Stephen Williamson: New Monetarist Economics

The Artist Replies

2012-01-29T16:32:00.000-08:00

In his post complaining about John Cochrane, Brad DeLong says

The problem is that there are a lot of influential bullshit artists out there. Cochrane is at least willing to try to engage. Lucas, Fama, Prescott, Posner, etc., etc. are not even willing to do that.

Seems to indicate some desire to engage with people on discussions concerning serious economic questions of the time, right? Wrong. In response to my appeal for engagement (combined, you might add, with some mild admonishment), DeLong responds with this old news, from 17 months ago. So much for that. This is my family's favorite joke, actually. Second-stupidest man alive. Always gets a good belly laugh around the dinner table.

Speaking of jokes. It's a little late for college admission essay-writing, but here's an essay assignment. Suppose your plane crashes in the mountains. You're trapped in the snow and have been waiting months for help. You have eaten all the food, and have long since abandoned the taboo on cannibalism. Brad DeLong and Newt Gingrich are on the plane, and both alive and well. Which one do you eat first? 200 words or less.*

Addendum: Seriously, though. Krugman in particular wants to propagate the view that what he calls "freshwater macroeconomics" (which has actually ceased to exist, but whatever) is hermetically sealed and unwilling to engage. DeLong seems to feel the same way. Thoma fancies himself to be an open-minded individual, but goes along. Why am I singling those three out? They seem to lead the Old Keynesian blogosphere. If you are an economist and interested in blogging, in a way that might be controversial from the point of view of those three people, don't think they want to engage. They do not. Their interest is in reverse-engineering policy recommendations, not in thinking seriously about new ideas. Their arguments consist of calling people stupid and/or making out that their opponents are somehow morally reprehensible. They are engaged in political journalism, not economic discussion.

*Let me explain further, in case you don't get it. The whole situation is totally disgusting, in many ways, just like this blog exchange. But you're faced with a quandary, and have to weigh the costs and benefits. There are the costs and benefits to society. There are personal costs involved. You're going to have to sit in the snow for a long time with the one who lives, and they are both REALLY hard to be around.

Brad DeLong: B.S. Artist

2012-01-29T09:22:00.000-08:00

Old Keynesians with blogs seem to have an unhealthy obsession with John Cochrane. Maybe it's his boyish charm. Who knows?

At the head Mark Thoma's daily list of writings-that-Mark-agrees-with is this post by Brad DeLong.

DeLong makes two points:

1. He seems to think that John has changed his mind about "stimulus spending," and quotes from Cochrane's blog post to try to make the point. If you actually read Cochrane's blog post I don't think you will come away with the same impression. I certainly did not. Here's a section:

The "stimulus" proposition is that additional spending -- whether needed or not -- raises output and general welfare. Pay people $1 to dig ditches and fill them up again, and the whole economy gains $1.5. Yes, endorsed by Krugman because it "feels like a job" (his back must not hurt like mine does) and by DeLong: "anything that boosts the government's deficit over the next two years passes the benefit-cost test--anything at all."

The "targeted," "infrastructure," and the whole worthy apparatus to monitor the wisdom of "stimulus" spending (see John Taylor) is, in the Keynesian model, beside the point, or at best a smokescreen to befuddle the ignorant masses. It would in fact be better if the money were stolen. Thieves have high marginal propensity to consume, and they can get that "spending" out fast in an economy with few "shovel-ready" projects.

Stimulus is a remarkable proposition, because micro fallacies morph into macro wisdom. We all lambaste mayors who tax small businesses (or borrow against future taxes) to build showpiece "jobs" projects. This way lies Buffalo. Yet for the economy as a whole, stimulus says, it's true. The hurricane should have been bigger, so the government would have spent more money to rebuild. Many stimulus advocates point to WWII spending. Think about what that means: all those tanks, ships, and airplanes on the ocean floor were not a terrible economic sacrifice we paid to win a desperate war. Every ship the Germans sunk let the government buy another ship, and gain a ship and a half worth of GDP in the process!

Hardly a pro-stimulus guy, I think.

2. DeLong seems to think that John's statements on public policy somehow ruined the 2008 stimulus package:

Perhaps Cochrane misled Michael McKee and Oliver Staley because he had simply not done his homework--had not thought the issues through at an Econ 1 level. Perhaps he was playing for Team Republican and knowingly telling them lies when they called him up and asked him about Jim Tobin.

I really don't care which.

What I do know is that his intervention made Christina Romer and Larry Summers and company's technocratic job more difficult at a crucial moment.

Well boo-hoo. The key problem with the stimulus was that, in fact, it was driven by Econ 1 thinking. That's the way that Brad DeLong and Christina Romer think. At best they are doing IS-LM, but mostly this is Keynesian Cross. There are plenty of good reasons why that just does not cut it. We can do a lot better. Any student educated in a top PhD economics program today has much better tools to address the question of what the fiscal authority should do in a recession. Cochrane is not perfect, but he's thinking about the right things.

Here's my recent thinking about the general issues at stake. I'm pretty much in agreement with Jim Bullard, though we may differ on some of the monetary policy issues. Bullard argues, basically, that Friedman and Mankiw were right. Fiscal policy is mainly about the long run. We should decide how large the government should be and what it should do, and there should be essentially no discretionary countercyclical fiscal actions. That doesn't say that we can't have appropriate social insurance - what some people would call "automatic stabilizers," such as unemployment insurance - that imply greater transfers, for example, in a recession than in a boom. Or, as Cochrane points out, there may be sound reasons - tax-smoothing for example - that imply that we should run a deficit during a recession and a surplus in a boom.

Finally, DeLong finishes with this gem:

The problem is that there are a lot of influential bullshit artists out there. Cochrane is at least willing to try to engage. Lucas, Fama, Prescott, Posner, etc., etc. are not even willing to do that.

I'm wondering who those "influential bullshit artists" are. Honestly, I have no idea what he is talking about. I'm also wondering why he's picking on Lucas, Fama, Prescott, and Posner. Those people are all septuagenarians. Personally, I'm quite happy that Lucas and Prescott are still engaged in what they do well. They regularly talk about economics in public, and participate in academic conferences. They are both a pleasure to talk to - I learn something from Bob and Ed whenever I see them. What more do we want from those guys? We want them to write blogs? What for? Fama and Posner are not even macroeconomists. Who gives a crap what they think of the stimulus package?

Well, Brad. I'm here and willing to engage. What's on your mind?

Lacker Dissent

2012-01-28T07:59:00.000-08:00

Jeffrey Lacker explains his dissent on the recent FOMC decision in this press release. He says:

"I dissented because I do not believe economic conditions are likely to warrant an exceptionally low federal funds rate for so long. I expect that as economic expansion continues, even if only at a moderate pace, the federal funds rate will need to rise in order to prevent the emergence of inflationary pressures. This increase in interest rates is likely to be necessary before late 2014.

"In addition, the Summary of Economic Projections (SEP) now contains detailed information on the forecasts of Federal Reserve governors and Reserve Bank presidents for the evolution of economic conditions and the federal funds rate under appropriate policy. My dissent also reflected the view that statements about the future path of interest rates are inherently forecasts and are therefore better addressed in the SEP than in the Committee's policy statement.

His reasoning, which I agree with, is that the Fed is going to get itself in trouble by making the commitment that it did, and that any useful foreward guidance we might get from the policy statement is already in the SEP, without the bad commitment.

Optimal Inflation

2012-01-27T12:45:00.000-08:00

Paul Krugman takes issue with the Fed's now more-or-less-explicit long-run inflation target of 2%. He thinks it should be 4% or 5%.

Here's the offending part of his blog post:

But why is the inflation target only 2 percent?

Actually, I understand why; the inflation hawks are still a powerful force that must be appeased. But the truth is that recent experience has made an overwhelming case for the proposition that the 2 percent or so implicit target prior to the Great Recession was too low, that 4 or 5 percent would be much better. Even the chief economist at the IMF says so. (OK, in real life it’s Olivier Blanchard, who is a very smart and also flexible-minded macroeconomist who just happens to be at the IMF for now — and I’m glad that he is!)

Comments:

1. The "inflation hawks" are NOT a powerful force on the FOMC. The Committee just voted, with one dissenting vote, to keep the target for the fed funds rate in the range 0-0.25% until the end of 2014. That's hardly a hawkish policy, and the Fed has already engaged in some massive and unprecedented quantitative easing, that is far from hawkish and conservative. Indeed, it is quite risky, and favored by the majority of FOMC members, who are basically old and new Keynesians, if they know any economics at all. Actually, the moniker I would prefer to apply to the "inflation hawks" is "serious economists" (for the most part - Fisher is not an economist).

2. The Blanchard paper that Krugman is referring to is this one. Here is what it says about the central bank's inflation target:

The crisis has shown that large adverse shocks can and do happen. In this crisis, they came from the financial sector, but they could come from elsewhere in the future—the effects of a pandemic on tourism and trade or the effects of a major terrorist attack on a large economic center. Should policymakers therefore aim for a higher target inflation rate in normal times,
in order to increase the room for monetary policy to react to such shocks? To be concrete, are the net costs of inflation much higher at, say, 4 percent than at 2 percent, the current target range? Is it more difficult to anchor expectations at 4 percent than at 2 percent?

The paper goes on to discuss the costs of the inflation, in more-or-less standard textbook terms. There's nothing new there. So, did Krugman actually read the paper or not? It doesn't really matter. The key point is that Blanchard is not recommending anything, he's just asking a question. There's no report on any research to answer the question; this is just Blanchard musing with his staff about how recent history might change how we think about monetary policy. Thus, Krugman's statement that "Even the chief economist at the IMF says so," is false.

But what of Krugman's argument? Krugman says (repeating the above):

But the truth is that recent experience has made an overwhelming case for the proposition that the 2 percent or so implicit target prior to the Great Recession was too low, that 4 or 5 percent would be much better.

He certainly seems convinced; "truth" and "overwhelming" are strong words. It's hard to see why, though, and he doesn't tell us. If you read Blanchard's paper, and look for the reasoning, you might see what Krugman has in mind. The basic idea is that a higher inflation rate gives the central bank more room to move. By Fisherian logic, if the real interest rate is constant in the long run, and the long-run Fisher effect holds, the long-run nominal interest rate will rise one-for-one with the long-run inflation rate. Having more room to move means that, if you subscribe to New Keynesian logic, then if the long-run inflation rate is 4% rather than 2%, on average you have an extra 2% by which you can lower the central bank's nominal interest rate target so as to correct sticky price distortions. There are at least 3 problems with this:

1. This presumes that the long-run costs of inflation are negligible, but to me this looks like an argument for wearing a sweater in July. You can always take it off if you want to cool down. I have written more on the costs of inflation here. Potentially the long-run costs of inflation are much larger than conventionally measured. Anyone who lived through the 1970s or, even better, comes from a country with a serious inflationary history, understands that inflation is bad.

