Saturday, July 31, 2010


Now seems a good time to take stock of what is in the real GDP series, since 2nd quarter 2010 National Income Accounts data were just released, and there was a substantial revision to previous estimates. Following a time-honored macro tradition, I'll look at different approaches to separating the trend in the data from cyclical behavior, and see what that tells us.

One approach to detrending time series is the Hodrick-Prescott (HP) filter. If you don't know how to do this, the HP filter actually has its own Wikipedia entry. HP filtering basically fits a time-varying trend to the data, and there is a parameter you can set that governs the smoothness in the trend. Here is a picture of the HP-filtered US real GDP data. The HP filter tells us that the most recent turning point was a deviation from trend which was not much more severe than the last one, which occurred in first quarter 2003. Further, the current deviation from trend is zero - the recession has been and gone. Of course this does not agree with how anyone seems to be thinking about recent history. What is going on?

The next chart shows you the raw data: the log of real GDP and the HP trend. The HP filter is agnostic - it doesn't know economics and it has no axe to grind. It wants to see a decrease in the trend rate of growth to fit the data - indeed, the current rate of growth in the HP trend is close to zero. I certainly cannot say that the HP trend is the efficient path for aggregate output, but neither can I say it is not. Indeed, Kydland and Prescott were willing to write down a model in which they argued that the deviations from the HP trend could be characterized as efficient.

Now, what if I take another approach to thinking about the trend in real GDP? A remarkable feature of per capita real income for the United States is that the time series, going back more than 100 years, does not deviate much (excluding the Great Depression and World War II) from constant trend growth of about 2% per annum. The standard growth theory we use in macroeconomics will give us this type of growth path if total factor productivity (TFP) is growing at a constant rate. This is somewhat reassuring, though we are not too solid on why TFP should be growing at a constant rate in the most technologically advanced country in the world.

If I fit a linear time trend to the log of real GDP for the post-World War II period in the United States, I get the following picture, where I am just showing the most recent data (though the trend was fit for the period 1947Q1-2010Q2). This chart gives us a different perspective relative to the last one. The trend growth rate in the post-World War II data was 3.28% per annum. From 1998 until late 2001, real GDP was above this trend, but has been below it since. Indeed, the difference between the trend and actual GDP begins to widen well before the onset of the most recent recession, and the current deviation is huge.

How huge? The next chart shows the percentage deviation of real GDP from a constant-growth trend. The current negative deviation is the largest we have seen in the post-WWII period - just short of 15%. Relative to previous experience, it's not impossible that real GDP could sometime return to the 3.28% growth trend line. This obviously requires a long period of sustained growth greater than 3.28%, but such growth rates were experienced in the early 1950s and in the 1960-1970 period.

But what if the US economy and the position of the US as a World technological leader has changed dramatically? Given the negative deviation of real GDP from the constant-growth trend during much of the last decade, we could think of that period as a period of depressed growth, where we never made up for what we lost in the 2001 recession, and then lost some more. Note in particular that GDP growth was buoyed up in 2000-2006 by the construction of houses which we had no business building. Once the housing sector fizzled, growth stagnated, and we all know what followed that.

Now, it is very important that we determine exactly what our future long-run growth prospects are. Is our long-run growth rate going to be lower than it was in the past? Will we ultimately converge to a growth path that is below the post-WWII trend but with roughly a 3.28% growth rate? Are there important inefficiencies in the US economy that are impeding growth (housing and mortgage market intervention and subsidies for example)? If so, we should figure this out, and do something about it.

My worry is that we are too focused on the last month's retail sales numbers, or last quarter's GDP report, and what the federal government or the Fed can do to "solve" short-run problems. We are not paying enough attention to what really ails us.

Thursday, July 29, 2010

Bullard and Deflation

The St. Louis Fed President, Jim Bullard, released a paper today that he has written on the possibility of a Japanese-style deflation occurring in the US in the near future. This is mainly a survey of a body of macroeconomic academic literature, and an interpretation of that literature in terms of the current monetary policy debate. This literature is fairly technical, even for your average macro nerd, so I'll try to give you a brief summary.

The departure point for Bullard's paper is published work by Benhabib et. al. on "The Perils of Taylor Rules" from 2001. A Taylor rule (discussed here) is a policy rule for a central bank that dictates how the central bank's interest rate target should be set in response to the inflation rate and the "output gap" (the deviation of real GDP from its desired level). Benhabib et. al. argued that, if a central bank follows a Taylor rule, then it is possible that the economy ends up in a permanent state with deflation and a zero nominal interest rate.

Why should we be concerned about this? As Bullard argues, much macreconomic analysis and policy discussion is carried on in the context of Taylor rules. Further, the Fed's actual behavior seems to conform to a Taylor rule. In the current context, according to Bullard, the US economy is getting dangerously close to the a state where the nominal interest rate is zero for an extended extended period, and could slip into an extended period of deflation. Why is this bad? Bullard says:
Perhaps the most important consideration is that in the unintended steady state the policymaker loses all ability to respond to incoming shocks by adjusting interest rates— ordinary stabilization policy is lost, and possibly for quite a long time. In addition, the conventional wisdom is that Japan has suffered through a “lost decade”partially attributable to the fact that the economy has been stuck in the deflationary, low nominal interest rate steady state illustrated in Figure 1.
So the idea is that we don't want to be in the zero-nominal-interest-rate world, as then the Fed has nothing to do, and since Japan suffered a lost decade, in part associated with some deflation, we want to avoid looking like that, even if we don't understand what deflation had to do with the decade getting lost.

Bullard suggests two remedies for the problem he lays out, which are (i) The FOMC should tone down this language:
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.
The suggestion seems to be that there should be a commitment to raise rates sometime in the future. (ii) Bullard says:
Under current policy in the U.S., the reaction to a negative shock is perceived to be a promise to stay low for longer, which may be counterproductive because it may encourage a permanent, low nominal interest rate outcome. A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities.

My comments are as follows:

Taylor Rules
Bullard says:
Active Taylor-type rules are so commonplace in present day monetary policy discussions that they have ceased to be controversial.
I'm not sure this is true or not. In any case, Taylor rules should be controversial. Take the 2001 Benhabib et. al. paper for example. The authors basically drop a Taylor-rule central bank into two different example economies. The first one is a Sidrauski-type money-in-the-utility function economy with a fixed endowment of goods. We know exactly what an optimal policy is in this economy - it's a Friedman rule with a zero nominal interest rate and deflation at the rate of time preference. There is nothing bad about the "bad" steady state here - it's the "good" steady state that is actually suboptimal. The other example is a sticky price economy with monopolistic competition. In this economy an optimal monetary policy involves having a constant inflation rate that trades off three distortions: the sticky price distortion, the Friedman rule (positive nominal interest rate) distortion, and the monopolistic competition distortion. In neither example is the Taylor rule an optimal policy rule that the central bank would choose to follow.

Any discussion of policy choices by a central bank needs to be conducted in models where the policy rules chosen by the policymakers make sense in terms of the information they have, their constraints, and their objectives.

Deflation and Japan
Most of what I have read recently on the potential for deflation in the United States currently and how this relates to the Japanese "lost decade" goes as follows. Problems in Japan started with a collapse in asset prices and an ensuing financial crisis. There was also a deflation and very low growth in GDP. In the US we have seen the collapse in asset prices, and the financial crisis. If we allow deflation, then surely we will have a lost decade of weak GDP growth.

