsequent published research. It's not for nothing that NYU, in the manner of various obituary writers, has a blurb ready to go should Paul ever collect a Nobel. Thus, it would appear that Paul singlehandedly shaped a large piece of modern macroeconomics as we know it, and should take credit for some of the bullshit he claims we are mired in. But, apparently he thinks it was someone else's fault.

A key part of Paul's paper has to do with what he views as flaws in the approach to identification in some modern macroeconomics, which he thinks yields bizarre results:
Macro models now use incredible identifying assumptions to reach bewildering conclusions.
He then sets up a straw man:
To appreciate how strange these conclusions can be, consider this observation, from a paper published in 2010, by a leading macroeconomist: "... although in the interest of disclosure, I must admit that I am myself less than totally convinced of the importance of money outside the case of large inflations."
In a paper that aims to debunk modern macro as pseudoscience, Romer here commits his first sin. Where's the citation, so we can check this quote? Of course, through the miracles of modern search engines, it's not hard to find the paper in question. It's this one, by Jesus Fernandez-Villaverde. Jesus is indeed a "leading macroeconomist," and I highly recommend his paper, if you want to learn something about the technical aspects of modern DSGE modeling.

It's useful to see the quote from Jesus's paper in context. Here's most of the paragraph in which it is contained:
At least since David Hume, economists have believed that they have identified a monetary transmission mechanism from increases in money to short-run fluctuations caused by some form or another of price stickiness. It takes much courage, and more aplomb, to dismiss two and a half centuries of a tradition linking Hume to Woodford and going through Marshall, Keynes, and Friedman. Even those with less of a Burkean mind than mine should feel reluctant to proceed in such a perilous manner. Moreover, after one finishes reading Friedman and Schwartz’'s (1971) A Monetary History of the U.S. or slogging through the mountain of Vector Autoregressions (VARs) estimated over 25 years, it must be admitted that those who see money as an important factor in business cycles fluctuations have an impressive empirical case to rely on. Here is not the place to evaluate all these claims (although in the interest of disclosure, I must admit that I am myself less than totally convinced of the importance of money outside the case of large inflations). Suffice it to say that the previous arguments of intellectual tradition and data were a motivation compelling enough for the large number of economists who jumped into the possibility of combining the beauty of DSGE models with the importance of money documented by empirical studies.
Paul wants us to think that the view expressed in the quote - that monetary factors are relatively unimportant for aggregate economic activity - is: (i) a mainstream view; (ii) a standard implication of "DSGE" models; (iii) total nonsense. First, the full paragraph makes clear that, as Jesus says, there is "an impressive empirical case" that supports the view that money is important. Jesus's parenthetical remark (the quote) states his skepticism, without getting into the reasons. Surely Paul should approve, as he thinks we're all too deferential to authority. Second, the New Keynesian research program is primarily engaged with the question of how and why monetary policy matters. We may quarrel about their mechanisms and the conclusions, but surely Mike Woodford can't be accused of arguing that monetary policy is irrelevant.

On the third point, that Jesus's skepticism is nonsense, Paul looks at some data from the Volcker disinflation. Volcker, as we all know, was Fed chair during the disinflationary period during the early 1980s. Here are Paul's conclusions:
The data displayed in Figure 2 suggest a simple causal explanation for the events that is consistent with what the Fed insiders predicted:
1. The Fed aimed for a nominal Fed Funds rate that was roughly 500 basis points higher than the prevailing inflation rate, departing from this goal only during the first recession.
2. High real interest rates decreased output and increased unemployment.
3. The rate of inflation fell, either because the combination of higher unemployment and a bigger output gap caused it to fall or because the Fed’s actions changed expectations.
So, that's a standard narrative that we hear about the Volcker era. What's wrong with it? First, it's incorrect to say that the Fed was "aiming" for a fed funds rate target at the time. It's quite interesting to read the FOMC transcripts from the Volcker era, in the context of modern monetary policy implementation. Volcker and his FOMC colleagues were operating on quantity theory principles. They aimed to reduce inflation by reducing the rate of money growth, without regard for the path of the fed funds rate, and you can see that in the data. Here's the fed funds rate during Volcker's time as Fed chair:
You can see that it's highly volatile leading up to the 1981-82 recession. And here's the growth rate in the money base, along with the unemployment rate:
The latter chart shows us that Volcker did what he said he was going to do - the money growth rate fell from about 10% in 1979 to about 3% in 1981. What about the real interest rate, which Paul focuses on?
I don't know about you, but the "simple causal explanation" in Paul's point #2 above doesn't jump out at me from the last chart. We could also look at the scatter plot of the same data:
Do high real interest rates make the unemployment rate go up? It's hard to conclude that from looking at this picture. But, the second chart (money growth rate and unemployment rate) does lend itself to a causal interpretation - money growth falls, then unemployment goes up, with a lag. That said: (i) The Volcker episode is basically one observation - we need more evidence than that; (ii) Raw correlations are suggestive only, as Paul evidently knows; (iii) If we had used the money growth/unemployment rate correlation observed in the second chart as a guide to monetary control in the post-Volcker era, we would have done really badly. As is well known, the relationship between monetary aggregates and other aggregate variables fell apart post-Volcker. I have never heard anyone in the Fed system mention monetary aggregates in a substantive policy discussion.