2. If the key macroeconomic inefficiencies we are faced with are the relative price distortions coming from sticky prices, those inefficiencies might more appropriately be corrected with fiscal policy than monetary policy. Krugman seems to be thinking that the zero lower bound is a big problem, but the zero lower bound need not bind.

3. Blanchard, like Krugman, seems to fear the zero lower bound because bad stuff can happen there. Well, we have been in our modern-day liquidity trap for more than three years now, and apparently we have not yet been sucked into the deflationary vortex with ever-increasing output gaps that these characters seem to be concerned with.

The FOMC Sticks Out Its Neck - Again

2012-01-25T17:34:00.000-08:00

The FOMC meeting that took place over the last two days was an important one. The first big piece of news is in the FOMC statement in this paragraph:

To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy. In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.

The previous statment from December read as follows:

The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.

So, policy is now to be more accommodative. Presumably something changed. Somehow the state of the world must look worse in some unexpected way on dimensions the Fed cares about. What could it be? In the first paragraph of the current statement, we learn that the recovery is proceeding, perhaps more slowly than might have been anticipated a year or two ago, but maybe a little more quickly than was expected at the last FOMC meeting. Inflation has decreased slightly, but the Fed had expected that, and the inflation rate is increasing in terms of core measures. So why the policy change? Why indeed?

This is a very risky policy move. By the end of 2014, the interest rate on reserves (IROR) will have been at 0.25% for more than six years. The Fed has never made such a commitment before, and they have no clue what will happen as a result. Here is what could happen. Months from now, a year from now, or whatever, banks may get the idea that bank reserves are a less attractive asset to hold. That would be triggered by better relative returns on alternative assets, which in turn could simply be the result of an ultimately-self-fulfilling higher inflation rate. Banks will start to abandon reserves and prices will rise. What should the Fed do under those circumstances? It should increase the interest rate on reserves to curb the inflation. But it committed today not do that. Everyone understands this, and that's what will get the inflation going. Once higher inflation really becomes entrenched, it's hard to get rid of. How do we get rid of it? Well, we know all about that, as some of us had to live through it in the early 1980s. Time for another recession.

This is a replay of the August 2011 decision, except worse. Recall that Fisher, Kocherlakota, and Plosser were opposed on that round, and note that Lacker dissented this time around. Kocherlakota's argument for dissenting last August was that the policy change was inconsistent with the FOMC's previous behavior, and the same argument applies here. Best guess is that Fisher, Kocherlakota, Plosser, Lacker, and perhaps others, are opposed this time around. That would be a serious disagreement, with some astute economists on the nay side.

The FOMC also released a statement that is supposed to clarify how it thinks about policy. This is notable in at least two respects. First, the FOMC is expanding the dual mandate:

The FOMC is firmly committed to fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates.

"Maximum employment" crept into the FOMC's language in recent times, but now they are entering into new territory by taking ownership over long-term interest rates. Here, the first law of central banking comes into play: Don't take responsibility for something you cannot control. A central bank controls an overnight interest rate, and any interest rate - like the interest rate on reserves - that it sets administratively. Sometimes, like now, that amounts to the same thing. Though in pre-Accord times the Fed could successfully peg long-term bond rates, it would be incorrect to say that this can be done under typical conditions. Indeed, under current conditions, though the Fed seems to think that its quantitative easing (QE) operations can move long bond rates, it is fooling itself.

The second piece of important information in this latter statement is:

The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate.

So now we have an explicit statement that the Fed's inflation target is 2%, as measured by the rate of change in the pce deflator (raw). That's not an explicit inflation target, as they make it clear that the dual mandate applies - they will tolerate more inflation if employment is lower than "maximum employment," whatever that is, and vice-versa.

The Fed is now also releasing more information on its forecasts, available here. These seem pretty optimistic on the inflation front. FOMC participants are not only forecasting close-to-zero short-term nominal interest rates for years in the future, they are also forecasting inflation rates well below 2% for three years and more into the future. I would love to see the models (and the add factors) that produce those forecasts.

Here's what we see in the data. The chart shows the pce deflator, the Fed's preferred price level measure, going back to January 2005, as compared to a 2% trend beginning at the same time. In level terms, we are now on the high side by about 2%. You have to be creative about the base period to find a case where the actual pce deflator is below the 2% growth path. Thus, it's hard to say that inflation is too low relative to its 2% target path. Given recent history, and the projection for monetary policy the Fed is going on, how could anyone be predicting inflation rates as low as 1.5% over the next several years? You tell me.

Here is another piece of information that will either make you laugh or cry. The release of information about the Fed's forecast was supposed to give us some inside information on what the Fed is thinking so that we can feel more secure. In Figure 2 of the forecast summary, we see when the FOMC participants predict "policy firming." Six participants seem more-or-less sensible, and are predicting firming in 2012 or 2013. But there are another six who are not predicting firming until 2015 or 2016. Now I'm not feeling more secure. I want to panic, because those people seem to be incompetent.

Economics is an Open Science

2012-01-18T17:48:00.000-08:00

Here's an article in the NYT which tracks a trend in the natural sciences and medicine (mainly) toward more open evaluation and discussion of scientific contributions. As Paul Krugman points out, economics has always been an open science, at least within the professional lifespans of people as old as Krugman and me. Even prior to rapid electronic communication, economic research was widely-circulated in working papers and at conferences and seminars prior to publication. The results were hashed over, reworked, and amended, with the ultimate published articles typically acknowledging the contributions of many other scholars on the road to completion. Publication was, and is, essentially a grade given to the work, i.e. a publication in the American Economic Review, Journal of Political Economy, or Econometrica, is A+, and you work down from there. Email communication and the internet served only to speed up the process and make work even more widely distributed. No more waiting for the Minneapolis Fed working papers in the mail.

As the NYT article tells you, things are not like that in the natural sciences or in medicine, for example, often because there are potentially large monetary gains and losses riding on the results. Natural scientists think that it is quite odd for anyone to be talking in public about their research results before they are published. Economic research can have very large implications for human welfare, but the path from a given research result to its effect on the public is typically so indirect and diffused, and the benefits so large to an economic researcher from claiming credit early for a given result, that no one is going to hide their work until it is published.

According to the NYT article, some scientists are complaining that the whole process of peer review and publication is "hidebound, expensive, and elitist." Do we have any of those problems in economics? I think "expensive" certainly applies, and the culprits in economics are the same ones as in the natural sciences. The NYT article states:

The largest journal publisher, Elsevier, whose products include The Lancet, Cell and the subscription-based online archive ScienceDirect, has drawn considerable criticism from open-access advocates and librarians, who are especially incensed by its support for the Research Works Act, introduced in Congress last month, which seeks to protect publishers’ rights by effectively restricting access to research papers and data.

Elsevier in fact owns many economics journals, and is well-known for extracting rents from libraries and subscribers. In the old print days, a publisher could provide useful services. Typesetting, printing, binding, and distributing print journals was a specialized task subject to increasing returns. Do publishers provide any value-added in 2011? Absolutely not. But as the article points out, publishers like Elsevier would like to pass laws like the Research Works Act that will allow them to continue to collect rents and impede the dissemination of scientific knowledge.

So, the expense of publication is a problem in economics. But is scholarly publication in economics "hidebound and elitist?" Krugman thinks so:

I have a somewhat jaundiced view of how the whole refereeing/publication system has ever worked; all too often, it seems to act as a way for entrenched doctrines to blockade new ideas, or at least to keep people with new ideas from getting tenure at a good school.

I'm going to disagree with Krugman here - not for the first time, of course. Editors, referees, and the economics profession can make mistakes. Sometimes it takes a while for us to catch on to a new idea and recognize what is important about it. Here's a good example. Expectations and the Neutrality of Money was rejected for publication by top journals (the American Economic Review, at least, as I remember the story), and published in the Journal of Economic Theory, at that time a relatively new journal with essentially no reputation. That article now has more than 3000 citations on Google scholar, was part of what Robert Lucas received a Nobel Prize in Economics for, and changed the methodology of macroeconomics in a rather dramatic way. The east coast economics establishment hated Lucas's paper (as Krugman still does) but that didn't stop the ultimate recognition of the work. For every inbred group of scholars eager to keep outsiders out, there are 5 journal editors who would be more than happy to publish new and pathbreaking work.

What about the blogosphere? Do blogs contribute to economic science? They certainly could, but most blogging on economics, including mine, is journalism. I'm very pleased that I don't have to acquire space in the Washington Post, the Wall Street Journal, or the New York Times to speak my mind, but I don't think that what I do here is serious science. Serious economic science is what is published in the top economics journals.

Fed Salaries

2012-01-18T09:26:00.000-08:00

This New York Times article is interesting. The author argues that the Fed now looks like a hedge fund, but Fed officials are not paid like hedge fund managers, and it goes from there.

This part is not quite on track:

The main difference between a hedge fund and the Fed is that the Fed effectively creates its own money, so it doesn’t have any borrowing costs, meaning yet more profits.

This is effectively the "creating money out of thin air" argument, which many people are confused about, including Sarah Palin. All financial entities create liabilities out of nothing, and buy assets. That is certainly not a distinguishing feature of the Fed. What makes the Fed different is its monopoly on a particular kind of circulating liability - currency. Otherwise, the Fed is a financial intermediary which issues liabilities - mainly currency and interest-bearing reserves - and holds assets. Why the author of the NYT article thinks the Fed looks like a hedge fund is that it intermediates across maturities, and much more so recently. The average duration of the assets in the Fed's portfolio has lengthened considerably since the financial crisis. Intermediating across maturities is considered risky, just as operating a hedge fund is risky. However, in the case of the Fed, the risk is borne by taxpayers. If short-term interest rates increase, then the Fed's profits fall, so the Fed has less to hand over to the Treasury, which has to make up the difference.

There are also some things in the NYT article about Fed salaries, which are certainly low relative to hedge fund salaries. Further, Fed salaries of top officials in the Fed can be lower than academic salaries. Ben Bernanke was probably earning more at Princeton than he is in Washington.

Here's a useful point:

Even so, people in private industry argue that you have to pay top dollar to get the best people and that the market demands it.

We even see this argument being made by the federal government. The regulator who oversees Fannie Mae and Freddie Mac, Edward J. DeMarco, has asserted that he had to pay the top six executives at Fannie and Freddie more than $35 million in combined pay over 2009 and 2010. He said that to do otherwise would be “irresponsible” because it would fail to retain and attract the appropriate people. Yet, the Fannie and Freddie executives are arguably doing even less sophisticated work than the Federal Reserve employees do.

Why these executives should be paid more than Mr. Bernanke and his colleagues defies reason. This is government work now.

Indeed.

We are the 1%

2012-01-18T09:20:00.000-08:00

From this New York Times blog post, if you are choosing among undergraduate majors and want to be in the top 1% of the income distribution, taking economics would be a good idea. Only the pre-med students did better in this respect.