I have not done research on Japan's lost decade, but what I know about it tells me that Japanese experience in the 1990s does not look much like recent US experience. The lost decade in Japan seems to have been about repeated financial crises due to an inability of policymakers and regulators to deal with problems in the financial industry. While the US potentially has future financial problems lurking (Fannie Mae, Freddie Mac, and unresolved moral hazard problems), problems in our financial industry were, for the most part, dealt with swiftly.

Someone will have to be more explicit about what caused the deflation in Japan, how that was connected to poor macroeconomic performance, and what that has to do with our current predicament in the United States. I'm not convinced.

Quantitative Easing
Bullard tells us that if we get a "negative shock" in the future, the Fed should buy long-term Treasury securities, as he feels this is effective, both in reducing long-term bond yields, and in increasing the inflation rate and inflationary expectations. He cites evidence that quantitative easing in the US and the UK had these effects. My response to this is a series of questions:

1. What negative shocks does Jim have in mind? Lower-than-expected inflation? A low GDP report? More bad news on sovereign debt in Europe? Is the purchase of long-term Treasuries the solution to every "bad" shock on the horizon? Why?

2. Does this mean the Fed is now interested in fine-tuning?

3. What theory explains the potential ability of the Fed to manipulate the term structure of interest rates by swapping interest-bearing reserves for long-term Treasuries? I need some structural empirical evidence - not just correlations.

4. If the Fed has the ability to lower long-term interest rates, and this is a good thing, why does the Treasury issue long-maturity securities if this only serves to crowd out private investment?

5. The Fed can get more inflation (though not much more) by reducing the interest rate on reserves to zero. If the Fed indeed wants more inflation, why doesn't it do that?

Tuesday, July 27, 2010

Solow in Grumpy-Old-Man Mode

Here is a report on hearings for the House Committee on Science and Technology. For mainstream economists who despair about the state of the profession and the public's misunderstanding of what we do, this will not help your mood.

The witness panel is basically 4 quacks and Chari. The witnesses appear to have been asked to give testimony on the "DSGE model" which the committee seems to view as representative of what a typical macroeconomist is up to. Robert Solow's testimony is representative of what is in the other testimony, though Page mainly tries to sell his ideas on complexity theory and does not do much criticizing. Solow has plenty of bad things to say about macroeconomics, but comes off as totally cluless. Here is how he starts out:
Here we are, still near the bottom of a deep and prolonged recession, with the immediate future uncertain, desperately short of jobs, and the approach to macroeconomics that dominates serious thinking, certainly in our elite universities and in many central banks and other influential policy circles, seems to have absolutely nothing to say about the problem. Not only does it offer no guidance or insight, it really seems to have nothing useful to say.
Well unfortunately, it's Solow who has nothing to say. Here is his main problem:
I do not think that the currently popular DSGE models pass the smell test. They take it for granted that the whole economy can be thought about as if it were a single, consistent person or dynasty carrying out a rationally designed, long-term plan, occasionally disturbed by unexpected shocks, but adapting to them in a rational, consistent way. I do not think that this picture passes the smell test. The protagonists of this idea make a claim to respectability by asserting that it is founded on what we know about microeconomic behavior, but I think that this claim is generally phony. The advocates no doubt believe what they say, but they seem to have stopped sniffing or to have lost their sense of smell altogether.
I should get Solow to sniff my models before I write up the papers. First, as Chari points out in his testimony, the majority of work in macro these days is done in heterogeneous agent models. Representative-agent is a useful baseline model in what we teach, but most serious research departs from that. Clearly Solow hasn't been paying attention. Next we have this:
An obvious example is that the DSGE story has no real room for unemployment of the kind we see most of the time, and especially now: unemployment that is pure waste. There are competent workers, willing to work at the prevailing wage or even a bit less, but the potential job is stymied by a market failure. The economy is unable to organize a win-win situation that is apparently there for the taking. This sort of outcome is incompatible with the notion that the economy is in rational pursuit of an intelligible goal. The only way that DSGE and related models can cope with unemployment is to make it somehow voluntary, a choice of current leisure or a desire to retain some kind of flexibility for the future or something like that. But this is exactly the sort of explanation that does not pass the smell test.
Now we know that Solow is really out to lunch. For more than thirty years, economists have been working on general equilibrium models of search and matching (including the Mortensen-Pissarides framework that Chari mentions) that have been used extensively to help us understand how labor markets work, and the role for policy in intervening in those markets. Then:
The point I am making is that the DSGE model has nothing useful to say about anti-recession policy because it has built into its essentially implausible assumptions the “conclusion” that there is nothing for macroeconomic policy to do.
Solow should take Chari's cue and attend the SED meetings. He would see a lot of papers where models are constructed in which there are financial and search frictions, and where there are important things that policy can do.

Question: Who chose these witnesses? Why can't the House Committee choose witnesses who are actually serious macroeconomists engaged in research and policymaking? The committee could have talked to, for example: Kiyotaki, Gertler, Woodford, Lucas, or Sargent, and actually learned something useful.

Saturday, July 24, 2010

What Happens if the Interest Rate on Reserves Goes to Zero?

The Fed is currently paying interest on reserves at 0.25%. As I have discussed before, the interest rate on reserves (IROR) is currently the relevant policy rate for the Fed. It essentially determines all short-term rates of interest. On Tuesday, as reported here and elsewhere, a rumor spread that the Fed was considering dropping the IROR to zero. On the following day, Bernanke, in his session with the House panel, made clear what the Fed's position is:
We are paying one-fourth of one percent so it's obviously a very, very low rate of interest. The rationale for not going all the way to zero has been that we want the short-term money markets like the federal funds market to continue to function in a reasonable way because if rates go to zero there will be no incentive for buying and selling federal funds, overnight money in the banking system, and if that market shuts down ... it'll be more difficult to manage short-term interest rates, for the Federal Reserve to tighten policy sometime in the future. So there's really a technical reason having to do with market function that motivated the 25 basis points interest on reserves.

That being said, it would have a bit of an effect on monetary policy ...

(and) we'd certainly consider that as one option.
What would happen if the IROR on reserves went to zero? Would the fed funds market shut down? Currently there is a massive quantity of reserves in the system, but nevertheless there is an active federal funds market (though much less activity than in normal times). Why? Even though the system is awash in reserves, Fannie Mae and Freddie Mac don't receive interest on their reserve accounts, and therefore want to lend. A surprising feature of financial markets currently is that the effective fed funds rate (currently at 0.18%) is lower than IROR (0.25%) - there is something inhibiting arbitrage here, as without that the effective funds rate should be 0.25%. Now, if the IROR goes to zero, then the GSEs no longer have an incentive to lend overnight. Maybe the fed funds market essentially shuts down then. Presumably this is what Bernanke is alluding to, though he is not being explicit. But why do we care if the fed funds market shuts down? After all, it would shut down because it's not needed. Is it going to be costly to start it up again once the Fed starts to tighten? Do fed funds traders get out of practice, or what? I don't think this makes sense. Surely there is plenty of scope, if the Fed wants to, to subsequently tighten. It can do this in one of two ways: (i) Conduct open market sales of assets, until the fed funds rate rises above zero; (ii) Raise the IROR.

