Tuesday, November 22, 2011

The FOMC Narrowly Dodges Some Bad Policies: FOMC Minutes, November 1-2

The minutes from the last FOMC meeting are interesting. There was a long discussion of proposals to change Fed policymaking in some fundamental ways. The proposals were:

1. Explicit Inflation Targeting Inflation targeting is standard policy at a number of serious central banks in the world. Why not do it here?
Many participants pointed to the merits of specifying an explicit longer-run inflation goal, but it was noted that such a step could be misperceived as placing greater weight on price stability than on maximum employment; consequently, some suggested that a numerical inflation goal would need to be set forth within a context that clearly underscored the Committee's commitment to fostering both parts of its dual mandate.
I think the people making this argument are less concerned with satisfying the constraints on monetary policy set by Congress, than with using the dual mandate as an excuse to pursue active Keynesian stabilization policy. If the Fed wanted to, it could set explicit inflation targets, and argue convincingly that this kills two birds with one stone. A stable inflation rate also "promotes maximum employment." Indeed, there are even versions of New Keynesian models that can produce that result.

2. Conditional Commitment This part of the discussion seems odd. It starts with this:
As noted in the staff briefing, economic theory and model simulations suggested that a policy strategy involving such commitments could foster better macroeconomic outcomes than a discretionary approach of reoptimizing policy at every meeting, so long as the public understood the central bank's strategy and believed that policymakers would follow through on those commitments.
Note here that the notion is that the change under consideration - making conditional commitments about future policy - involves commitment vs. discretion. Later in the discussion, people are much more explicit about what they mean by conditional commitment:
In this vein, a number of participants expressed support for the possibility of clarifying the conditionality of the Committee's forward guidance about the trajectory of the federal funds rate through setting numerical thresholds for unemployment and inflation that would warrant exceptionally low levels for the policy rate.
The key point here is that, in fact, the proposal involves abandoning commitment. The current commitment involves "reoptimizing policy at each meeting," which is taking into account all the unforeseen circumstances that occurred since the last FOMC meeting. Conditional commitment is bad commitment, as we cannot commit conditionally to a policy response to an event that is not foreseen. Such events can in practice swamp everything else. Committing to a policy of reoptimizing at each meeting is in fact good commitment.

3. Nominal GDP/Price Level Targeting Here's the discussion:
The staff presented model simulations that suggested that nominal GDP targeting could, in principle, be helpful in promoting a stronger economic recovery in a context of longer-run price stability. Other simulations suggested that the single-minded pursuit of a price-level target would not be very effective in fostering maximum sustainable employment; it was noted, however, that price-level targeting where the central bank maintained flexibility to stabilize economic activity over the short term could generate economic outcomes that would be more consistent with the dual mandate.
The key question is what model the staff was using. Most likely it was the FRB US Model. If so, this is bogus. As members of the public, we cannot look at this model, but you can find bits and pieces of it in Fed publications. While there are words in those publications that might make you think this model might have some connection to any macroeconomics done post-1970, I don't think so. Best guess is that the FRB US model looks like the typical expanded IS-LM macroeconometric models developed pre-1970. If so, we can't take it seriously. Who cares if NGDP targeting "works" and price-level targeting does not, in that context? Get serious. See my post on NGDP targeting.

In any case, the FOMC decided not to take action on any of these proposals for now. There are some bad ideas floating around though, so beware.

Dan Hammermesh

Did Hammermesh suffer a trauma at the hands of some macroeconomist? Did Ed Prescott make fun of him? What do you think explains this? The relevant passage is this one:
Interviwer: Here is one of the questions I wanted to ask you, with regards to Heilbroner’s book. With the economics profession, in the aftermath of the financial crisis, being somewhat in disrepute…

Hammermesh: Stop! Stop, stop, stop. The economics profession is not in disrepute. Macroeconomics is in disrepute. The micro stuff that people like myself and most of us do has contributed tremendously and continues to contribute. Our thoughts have had enormous influence. It just happens that macroeconomics, firstly, has been done terribly and, secondly, in terms of academic macroeconomics, these guys are absolutely useless, most of them. Ask your brother-in-law. I’m sure he thinks, as do 90% of us, that most of what the macro guys do in academia is just worthless rubbish. Worthless, useless, uninteresting rubbish, catering to a very few people in their own little cliques.

Interviewer: I’m not sure most people in the outside world would make a distinction between macro and microeconomists.

Hammermesh: I know. It’s up to us to educate them. I got this line from a friend in architecture the other day. He said exactly the same thing. I went through the same litany, trying to disabuse him of this notion. It’s like pushing a stone up a giant hill. It’s not going to get me very far, I agree. But nonetheless it is the case that most of us, and most of what we do, remains tremendously useful, tremendously relevant, and also fun!

Interviewer: The point I was going to make is that with the public perception of economics being on the negative side right now, and the limitations of economics being highlighted in the media, this book, The Worldly Philosophers, is just fantastic at showing what an amazing thing economics was, what amazing insights it brought to bear on the world. People just hadn’t thought about things in that way before.