Paul's point #3 above reflects a Phillips curve view of the world - a higher "output gap" causes lower inflation, and lower expected inflation causes lower inflation. Though that story may appear to fit the Volcker experience, Phillips curves are notoriously unreliable. Just ask the people who keep predicting that low interest rates will make inflation take off. A more reliable guide is the Fisher effect, which fits this episode nicely. This is a scatter plot of the inflation rate vs. the fed funds rate, from the peak in the fed funds rate in June 1981 until the end of Volcker's term, with the observations connected in temporal sequence:
More often than not, the fed funds rate and the inflation rate are moving in the same direction. An interpretation is that Volcker reduced inflation by reducing the nominal interest rate - that's just Neo-Fisherism 101. Indeed, most of our models have neo-Fisherian properties, even when they have Phillips curve relations built in, as in New Keynesian models.

What's the conclusion? None of what Paul claims to be obvious concerning the effects of monetary policy during the Volcker era is actually obvious. Many hours have been spent, and many papers and books have been written by economists about the macroeconomic effects of monetary policy. But, given all that work, Jesus is not being unscientific in his skepticism about the importance of monetary factors for aggregate economic activity. It's widely accepted that central banks can and should control inflation, but there is wide dispersion - for good reasons - in views about the quantitative real effects of monetary policy.

So much for the case that modern macro leads to obviously false conclusions. What else does Paul have to say?

1. Paul doesn't like the notion of modeling business cycles as being driven by what he calls "imaginary shocks." Of course, economics is rife with such "imaginary shocks," otherwise known as stochastic disturbances. In macro, one approach - and an arguably very productive one - to constructing models that can be used to to understand the world and allow us to formulate policy, is to construct structural models (based on behavior, optimization, and market interaction) that are stochastically disturbed in ways that we can analyze and compute. Such models can produce aggregate fluctuations that look like what we actually observe. There are other approaches. For example, we can construct models with intrinsic rather than extrinsic aggregate uncertainty - models with multiple sunspot equilibria. Roger Farmer, for example, is very fond of models with self-fulfilling volatility. These models were popular for a time, particularly in the 1990s, but never caught on with the policy people. With respect to business cycle models with exogenous shocks, I can understand some of Paul's concerns. If I can't measure total factor productivity (TFP) directly, what good does it do to tell me that TFP is causing business cycles? If I have a model with 17 shocks and various ad-hoc bells and whistles - adjustment costs, habit persistence, etc. - is this any better than what Lawrence Klein was doing in the 1960s? But, and I hate to say this again, but economics is hard. In contrast to what Paul thinks, I think we have learned a lot in the last 30+ years. If he thinks these models are so bad, he should offer an alternative.

2. Paul thinks that identification - in part through the use of Bayesian econometrics - in modern macro models, is obfuscation. I might have been inclined to agree, but if you read Jesus's paper, he has some nice arguments in support of the Bayesian approach. Again, I recommend reading his paper.