Now, what would be the effects of a decrease in IROR to zero? As Bernanke says, not much. Reserves would become slightly less attractive to banks, and in the course of trying to shed them, the price level would rise by a small amount, reserves would fall, and the quantity of currency (in nominal terms) would rise.

Friday, July 23, 2010

Fed Targets

What do we want a central bank to do? The initial mandate given to the Fed, in the Federal Reserve Act of 1913, was to "furnish an elastic currency." What the framers of the Act appeared to have had in mind was intervention by the central bank to smooth the effects of predictable seasonal fluctuations in the demand for currency, and to prevent the banking panic episodes that had occurred during the National Banking era after the Civil War. Intervention was to occur primarily by use of the discount window - there did not appear to be a good understanding of open market operations and their effects in 1913.

After World War II, with the growing influence of Keynesian Economics, Congress passed the Employment Act of 1946. This Act was passed in a context where the Fed had little to do. Between 1942 and 1951, the Fed was committed to pegging interest rates on government bonds, so the Act applied essentially only to the fiscal authority, setting up the Council of Economic Advisers, requiring the President to issue an annual Economic Report, and required the federal government to "promote maximum employment, production, and purchasing power." Of course, given the vagueness of that statement and the lack of any incentives, the Act had no teeth at all.

The Employment Act was amended in 1978, in the form of the Full Employment and Balanced Growth (or Humphrey-Hawkins) Act, with language that referred specifically to the Fed. The Chairman of the Board of Governors was required to testify to Congress on a regular basis, and was required by the Act to maintain long-run growth, minimize inflation, and promote price stability. The 1978 Act was somewhat more explicit than its precursor in setting goals for the federal government and the Fed, but it also has no teeth. However, both Acts enshrine the idea, presented to masses of freshman undergraduates in economics programs, that the government, through its monetary and fiscal authorities, is responsible for keeping us employed and subject to low inflation.

Though vague, the emphasis on real rather than purely nominal objectives for monetary policy is different from what is done in some other countries, particularly those with explict inflation targets, like New Zealand, Canada, or the UK. The Fed, while sometimes viewed as more independent than the average central bank in the world, seems somewhat more tied to Keynesian-type stabilization policy than some other central banks, through the above Acts of Congress.

Now, Old Keynesians of course had their opponents, the Old Monetarists, lead by Milton Friedman. Friedman thought that discretionary stabilization policy was generally harmful, due to the fact that we do not know enough about how the economy works, measurement is imperfect, policymakers work slowly, and policy itself works slowly, once implemented. Friedman's proposed solution was to bind the central bank to a policy rule, but unfortunately he picked the wrong one. Central bank experiments with money growth rules in the 1970s and 1980s were a failure, for well-known reasons. The Fed's current operating procedure - peg the policy rate between FOMC meetings - works because it optimally absorbs a variety of anticipated and unanticipated shocks to financial markets and payments arrangements that dominate over a short horizon.

The Taylor rule paper changed things dramatically for Keynesian-minded macroeconomists. The Taylor rule determines the current setting for the Fed's policy rate (in normal times, the fed funds rate) as a function of the observed inflation rate and the "output gap," specified in Taylor's original paper as the deviation of real GDP from trend. The Taylor rule permits one to be a Keynesian - Keynesian economics being a justification for putting the output gap in the policy rule - while also avoiding discretion, and therefore staying out of trouble with the Old Monetarists. The Taylor rule ultimately became enshrined in New Keynesian Economics, and is a very visible part of the policy narrative within all central banks currently.

Part of the attraction of the Taylor rule for central bankers was that it required no change in their thinking. Indeed, part of Taylor's original sales pitch for his rule was that it fit recent (in 1993) Fed behavior. Central bankers could then rest easily, given the notion that they had finally solved the monetary policy problem. Indeed, features of the US times series data after the early 1980s helped to promote this view. One of my favorite speeches by Ben Bernanke when he was still a Fed Governor is this one, from 1994, on the Great Moderation, the period following the 1981-82 recession until 2007. As we all remember, the Great Moderation was a period of relatively low real GDP volatility and low inflation in the United States.

Bernanke's speech makes the case that better monetary policy was an important (though not the only important) contributor to the Great Moderation, and uses the Taylor rule and the "Taylor curve" to organize our thinking about this. In public statements like this, and in the direction that research took in the Federal Reserve System and other central banks, the Fed set itself up for criticisms like this one, from Paul Krugman. Krugman simply takes the standard quadratic-loss objective function that we can use to derive a Taylor rule, and plots the implied losses over time. Of course, the loss grows substantially beginning in mid-2008 until the present, driven by a growing "output gap" and a decrease in inflation below an assumed 2% target.

On the Fed's terms, Krugman's criticism is quite reasonable. By buying into the Taylor rule language and in public statements by its officials, the Fed has implicitly accepted that:

1. The central bank should care about two things: the inflation rate and aggregate economic activity.
2. The central bank can determine what the inflation rate and aggregate economic activity should be at any point in time.
3. A fixed rule should determine a federal funds rate target as a function which is increasing in the observed inflation rate, and decreasing in the gap between observed economic activity and what aggregate economic activity should be.

On point 1: It seems well-recognized that long-run inflation, and an uncertain inflation rate are costly, and that inflation is a monetary phenomenon and therefore under the control of the central bank, at least over long periods of time. However, there seems to be no agreement among macroeconomists concerning the effects of monetary policy on real macroeconomic activity and the role of policy in affecting such activity. Even basic New Keynesian theory does not provide for such a role. In the standard New Keynesian framework, inefficiencies arise because of relative price distortions, which arise from price stickiness. The problem can be cured with price stability - there is no need in the New Keynesian world for the central bank to pay any attention to some "output gap" measure.

On point 2: What is the appropriate long-run inflation rate? We seem to have no idea. Here, I discussed what our models tell us, which is that some deflation (in some cases all the way to the Friedman rule) is optimal. Somehow, the Fed seems to have arrived (as far as we can tell) at an optimal long-run inflation rate of 2% per annum. But there is no good science to back this up, other than the lay-low principle of central bank political economy: 2% keeps you out of trouble. What about the output gap? Clearly no one has a clue how to measure this. The correct measure would be the difference between current real GDP and efficient real GDP, but typically the measure used is something like what Taylor originally proposed - the difference between trend and actual real GDP (or trend and actual unemployment rate). Under the current circumstances, I am not sure whether what I am seeing is close to efficient or not. Is the unemployment rate high because of some inefficiency arising from wage and price stickiness, an inefficiency due to malfunctioning credit markets, or has the matching process in labor markets become less efficient (due to mismatch - see here and here). Which it is determines whether monetary policy can or should do anything about it.

On point 3: Oddly enough, the Taylor rule is not an optimal policy rule that can be derived in any well-articulated monetary model that I know about. As I pointed out above, it is not optimal in basic New Keynesian models, though Woodford has some slippery ways of coaxing it out of his models (see here).

What is the bottom line? (i) Obviously we need to know more. More research is needed on the costs of inflation and the role of monetary policy. (ii) Until we know more, central bankers should be more humble (if they aren't humbled enough by recent events) and so should people like Krugman, who seem very certain about what they think the central bank should do. (iii) I think a superior approach to central banking in the United States would be to adopt explicit inflation targeting, as has been done in other countries. Why? The public (and indeed some well-known economists) seem to have the impression that central banking is an engineering problem whereby the Fed delivers the "correct" level of real GDP or the correct unemployment rate. Inflation targeting would help to dispel that notion. What should the target be? Good question - I'm groping for an answer here. In his younger days, Bernanke was clearly in favor of inflation targeting. Obviously he has been distracted of late, but maybe now is the time to get the ball rolling.