Bullard's "Death of a Theory" Paper

2012-01-13T11:53:00.000-08:00

Jim Bullard has posted his "Death of a Theory" paper here. This is essentially a call for a return to pre-financial-crisis views of the relative efficacy of fiscal policy and monetary policy for stabilization. Before the financial crisis, even New Keynesians were primarily focused on monetary policy. Mike Woodford's "Interest and Prices," for example, is almost exclusively a handbook on monetary policy. The views of New Keynesians on fiscal policy seemed to have been more or less consistent with those of Milton Friedman. Fiscal policy matters, but fiscal policy is about the long run. The process of making fiscal policy decisions is awkward and time-consuming, and we know little enough about how the economy works that stabilization using fiscal policy is inappropriate.

Things have changed since the financial crisis, however. Governments have been putting fiscal policy to use for stabilization purposes, and New Keynesians have jumped on the bandwagon. Bullard's paper argues, in light of the evidence and the economics literature, that the pre-financial crisis view is entirely appropriate, i.e. fiscal policy should focus on the long run and leave the short run to the central bank. Bullard says:

In short, existing political processes are, generally speaking, far too cumbersome and contentious to enact effective and timely short-term actions in response to market events. They are ill-equipped to deliver the types of subtle tax and spending interventions that may actually be effective according to a careful reading of the available macroeconomic literature on the topic.

Here's part of what the content of the paper is about:

I will describe and comment on two strands of the macroeconomic literature in this area, one highly formalized and the other intuitive but rhetorically potent. The first is the heavily studied fiscal multiplier idea in the context of New Keynesian DSGE macroeconomics. The second is less studied and not formally articulated very often. It is that a substantial increase in deficit-financed government purchases sends a signal to the private sector that a high growth regime is possible and likely going forward. This could influence private sector expectations and lead to a virtuous equilibrium in which actual output and employment are high. Rhetorically, this seems to be what many advocates have in mind, even if this is not what happens inside most of the macroeconomic models used to analyze this issue.

This is interesting, as it highlights an aspect of policy recommendations coming from hardcore Keynesians - Krugman for example - that do not make clear what the underlying source of inefficiency in the economy is. From a Keynesian point of view, the inefficiency could be sticky wages and prices, on the one hand, or a coordination failure, on the other. What the policy response should be depends on the inefficiency, though not every Keynesian understands this. As Bullard states, the type of coordination failure that some Keynesians appear to have in mind - self-fulfilling beliefs about the future driven by fiscal policy - has not really been formally studied.

Alan Krueger Tries to Justify Income Redistribution

2012-01-12T18:23:00.000-08:00

Here's a speech from yesterday by Alan Krueger, on income distribution. It's clear this is an attempt to provide some economics to support the ideas in a previous Obama speech. Maybe we should not give Krueger a hard time about his speech, as he is just out there doing his job. However, I think honesty and good economics are important, so let's see what Kreuger has to say.

It is by now well-known that there has been an increase in the dispersion of income in the United States, beginning perhaps as early as 1970. Krueger discusses this, but he also wants to make the case that there is less mobility across the income distribution than there once was, and less mobility in the United States than in other countries. Kreuger cites as evidence some work by Miles Corak at the University of Ottawa. Corak's "Great Gatsby curve" which shows a positive correlation between income inequality and immobility across levels of income within a country. Of course, this only establishes a correlation that exists in the data. Kreuger is making a policy speech. What we really care about in this instance is the effects of particular policies. To evaluate those, we need a serious structural model on which we can run experiments to evaluate alternative policies and compare their effects on economic welfare.

Krueger tells us about some of the causes of the increase in income inequality in the United States. This is pretty standard, though he has a funny way of assembling the evidence:

In the mid-1990s, I did a poll of a nonrandom group of professional economists attending a conference at the New York Fed. I asked them the extent to which various factors contributed to the rise in inequality.

Hopefully everyone understands why it is a bad idea to take a poll among economists to get a serious answer to any question. If I want to understand why income inequality has increased in the United States, I will read the relevant peer-reviewed published research, sift the arguments, and then draw some conclusions. Fortunately, in this case Krueger actually came up with an answer that is consistent with the received research. If Krueger had asked the same group of people to each write down their estimate of the government spending multiplier, I can assure you that he would get nonsense.

As is well-known, there are three key factors driving the increase in income dispersion. These are technical change, the scarcity of skilled workers, and import competition. Krueger, for political reasons, wants to attribute some blame to the Bush (W) tax cuts, but I think it is well-recognized that the effect of the change in the income tax schedule in this instance is relatively minor. He also talks about union membership and the minimum wage.

Here's where he starts to go off the rails:

Now, I could see why someone could support tax cuts for top income earners if they had materially benefited the U.S. economy, but the macro evidence is clear that the economy did not perform better after last decade’s tax cuts than it did after taxes were increased on top earners in the early 1990s. I already showed you evidence that income growth was stronger for lower and middle income families in the 1990s than it was in the last 40 years overall. This next chart shows that there was more job growth in start-ups in the 1990s than in the 2001-2007 period [Figure 11]. Across all businesses, job growth was much weaker in the 2000s than in the 1990s. So there is little empirical support for the claim that reducing the progressivity of the tax code has spurred income growth, business formation or job growth.

It is well-known as a theoretical proposition that the income tax has negative incentive effects. The key question, though, is how large those effects are. For more on this see this previous post of mine, particularly the part on Diamond/Saez toward the end. I think one can make a case that the incentive effects are large, particularly in the long run. When Krueger points to the fact that the Bush tax cuts were followed by poor economic performance, we know that's not serious evidence, as there were too many other things going on over that period.

In the next part of his speech, Krueger wants to tell us about the harmful effects of inequality. This starts off OK, by appealing to our sense of fairness. Maybe this income inequality is denying people opportunities? We could be seriously misallocating resources if high ability poor people are not being educated while low ability rich people are going to Harvard. But Krueger comes up with some pretty strange ideas as well. The first strange idea he attributes to Raghuram Rajan, which is that high income inequality encourages "families to borrow beyond their means." I haven't read Rajan's book, but Krueger could be mischaracterizing Rajan's ideas. My understanding is that, rightly or wrongly, what Rajan is arguing is that government attempts to redistribute income, working in part through Fannie Mae and Freddie Mac, contributed to the financial crisis. Krueger makes Rajan sound more like Robert Frank, which involves a very different set of ideas.

The second strange idea, attributed to Robert Reich, is that the increase in income dispersion is bad because it reduces "aggregate demand," since high-income people save more than low-income individuals do. To buy this idea, you have to think that we collectively make the wrong consumption/savings decision, and that redistributing income from rich to poor will move us toward a better national allocation of income between consumption and savings. Imagine a world with two people. A has 5 banana trees and B has 20 banana trees. A spends all his working time picking bananas and eating them. B spends half of her working time picking bananas, and the other half of her time planting new banana trees and tending to them. Krueger thinks the world in which A and B live would be better if someone took bananas away from B and gave them to A. I have no idea why he thinks that.

So what policies does Krueger have in mind? The first is health care, which of course is already done, and scheduled to be fully-implemented by 2014. There is a clear redistributive aspect to the Affordable Care Act. Those who stand to benefit from it are the poor, and it will be paid for disproportionately (because of progressive taxation) by the rich. I know this is controversial, but I don't think it should be. The Act won't do anything much to deliver health care more efficiently in the United States, but I don't have a problem with it. I'm from Canada. A second thing he pushes has to do with the American Jobs Act, which again we know about already.

Krueger then gets into some controversial territory - the financial industry and taxation. First, Krueger says "we must adequately regulate excess risk-taking and corrupt practices in financial markets." No one would argue with that statement. Who wants too much risk-taking or corruption in financial markets? However, what does that mean? How do we know excessive risk-taking when we see it? What do we do about it? Financial firms are of course very good at hiding "corrupt practices." How do we root those practices out? How do we tell useful financial innovation from innovation that is there only to obfuscate and allow what is essentially theft? Some people want to put a tax on all financial transactions. But that seems too blunt a tool for correcting the actual problems.

Second, here's a tax proposal:

It also means that we can’t go back to tax policies that didn’t generate faster economic growth or jobs, but rather increased inequality. Instead of going backwards, we should adhere to principles like the Buffett Rule, which states that those making more than $1 million should not pay a lower share of their income in taxes than middle class families. We should also end unnecessary tax cuts for the wealthy, and return the estate tax to what it was in 2009.

We know what he means by "tax policies that didn't generate faster economic growth." He told us that those were the Bush tax cuts. It's not clear whether he wants to let the Bush tax cuts expire, or just have the top marginal rate revert to its pre-Bush era value. The difference matters, particularly for how this is sold politically.

It seems clear that Krueger knows the economics literature, as he should. The interpretation of some of the evidence is stretched, though.

Death of a Theory

2012-01-12T12:39:00.001-08:00

James Bullard, St. Louis Fed President, has posted some slides for a talk at last week's ASSA meetings in Chicago. This seems to be a preliminary snapshot of a paper he is supposed to release this week. The topic is the relative efficacy of fiscal and monetary policies in the current circumstances. I'll write more on this when the paper is released.

Taylor Rules and the Fed

2012-01-11T18:39:00.000-08:00

Greg Mankiw has a post on Taylor rule predictions and liquidity traps. Mankiw points out that, if you fit a Taylor rule to the data, that rule should soon give a prediction in positive territory. A common argument in the Fed system that has been used for a long time now (see for example this 2009 piece by Glenn Rudebusch) is that, since fitted Taylor rules predict a negative fed funds rate, the Fed should be taking some kind of unusual accommodative action, since of course the Fed is constrained by the zero lower bound on the fed funds rate.

Here's how John Williams, President of the San Francisco Fed, explains it:

We at the Fed have guidelines that allow us to set interest rate targets based on the levels of unemployment, inflation, and other economic indicators. So what do those guidelines tell us now? With inflation under control and unemployment so high, those guidelines tell us something most unusual: the federal funds rate should actually be in negative territory.

Of course, it’s not possible for the federal funds rate to go below zero, which is about where we’ve put it for the past three years. But that doesn’t mean that we are out of ammunition. We’ve created new ways to stimulate the economy. For example, we’ve purchased over one-and-a-half trillion dollars of longer-term securities issued by the U.S. government and mortgage agencies.

So, when our Taylor rule predicts a negative fed funds rate, apparently this tells us that quantitative easing (QE) is appropriate. Never mind that the model we are using (a New Keynesian model for Williams) does not tell us how QE works or how much of it we should be doing. Actually, no one has a serious model that can justify quantitative easing, though Williams wants to convince us that it's just Econ 101:

This policy works through the law of supply and demand. When we buy large quantities of securities, we increase demand for those securities. Higher demand equals lower interest rates. As the yields on longer-term Treasury securities come down, other longer-term interest rates also tend to fall. That reduces the cost of borrowing on everything from mortgages to corporate debt. Our securities purchases are an important reason why longer-term interest rates are at or near post-World War II lows.

It's simple! It's easy! It works!