3. The remaining sections of the paper, 6 through 10, are mostly free of substance. Paul asserts that macroeconomists are badly behaved in various ways. We're overly self-confident, monolithic, religious rather than scientific, we ignore parallel research programs and evidence that contradicts our theories. He seems to have it in for Lucas, Sargent, and Prescott, who apparently are engaged in some mutual fraudulent conspiracy. My favorite section is #9, "A Meta Model of Me." This paragraph sums that up:
When the person who says something that seems wrong is a revered leader of a group ... there is a price associated with open disagreement. This price is lower for me because I am no longer an academic. I am a practitioner, by which I mean that I want to put useful knowledge to work. I care little about whether I ever publish again in leading economics journals or receive any professional honor because neither will be of much help to me in achieving my goals. As a result, the standard threats ... do not apply.
This is supposed to convince us that Paul is being up front and honest - he's got nothing to lose, and what could he possibly gain from bad-mouthing the profession? Well, by the same logic, Brian Bazay had nothing to lose and nothing to gain by pushing me down in the school yard. But he did it anyway. In my experience, there is a positive payoff to demonstrating the weakness of another economist's arguments in public - and the bigger the economist, the bigger the payoff. If macroeconomists were actually as wimpy as Paul says we are, I wouldn't want to belong to this group. In general, economists are an argumentative lot - that's what we're known for. As Paul says, he's not an academic any more. Maybe he's been away so long he's forgotten how it works.

So, this is a pseudoscientific paper purporting to be about the pseudoscientific nature of modern macro. It makes bold assertions, and offers little or no evidence to back those assertions up. There's a name for that, but fear of shunning keeps me from going there. :)

Thursday, September 8, 2016

Central Bank Liabilities Part II: Currency, Negative Nominal Interest Rates, etc.

Central banks are indeed banks. As financial intermediaries, their social role depends on what a central bank can do that some private financial intermediary cannot, or cannot do as well. Fundamentally, financial intermediation is asset transformation - how the intermediary structures itself so that its liabilities have attractive properties as compared to its assets. In our changing world, central banks have to adapt their liabilities to evolving technologies and macroeconomic developments. My first installment on this topic was about new types of central bank liabilities - the idea that a central bank's reach could expand beyond supplying old-fashioned currency, with a focus on liquid overnight liabilities that reach into the upper levels of financial interaction, beyond retail payments.

This installment will deal specifically with currency. Are paper money and coins going the way of the dinosuars? Should they? If we were to eliminate or significantly curb the circulation of Federal Reserve notes and coins in the United States, should the Fed issue new types of liabilities to replace them? What types of liabilities might work, and how should they be managed? You can find plenty of writing on this topic recently. Ken Rogoff and Larry Summers make a case that we should elminate large-denomination currency. Agarwal and Kimball, Kocherlakota, Goodfriend (new version), and Goodfriend (old version) discuss various schemes for either eliminating currency or making it more costly to hold. In contrast to Rogoff and Summers, who think eliminating $100 Federal Reserve notes, for example, will put a big dent in undesirable and illegal activities, the latter group of authors is interested in ways to effectively implement negative nominal interest rates.

What does standard monetary theory tell us about how much currency we should have? The basic logic comes from Friedman's "Optimum Quantity of Money" essay - what's come to be known as the "Friedman rule." If the nominal interest rate on assets other than cash is greater than zero, then people economize too much on cash balances. Cash balances are costless to create, and economic forces will create the optimal amount of real cash balances if the central bank acts to equate the rate of return on cash to the rate of return on other safe assets. There are different ways to do this. One approach is for the central bank do whatever it takes to make the nominal interest rate on safe assets zero forever. Another approach, if feasible, is for the central bank to pay interest on cash at the nominal interest rate on safe assets. There are other approaches, but we'll stop there.

How do we connect the Friedman rule with what people are saying about currency? Those people are saying we have too much currency, but the Friedman rule says that a zero nominal interest rate is just right, and otherwise (with nominal interest rates above zero) we have too little currency. Of course, there's a lot going on in the world that is important for the problem at hand, and is absent in standard monetary models. First, currency is certainly not costless to create. Real resources are used up in designing currency so as to thwart counterfeiters, to print and distribute it (think about guards and armored trucks), and to maintain it (taking in and shredding worn-out notes). Second, currency can be stolen. A virtue of currency is its anonymity - people will accept my Federal Reserve notes without worrying about my personal characteristics - but this also makes currency easier to steal than some other assets. Third, the use of currency implies social costs. Again, a virtue of currency is its anonymity, in that the existence of currency allows us to conduct transactions in private. In some ways, we might think this is consistent with democratic notions of individual freedom - we can conduct whatever transactions we want out of the reach of surveillance. But this anonymity also lowers the cost of carrying on domestic illegal activity, and international activity that might be harmful to domestic interests, which is what Rogoff and Summers are on to. The illegal domestic activity could be various aspects of the drug trade and organized crime, while harmful international activity might involve, for example, the international market in military weapons.