Hammermesh: I agree, and a lot of the insights are still very much valid. Nonetheless, all the people in the book have been defunct for at least 60 years now. There have been some great economists since then, in the last 30 to 40 years. For example, George Akerlof, with his notion of asymmetric information and the failure of markets. It’s a truly brilliant idea and it’s ubiquitous in our lives. There’s Gary Becker, who in my view is the top economist of the last 50 years. His notions of family bargaining and how families behave are terribly important, and affect how, in the end, we all think. These guys who Heilbroner is talking about and the other ones of the last 50 years – none of whom is a macro person, by the way – have had equal influence. It goes on. It just is no longer stuff that is relevant to the macroeconomy. Unfortunately that’s a very important area and we have been derelict on it.

Interviewer: What’s the solution, do you think?

Hammermesh:* I do believe in markets. People are interested in being useful in this profession. It doesn’t mean the people who were the bad guys from the last 20 years in macro are going to be doing anything different. They’re incapable of doing anything different! But markets do work and the dead and useless get shoved aside by the young and useful. I’m a tremendous optimist. I do believe markets work and that people run to fill niches. There’s an obvious niche here, and you’re already starting to see it being filled. I’m sure the journals in academe are going to reflect this change too.
The interviewer actually has got the picture here, when she says: "I’m not sure most people in the outside world would make a distinction between macro and microeconomists." Indeed, that was what the post-1970 revolution in macroeconomics was all about. The early revolutionaries - Lucas, Sargent, Wallace, Prescott, for example - had and have a tremendous amount of respect for the advances made in microeconomics. They, their students, their students' students, etc., used those advances to move the science of macroeconomics forward. It seems extremely odd that Hammermesh does not embrace modern macro. Maybe he doesn't know what it is? I'm sure Ed Prescott's views of Becker's work, and of Akerlof's early contribution to information economics are not that different from Hammermesh's. Hammermesh should read my defense of contempoary economics.

There is actually nothing new about Hammermesh's views of modern macro, which predate the financial crisis. Just ask some of those excellent macroeconomists who no longer work at UT Austin. One of the amusing aspects of this is that Hammermesh is the author of "Professional Etiquette for the Mature Economist." How do you put these two sentences in the context of maturity and etiquette?
I’m sure he thinks, as do 90% of us, that most of what the macro guys do in academia is just worthless rubbish. Worthless, useless, uninteresting rubbish, catering to a very few people in their own little cliques.

*This appears to have been edited from a previously-posted version, where Hammermesh's answer to the question read:
I do believe in markets. We had some useless macro guys here who just left, thank God, and we’re now looking for replacements. I do think the failure of these people is conditioning how we search for a replacement. I’m quite sure the journals in academe are going to reflect this too. People are interested in being useful in this profession. It doesn’t mean the people who were the bad guys from the last 20 years in macro are going to be doing anything different. They’re incapable of doing anything different! But markets do work and the dead and useless get shoved aside by the young and useful. I’m a tremendous optimist. I do believe markets work and that people run to fill niches. There’s an obvious niche here, and you’re already starting to see it being filled.
Notice what got deleted.

Sunday, November 20, 2011

The ECB and Last-Resort Lending

There is a lot of talk recently about the possibility that the European Central Bank (ECB) could act as a "lender of last resort" to mitigate the European sovereign debt crisis. The Germans are against it, and the southern Europeans (who might stand to gain from such as policy) are for it. France may be sympathetic.

What is a lender of last resort? A key role for a central bank of course, is in acting as a lender-of-last-resort to the private banking system. The conventional view of banking is that the key function of banks - transforming illiquid assets into liquid liabilities - leaves an individual bank open to runs. According to the standard logic an otherwise sound bank could fail due to an illiquidity problem. Depositors run to the bank to withdraw their deposits under the assumption that everyone else will do so. The bank is unable to sell its assets at their "full value" so as to satisfy withdrawal demand, and it fails. However, a central bank willing to accept the bank's assets as collateral can lend to the bank, allowing deposits to be converted into currency, and this can quell the panic. In a full-blown systemic financial panic, the central bank can extend this credit to the entire banking system.

The key problems for a central bank are in determining what will qualify as eligible collateral for a central bank loan, what the haircut might be on such collateral, and at what rate the central bank should lend. Moral hazard comes into play, and central banks are leery of extending the lives of banks which are actually insolvent and not simply illiquid.

The Diamond-Dybvig model is thought by some to justify a lender-of-last-resort role for a central bank, but that is incorrect. The original model, and its extensions, does not incorporate anything that resembles central banking - indeed the basic model is not monetary (Diamond Dybvig also has no role for deposit insurance, but that's another story). Some things though, such as the the liquidity transformation role of banks and moral hazard problems in banking, I think are well understood.

In general, there are not many complaints about the Fed's lender-of-last-resort role in the financial crisis. Though the Fed may have been overzealous in lending in unconventional ways to unconventional borrowers, mainstream opinion seems to be that the Fed's lending during the crisis was necessary.