What if we take the San Francisco Fed approach seriously. Mankiw's Taylor rule looks like this:

R = 8.5 + 1.4(i - u),

where R is the fed funds rate, i is the year-over-year inflation rate, and u is the unemployment rate, all in percentages. Of course the predicted value for R that we get given current data depends critically on the inflation measure that we use. Provided my arithmetic is correct, I get 1.4%, -0.3%, 0.1%, and -1.0%, if I use headline CPI, core CPI, PCE deflator, or core PCE deflator, respectively. So if I'm Mankiw, and I follow Williams's logic, it would be hard to make a case for QE3, for example, and I might want to start to think about raising the interest rate on reserves (IROR).

Alternatively, I could use a Taylor rule like Glenn Rudebusch's, which is:

R = 2.1 + 1.3i - 2.0G,

where G is the gap between the actual unemployment rate and the "natural rate." Here of course, the predicted value for R depends not just on the inflation measure we choose, but on what the natural rate is. For the contribution to R from the constant and inflation, if we use the four alternative inflation measures above we get numbers between 4.3 and 6.5. What is the natural rate? In New Keynesian parlance, that would be the unemployment rate in a world with flexible wages and prices. Hardliners at one extreme might think that in the flexible-wage-and-price world the unemployment rate would be what it was before the recession started, i.e. about 4.5%. In that case, the contribution from the gap would be -8.0. Hardliners at the other extreme might say that the outcome we are looking at is efficient, in which case the gap is zero, and there is no contribution from unemployment. Thus, our predictions could run anywhere from -3.7% to 6.5%. Maybe we should tighten. Maybe we should not. In any case, if we buy into this way of looking at things, it really does not tell us much. I think I could be a regular New-Keynesian Phillips-curve Taylor-rule kind of guy, and still be arguing for raising the IROR and arguing against QE3.

But there seem to be some people on the FOMC who want more accommodation. Not happy with a Fed balance sheet that has more than tripled in size, a policy rate at 0.25% until mid-2013, and new forward guidance about the Fed's intentions, Charles Evans is yelling for more. Recall that Evans has now been the sole dissenter on the FOMC in the last two meetings. The language in the FOMC press release has been:

Voting against the action was Charles L. Evans, who supported additional policy accommodation at this time.

What does Evans want and why?

The traditional course of action when inflation is below target and real output is expected to be below potential is to run an accommodative monetary policy. I support such accommodation today. And I believe the degree of accommodation should be substantial.

Note that this in not quite Taylor-rule language. He's saying that the forecast for real output matters - "real output is expected to be below potential." Two comments here:

1. Inflation is not below target, unless you cherry pick and take the core PCE deflator, which is running at 1.7% year-over-year. At the high end, headline CPI inflation is running at 3.4% - well above the Fed's implicit 2% target.
2. If you are recommending "accommodative" policy, you should have an idea what that means in the current context.

Evans and Williams are speaking more-or-less the same language on liquidity traps:

I believe that the disappointingly slow growth and continued high unemployment that we confront today reflects the fact that we are in what economists call a “liquidity trap.” Let me explain. In normal times, real interest rates—that is, nominal interest rates adjusted for expected inflation—rise and fall to bring desired savings into line with investment and to keep productive resources near full employment.

This market dynamic is thwarted in the case of a liquidity trap. That is, when desired savings increase a great deal, nominal interest rates may fall to zero and then can go no lower. Real interest rates become “trapped” and may not be able to become negative enough to equilibrate savings and investment. That is where we seem to be now—short-term, risk-free nominal interest rates are close to zero and actual real rates are modestly negative, but they are still not low enough to return economic activity to its potential.

That last sentence is very unconvincing. The zero lower bound is a problem in New Keynesian economics because it implies that you cannot reduce the real rate to the "Wicksellian natural rate." The real rate is thus inefficiently high in a liquidity trap. But it seems real rates are actually pretty low. Indeed, the five-year TIPS yield is down to -1.0%, and even the 10-year TIPS yield is negative. Evans seem pretty certain about what "low enough" real interest rates are, and what "potential" output is. I wish he would explain these things to us, so that we all know.

Finally, there are some arguments about why we should tolerate an inflation rate of as much as 3%, so as to escape from our liquidity trap. These arguments seem based on Ivan Werning's paper, which you can find on this conference program. The model in Werning's paper is essentially the 1970s version of New Keynesian economics - the stripped-down linearized two-equation version. There's an "IS curve" and a "Phillips curve," describing the trajectories for the inflation rate and the output gap, given the nominal interest rate, which is set by the central bank, subject to the zero lower bound. Then, evaluate how policy rules perform according to a quadratic loss function. But what's the optimal inflation rate? What's potential output? Werning's paper does not answer those questions, and those are the ones we need to have answers to.

For someone who is holding out on the FOMC for something more "accommodative," Evans is not telling us a lot about how he wants to do the accommodation. There's some stuff in there about how Fed policy should be much more explicit about addressing its dual mandate by setting numerical objectives for the unemployment rate, for example. However, it's unclear whether that is the key point of disagreement with the rest of the FOMC.

Small and Large Footprints: Reserves and the Fed

2012-01-04T14:16:00.000-08:00

As most economists are well aware, financial institutions in the United States currently hold a very large stock of reserves - deposit accounts with the Fed. The first chart shows the stock of reserves for the last five years. Before the financial crisis, the primary role of reserves was as a means of payment among large financial institutions. Commercial banks of course have to fulfill reserve requirements, but given financial innovation that allows banks to essentially bypass the requirements, it is most useful to think of reserve requirements as irrelevant in the United States. Pre-financial crisis, a stock of $5 billion to $20 billion in reserves was sufficient to support all intraday financial payments and settlement in the United States. It is important to note that this small quantity of reserves was funding a huge quantity of daily payments. Indeed, in 2008, the average daily value of transactions on Fedwire (using reserves) was $2.7 trillion, so the intraday velocity of reserves is immense. It is important to take account of intraday credit extended by the Fed as well, which is essentially outside money created within a day that goes away overnight. In 2008, average daylight overdrafts (as within-day Fed credit is called) were about $62 billion.

Since the financial crisis, as can be seen in the chart, reserves have grown to the neighborhood of $1.6 trillion - more than 100 times the typical stock of reserves in the pre-crisis period. What implications does this have? During the financial crisis and shortly after, it was common for economists and Fed officials to discuss "exit strategies." The typical view was that we were in the middle of unusual circumstances requiring unusual monetary policy interventions, but that these interventions would eventually be unwound. Here's a speech that Charles Plosser made in September 2010. Plosser says:

As I have argued in past speeches, the Fed will need to shrink the size of its balance sheet toward pre-crisis levels and return its composition to all Treasuries.

This necessarily involves shrinking reserves outstanding to pre-crisis levels. Further, Plosser has some comments on reserves specifically:

There are two proposed mechanisms for implementing IOR [interest on reserves], both of which can impinge on central bank independence. One IOR operating mechanism is the floor system, in which the central bank sets its policy rate equal to the IOR. Under this framework, the central bank supplies enough reserves so that the banking system faces a perfectly elastic supply schedule of reserves.16 Under such a floor system, the Fed’s balance sheet is divorced from interest rate policy because an unlimited amount of reserves are available at the IOR-policy rate. Some have described the floor system as the “big footprint” central bank because its balance sheet can be large without directly affecting the monetary policy instrument, the IOR. Some think that this approach has advantages because it would enable the central bank to provide liquidity in a financial crisis without necessarily altering the stance of monetary policy.

The other IOR operating mechanism is the corridor system, in which the central bank’s policy rate is a market rate that is always between the rate charged at the discount window and the IOR. The corridor system does impose constraints on the size of the balance sheet because the supply of reserves would be set at a level that achieves the targeted interest rate. Thus, this might be called the “small footprint” central bank.

Thus, the system the Fed currently operates under is a floor system, whereby there is a large stock of reserves outstanding overnight, and the interest rate on reserves essentially determines the overnight interest rate (with some slippage in the United States due to GSE reserve accounts). the alternative system, the corridor system, is what the Bank of Canada currently adheres to. In Canada, reserves essentially go to zero overnight, and intervention by the Bank determines the overnight rate, which is higher than the interest rate on reserves and lower than the rate at which the Bank lends to financial institutions.

Plosser has some reasons not to like the "big footprint" floor system. Something I could add is that, under a corridor system the Fed gets current information on the daily shocks hitting the payments system and financial markets more generally. If the demand for overnight reserves rises or falls, the Fed has to intervene in the overnight market in order to achieve its target for the fed funds rate. If the same things happen under a floor system, this would have to be reflected somehow in the quantity of reserves outstanding, but there are currently many other factors, such as movements in and out of Treasury accounts, that also affect reserves. Maybe the Fed can untangle all these things; maybe not. The key problem is that the reserves are an accident waiting to happen. The Fed can always counteract higher inflation by increasing the interest rate on reserves under a floor system, but if it does not tighten when the appropriate time comes, the danger is a self-fulfilling expectation of higher inflation.

In my opinion, since quantitative easing is irrelevant under current conditions, one could reverse it with no effect. That is, the Fed could sell $1.6 trillion in Treasury securities and mortgage backed securities, reduce overnight reserves to some small amount on the order of what existed pre-crisis, and nothing much would happen. Then we would transit from a floor system to a corridor system.

There is another argument being made, though, as to why a big-footprint floor system might be a good idea. Unfortunately I can't find a link to this paper, but here are some slides from a presentation by Jamie McAndrews at a recent Bank of Canada conference. People who concern themselves with the economics of payments systems (and there should actually be many more of such people), including Jamie's group at the New York Fed, focus on issues to do with the timing of payments during a given day among financial institutions, the Fed's policies toward daylight overdrafts, and how these things relate to general monetary policy issues. If reserve balances are too scarce during the day, then financial institutions might delay payments they need to make, and a type of coordination failure arises. One could always make a payment by taking out a loan (a daylight overdraft) from the Fed, but that is costly as the Fed charges interest on daylight overdrafts, and there are also credit limits. Why? The Fed is worried about systemic risk. If the Fed extends too much daylight credit, there may be a danger of systemic default where the Fed ends up holding the bag.

But, as McAndrews and company point out in their paper, the large quantity of reserves that has existed in the financial system post-crisis appears to have speeded up clearing and settlement in the payments system, and reduced the quantity of daylight overdrafts. They don't come up with measure of the welfare benefits, but it seems there has to have been a dramatic reduction in payment delay costs.

Is this a serious argument, or just part of an attempt by the Fed to justify the existence of a very large quantity of reserves that now appears to be out there indefinitely? It's important to recognize that reserves held overnight, and daylight reserves are very different animals. Overnight reserves, which is what is measured in the above chart, just sit. They are not used in transactions. Currently, most of the reserves in existence during the day also sit, but some of them are used in clearing and settlement among financial institutions - a transactions role for reserves. If we wanted it, we could have a lot of reserves in daylight hours, and zero reserves overnight. There are different ways to do this: (i) The Fed could inject the outside money every day through daylight overdrafts. If there is some worry about default risk, the Fed could take collateral against the daylight overdrafts, as in other large-value payments systems in the world. (ii) The Fed could conduct an open market purchase each morning. (iii) The Fed could do a reverse-repo in the overnight market at the end of each day.