Thursday, July 15, 2010

FOMC Minutes, June 22-23

FOMC minutes for the most recent meeting were released yesterday. Two interesting issues relate to the composition and size of the asset side of the Fed's balance sheet, and to the future path for inflation and what to do about it.

Balance Sheet Issues
Early in minutes, there is reference to a person I did not know about:
The Manager of the System Open Market Account (SOMA) reported on developments in domestic and foreign financial markets during the period since the Committee met on April 27-28, 2010.
The Manager of the SOMA holds a position at the New York Fed, and is appointed by the FOMC. He/she attends FOMC meetings, and on this occasion was called on for an extensive discussion of Fed balance sheet issues. Currently, the composition of the Fed's assets is very unusual. The average maturity of Treasuries held by the Fed is much longer than would have been normal in the past, and the Fed is holding a very large quantity of mortgage-backed securities (MBS) and agency securities, most of which are long maturity assets. Normal practice for long-maturity treasury securities held by the Fed in the past was to roll these over as they matured according to a fixed rule, as described in the minutes. The SOMA manager described some alternative scenarios for altering the fixed rule, these ideas were batted around, and the FOMC opted to stick to the fixed rule.

What's going on here? If we focus solely on Treasury securities, one aspect of the Fed's recent policy has been to move much more heavily into long-maturity Treasuries. Why? The Fed appears to believe that it can manipulate the term structure of interest rates. Short rates cannot go much lower, so it has attempted to force long rates down by buying long Treasuries. Could this be successful? Traditional central banking lore says no. Central bankers appear to operate on the belief that central bank actions have their effects in terms of returns on short-maturity assets, with little or no effect at the long end. Under the current circumstances, if the private sector can arbitrage across maturities, a swap of reserves for long Treasuries (or short Treasuries for long Treasuries) should not matter. Moving long rates down would have to depend on some inability to arbitrage, and I'm not sure that there is any evidence that such a friction exists.

Now suppose that a movement towards long Treasuries by the Fed is irrelevant. Does that mean it's innocuous? The Fed is now intermediating across maturities - the liabilities (currency and reserves) are all short maturity, and the assets go up to 30-year maturities. As is well-known, during the financial crisis, some financial institutions got into trouble due to a mismatch between the maturity of assets and liabilities, for example Gary Gorton is fond of a story about "repo runs." But the Fed is obviously not subject to runs. Currency is not redeemable in anything, and reserves can be withdrawn as currency, which is not redeemable. What is the maturity risk for the Fed? As the economy recovers, returns on alternative assets to reserves will start to look more attractive for banks. In order to control inflation, the Fed will have to raise the interest rate on reserves to make reserves more competitive relative to other assets. Now, while the Fed is currently making record profits (see here), they would not be if short-term interest rates had to rise significantly. What difference does this make? Profits made on Fed intermediation activities are just returned to the Treasury. Why would it matter if these profits are lower? Less revenue for the Treasury means they have to make it up somehow, and there is nothing that suggests that more taxation is in the wind. Thus, this means the Treasury has to issue more claims to pay US dollars in the future. If we think that what matters for long-run inflation is the growth rate in total (consolidated) government nominal debt, then this has to come back to bite the Fed in some fashion.

The maturity issue also matters in terms of the Fed's large holdings of MBS and agency securities. While there are clearly concerns on the FOMC about this, the minutes make clear that any decisions about addressing the maturity mismatch issue, or selling MBS, will be left for another day.

In the minutes, we have this:
Over the medium term, participants saw both upside and downside risks to inflation. Several participants noted that a continuation of lower-than-expected inflation and high unemployment could eventually lead to a downward movement in inflation expectations that would reinforce disinflationary pressures. By contrast, a few participants noted the possibility that a potentially unsustainable fiscal position and the size of the Federal Reserve's balance sheet could boost inflation expectations and actual inflation over time.
I'm assuming that the concerns about deflation were coming in part from Eric Rosengren. His recent interview with the WSJ sounds a lot like Krugman. In the background is a "deflationary trap" model. The notion seems to be that we can get sucked into a black hole of deflation in which we can be lost for a decade or so, just like Japan in the 1990s. This makes absolutely no sense to me, but I'll have to investigate further - I'll let you know what I find out.

Another section in the minutes gives us this:
However, members noted that in addition to continuing to develop and test instruments to exit from the period of unusually accommodative monetary policy, the Committee would need to consider whether further policy stimulus might become appropriate if the outlook were to worsen appreciably.
As I've commented before, the "instruments" in question here, the term deposit facility and reverse repos, accomplish nothing in terms of "exit." Further, as I discussed here, the Fed really has no room to move. It could buy more MBS, which if it has any effect, serves only to reallocate credit toward housing from more productive alternatives, and buying more Treasuries does essentially nothing under the current regime.

Monday, July 12, 2010


I had a long-run plan not to write about Krugman, and a short run plan for this morning to revise my paper, but I'm afraid both of those plans are in the toilet, after reading Krugman's NYT column this morning. Krugman's argument seems to be following:

1. Deflation is something we associate with bad outcomes - e.g. Japan in the 1990s and the Great Depression.

2. The inflation rate is currently very low in the US, and getting lower, and it will likely enter negative territory in the near future.

3. The Fed can and should do something about this, but it is ignoring the problem.

Is deflation a bad thing? Conventional monetary theory says no. Friedman's argument from his "Optimum Quantity of Money" essay is that the nominal interest rate represents a distortion which we want to get rid of. In general this implies that, on trend, prices should fall over time - trend deflation is optimal. Now, my deceased friend Bruce Smith was fond of calling the Friedman rule an embarrassment for monetary economics. All of these models are telling us the nominal interest rate should be zero forever, but no central bank actually does this. Further, as Krugman recognizes, deflation tends to be associated with bad stuff.

Some theories do, however, take us away from the Friedman rule as a policy prescription. The Friedman rule corrects a long-run distortion - anticipated deflation gives money an appropriately high social return. However, New Keynesians focus on the short-run distortions that come from sticky prices. Combine this with the long-run Friedman-rule distortions and you get optimal inflation somewhere between zero and Friedman-rule deflation, but it's still an optimal deflation. I got a similar result in a non-Keynesian model with a different kind of short-run relative price distortion. A recent idea I like better, which relates to this discussion takes account of the notion that we should take currency seriously. Currency, which finances most of the central bank's asset holdings in normal times, has many direct costs and indirect social costs associated with its use - counterfeiting, theft, and various other illegal activites. Inflation taxes these undesirable activities, which is good, but inflation is also bad for well-known reasons. In any event, taking account of the costs of using currency as a medium of exchange will give us an inflation rate above the Friedman rule rate, and could indeed tell us that the optimal inflation rate is positive, and that this optimal rate could fluctuate over time.

Is the inflation rate currently low and falling? Let's look at the broadest possible measure of inflation, the rate of change in the GDP price deflator. If we look at year-over-year percentage changes in the GDP price deflator, in the chart, we certainly see a rate of change that is low and falling. Indeed, the inflation rate, measured this way, is currently at 0.5%.