Currency is a remarkably resilient payments technology. As I pointed out in my last post, the ratio of U.S. currency to GDP is as high as it was in the 1950s, and has risen since the beginning of the financial crisis. Though about 80% of the stock of Federal Reserve notes consists of $100 bills, currency still shows up in surveys of legal payments as an important transactions medium. As we might expect, this Boston Fed publication indicates that currency is used much more intensively by poor people than by the rich. The advantages of currency are obvious. It's easy to carry around (except if you want to buy a house or a car with it, for example); it comes in small denominations, making it convenient for small transactions; and it provides immediate settlement without the use of electricity (unless the other party in the transaction needs to open the cash register).

So, any scheme to eliminate currency altogether faces significant potential costs. Unless an alternative low-tech payments medium can be provided, a lot of poor people (and possibly some rich ones as well) are going to be worse off. But Rogoff and Summers have a point - it's hard to see what the benefits of $100 bills are. In fact, there would not be much loss in convenience for legitimate exchange from eliminating $50 notes as well. The U.S. government, however, would lose part of the revenue from the inflation tax. How large is that? U.S. currency outstanding is about $4500 per U.S. resident, so a 2% inflation rate generates about $90 per person in seignorage revenue. If eliminating $100 and $50 bills reduced the stock of currency outstanding by about 70% (assuming that some of the existing demand migrates to other denominations), the loss would be about $63 per person, which perhaps is a small price to pay for putting a serious dent in criminal activity and terrorism. Thus, what Rogoff and Summers are proposing seems like a no-brainer.

My best guess is that no one would be talking about currency much if it weren't for the negative interest rate enthusiasts, which gets us into a very different set of issues. Here's their (Kocherlakota/Agerwal/Kimball/Goodfriend) argument:

1. Take as given that the most important role (at the extreme, the only role) for monetary policy is correcting the distortions arising from sticky wages and prices. That's a key assumption - none of these authors thinks it is necessary to defend that.
2. The real interest rate is low, for reasons unconnected to monetary policy, and is expected to remain low into the indefinite future. It's hard to quarrel with this, but the reasons for the low real interest rate could matter.
3. (1) coupled with (2) implies that, in pursuit of inflation-targeting and output-gap targeting, the central bank will in the future be encountering the zero lower bound (if indeed it is a bound) with greater frequency.
4. Once constrained by the zero lower bound, there are losses in economic welfare due to output gaps and departures from inflation targets.
5. Such welfare losses can be avoided, if only nominal interest rates can go negative - this relaxes the zero lower bound constraint.
6. There are no costs to negative nominal interest rates, only benefits.

The hardline NK (New Keynesian) view, shared by Agarwal/Kimball/Kocherlakota/Goodfriend (AKKG) is that things that get in the way of the downward descent of nominal interest rates are an "encumbrance" that we are better off without. In this respect, currency just gets in the way. As the argument goes, a negative nominal interest rate on reserve balances will tend to make all safe short-term rates of interest negative. But for banks, there's a problem. The bank's assets are close substitutes for assets earning negative rates of interest, but its deposit liabilities are substitutes for zero-interest currency. So banks are squeezed - if they lower deposit rates, they lose small depositors; if they don't their profit margin goes down.

What to do about that? AKKG argue that there should be programs put in place to make currency less desirable, thus giving bank depositors a poor alternative to flee to. In Goodfriend's 2000 paper he suggests a scheme for taxing currency - equip every Federal Reserve note with a strip. Whenever the note returns to a bank, the bank charges the accumulated tax since the note was last turned in, and deducts this from your deposit. Alternatively, Agarwal and Kimball suggest a scheme for a changeable exchange rate between currency and reserves. The current arrangement between financial institutions holding reserves and the Fed, is that reserve balances can be converted one-for-one into currency, and vice-versa (presumably with service fees added for armored trucks and such). Under the Agerwal/Kimball arrangement, during periods of negative interest rates the rate at which reserves can be converted to currency would decline over time to match the negative interest rate on reserves.