With regard to the last option, reverse repos have become a bigger deal recently. The Fed once proposed reverse repos (along with term deposits at the Fed) as a "reserve-draining" tool - part of an exit strategy. The second chart shows that the value of reverse repos on the Fed's balance sheet is currently about triple what it was before the financial crisis.

So, there seems a way to have our cake and eat it too. The Fed can have a small footprint, and also make reserves sufficiently plentiful during daylight hours to make large-value financial transactions occur efficiently.

The Fed and Forward Guidance

2012-01-04T13:20:00.000-08:00

The news from the December 13 FOMC minutes is in the very last part, following the policy decision, and relates to "forward guidance," i.e. information that comes from the FOMC about the future path for policy instruments. Here's the relevant passage in the minutes:

After the Committee's vote, participants turned to a further consideration of ways in which the Committee might enhance the clarity and transparency of its public communications. The subcommittee on communications recommended an approach for incorporating information about participants' projections of appropriate future monetary policy into the Summary of Economic Projections (SEP), which the FOMC releases four times each year. In the SEP, participants' projections for economic growth, unemployment, and inflation are conditioned on their individual assessments of the path of monetary policy that is most likely to be consistent with the Federal Reserve's statutory mandate to promote maximum employment and price stability, but information about those assessments has not been included in the SEP.

A staff briefing described the details of the subcommittee's recommended approach and compared it with those taken by several other central banks. Most participants agreed that adding their projections of the target federal funds rate to the economic projections already provided in the SEP would help the public better understand the Committee's monetary policy decisions and the ways in which those decisions depend on members' assessments of economic and financial conditions. One participant suggested that the economic projections would be more understandable if they were based on a common interest rate path. Another suggested that it would be preferable to publish a consensus policy projection of the entire Committee. Some participants expressed concern that publishing information about participants' individual policy projections could confuse the public; for example, they saw an appreciable risk that the public could mistakenly interpret participants' projections of the target federal funds rate as signaling the Committee's intention to follow a specific policy path rather than as indicating members' conditional projections for the federal funds rate given their expectations regarding future economic developments. Most participants viewed these concerns as manageable; several noted that participants would have opportunities to explain their projections and policy views in speeches and other forms of communication. Nonetheless, some participants did not see providing policy projections as a useful step at this time.

At the conclusion of their discussion, participants decided to incorporate information about their projections of appropriate monetary policy into the SEP beginning in January. Specifically, the SEP will include information about participants' projections of the appropriate level of the target federal funds rate in the fourth quarter of the current year and the next few calendar years, and over the longer run; the SEP also will report participants' current projections of the likely timing of the first increase in the target rate given their projections of future economic conditions. An accompanying narrative will describe the key factors underlying those assessments as well as qualitative information regarding participants' expectations for the Federal Reserve's balance sheet. A number of participants suggested further enhancements to the SEP; the Chairman asked the subcommittee to explore such enhancements over coming months.

Following up on the Committee's discussion of policy frameworks at its November meeting, the subcommittee on communications presented a draft statement of the Committee's longer-run goals and policy strategy. Participants generally agreed that issuing such a statement could be helpful in enhancing the transparency and accountability of monetary policy and in facilitating well-informed decisionmaking by households and businesses, and thus in enhancing the Committee's ability to promote the goals specified in its statutory mandate in the face of significant economic disturbances. However, a couple of participants expressed the concern that a statement that was sufficiently nuanced to capture the diversity of views on the Committee might not, in fact, enhance public understanding of the Committee's actions and intentions. Participants commented on the draft statement, and the Chairman encouraged the subcommittee to make adjustments to the draft and to present a revised version for the Committee's further consideration in January.

The FOMC statement has, since August 2011, contained this language:

The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.

The last few words are the forward guidance, i.e. barring some unforeseen dramatic events, the policy rate will not change until mid-2013. Given the failure of the recovery from the recession to proceed as quickly as anticipated, the Fed is under intense pressure from some quarters to do something more than what it has already done, which includes: (i) lowering the interest rate on reserves (now the key policy rate) to 0.25%, where it has been since October 2008; (ii) purchasing large quantities of mortgage-backed securities, agency securities, and long-term Treasury securities, resulting in a more-than-tripling in the size of the Fed's balance sheet. The idea behind forward guidance is that anticipated Fed policy actions are important for economic activity; if anything they are more important than what we actually see the Fed doing today. Such anticipated future monetary policy actions are critical for how consumers and businesses make decisions about borrowing and lending in credit markets, and those decisions are critical for the economic recovery.

Recall that the type of forward guidance in the current FOMC statement was the subject of some controversy in August 2011. Fisher, Kocherlakota, and Plosser dissented from the original FOMC decision, in part because they thought this was inappropriate forward guidance - essentially the wrong kind of commitment. Since August 2011, other FOMC members have apparently been thinking about other kinds of forward guidance, with Charles Evans being perhaps the most vociferous. He would apparently have liked to have seen specific language in the FOMC statement making future policy actions specifically contingent on the unemployment rate and the inflation rate.

What was actually adopted seems a compromise. The FOMC will now include information in its Summary of Economic Projections about the future Fed policy that actually goes into the forecasts. As I understand it, The Summary of Economic Projections represents some averaging across forecasts made by each regional Federal Reserve Bank and by the staff at the Board of Governors in Washington. When for example the Federal Reserve Bank of Boston staff do a forecast, part of the forecast has to be the future path for the Fed's policy rate, and perhaps the future paths of some items on the Fed's balance sheet, if those things are in the model the Boston Fed is using. I'm not sure how they do that, as I have never been in on one of these exercises. Maybe they simply fix a future path for the fed funds rate, and then make the forecast conditional on that. Maybe their model contains an estimated policy rule, and then part of the forecasting exercise involves tweaking that rule with add factors to produce a forecast that the forecasters feel comfortable with. For the Boston Fed, the latter would be the sensible procedure, one would think.

So, what we will now see, instead of this summary of economic projections is one that includes some averaging of forecasts for future Fed policy. What do you think this will communicate to us? For anyone who wants the information, and is willing to pay for it, Macroeconomic Advisers, for example, can probably forecast the behavior of the Fed as well as the Fed can forecast itself. So given that you care about these things, you already subscribe to Macro Advisers, and the extra information from the Fed has close to zero value. For the rest of the general public, the Summary of Economic Projections is almost certainly not on your radar screen. Maybe the information could be filtered through the media in a reasonable way, but the result might just be an increase in confusion. More information is not always better.

Addendum: I ran across this speech by Charles Plosser which perhaps makes clearer what the FOMC has in mind here. Plosser says:

The Summary of Economic Projections provides a better and more natural way to convey the Committee’s sense of the future path of policy. Currently, the SEP indicates individual policymakers’ forecasts of the key economic variables, including output, inflation, and unemployment conditional on each policymaker’s assessment of “appropriate policy” in the absence of further shocks. I think a more appropriate and meaningful way for the Committee to convey forward guidance would be to report information about Committee members’ underlying view of “appropriate policy.” This additional information would provide a useful picture of the range of views of future policy as envisioned by the policymakers. These views would not constitute a commitment to follow a particular path but would evolve as economic conditions changed. This information would add a useful signal to the markets as to the thinking of the Committee on an ongoing basis.

Plosser hopes that people will understand that the extra information included in the SEP is there just to reveal "the thinking of the Committee," and will not be interpreted as a solid commitment. People do get confused, though.

Ricardian Equivalance Heat

2011-12-28T18:20:00.001-08:00

Here's the latest word from Paul Krugman on Ricardian equivalence. First Lucas doesn't understand it. Now, not only does David Andolfatto not understand it, he can't read either. What's the world coming to? Who taught that idiot Andolfatto anyway? Send him back to Surrey for reading lessons. Maybe he should consider going back to drywalling.

Here's what Krugman says:

I accused Lucas of not understanding Ricardian equivalence. Here’s Lucas’s argument:

But, if we do build the bridge by taking tax money away from somebody else, and using that to pay the bridge builder — the guys who work on the bridge — then it’s just a wash. It has no first-starter effect. There’s no reason to expect any stimulation. And, in some sense, there’s nothing to apply a multiplier to. (Laughs.) You apply a multiplier to the bridge builders, then you’ve got to apply the same multiplier with a minus sign to the people you taxed to build the bridge. And then taxing them later isn’t going to help, we know that.

That’s saying that the spending response to expected future taxes leads to a fall in consumption that exactly offsets the expansionary fiscal policy. If that’s not a Ricardian equivalence argument, what is it?

What's Lucas saying? There's a bridge, it's funded by increasing taxes. Lucas says it doesn't make any difference that the government does this. He also says the answer doesn't change if the taxes that pay for the bridge are current taxes or future taxes. The last part of that is Ricardian equivalence. So what is wrong with that argument? It could be the spending actually matters, regardless of how it is financed, and we could argue about that. It could be that Ricardian equivalence does not hold in practice, and we could argue about that. Does Lucas somehow indicate in that line of reasoning that he doesn't understand Ricardian equivalence? Absolutely not. I was telling people that I thought Krugman had to understand Ricardian equivalence. My undergraduates get it. Why can't he? I don't want to be accusing the poor man of lack of understanding or poor eyesight. Maybe he can clear this up?

Here's another puzzler for you:

Then Andolfatto says that Lucas was arguing that it matters how government spending is financed. No, he wasn’t. Right there, he argues that government spending doesn’t matter at all:

If the government builds a bridge, and then the Fed prints up some money to pay the bridge builders, that’s just a monetary policy. We don’t need the bridge to do that. We can print up the same amount of money and buy anything with it. So, the only part of the stimulus package that’s stimulating is the monetary part.

So he was saying that government spending can’t raise aggregate demand. Period.

Figure that one out and I'll give you a prize. Krugman starts off by tellling us he's going to show us that Andolfatto was wrong. But put this Lucas quote together with the previous one, and Andolfatto's interpretation seems to be exactly what Lucas said. Lucas told us in the first quote that the government spending won't matter if it's paid for through taxation (present or future). Then, in the second quote, he says that it will matter if the Treasury issues debt to finance the expenditure, and the Fed buys the debt. What Krugman says to summarize, i.e. "so he was saying the government spending can't raise aggregate demand," is essentially correct, but that is not in contradiction to what Andolfatto said. I would not use the words "aggregate demand" in relation to what Lucas was talking about, but we'll let that one go.

Here's where Krugman heads for the gutter:

Look, I know people want to defend Lucas and hit at me, but what Lucas said there betrayed a fundamental failure to understand the implications of debt-financed spending — followed by an outright smear against Christy Romer.