But are demands that the ECB play a "lender of last resort" role in Europe simply requests for the central bank to perform its conventional role? The argument seems to be that Italy and Spain, for example, because they are not running primary deficits, are like the bank that is suffering from an illiquidity problem, and not like the bank that is actually insolvent. According to this argument, bondholders are "running" on Italy in the sense that they are demanding very high interest rates. In this sense, an Italian default could be self-fulfilling, just as failure could be self-fulfilling if there is a run on a bank. Then, according to the argument, it makes sense for the ECB to step in and buy Italian government debt - or the debt of any other European government subject to this "liquidity" problem.

But hold on here. In the case of conventional central bank lending, for example as one might envision in response to a pre-Federal Reserve or Great-Depression-era banking panic, the central bank is replacing the liquidity that the public has lost confidence in - bank deposits - with liquidity that it views as roughly equivalent - currency. Is that the case if the ECB buys debt issued by European governments? Well, maybe so. Deposits at the ECB are not quite the same as the safe government debt which the bondholders want, as central bank deposits are not as widely traded as government debt (not all financial market participants can hold an account with the ECB). But, anyone can hold a deposit with a bank in the EU, and banks in the EU hold reserve accounts at the ECB, so this does not seem to be a problem. Thus, it seems the ECB can indeed convert "illiquid" government debt into liquid central bank liabilities.

But to actually quell the panic, the ECB must be able to lower the bond yields on the debt it is purchasing. Is this actually possible? Let's take a look at the current ECB balance sheet. The size of the balance sheet is about 2.3 trillion Euros, as compared to about 1.5 trillion Euros in January 2008. Thus, the expansion in the ECB balance sheet is nothing like the tripling that occurred in the United States, but there are features that are qualitatively similar. For example, there has been an expansion in the debt obligations of ECB member countries held by the ECB(much like QE2, though a smaller intervention) and the ECB currently holds reserves in excess of requirements. On its most recent statement, the quantities apparently in excess of reserve requirements are 144 billion Euros in the deposit facility and 183 billion Euros in term deposits.

These quantities of excess reserves are not as large as in the United States, but I think you can see the effects of these reserves on interest rates in the European overnight market. Recent data shows the overnight rate near the bottom of the interest rate "channel," with the lower bound determined by the interest rate on the ECB's deposit facility, currently at 0.5%. Note, for example in early 2008, that the overnight rate would typically be close to the middle of the band.

Thus, my working hypothesis is that, given a sufficiently large stock of excess reserves in the EU, the interest rate on ECB deposits is determining the overnight rate in Eurpope, much as the interest rate on reserves in the United States is determining short-term interest rates here. Just as in the US then, purchases of government securities by the ECB do not matter, at the margin. The ECB can buy government debt, but in spite of the fact that the debt they are buying may be risky and the liabilities they are issuing may be much less so, the ECB has no advantage over the private sector in intermediating Italian debt, for example. Buying Italian debt will not change the path for prices, and cannot change the prospects for a default on Italian debt.

If the ECB were to lower the interest rate on its deposits, this would indeed raise the price level and allow all EU members to implicitly default on a piece of their debt outstanding. Some EU members obviously want this. Others, like Germany, understand that the reason they can borrow at low rates is because the ECB made a commitment in its charter to price stability.

In any event, just as quantitative easing is currently not a solution to anything in the United States, "lender-of-last-resort" lending by the ECB will do nothing for Europeans.

Thursday, November 10, 2011

Mankiw Protest

This story is last week's news, but I thought it was interesting. A group of students in Mankiw's introductory economics class walked out on him, and posted this statement in the Harvard Political Review. Here's a story in the Harvard Crimson, and this is an interview with Mankiw on NPR.

Basically, the students are accusing Mankiw of bias. They seem to think that he might be making stuff up, there's too much Adam Smith and not enough Keynes in his course, and they're worried about the "corporatization of higher education." I think of Mankiw's intermediate macro text, for example, as pretty middle-of-the-road, and very heavy on Keynes for my taste. Obviously these students are very confused and, I think, biased. My guess is that, if I showed up to teach Mankiw's class with my non-Ivy League ways, told them I was a Democrat, and taught out of Mankiw's book, that they would not be complaining about me.

What these students don't get is that taking Mankiw's class will actually give them the knowledge they need to be more effective political leaders, in a movement that looks quite ineffective and rudderless. A good dose of serious economics can help them isolate the defects in economic policies, and can show them how they can help poor people in effective ways. Knowledge is power, as I like to tell Ron Paul's supporters, who are equally confused.

Tuesday, November 1, 2011

Keynesian Economics

I'm trying something a little different here. Think of this as a response to one of the commenters on my last post. This is a very preliminary version of a paper I'm writing. This is my attempt to understand Keynesian economics. The departure point is this post.

I essentially took Farmer's idea, simplified it so that I could understand what he is doing, and then expanded on it, in part by incorporating monetary exchange. I have some ideas about what it all means, but have not quite settled on how I want to write it or what else I might want to include.

This is what I think is the basic Keynesian idea, with no funny business involved. There's suboptimality, and fiscal and monetary policy can correct it. Then you have to ask whether you buy the story or not. Let me know what you think.