The Goodfriend scheme seems problematic as, if the vintages of Fed notes ("vintage" meaning the time since the tax was last paid) are known, then notes should trade at different prices. This of course messes up the whole currency system, according to which the denominations are set up so that it's easy to make change - seems hard to do that if one note marked with a 10 trades at 97% of the value of another note marked with a 10, for example. All of these schemes will not make things any better for banks, who are in part selling a convenience to small depositors - the right to exchange their deposits one-for-one with currency, which these people find useful for making transactions. And people and firms are quite ingenious when it comes to getting around regulations. If a negative interest regime is in place for a long time (something of course the advocates don't imagine, but no one in Japan imagined they would have interest rates close to zero for over 20 years either), this creates profit opportunities for various types of cash hoarding operations. Hoarding cash is an activity subject to increasing returns. A financial intermediary could, in principle, set itself up as a simple currency warehouse, supplying safekeeping services, and make a profit in such an environment. Of course, AKKG, or people like them, could think up many ingenious ways to thwart such arbitrage schemes.

But would all this be worth it? In the process we would put sand in the gears of financial institutions that are serving a useful social function, and for what? We're going to have better monetary policy, apparently. This part of the story gets a bit complicated. Academic Keynesian economics is a well-defined thing - it's clear what it is, and you can evaluate it and determine for yourself whether or not it's useful. Keynesian economics in practice can sometimes be a completely different beast, saturated with myth rather than science. One myth is that, in reducing nominal interest rates, we can have our cake and eat it too. Conventional wisdom seems to be that reducing nominal interest rates increases inflation and reduces unemployment. That's just Phillips curve logic, right? Wrong. Even in basic New Keynesian (NK) models with Phillips curves, lower nominal interest rates make inflation go down - that's basic neo-Fisherism. The Fisher effect is ubiquitous in models, and it's there in the data too. Here's an example. Data for Switzerland on the overnight nominal interest rate and inflation look like this:
The Swiss went to negative interest rates at the beginning of 2015. Since then inflation has also been below zero. Of course, monetary policy isn't the only factor affecting the inflation rate. There is substantial variation in inflation in the chart, but you can see the trend. Negative nominal interest rates for 21 months in Switzerland are hardly making inflation explode.

As is well-known, a belief that low nominal interest rates cause high inflation inevitably leads to self-perpetuating low nominal interest rates and low inflation. That's part of the force behind the negative nominal interest rate lobby. Surely, they think, pushing interest rates into negative territory will cure the low-inflation problem. Well, sorry, adding another hole to your shoe doesn't fix your shoe.

But, the other motivation for negative nominal rates is stabilization policy. It may be true that a lower bound of zero gives the central bank less room to move when real interest rates are persistently low, but some people seem to find it difficult to reconcile themselves to the realities of the stabilization policy they claim to believe in. If we really think that moving a short-term nominal interest rate around has large real effects on aggregate economic activity, we have to recognize the need to make intertemporal tradeoffs. That is, we may think that lowering nominal interest rates confers some benefit, but we can't always be moving nominal interest rates down. Sometime they have to go up. Seemingly, a key principle of monetary stabilization is that it's less costly at the margin to increase nominal interest rates in good times than in bad times. Also, that it's of less benefit, at the margin, to lower nominal interest rates in good times than in bad times. Therefore, optimal monetary stabilization is about increasing interest rates in relatively good times, and reducing them in relatively bad times, while on average hitting an inflation target. Every time interest rates go up, central bankers are asking people to bear some short-term pain, in exchange for larger future short-term gains from lowering interest rates. Larry Summers, for example, seems to have a hard time recognizing this. According to him, we're in a long period of secular stagnation, which implies that we're in a relatively good state compared to the future. Further, Summers is very concerned with the fact that interest rates can't go down much if a recession happens. So, one might think he would be in favor of interest rate increases now, but he's not. Go figure.