Why should the inflation rate continue falling? New or Old Keynesians might think that the output gap matters for the inflation rate, in Phillips curve fashion, and that the current large output gap (however measured) should ultimately produce deflation. But as Bob Hall reminded us in his Society for Economic Dynamics plenary talk last Thursday, recent output gaps appear to have had no effect on the inflation rate. Further, this evidence tells us that Phillips curve relationships are not useful for forecasting inflation. Certainly there is no quantity-theory-of-money inflation story that would cause us to forecast a further reduction in inflation to negative territory.

Now, even if we thought that the threat of deflation were looming, should the Fed be castigated for ignoring this? What could the Fed be doing to produce more inflation? Under the current regime (with positive excess reserves), the relevant policy rate in the US is the interest rate on reserves, which is currently 0.25%. The Fed could go to zero, but obviously that will not produce much inflation, and then we would only get a level effect on the price level. Krugman suggests the following:
But the message of Mr. Bernanke’s 2002 speech was that there are other things the Fed can do. It can buy longer-term government debt. It can buy private-sector debt. It can try to move expectations by announcing that it will keep short-term rates low for a long time. It can raise its long-run inflation target, to help convince the private sector that borrowing is a good idea and hoarding cash a mistake.
What about that? First, the Fed has already acquired a rather large quantity of long-maturity Treasuries and agency securities, and a very large quantity of mortgage backed securities. But, Krugman wants the Fed to buy more. Would this have any effect? Absolutely not. Swaps of reserves for private or public debt under the current regime (positive excess reserves) are essentially neutral (no effect on prices or quantities). The only instrument the Fed has currently for affecting the path of the price level is the interest rate on reserves, and that cannot go much lower, as Krugman points out. Should the Fed be committing to keeping short rates low indefinitely? Absolutely not, as there are inflation risks that Krugman does not recognize. Some people are worried about the maturity mismatch on the Fed's balance sheet. Others, including John Cochrane and Chris Sims, are worried about the inflationary implications of government deficits. These concerns may be unwarranted, as I'm now making the case that Krugman's deflationary concerns are unwarranted. In any case, we're in uncharted territory, and Krugman should not be so sure of himself.

Sunday, July 11, 2010

Real Business Cycles

Aggressive comments attached to my posts are a sure sign that links elsewhere in the blogosphere are giving me readers that don’t normally come here. That was certainly the case with this piece, which Mark Thoma, and in turn Paul Krugman paid some attention to. This gives me a useful opportunity to address issues related to real business cycle theory and its place in modern macroeconomics.

Milton Friedman and the Old Monetarists seemed to be short-run Keynesians. When pressed to write down his vision of sources of short-run nonneutralities of money, Friedman’s framework was essentially standard IS/LM. In contrast to mainstream Keynesian views at the time, however, Friedman was firmly anti-interventionist. Attempts at stabilization policy, either through monetary or fiscal means, according to Friedman would inevitably make things worse. For Friedman, policy could mess things up because of policy-making lags, imperfect information about the structure and state of the macroeconomy, and the “long and variable lags” associated with the effects of monetary policy (and fiscal policy too).

Then, along came the Phelps volume and Lucas’s pathbreaking 1972 Journal of Economic Theory paper, and macreconomists began to think about the world in an entirely different way. In the Keynesian world, fluctuations in aggregate economic activity are inefficient, and the logic appeared to be consistent with what we observe. We find ourselves in the middle of a recession. In terms of the its basic fundamentals, the economy looks more or less the same as it did before the recession happened. There is roughly the same set of people, with the same skills. The same buildings and machines are in existence, and we know just as much about how to produce stuff as we did before the recession happened. However, we are producing less and more people are out of work. Surely something has gone wrong, and the government can do something about it, by spending more and relaxing monetary policy to put people back to work.

However, the Phelps volume writers and Lucas got us thinking about the following. An unemployed person is someone who answers the labor force survey in a particular way. This person is engaged in a particular activity – search – and we can analyze this process just as we would analyze anything else in economics, as involving choice and incentives. Due to a mismatch between the workers that firms want and the jobs that workers would like to have, separations due to various factors, and people moving in and out of the labor force, there will always be unemployment. Further, fluctuations in these factors determining unemployment will make the unemployment rate fluctuate. Indeed, we might imagine fluctuations in unemployment that are purely efficient – there may be nothing the government should do about this. Also, according to Lucas’s 1972 model, monetary policy could be causing inefficient fluctuations. Indeed, there could be states of the world where GDP is inefficiently high. Thus, the government could be actively screwing things up, in line with Friedman’s thinking.

Next, along come Kydland and Prescott in 1982, with what later became known as real business cycle analysis. In terms of the economics, the Kydland-Prescott framework was not very radical, being an elaboration of received growth theory, stemming from the work of Solow, Cass-Koopmans and Brock-Mirman. However, in a lot of ways Kydland and Prescott were thinking outside the box, and they were very much in the faces of mainstream macroeconomists, in a much more aggressive way than were Lucas, Sargent, and Wallace in the previous decade. Kydland and Prescott offended econometricians, by calibrating rather than estimating, and by using unconventional time series filters (i.e. the Hodrick-Prescott filter) to separate the the business cycle components of time series from the trends. They also gave economists license to contemplate the possibility that business cycles could be bad events that we should do nothing about – government intervention could serve only to make the problem worse, analagous to how Lucas's 1972 model works, but for different reasons.

For some macroeconomists who were brought up on the Keynesian paradigm, and were highly invested in it, this was heresy. Some older prominent economists, including Tobin and Solow, resisted, and some prominent young economists, including Larry Summers, did as well. For young researchers who received their education during the 1970s and 1980s (this includes me of course), the new paradigms were exciting. The economics of Kydland, Prescott, Lucas, Sargent, and Wallace looked more firmly grounded in the solid general equilibrium theory developed by Arrow and Debreu, and these people had good arguments which appeared to match well with empirical observations. Relative to this, mainstream Keynesian economics just looked mushy. Who would want to tie their caboose to that train?

Now, though Kydland and Prescott presented an extreme view of business cycles, which could be interpreted as telling us that the government is irrelevant, the general spriit of the approach is something entirely different from that. The key lesson is that we need to impose the same discipline on the evaluation of macroeconomic government policies as we would in any other field of economics. Skepticism about the role of government is healthy, and every government program and intervention should be justified in terms of correcting some externality or market failure. In the language of Pat Kehoe (or maybe this comes from Lucas – I’m not sure), we don’t want to justify government intervention based on a “chicken model.” In a chicken model, we assume that chickens are good, that the private sector cannot produce chickens, and that the government can, and therefore should, produce chickens. A Principles-of-Economics Keynesian-Cross model is basically a chicken model. In it, we assume that more GDP is a good thing, and the government can give us more GDP – essentially for free – by increasing government spending on goods and services. The logical conclusion from such a model is that we could make ourselves infinitely well off with a government of infinite size. Keynesian Cross macroeconomics is basically the macroeconomics of Paul Krugman – what he is peddling to the general public.