A fundamental failure to understand...? That's not the problem here at all. One could construct a coherent set of debating points, based on theory and empirical work, to counter what Lucas is saying, but there's no fundamental failure to understand something. I think it would be fun to have that debate, and I'm sure Lucas would be game. On Christy Romer, it helps to read the whole transcript of Lucas's talk, which is available here. The earlier quotes were taken from the main talk, which apparently was never written down. It looks like Lucas is making it up on the spot, presumably from notes. The Christy Romer stuff is in the Q&A at the end. Here's the relevant part:

QUESTIONER: Ben Steel, Council on Foreign Relations. Bob, I edit a journal called International Finance and I get a lot of submissions from people who build big models -- big economic models -- and the shortest referee reports I get back condemn these submissions by saying this model is subject to the Lucas critique. In the last session, we had quite an animated discussion which spilled over into the lunch about models on fiscal multipliers, what they are.

On the one extreme, we have models by people like Mark Zandi at Moody's who say that the fiscal multiplier for the spending initiatives we're discussing are on the order of 1.5. On the other hand, we have people like Robert Barro at Harvard who say there's zero or negative. How would you go about applying the Lucas critique to these types of models to sort of educate us in how we should think about the validity of these models?

LUCAS: Do I need the Lucas critique for -- I'm with Barro is the short answer. (Laughter.) The Moody's model that Christina Romer -- here's what I think happened. It's her first day on the job and somebody says, you've got to come up with a solution to this -- in defense of this fiscal stimulus, which no one told her what it was going to be, and have it by Monday morning.

So she scrambled and came up with these multipliers and now they're kind of -- I don't know. So I don't think anyone really believes. These models have never been discussed or debated in a way that that say -- Ellen McGrattan was talking about the way economists use models this morning. These are kind of schlock economics.

Maybe there is some multiplier out there that we could measure well but that's not what that paper does. I think it's a very naked rationalization for policies that were already, you know, decided on for other reasons. I don't -- I'd like to talk about the Lucas critique but I don't -- I don't think we can -- (chuckles) -- deal with that issue.

The question is about models and multipliers. Lucas tells us a story about how he imagines Christy Romer does her job. In fact, you can see how she does it in this speech from February 2009. She talks about how she and Jared Bernstein used some "very conventional macroeconomic models" to come up with a multiplier of 1.6, which she thinks is on the low side. As Lucas says, he thinks exercises like that are "schlock economics," and he's right. The "very conventional macroeconomic models" Romer is talking about are large-scale macroeconometric models which are fundamentally the same as the ones constructed in the 1960s and early 1970s - the FRB/MIT/Penn model for example. Those were the models Lucas criticized when he wrote this paper, which is part of what the question was about. It's not a smear to question someone's methods. Sorry, Paul.

Here's the finishing paragraph, and it's a winner:

Ever since I started writing about the failures of modern macro, I’ve been attacked by people claiming that I just don’t understand the depth of their thought. Each time it turns out that they either are making basic errors or simply can’t manage to read what I and others actually wrote. And here we have another example.

You have to pity the poor man who wrote that. Viciously attacked by arrogant failures who just can't get it right.

Well, give me a break. What does Paul Krugman want exactly? If you go around badmouthing the cumulative work over 40 years of many macroeconomists - work that has been vetted by mainstream economic journals, hashed over in many hours of seminars and conferences, and awarded many prizes, including several Nobels - do you want a pat on the back, or what? The smearing isn't being done by Bob Lucas here.

War On Shallowness

2011-12-27T08:36:00.000-08:00

I'm pleased to hear that Paul Krugman does not like shallowness, particularly in the blogosphere. My guess is that most people would have a hard time putting his post into context, but I think he wrote it as a reply to my last post. Follow the "pulling rank" link in his last paragraph. Too bad that Krugman went shallow on this one. It would be much more interesting if he actually addressed the issues.

As an update on John Quiggin and Zombie Economics, (which initially set Krugman off on his "pulling rank" nonsense), if you have not read my longer critique of Quiggin's book, it is published in the Australian National University E Press. The paper is not just about Quiggin's book. It also serves as a response to the people who think that all of modern macroeconomics needs to go out the window because the financial crisis happened. Apparently Quiggin seems bothered by my critique, though he does not address the substance. It seems he would be happier if it had been written by an Australian, and not just another colonial.

Ricardian Equivalence Redux

2011-12-26T11:01:00.000-08:00

I just read Paul Krugman's most recent blog post. This is typical. Krugman is repeating an argument he has been making for a long time. He wants you to think that he has it right, and that there are some "freshwater" (whatever that is) bad people out there who have it all wrong. How could they be so stupid?

For reference, here's something I wrote back in March of this year on Ricardian equivalence, when Krugman was on about this before.

Krugman tries to pick on Lucas in his blog post, as "betraying a complete misunderstanding of his own doctrine," and quotes this, which comes from a panel discussion at a conference:

If the government builds a bridge, and then the Fed prints up some money to pay the bridge builders, that’s just a monetary policy. We don’t need the bridge to do that. We can print up the same amount of money and buy anything with it. So, the only part of the stimulus package that’s stimulating is the monetary part.

…

But, if we do build the bridge by taking tax money away from somebody else, and using that to pay the bridge builder — the guys who work on the bridge — then it’s just a wash. It has no first-starter effect. There’s no reason to expect any stimulation. And, in some sense, there’s nothing to apply a multiplier to. (Laughs.) You apply a multiplier to the bridge builders, then you’ve got to apply the same multiplier with a minus sign to the people you taxed to build the bridge. And then taxing them later isn’t going to help, we know that.

I don't agree with everything Lucas said in that quote, but I think I can safely say that I know Lucas better than Krugman does. I think I understand what ideas he is attached to, and there is nothing in the quote that is inconsistent with those ideas. Further, for something pulled out of an off-the-cuff panel discussion, it's reasonably coherent.

Lucas of course was a primary force behind the revolution in macroeconomic thought that occurred post-1970. But he is also very much an old-school Milton Friedman quantity theorist - an Old Monetarist if you like. That's what is behind the first part of the quote. He's thinking that it's monetary policy that is important, and that monetary policy effects will drive the effects of the stimulus. You may think that's wrong, but that's part of what he thinks.

In the latter part of the quote he has a particular view of the effects of the spending package put in place in 2008. Supposing it is funded by taxation - current or deferred - he thinks it doesn't matter much. Now, even in the context of non-Keynesian macroeconomics, there are reasons why government spending can matter. There are wealth effects; public spending and private consumption might be complementary; a recession may be a good time for public investment in infrastructure. Maybe in the context of the 2008 spending package, Lucas thinks that those things do not matter so much. Maybe he thinks that the planned spending was not thought through very well, and we are better off without it. In any event, I don't see anything in the quote that we would want to condemn Lucas for. The weird part of this is that Krugman is picking on Lucas over Ricardian equivalance. The only piece of the quote that relates to that is the last part: "And then taxing them later isn't going to help, we know that." That's just stating the Ricardian equivalence proposition, which is that the timing of taxation does not matter. Tax me now; tax me later; it does not make any difference. Lucas certainly isn't getting anything wrong.

Next, Krugman wants you to think, not only that Lucas is confused, but that he's somehow besmirching Christina Romer. If you read the quote, Lucas is not saying anything bad about Romer, he's just thinking about the realities of government. In my opinion, Christina Romer deserves besmirching, but all Lucas is saying is that, likely, Romer was not driving the policy, and that her job was to defend it, which is what she did.

Here's the really funny part of Krugman's post:

I’ve tried to explain why Lucas and those with similar views are all wrong several times, for example here. But it just occurred to me that there may be an even more intuitive way to see just how wrong this is: think about what happens when a family buys a house with a 30-year mortgage.

Suppose that the family takes out a $100,000 home loan (I know, it’s hard to find houses that cheap, but I just want a round number). If the house is newly built, that’s $100,000 of spending that takes place in the economy. But the family has also taken on debt, and will presumably spend less because it knows that it has to pay off that debt.

But the debt won’t be paid off all at once — and there’s no reason to expect the family to cut its spending right now by $100,000. Its annual mortgage payment will be something like $6,000, so maybe you would expect a fall in spending by $6000; that offsets only a small fraction of the debt-financed purchase.

Now notice that this family is very much like the representative household in a Ricardian equivalence economy, reacting to a deficit financed infrastructure project like Lucas’s bridge; in this case the household really does know that today’s spending will reduce its future disposable income. And even so, its reaction involves very little offset to the initial spending.

How could anyone who thought about this for even a minute — let alone someone with an economics training — get this wrong? And yet as far as I can tell almost everyone on the freshwater side of this divide did get it wrong, and has yet to acknowledge the error.

Apparently that is supposed to be an "intuitive" way to think about Ricardian equivalence. This is an excellent illustration of Krugman's confusion. The example actually tells you nothing about Ricardian equivalance, or anything remotely related to the effects of government actions on the behavior of private economic agents.

What's going on? In Krugman's example, a family takes out a $100,000 mortgage loan to purchase a house. This family now has $100,000 in debt, and someone else in the economy has a $100,000 asset. What is happening in the aggregate? If this is a new house, then the private sector collectively is foregoing current consumption, and investing in a house which will provide a future stream of consumption. If it's an existing house, then this could be a wash. For example, suppose that the family that sold the house takes the $100,000 it receives from the sale and puts it in a bank that makes the mortgage loan to the family that buys the house. Where is the Ricardian equivalence lesson in all that?

Ultimately, Krugman should be able to do better than this. We're accustomed to his nasty side, but at least he could provide some useful instruction.

Back to the Old Grind

2011-12-14T13:13:00.000-08:00

I've been taking a bit of a break from full-scale Krugman confrontation lately. What he writes here, in his "wonkish" way, is basically more of the same, but I thought I would extract this bit and comment on it:

Early on in this crisis I and quite a few other economists — but not enough! — declared that we had entered a classic liquidity trap. This is a situation in which even a zero short-term interest rate isn’t low enough to restore full employment; it is, if you think through the logic, a situation in which desired saving, or more accurately the savings people would make if we were at full employment, exceed desired investment even at a zero interest rate.

The liquidity trap — which is in effect a special case of IS-LM analysis — has some special properties. Notably, even large government borrowing won’t drive up interest rates (not unless the borrowing is enough to restore full employment), and you can print as much money as you like without causing inflation.

1. This is not a "classic" liquidity trap. As I discuss at length here, in a classic liquidity trap the central bank is essentially trying to accomplish something by swapping currency for government debt, and those two assets are essentially the same. The nature of the liquidity trap we are now in is that a swap of interest bearing reserves for T-bills accomplishes nothing, because those two assets are the same, and that would be true whether the interest rate on reserves were 0.25%, 5%, or 20%. What gives rise to the modern-day liquidity trap is that there is a large positive stock of excess reserves in the financial system. Further, this liquidity trap is even more damning, as quantitative easing will not accomplish anything either - swaps of short-term debt for long-term debt simply get undone by the private sector.