Just as wrongheaded inflation control can lead to perpetually low nominal interest rates, so can wrongheaded stabilization policy. People who are single-minded about stabilization always see inefficiency when they look at the economy. Things are never quite right, so there's always a reason to lower interest rates. Given these tendencies among policymakers, perhaps a zero lower bound is a good thing. It's a constraint that prevents well-intentioned interventionists from defeating themselves, in terms of their own goals.

Where does this leave currency? Rogoff and Summers seem to have good arguments for getting rid of large-denomination currency. Getting rid of all currency, or making its use more costly seem like too high a cost, given the likely benefits of negative interest rate policy - about which proponents seem pretty confused. Central banks should, however, be thinking about electronic alternatives to currency. Blockchain technologies are potentially useful, and could be tied to the decentralized transfer of central bank liabilities. There are private alternatives to currency, for example Green Dot provides stored-value cards that are not tied to checking accounts. Would it be a good idea for central banks to issue stored value cards? In any case, we're not there yet with these alternative payments technologies so, for the time being, currency is a convenient low-tech payments instrument that we should keep.

Friday, September 2, 2016

Central Bank Liabilities: Part I

In this first installment, I'll discuss issues related to Greenwood, Hansen, and Stein's Jackson Hole paper, and leave discussion of the future of currency for installment #2.

An important model for modern central banking was the Bank of England, founded in 1694, which subsequently developed a symbiotic relationship with the British crown. The crown needed to finance spending, particularly on wars, and the Bank was looking to make a profit. The crown granted the Bank an ever-expanding monopoly on the issue of circulating currency, culminating in Peel's Bank Act of 1844, under which the Bank became the sole supplier of circulating currency in the UK (save for some grandfathered Scottish private banks, which are still issuing currency in 2016). Given the Bank's monopoly on currency issue, it could lend to the crown at a low interest rate, and still make a profit. The Bank, through experimentation or accident, discovered crisis intervention. During financial panics the Bank could, through judicious use of information available to it, engage in lending to banks with liquidity problems (banks experience a lot of bank note redemptions). In so doing, the Bank would expand its note issue to fund lending to banks that it deemed illiquid but solvent and, on the flip side of that, give those holding bank notes a safe asset to run to. The Bank did this, driven by its motive to make profits on superior information.

It wasn't like some economist was promoting the idea that a monopoly on currency issue and financial crisis intervention were the natural province of a central bank, or that this central bank should be have some form of public governance. Those ideas came much later. Indeed, the Bank of England remained a private institution until 1946. However, the Federal Reserve System was founded as a public institution, albeit with semi-private governance, in terms of how the regional Federal Reserve Banks are run. The work that led up to the Federal Reserve Act of 1913 included, for example, the National Monetary Commission, created by Congress to study the U.S. financial system, and systems elsewhere in the world, and to come up with recommendations for reform. The Commission produced volumes of useful stuff, which you can find on Fraser. The basic ideas in the Federal Reserve Act are that the role of a central bank in the United States was to: (i) through its monopoly power, provide a safe currency; (ii) make the currency "elastic," i.e. make the supply of currency respond to aggregate economic activity, and to financial panics, by way of discount window lending.

Basically, the framers of the Federal Reserve Act had in mind an institution that would play the same role as the Bank of England, but the motivation was different. A currency monopoly for the central bank was seen as socially beneficial, as experiments with private currency issue in the U.S. had not turned out well. And crisis intervention was seen as a means for preventing the disruption to the aggregate economy that had occurred during the banking panics of the National Banking era (1863-1913).

Fast forward to 2016. In some ways things haven't changed. U.S. Federal Reserve notes are basically the same stuff (with some anti-counterfeiting features added) they were in 1914, and currency is still an important Fed liability. Here's the stock of currency relative to U.S. GDP:
The ratio of currency to GDP has risen to close to 8% from less than 6% before the financial crisis, and is at the same level as in the mid-1950s. Retail payments using currency have fallen, but perhaps not as much as one might think. For example, surveys by the Boston Fed show a declining use of currency, but currency is still important in consumer payments, accounting for 26.3% of payments in 2013, as opposed to 31.1% for debit cards. But, the quantity of Federal Reserve notes per U.S. resident is about $4,500 currently. I don't know about you, but I'm not holding my fair share of that. In this chart you can see that, by value, about 80% of currency outstanding is in $100 notes, and studies indicate that about half of the stock of U.S. currency is held outside U.S. borders. There are some legitimate questions about the role played by currency, and whether its use should be curtailed, but more about that in the next installment.