What about Prescott’s remarks last Wednesday about the causes of the current recession? What should we make of that? To me, Prescott’s narrative did not make any sense, in terms of what I know about the facts. To be fair, we should wait to see how he spells this out in terms of a rigorous argument with an explicit model he can use to confront the data. However, to make myself clear (to people like Krugman), what I was quarreling about had nothing to do with the competitive paradigm or basic neoclassical growth theory. My only problem was with the shocks that Prescott was evoking to explain events. It could well be that we could ultimately come to an understanding of the financial crisis and the recent recession as an economically efficient macroeconomic response to events. In this context, we might come to think of the policy responses to the crisis – the extreme actions of central banks and the US stimulus bill – as being wrongheaded. In spite of the fact that important factors that gave rise to the recent recession were the result of errors in the design and regulation of the US financial system, it could be that the temporary government intervention in response to the recession was wrong. In my view, some of the US monetary policy intervention was the right thing to do, and maybe some elements of the stimulus bill were appropriate, but I could be wrong.

Now, serious New Keynesian economists do not peddle chicken models in the same sense as the Old Keynesians, like Krugman. These people, including Jordi Gali, Mark Gertler, and Mike Woodford, deal with models where inefficiencies arise for reasons that any economist could understand. The basic sticky price frictions in their models yield relative price distortions that happen to be correctible (subject to the zero lower bound on the nominal interest rate) by monetary policy. These people use conventional theory, developed by Arrow, Debreu, Solow, Cass, Koopman, Brock, Mirman, and Prescott, to derive their conclusions. That has been the great victory of Lucas, Prescott, Sargent, Wallace, and others. Their theoretical methods are now widely-accepted, and in terms of empirical work New Keynesians and others now use a wide array of calibration and estimation techniques. No one would shy away from New Keynesian economics because it is too mushy.

My problem with New Keynesian economics (in addition to its treatment of monetary and financial frictions) lies with the basic sticky price assumption which leads to what I referred to here as “incoherence.” This was a little too harsh a word, but what the heck. One problem with the New Keynesian approach is that there is a chicken model lurking in there. Price flexibility is good, the private sector cannot produce it, but appropriate monetary intervention can produce the equivalent of price flexibility. Another way to look at this is that we do not understand pricing decisions at the level of production, distribution, and retail sales, and the relationship of these pricing decisions to other elements of productive decisions (employment and investment) enough to really say whether there are frictions or externalities arising from those decisions that matter in a serious way for macreoeconomics. No one has a convincing theory (or indeed any theory) to tell us why pricing should matter for macroeconomic activity and policy in the way Old and New Keynesians want it to. That, I think, is the challenge for Keynesian economics. Until that is resolved, I am content to seek explanations for aggregate phenomena and roles for economic policy in financial and monetary frictions.

Saturday, July 10, 2010

New Keynesians and New Monetarists

What's the difference between a New Keynesian and a New Monetarist? This sounds like I'm leading off to tell a joke (a duck walks into a bar...), but I'm not. A New Keynesian thinks that the real interest rate is too high, while a New Monetarist thinks the real interest rate is too low.

In New Keynesian theory, the basic idea is that the key inefficiency that monetary policy should be correcting arises from the sticky price friction. It is costly or impossible for firms to change prices frequently, and if there is general inflation or deflation there will be relative price distortions that cause welfare losses. In the New Keynesian framework, price stability will generally fix the problem, subject to some slippage due to what the central bank can and cannot observe at any given time. However, a particular problem, which I think is the key to how New Keynesians think about the current state of the world, is that the nominal interest rate cannot fall below zero (the "zero lower bound"). In a severe downturn, from standard intertemporal economics, efficient allocation of resources dictates that the real interest rate should be low, but this is not going to be consistent with price stability and a non-negative nominal interest rate. The best the central bank can do is to set its policy target nominal interest rate to zero, and the real interest rate is then too high relative to what it would be in an efficient flexible price world. This is essentially the story that Bob Hall told on Wednesday, and it's consistent with all or most of the New Keynesian work I have seen at the SED meetings here in Montreal.

From a New Monetarist point of view, a key element of the financial crisis relates to the scarcity of liquid assets. There is one type of liquid asset, which is outside money. Currency and bank reserves play their own unique roles as media of exchange in retail and large-scale financial transactions. A second important set of liquid assets are (in the US) Treasury securities, and various intermediated private assets that are implicitly traded through the exchange of various intermediary liabilities. When the Fed conducts an open market purchase of Treasuries, it swaps the first type of liquidity for the second. My view is that one reason this matters is that it increases the scarcity of the the second type of liquidity. The financial crisis also increased the scarcity of the second type of liquidity. For example, some mortgage backed securities, which had been widely traded in financial markets, and had served as collateral in various credit arrangements, dropped in value and were no longer traded. An increased scarcity of the second class of liquid assets is reflected in a lower real interest rate - these assets carry a larger liquidity premium. The correct central bank response to such a phenomenon, in additional to stepping in temporarily take up some of the intermediation functions that seemed to have shut down in the private sector, is to sell Treasuries, not to purchase them (which would increase the first type of liquidity, not the second). As you can see from this picture, which I lifted from Curdia and Woodford, this is pretty much what the Fed did in the financial crisis. The Fed balance sheet expanded, but they actually reduced their holdings of Treasuries. The key point is that an important phenomenon in a financial crisis is a shortage of "type 2" liquid assets, reflected in a low real interest rate, rather than a real interest rate that is too high, as in New Keynesian theory.

By the way, thanks to Ricardo Lagos for helping me think through this.

Friday, July 9, 2010

More on Prescott at the SED

Blogging never fails to be interesting for me. Given who I typically talk to and what I typically read, I would never have imagined what ideas are floating around. Here is what I learned from the comments on my last blog post:

1. There is a segment of the population that is as unhappy with economists as they are with bankers, the Congress, the executive branch, or the judicial branch, for that matter. I understand that, for people not trained in economics, economic issues can be very difficult to sort through. The difficulty is acute, in part, because the stakes are so large. Governments and central banks have the ability, through their actions, to reallocate resources in ways that favor some segments of the population relative to others. Economists (or so-called economists - you don't need a license to call yourself one) are quite willing to sign on (explicitly or otherwise) with political parties to make the case that particular policies are somehow good for everyone (in the sense of being "good for the economy" or economically efficient), when the truth is that what they are advocating has more to do with reallocating wealth and income to their base of support. Republicans do it. Democrats do it. The result is that, at any time, one can find economists, some with excellent credentials, including Nobel prizes, giving what appears to be conflicting advice. How could the average person sort out this noise? I have no particular advice to offer, other than to educate yourself. Take an economics course, read, and think.

2. Some people are scary. You know the ones I mean.

3. I got a well-reasoned reply from someone who was actually at the financial crisis workshop, which was this:
Anonymous said...

I won't claim to speak for Ed, but my understanding of the third point is a bit different than yours, Steve. I don't think he really believes that expectations of higher future taxes are depressing labor supply. As you noted, this seems a bit ridiculous. But it does seem reasonable to think that expectations of higher future taxes are depressing private investment, which as you pointed out from Bob Hall's remarks, is one of the major components GDP that is suffering right now. It seems clear that the federal government has borrowed and spent a significant amount over the last 24 months or so. And we have some big obligations looming on the horizon as well (ongoing war costs, social security, and health care, to name a few). Our national debt isn't going away anytime soon, so we either have to cut spending (not likely), monetize the debt (I doubt the Fed will allow for significantly higher inflation), or see higher taxes sometime in the future. The latter seems most likely. If nothing else, it seems we're going to see at least some tax increases as the Bush tax cuts expire. It's clear that taxes affect return on investment, and business unsure of future tax rates might be less willing to make risky investments because of that uncertainty. That was my take on Ed's argument, and it seems reasonable. Let me know if I'm way off base here.
1. It is a difficult to interpret what Ed was saying, as he was not specific enough, and certainly didn't lay out an explicit model. One thing I did not mention was the discussion of intangible capital, which relates to this paper. This may relate to the capital taxation arguments this commenter makes.