2. Make government borrowing large enough, and interest rates will go up alright, liquidity trap, no liquidity trip, "full employment" (whatever Krugman thinks that means) or no full employment. We understand what that is all about. Make the government debt large enough, and it's unsustainable.

3. You can't "print as much money as you want without causing inflation." In spite of the fact that, in our modern-day liquidity trap, swapping reserves for government debt does not matter, the fact that the reserves are out there can matter for future inflation, but that depends on future central bank actions. If something happens to make the banks less willing to hold the reserves, the Fed can increase the interest rate on reserves so that the banks want to hold the reserves, with no resulting inflation. If Krugman means to say that the banks are going to hold the reserves indefinitely at 0.25%, then that's not right.

4. To say that IS/LM - a model with no dynamics, two assets ("money" and "bonds"), no credit, no default - is going to enlighten us, in the way Krugman thinks it does, about "how the world works," is a pretty bold statement, to say the least. More on that here.

Krugman finishes up with:

The moral of the story, then, is that one view of macroeconomics has held up very well in the Lesser Depression; the alternatives have been shown wrong again and again.

How are we supposed to evaluate that? IS/LM seems a complete non-starter. How can you say it "holds up?" What are the alternatives that he wants to compare this to anyway? Are those alternatives something anyone even thinks about? As usual, you know the answers. The alternatives are straw men that exist only in Krugman's mind.

Positional Goods for the Holidays

2011-12-13T07:47:00.000-08:00

Not content with the Santa-on-the-roof from days of yore, positionators have now discovered the two-storey inflatable reindeer. A status-enhancer if I ever saw one. You're saying that if boot polish applied to your balding head was good enough for Grandpa, that it's good enough for you. Forget it. We now have the hands-free hair rejuvenator. At $699.95, this will position you well. However, if that is a strain on your positional budget, $69.95 will get you a room-tidying pickup robot.

The World According to Frank, Part II

2011-12-10T10:58:00.000-08:00

This is a followup to my previous post. Robert Frank likes to talk about "positional goods." These are goods I like, not because they confer any direct benefit on me, but because I feel happy when I have more of this type of good than what others have. Similarly, I feel worse when others have more of this good than I do. Examples are large houses that are mostly empty or Beamers driven by people who couldn't tell the difference between riding in a Beamer and riding in a Hyundai if they closed their eyes. An extreme example is this house in India. Frank thinks that positional goods are ubiquitous and lead to social waste - basically, a lot of time and resources wasted over nothing. From his point of view the social welfare loss is large, and can be corrected with a progressive consumption tax.

But hold on. Aldo Rustichini likes to study envy and regret. He is an economic theorist who also has in interest in economic experiments and neuroeconomics. Rustichini likes to view envy and regret as elements of psychology that propel learning and economic development. Envy is a force that makes me want to replicate the successful behavior of others, while regret is a force that helps me to correct my own errors so that I can become successful.

To motivate these ideas, Rustichini likes to talk about how performance is evaluated in elementary schools in the United States. I went to elementary school in the 1960s in Canada, where we were graded in each subject, and were given a report card to take home with little else other than the odd short comment next to the grade - "shows promise," "improvement needed," etc. Grades were of course supposed to be private, but we knew what was going on. I felt good. Some others felt bad. Concern that some children in elementary school might feel bad led people in Schools of Education to push for changes in performance measurement in elementary schools. By the time my own children went to elementary school in the United States, grades had been ditched in favor of a lot of words that the teachers had to put together to describe performance on a report card. The parents get roughly the same message, but now the kids have a harder time figuring out who the top performers among their peers are.

Rustichini seems to think that grades in elementary school are a good thing, and that the modern wishy-washy approach to student evaluation is thwarting envy, which will actually reduce the amount of learning that takes place. If you know who the top performers are in your class, you can watch them, see what they do, and try to replicate it. Maybe you can get them to show you a few things.

What about "positional" goods? These can actually be performing a useful economic role, even if they are pure "waste" in the conventional sense. This is what signaling is all about. In a signaling model, acquiring a signal may be costly and a pure waste, but it reveals information because the signal is less costly to acquire for "good types." Sometimes people argue that there is a signaling component to higher education. It doesn't matter that you didn't learn anything in college, because employers know that only the smart and diligent ones actually finish.

To get envy working as a force for social good, we need to be able to correctly identify economic successes. How are we going to do that if the successful people hide their wealth? Someone who pushes her Beamer off a cliff in public is demonstrating to us that she is successful - so successful that she can waste resources. I see this and it makes me curious. How does a person get so rich that they would be willing to destroy their Beamer? Maybe I can replicate her behavior and get rich too, not because I want to destroy Beamers, but because I want to relax my budget constraint in a big way.

You don't want to tax the positional goods or pass laws against having them, for the same reason that you don't want to take grades away from the elementary school kids. In doing so, you are thwarting envy. When you do that, you will get less learning and less innovation, and on average we will all be worse off.

Inequality and Taxation

2011-12-08T08:35:00.000-08:00

This seems what everyone is focused on - occupiers, partiers, people who want to stay in office, people who want to kick those people out of their offices, etc. Plenty has been written on this, but I'll extract a small sample here in an attempt to sharpen the ideas.

Let's start with the series that Robert Frank recently contributed to Slate. If you're unfamiliar with Frank, his view of the world is dominated by externalities. Why is inequality bad? That's because the filthy rich make the poor feel so bad that the poor will do any number of reprehensible things in an attempt to consume more. Frank is concerned with "habit."

Economists like to think about two kinds of habit - internal and external. With internal habit I care not only about my current consumption, but about my current consumption relative to my past consumption. I'm better off with more current consumption, but more past consumption makes me currently worse off. With preferences like these, I become accustomed to a high standard of living. I'm much happier if I have always been poor than if I am poor today and rich yesterday. Internal habit is used a lot in macroeconomics. You see it in estimated New Keynesian models, for example Christiano/Eichenbaum/Evans, and in work on asset pricing. I think this has more to do with adding free parameters to fit the data than any micro evidence to support the idea, but there you are.

In any case, internal habit is not going to help the arguments of people who want to redistribute income from rich to poor. Internal habit will tend to favor the status quo, as there will be large transition costs in terms of lost welfare from making the rich poorer. Further, if everyone in the economy has preferences with internal habit, I'm not sure what is Pareto efficient, or if anyone has even solved that problem. For all I know, you solve the problem and it looks completely goofy.

Frank is concerned with external habit - envy, essentially. This is an externality, sometimes called "keeping up with the Joneses." I am worse off the better off my neighbor is. In Frankworld the poor are so overcome by envy that we might as well take the wealth of the rich and throw it away. This would make the poor feel immensely better. Something like kicking a banker in the nuts. Conversely, the rich get some of their happiness from having more possessions than the poor, and flaunting all that stuff. Seymour Cray, for example, liked to build a sailboat every year, but apparently did not sail it. Each year, he would burn the old boat to make room for the new one. However, it's not clear we want to think of Seymour Cray as an example of the typical behavior of rich people. His Wikipedia entry tells us:

Another favorite pastime was digging a tunnel under his home; he attributed the secret of his success to "visits by elves" while he worked in the tunnel: "While I'm digging in the tunnel, the elves will often come to me with solutions to my problem."

Frank seems to think that external habit implies that we should all consume the same quantity. Thus, no more envy. Let's explore this idea further. External habit tells us something about the types of neighbors we like to have. Frank says that the best neighbor the richest person in the population could have is the poorest one in the population, as that makes him or her feel really good. But there is a problem, which is that the best neighbor the poorest person can have is the next poorest one. If you let everyone choose their neighbors, what will they do? This problem has actually been solved. Some of Ken Burdett's marriage models with search fit this exactly. The result is that there is positive assortative matching. Like types tend to match - poor with poor and rich with rich. Frank's theory thus explains neighborhood stratification, something which happens everywhere, and with a vengeance in St. Louis. So far, the theory looks pretty good.

However, note that you would also get positive assortative matching if the externality goes the other way. If any individual feels happier the richer their neighbor is, then we get exactly the same outcome, with the same neighborhood stratification. Similarly, suppose in the marriage matching story that every individual prefers a taller partner to a shorter one. Then, there will tend to be matching of tall types with tall types, and short types with short types. But if each individual prefers a short partner to a tall one, you get the same result.

So, which do you think it is? Do I prefer having a rich neighbor or a poor neighbor? If it's the former, and we follow Frank's logic, he has a lot of explaining to do. Given the conclusions he makes in the latter case, in the former case it would be a better society if we made one person enormously rich, with the rest of us living at subsistence.

What does Frank think explains the recent increase in income dispersion in the United States? The received explanation for this is basically "supply, technology, and trade." Changes in technology have changed the relative demands for high-skill and low-skill workers, high-skill workers are scarce because it is very costly to acquire the skills, and low-skill-intensive goods can be produced more cheaply abroad than used to be the case. A small amount of the increase in dispersion in income is due to the US income tax becoming less progressive. But Frank has a different idea. This also has something to do with technology, though.

Frank uses the example of music. Everyone in the world can now hear the best guitar player in the world, without going out of the house. So why should I pay any attention to the second-best guitar player in the world? Ultimately, the best guitar player in the world gets a huge market share, and second best gets close to nothing. Society then consists of a small number of stars getting enormous salaries and the rest of us getting close to nothing. But surely if second-best is willing to work for a little less, I might prefer that. Or seeing #500 guitar player in the local bar for a $5 cover charge could dominate paying $200 to sit in a nosebleed seat in Madison Square Garden to see #1.

What seems to make Frank's argument fall apart is congestion and scale economies. You can see this when he gets to his other examples. Frank wants to think of his university president, David Skorton, as one of these superstars. First, contrary to what Frank seems to think, my guess is that Skorton earns something in the range $500K-$600K. An odd characteristic of the market for university presidents is that the high-paid ones are mostly at schools you have never heard of. There may be a theory that explains that, but I don't think it's the one Frank has in mind. Second, Skorton was my university president once as well. People at the University of Iowa thought of Skorton as a good guy, but I don't recall the word "superstar" floating around.

Frank wants to dismiss corporate governance explanations for high executive compensation, but I'm not sure he's right. Small differences in the ability of a CEO may indeed make huge differences in corporate outcomes, but it's very difficult for a Board to discern those differences. How do you tell a good one from a bad one? Thus, you can't rely on those small differences to explain huge differences in compensation.

Finally, Frank gives us his solution to inequality, which is a progressive consumption tax. A consumption tax is sometimes thought to have some virtues relative to the income tax as a means for generating revenue, but as typically envisioned, it would also be less progressive than the income tax. Replace the current federal income tax with flat-rate value-added tax generating the same revenue (I'm neglecting the issue of deductions), and income dispersion will increase.

The problem is that, if the consumption tax is collected at the point of sale, it has to be a proportional tax. We can't have retailers checking their customers' total consumption, and even if they could there would be ways to game the system. Frank's suggestion is that consumers report their incomes and net asset positions, from which we can determine individual consumption, which we then tax progressively.