The key point is that, if we took large-denomination currency - which is likely serving no useful social function - out of the mix, only a small part of the existing Fed portfolio would be funded by what was once thought to be the primary central bank liability. As it is, even with all those $100 bills included, interest-bearing Fed liabilities are greater than the quantity of currency outstanding:
The key Fed liabilities are, in order of magnitude (from small to large):

1. Reverse repurchase agreements, or ON-RRPs, used in "temporary open market operations." This is overnight lending to the Fed, with securities in the Fed's asset portfolio used as collateral. ON-RRPs are roughly reserves by another name - overnight interest-bearing liabilities of the Fed that can be held by a wider array of financial institutions than are permitted to have reserve accounts with the Fed. In particular, money market mutual funds cannot hold reserves, but they are key participants in the ON-RRP market. ON-RRPs play an important role in post-liftoff Fed implementation of monetary policy. The idea is that the ON-RRP rate, currently 0.25%, puts a floor under the fed funds rate, so that fed funds will trade between the interest rate on excess reserves (IOER), currently at 0.5%, and the ON-RRP rate.

2. Reverse repurchase agreeements held by foreign government-related institutions. This is somewhat mysterious, and explained here. Just as there is a foreign demand for Treasury securities, there is a foreign demand for very short-term liabilities of the Fed.

3. Currency. We know what this is about.

4. Reserve balances. As is well-known, this quantity has grown substantially, as this stuff financed the Fed's large-scale asset purchases post-financial crisis.

We're now in a world in which interest-bearing Fed liabilities have become very important. Is this a temporary change, or is it permanent? Should it be permanent? This gets us to Greenwood/Hansen/Stein (GHS). Basically, their answer to the last question is yes. GHS first argue that short-term safe assets are useful in financial markets and that, by looking at market interest rates, we can find evidence of "moneyness" for these assets. If assets are used in facilitating some kind of exchange, or they are in wide use as collateral, they bear a liquidity premium. That is, people are willing to hold these assets at lower rates of return than seem consistent with the actual payoffs on these assets. For example, Gomme, Ravikumar, and Rupert calculate real rates of return on capital in the U.S. since 2007 of from 5%-7% (after tax, for all capital). But here are some short term nominal rates of return:
Before December 17, 2015 (liftoff date), the IOER was 0.25% and the ON-RRP rate was usually 0.05% (with some experimentation). After that date, IOER was set at 0.5% and ON-RRP at 0.25%. In the chart, you can see that, after liftoff, the fed funds rate has typical fallen in the range 0.35%-0.40%, except at month-end and quarter-end (for technical reasons). Also, four-week T-bills trade in the same ballpark as ON-RRP, with some variation.

What can we conclude? (i) Reserves are a less liquid asset than ON-RRP or short-term Treasury debt. Reserves can be traded among a smaller set of financial institutions than these other assets, and you have to pay banks more to take reserves than to take T-bills or ON-RRP. (ii) Short-term Treasury debt and ON-RRP seem to have roughly the same liquidity properties.

So, once the case has been made that short-term safe assets bear liquidity premia, reflecting their usefulness in financial markets, who is going to supply these assets? There are three options: (i) the private sector; (ii) the Treasury; (iii) the Fed. GHS argue that the private sector does not do a very good job of this. Why? First, there are some "externalities" involved, according to GHS. This is somewhat vague, but GHS seem to have in mind that private sector production of short-maturity assets involves intermediating across maturities, which is risky. And maturity transformation makes these private financial intermediaries sensitive to market stresses, according to them. Second, regulatory changes, for example the Supplementary Leverage Ratio requirement, gums up the private sector's ability to produce safe short-maturity assets. GHS also argue that the Treasury does not issue enough short term debt, because it is worried about the risk of auction failure if it has to roll over a lot of short-term debt.