2. Whether it's anticipated labor income taxes or capital income taxes, it seems very difficult to make the case that this could be driving this large recession. We have known about the government's obligations (defense spending, health care costs, social security) for a long time now. I don't know how you make the case that the weight of these obligations somehow came home to roost in fall 2008. In terms of the actual outcomes, as Hall noted in his talk, the size of government (that's total - federal, state, and local) has not increased recently. As well, the February 2008 stimulus package included $275 billion in tax cuts. I'll leave it to someone else to determine the tax implications of the health reform bill - that one is debatable. As the comment notes, there are serious budgetary problems at all levels of government in the United States. The state governments (and this is particularly acute in Illinois and California) are forced to face the problem in the present, but ultimately the federal government will have to face the reality of its present-value budget constraint (i.e. debt is debt - the government has to ultimately find a way to pay it off). But I don't think any of this helps Prescott make his case.

3. Prescott never addressed issues related to the housing market, which is central to the conventional narrative on the financial crisis. My view of this is the following. Incentive problems in the mortgage market caused us to accumulate a large stock of housing capital, essentially on false pretenses. On top of that stock of housing capital was built a structure of collateralized credit and asset trading that was supporting a significant fraction of aggregate economic activity. Housing prices fell because the reality of the false pretenses became apparent to people who were engaged in the financial trading supported by the false-pretense-housing. Now that the false-pretense demand for housing has gone away, we are not going to be building many houses for a while, and financial markets are having to restructure themselves, by finding other ways to support credit activity than through the construction and trading of mortgage-related securities. If we are going to address issues related to capital taxation, we should think carefully about how we treat the housing sector in the US. This sector has been heavily subsidized, for no good reason, through the mortgage interest tax deduction, Fannie Mae and Freddie Mac, and through the recent activities of the Federal Reserve System. Note that this is a pure consumption subsidy, of the flow of consumption services from housing. The subsidization diverts resources from productive investment, in part by making credit more costly for firms investing in plant and equipment.

Thursday, July 8, 2010

SED Report

I'm here at the SED (Society for Economic Dynamics) meetings in Montreal. I love this city. The place is very liveable - great in the summer (though it's hot today), and I love the winter here too (that's a Canadian thing, or maybe memories of my grandfather pulling me around in a sled).

Yesterday afternoon, I attended this workshop at the Universite de Montreal (sorry, can't find the accents) on the financial crisis. In this, we got a familiar rehash of events during the crisis, but there were also some noteworthy goings-on.

1. Bob Hall reviewed the key features of the aggregate data in a useful way. Important points were: (i) In terms of the the components of GDP, the downturn is all in consumer durables and investment. It's important, I think, to remember that there are key sectoral aspects to the recession. One initial source of our problems was the poor incentive structure (in the US) that caused us to build more houses than we should have. The ensuing related problems in financial markets had much of their real impact in the markets for durables, where credit is important. (ii) Average labor productivity typically falls in a recession. This time it has not. (iii) An interesting set of labor market observations, which you can see on Rob Shimer's web page relate to the Beveridge curve, or the typical negative correlation between unemployment and vacancies. Since 2000, the data fall on what appears to be a stable Beveridge curve (though of course we know this relationship is no more structural than the Phillips curve). Since late 2009, however, the vacancy rate has been rising, but the unemployment rate has been stuck at just below 10%. For what it's worth, here is an anecdote consistent with these observations. What the data indicates is fundamental mismatch in the labor market, between the skills that firms want and the skills the unemployed have. There is long-run structural change going on in the US economy - including a shift from manufacturing to services, and a shift in demand from low-skilled to high-skilled labor. We're all aware, I think, of the increase in the wage gap that developed 30 or so years ago between college-educated workers and those with less education. The housing boom masked some of what was going on, as it absorbed a lot of low-skilled workers. With the collapse in housing construction, we're stuck with the fallout - what some would call structural unemployment - which is making the unemployment rate higher than it would otherwise be.

2. Narayana Kocherlakota reprised his proposal for "rescue bonds," which I discussed here. This is interesting, but for purely academic reasons. I don't think it has any practical merit, for reasons I discussed in the earlier piece. Lucas made a good point, which left Narayana sputtering a bit. The idea is that, in an economy with a great deal of government intervention, we seem to find externalities everywhere we look. Lucas's example (if my memory has not failed me entirely) concerns a diabetic living in Canada (I'm adding that) who is imposing an "externality" on society if he/she does not treat his/her diabetes - this will just increase health care costs for the rest of us. The fundamental problem, if there is one in this example, really has nothing to do with externalities. Now, the problems of financial regulation Narayana is thinking about have to do with basic frictions - private information and limited commitment. Beginning in the 1970s, economists developed what we now know as mechanism design theory to think about how resources should be allocated in economies with private information and limited commitment. In mechanism design theory, "externality" is not part of the language, and it's not a useful concept. If mechanism design has a problem, it's that it does not tell us how to implement the solution to the mechanism design problem. What is the government supposed to be doing, and what is the private sector supposed to be doing? How do we interpret this solution in terms of "markets" or "regulation?" Obviously we have a lot of work to do.

3. Ed Prescott did pathbreaking work in the economics profession, and his Nobel prize is well-deserved. His work with Finn Kydland made macroeonomists more quantitatively disciplined, and serves as a benchmark for most of the work done in macro in the last 30 years, including New Keynesian economics, models with financial frictions, and incomplete markets models. However, I doubt that there were any people in the room yesterday who took Ed seriously. Ed's key points were: 1. Monetary policy does not matter. 2. Financial factors are the symptoms, not the causes, of the recent downturn. 3. The recession was due to an Obama shock, i.e. labor supply fell because US workers anticipate higher future taxes.* Bob Hall suggested that this would require a Frisch labor supply elasticity of about 27, which seems ridiculous. However, Ed stuck to his guns and thus seemed - well, ridiculous. As a basic framework, the real business cycle model is obviously useful - you can't argue with a basic framework of preferences, endowments, technology, and optimal choice. I think we know by now, though, that financial factors have a lot to do with what we are measuring as TFP (total factor productivity). We certainly should not be listening to suggestions that central banks are irrelevant - these institutions can clearly reallocate resources in a big way when they want to.

*As a commenter pointed out, Prescott may have been talking about capital income taxes, though it was hard to tell. And, as Rody Manuelli pointed out, the labor supply story makes no sense in the context of Prescott economics anyway. In a Prescott world, we would substitute leisure intertemporally in response to higher future labor income tax rates - labor supply in the present would go up, not down.

Monday, July 5, 2010

Unemployment Insurance

Krugman's column this morning gets a B. He arrives at the right conclusions (more or less), and includes some useful economics, but loses points for:
Yet the Senate went home for the holiday weekend without extending [unemployment insurance] benefits. How was that possible?