The heart of the argument is that the Fed has advantages over both the private sector and the Treasury in issuing short-term debt. But what kind of short-term debt should the Fed issue? Currently, the choice is between reserves and ON-RRP, though in principle we can think about the possibility the Fed could issue Fed bills - short term circulating debt that looks exactly like Treasury bills. The Swiss National Bank can issue such securities, for example. But, if wer're constrained to considering only reserves and ON-RRP, it seems clear that ON-RRP is much more successful in serving the liquidity needs of financial markets than are reserves. After all, you have to give the institutions that are permitted to hold reserves a 25 basis point inducement to get them to do so.

So, it seems that, in general, ON-RRP is a better instrument for the purpose than reserves. As GHS point out, if the Fed were to expand its ON-RRP program and shrink reserves, this would amount to savings for taxpayers, given the level of short-term market interest rates. This is becasue the Fed could have the same effect on market interest rates, but be paying lower interest on its liabilties, thus handing over larger transfers to the Treasury. What expands the ON-RRP program? One approach would be to set the ON-RRP rate equal to IOER.

But, how large should the Fed's ON-RRP balances be, and what's the optimal size for the Fed's balance sheet? Prior to the financial crisis, the size of the Fed's balance sheet was essentially determined by the demand for currency (in real terms), given the level of market interest rates, as the quantity of reserves was very small, and almost all of the Fed's asset portfolio was financed with currency. If we take the GHS proposal at face value, there should be a similar natural limit for ON-RRP. If the Fed sets an ON-RRP rate, and conducts a fixed-rate full-allotment auction, with IOER equal to the ON-RRP rate, what could happen? (i) the Fed reaches the upper bound on securities that it can use as collateral in ON-RRPs - it gets more bids than it can satisfy. (ii) the Fed does not reach the upper bound on available collateral, and there are some reserve balances outstanding. In case (i) it seems the ON-RRP program is too small, and in case (ii) it's the right size, but the Fed's balance sheet is too large. The bottom line, if we accept GHS's hypothesis that a Fed supply of short-term interest-bearing liquidity is a good thing, is that the market can determine how much of this stuff it needs. I should make it clear that this is my conclusion, not theirs. But I think this is the logical implication of their analysis.


1. How does this relate to quantitative easing (QE)? GHS seem to think this is a different issue - that QE is aimed at some short-run problem, and the role for ON-RRP is long-run. I don't think so. What GHS is putting forward is indeed a theory of how QE works. They are assuming that the Fed has a special role in maturity transformation, and when the Fed does this it matters. And this matters all the time, not just in unusual circumstances, so the implication is that QE should be an ongoing thing. But it seems there is a role for long-maturity debt in financial markets too - presumably the Fed shouldn't be sucking up all the long-maturity assets in existence, and GHS don't seem to be thinking about that.

2. I've got doubts about whether there are limitations on the private sector's ability to intermediate across maturities. Turning long Treasury debt into overnight debt is risky, but there are ways to manage such risk. It's not clear that the Fed and Treasury are any better at bearing such risks than are private financial institutions.

3. If the problem with private sector liquidity transformation is what can happen in crises, why shouldn't the Fed's intervention be confined to crisis times? For example, expand the ON-RRP program in a crisis, and contract it when the crisis is over.

4. A concern of GHS is a possible flight to safety during a panic. The argument is that, during times of financial stress, financial market participants could abandon private sector liquidity for ON-RRPs, and that could be bad. The "cure" for this is caps on the ON-RRP program. I've always found this idea puzzling. In the ON-RRP auction, the Fed can either set the quantity, or the price, but they can't set both. If there's a binding cap on the ON-RRP program, the price is too low, i.e. the ON-RRP rate is set too high. Presumably, in a crisis the correct policy is to lower the ON-RRP rate.

5. GHS's explanation for why the Treasury did not, or could not, issue more short-term debt did not make sense to me. This seemed more like a call for the Treasury to do a better job of auctioning their securities. Further, if a Treasury auction "fails" on a given day, I'm not sure why that's the end of the world. For example, the Treasury has a reserve account with the Fed, and the balance looks like this:
You can see that the balance in this account fluctuates a lot - it's an important buffer for the Treasury in managing cash inflows and outflows. Further, the average size has increased substantially, to around the $300 billion range. If rollover risk is greater with more short debt outstanding, why can't the Treasury have a larger average balance in that account?

In general I found this paper very useful. It's the first coherent story I've seen about a legitimate role for a central bank in what we would typically call "debt management." But much more research and thought needs to go into these questions.