The answer is that we’re facing a coalition of the heartless, the clueless and the confused.
I prefer to be charitable. Ignorance (I guess that is the clueless and confused part) is a good explanation for a lot of behavior, and is easily cured with education.

Why is unemployment insurance (UI) provided by the government, and not by the private sector? To my knowledge, and perhaps surprisingly, economists who analyze UI systems typically don't answer this question. I think the answer is closely related to why (in my opinion) a well-designed government-run health insurance program works well. In the UI business, standard problems of moral hazard (behavior of the insured affects the chances of suffering an insured loss) and adverse selection (the insurer has a hard time differentiating bad insurance risks from good ones) are severe. The insurer of unemployment cannot observe how much effort the unemployed put into searching for work, and cannot determine whether the unemployed are excessively choosy in terms of the jobs they will accept. As well, as with private health insurance, a market in private unemployment insurance would likely degenerate, by way of the adverse selection problem, to a state of affairs where only high-risk (for unemployment) workers buy insurance policies, and the high prices of the insurance keep the low-risk workers out of the insurance pool. This argument is far from airtight, though, as we now have to ask why the private market seems to work in terms of auto insurance and homeowners' insurance, but not for health and unemployment. However, let's go on.

If we accept that the government should be providing unemployment insurance, we also have to accept that there are some frictions in loan markets that prevent unemployed people from smoothing their consumption over time in the face of unemployment shocks. Credit market frictions, or what we think of as credit market constraints, can make government tax policy matter. For example, a government transfer - unemployment insurance benefits - can increase economic welfare, in spite of the fact that the government will have to finance the transfer by increasing someone else's tax burden, either now or in the future.

Thus, we think that governments can improve welfare by providing unemployment insurance, and there can be a cyclical role for generous unemployment insurance when aggregate economic activity is low and credit market frictions are more severe. Unemployment insurance is targeted toward people who are credit constrained, and therefore arguably a more efficient policy tool than broad tax cuts. However, the government is still faced with the severe moral hazard and adverse selection problems inherent in all UI programs, and needs to design these programs so as to provide the correct incentives. It is well-known that more generous unemployment insurance increases the average unemployment rate - this is well-documented in data from Europe and Canada relative to the US, for example, and is consistent with standard search theory.

The theory of dynamic incentives, as applied to UI, in work by Shavell and Weiss, Hopenhayn and Nicolini, for example (see this paper for the references) tells us that the UI system in the US is likely far too stingy. Generally, the idea is that replacement rates (the ratio of the UI benefit to income when working) should be higher, and benefits should continue for much longer, declining over time. In normal times, UI benefits in the US conform to a replacement rate of about 50% for 26 weeks, then go to zero. In most developed countries, UI is much more generous. For example, in Canada, UI benefits continue for longer, are geared to local labor market conditions (probably a bad idea, actually), and include maternity leaves, parental leaves, compassionate leaves, and illness.

What's the conclusion for current policy in the United States? Krugman is right, in that extending UI benefits under the current conditions would be a good idea. Incentive problems matter, but theory tells us that we should cut the unemployed some slack during a downturn. For the long term, reform of UI in the United States would be useful, but as usual, that would be complicated. UI is in part governed by a framework of Federal law, but the details and funding are worked out by the States. Good luck with that.

Sunday, July 4, 2010

Canada on the Fourth of July

I know this is a strange topic for July 4th, but here goes anyway. Given the recent G8 and G20 meetings, Canada is on our minds somewhat more than is usually the case (and even then, maybe not so much), so I thought I would take the opportunity to review recent events there.

On this July 4th, Canada is looking like the country that does everything right. Canadians are in one sense intrinsically modest (though of course we can think of many counter-examples, including my coauthor from Winnipeg), but they also tend to think of the country south of the border as populated by gun-toting lunatics who treat their disadvantaged badly - a place one would rather not be. But how has Canada been doing? First, let's look at the recent path of real GDP relative to the United States. What you see here, in the first chart, is that the recent recession was not so different in Canada relative to the US, but the turning point in real GDP came later in Canada, the recession was not quite as deep, and the rebound has been faster. Labor (or labour, for Canucks) market behavior (behaviour) has been quite different however, as we see in the second chart. For various reasons (unemployment insurance and sectoral/regional variation), the unemployment rate tends to be higher in Canada as you can see up to about the end of 2007. However, the increase in the unemployment rate in percentage points in the United States from the most recent trough to the most recent peak was more than twice what it was in Canada, and the Canadian unemployment rate is now almost 2 percentage points lower.

Behavior in the housing market has also been dramatically different from US experience, as shown in the third chart which depicts housing starts in the two countries. While the US has experienced a long decline in housing starts since 2006, with the current level of starts at about 40% of what it was in 2000, Canadian housing starts have rebounded from a short-lived drop in the recession to a level 40% higher than in 2000.

In terms of the state of government finances, Canada stands out among highly-developed economies. In the last chart, we show the total government surplus as a percentage of GDP in the US and Canada. Here, note that the Canadians ran surpluses until the recent recession, with the current deficit standing at about 2% of GDP. Of course we all know about recent US experience.

Now, Canada does not seem to be consistent with any of the narrative threads I am familiar with in the United States. If the Tea Party people were correct, a country with generous social insurance, including government-provided health care, should not be doing well, and certainly should not be capable of being fiscally responsible. If the Krugmaniacs were correct, Canada should not be bouncing back from the recession with such a low unemployment rate without a much more heavy dose of Keynesian stabilization policy.

The experience of Canada and the US demonstrates how government matters. When a financial system gets off on the right foot initially, as Canada's did,, when the government regulates its financial system appropriately, and when the government is fiscally responsible, things go well. When those things don't happen, look out. Financial crises and generally bad economic conditions not only lead to hardship which is much more severe for some than for others, but also give us potential calamities in economic policymaking. Central banks and fiscal authorities panic, lunatic fringe movements gain traction, and economists seeking the vindication of their own ideas run around attacking each other.

Friday, July 2, 2010

The Employment Picture

The employment report for June might make one somewhat pessimistic about growth in aggregate economic activity. Certainly some of the private sector economists surveyed here think so. The establishment survey showed a decline in seasonally adjusted employment (see the chart), and the household survey also showed a second monthly decline, seasonally adjusted (see the second chart). As usual, we have to be cautious about reading too much into one-month changes in time series that include a lot of measurement error. However, there appears to be accumulating evidence that things are not going so well.

But let's not be too hasty. Following the same approach as for last month's employment report, I looked at the 12-month growth rates in unadjusted establishment employment (see the third chart).Now this looks more innocuous. Employment growth is still negative (just barely) year-over-year, but it is coming back strongly, and faster than was the case during the last recession.

Conclusion: How you filter the data matters a lot. There is no reason you should trust my year-over-year filter more than what the BLS uses (X11, X12, or some variant) to do seasonal adjustment, but at least the year-over-year filter is simple enough for a simpleton like me to understand exactly what it is doing. The more I think about seasonal adjustment, the less I trust it, particularly at times like this when all the unusual shocks hitting the economy are likely to confuse X11 (X12, or whatever). The reason we use seasonal adjustment is so that we can conveniently eyeball time series. If we could train ourselves to eyeball the unadjusted series, that would be great. I actually tried with the unadjusted employment series and just gave myself a headache. Maybe Jeff Miron can do this, but I can't.