Frank thinks that a progressive consumption tax will cure all our problems. Frankly, I don't see it. First, Frank has not thought through the tax evasion problem. How easy would it be to cheat in this system, relative to the current one? The cheating one would want to do is to under-report income and over-report asset accumulation. The income under-reporting problem is one that exists currently, so that is no different. However, over-reporting of assets is something new altogether. One could imagine that over-reporting could be quite easy. This might amount to shady appraisals or asset valuation that could be very difficult to check.

Second, even if you can solve the evasion problem, what do you gain relative to a progressive income tax? With a progressive consumption tax, individuals have a greater motive for consumption smoothing over time. This works like an increase in risk aversion - not clear this is a good thing. Also, the consumption tax does not actually promote savings relative to the income tax, except because people are effectively more risk averse and will self-insure by saving more. Again, this is hardly a good thing. Otherwise, saving is just postponed consumption. If my current consumption is taxed and my future consumption is taxed, that's a wash in terms of the effect on savings. Indeed, ultimately the distortion shows up in labor supply.

Next, some people have shown interest in this paper by Diamond and Saez. A key result that seemed to get these people excited is the calculation of a top optimal marginal tax rate (including all taxes) of 73%, relative to the current rate of 42.5%. There are two key assumptions that Diamond and Saez make to come up with the 73% optimal rate. First, we should not care about the welfare (at the margin) of the rich people. This argument is based solely on the notion that marginal utility of income is low for the top income-earners. Second, Diamond and Saez use a "behavioral elasticity" of tax revenue with respect to the tax rate of 0.25. To see how this matters, if you use their formula and an elasticity of one, you get an optimal top tax rate of 40%.

Now, I know it is fashionable to dump on rich people, but I'm not sure we want to discount their welfare as much as Diamond and Saez want to. Preferences will matter here. For example, if we take internal habit persistence seriously, as some people like to, that could make us want to weight the rich and poor equally, by Diamond and Saez's logic. I'm not committed to habit persistence, but there may be some features of behavior that are not consistent with log utility, for example. Further, Diamond and Saez are thinking in static terms. In reality, there is mobility within the income distribution, and how much mobility is an important issue here. Given mobility within the income distribution, we all care, for selfish reasons, about how the rich are treated, as we all could be rich some day, or our descendants could be rich.

Finally, I have no idea where that "behavioral elasticity" is coming from, and I don't trust it. My best guess is that it includes none of the factors that I think are important in addressing the problem. What we need here is a dynamic general equilibrium model that can take account of the short run and long run effects of a change in the income tax schedule. My best guess is that "behavioral elasticity" means that Diamond and Saez are measuring the effects of tax evasion and the intensive margin of labor supply, and that's all. If so, I think they miss most of what is important:

1. There's also an extensive margin. Tax people at a higher rate, and some drop out of the labor force.
2. Taxes affect occupational choice. Some work by Manuelli/Seshadri/Shin says that the effect of taxes on human capital is big time. Why do I want to undertake a costly and risky investment for a very small payoff?
3. Entepreneurial activity has to be very elastic with respect to tax rates at the top end. Why would I want to risk my own wealth or that of my close family for a very big payoff with very low probability, if that big payoff is taxed at 73%?
4. The United States is highly dependent on highly-skilled labor that migrates here from other countries. With a top tax rate of 73%, the Indian engineers might prefer to work in India, and the Canadian professors might prefer Canada.

Thus, I think it is likely that tax revenue is much more elastic with respect to the tax rate, particularly in the long run, than Diamond and Saez are letting on. To evaluate this properly, you need a serious model, and they have not provided one.

Discount Window Lending, Part III

2011-12-06T18:34:00.000-08:00

As a followup to this post and this one, I think we finally have this sorted out. Some people were arguing that the Fed's lending to financial institutions during the financial crisis was subsidizing those financial institutions. But the bulk of lending was through the Term Auction Facility (TAF), and it appears that, if there was any subsidizing, that it had to occur through TAF. But, we have a record of all the loans made through TAF in the excel spreadsheet here. As you can see, the best deal that anyone was getting on a TAF loan was 0.20%, and all those loans occurred on January 2, 2009. Otherwise, the best deal was 0.25%, and no one could make a profit on that, given that the interest rate on reserves was 0.25% at the time, and the fed funds rate was lower than that, as were short T-bill rates.

So, was the Fed doing the appropriate thing? Maybe reading Lombard Street will help us? Fat chance. As Andolfatto can tell us, there's not a lot in Bagehot to go on. Bagehot tells us that the lender of last resort should "lend freely and at a penalty rate" during a crisis, which if anything seems like a contradiction. If you really want the banks to take the liquidity injection, you should not be penalizing them. Of course it makes sense that the Fed should not set up lending facilities which allow banks to simply make arbitrage profits, but that does not appear to have been happening during the financial crisis. Further, if the Fed was giving the posted collateral the correct haircuts, it was not taking on undue risk, and certainly the Fed does not seem to have come out on the short end of the stick on its lending. I have some too-big-to-fail moral hazard concerns, but that is about it.

The key question with these lending programs, as with any lender-of-last-resort lending, is why the central bank should not just buy the assets, instead of extending loans and taking the assets as collateral. I think the basic logic has to be that the central bank could buy the assets at their market price, but the market price is viewed as being inefficiently low. Instead, the central bank extends a loan for more than the market price of the collateral, and essentially takes the assets at a high price, temporarily. But, alternatively, the central bank could make an offer to buy quantity x of asset y at price p, and see how many offers come at that price. If total offers exceed x, then the central bank uses a lottery to choose.

Questions like this come up when we try to model how collateral is used in financial transactions. Indeed, I have never seen a satisfactory model of collateral. Basically, you have to explain why it is that someone who wants to borrow, and has an asset that they can use as collateral, does not just sell the asset. One can see how this works with mortgage lending, but in general it seems a difficult problem.

Update on Discount Window Lending

2011-12-06T12:51:00.000-08:00

As an update to this post, Ben Bernanke has sent a letter to the Senate Banking Committee defending himself against news reports from last week. Some of the defense deals with various double counting in the reports, which seemed obvious. Here is an interesting part at the end:

Most of the Federal Reserve's lending facilities were priced at a penalty over normal market rates ...

The Bloomberg story says:

During the crisis, Fed loans were among the cheapest around, with funding available for as low as 0.01 percent in December 2008...

Of course, those two statements can both be true.

Raquel Fernandez the Cynic

2011-12-04T10:31:00.000-08:00

Here's an interview with Raquel Fernandez. This concludes with:

Economists essentially have a sophisticated lack of understanding of economics, especially macroeconomics. I know it sounds ridiculous. But the reason why I tell people they should study economics is not so they’ll know something at the end—because I don’t think we know much—but because we’re good at thinking. Economics teaches you to think things through. What you see a lot of times in economics is disdain for other's lack of thinking. You have to think about the ramifications of policies in the short run, the medium run, and the long run. Economists think they’re good at doing that, but they’re good at doing that in the sense that they can write down a model that will help them think about it—not in terms of empirically knowing what the answers are. And we have gotten so enamored of thinking things through that the fact that we don’t know anything needs to bother us more. So, yes, it’s true that the average guy on the street doesn’t understand economics, and it’s also true that we don’t understand economics. We just have a more sophisticated lack of understanding than the guy on the street

Fernandez knows something, about which she is quite certain. As economists, we really don't know anything at all. Apparently we are good at thinking, but it's just fooling around - nothing more serious than video games.

Fernandez is frustrated:

The methodology of economics is so strong that we have had a large impact on many fields, from political science to sociology and even neuroscience. It’s been a very successful paradigm in that what economics does very well is think rigorously. But sometimes that’s not been very fruitful in the sense that there are certain questions that you can’t ask because you don’t know how to model them.

Ah, those pesky models, getting in the way of fruitful science.

Fernandez thinks we're not scientists:

... as “scientists” we often don’t have much to say. I don’t think we are scientists. I think we’re more like doctors in the sense that we do research, but in the end there’s a patient, and you have to say, given one’s knowledge, what’s the best way to treat the patient?

Well, when I think about my doctor, what she does looks to me like applied science. She wants to do some tests on me. I ask her some questions about it. She cites scientific evidence from published research. When I talk to Jim Bullard I get the same vibes. He's doing applied science. He knows what's in the journals. He talks to his staff and other economists, and uses frontier knowledge to argue for good policy choices. That frontier knowledge is based on theory, i.e. models, and empirical evidence. Science, basically.

Fernandez thinks we don't love Paul Krugman enough:

But the people who go and give advice usually end up with a very bad rap in economics. I am amazed at how much hatred—and I will say hatred—Paul Krugman evokes from some fellow economists. But one of the reasons for this is that he says things for which there is not “scientific” support and which go against what these people believe is "good" economics.

She's confused here. Krugman does not get a bad rap because he chooses to give advice. He gets a bad rap because some people, me included, think he is giving bad advice. We don't hate the man, we just disagree with him. And yes, this has a lot to do with science (no scare quotes).

Discount Window Lending, Secrecy, and Stigma

2011-12-03T14:19:00.000-08:00

This story is months old, but received some attention in the last week. In March, the Fed released the details of its lending during the financial crisis, under court order. Whether it took Bloomberg 9 months to process the information, or the timing just seemed right, Bloomberg had a story this week (I think; there is no date on the post) on the details. Further, Eliot Spitzer (how could we forget him?) and Jon Stewart picked up on it.

It has of course been well-known for a long time that the Fed lent to financial institutions, particularly large ones, in a massive and unprecedented fashion during the financial crisis. This is the first instance I know of the release of information about the details of the Fed's lending operations - who received the loans, how much, and at what interest rates. Typically we know the total quantities of discount window lending through the Fed's primary and secondary facilities, which appears in the Fed's reported balance sheet numbers, but little else.

It would be useful at this point to review the Fed's key lending programs to financial institutions that were active during the crisis. In the chart, I show the Fed's lending through the Term Auction Facility (TAF), the Term Asset-Backed Loans Facility (TALF), primary credit (regular discount window lending), and the specific AIG lending program (which gets its own line on the Fed's balance sheet).

As you can see in the chart, total lending by the Fed gets up to at most $600 billion - nowhere close to the $7 trillion that got gasps from Jon Stewart's studio audience, but nevertheless some serious pocket change, considering that the size of the Fed's balance sheet pre-crisis was about $900 billion. The interesting thing here is that, early in the crisis, lending to AIG and through the primary credit facility totaled less than $200 billion at most, with the majority of the lending conducted through the TAF. Thus, most of the discount window lending during the crisis occurred by way of auctions rather than through conventional lending. Note that some of the media stories focused on the fact that some of the loans went out at 0.01%, when the discount rate (the rate on the primary facility) was 0.5% at its lowest. These 0.01% loans had to occur through TAF.

The Bloomberg story makes a calculation that the Fed gave away $13 billion to various financial institutions, but if most of the funds were auctioned off, this can't be right. But how could a financial institution win an auction at 0.01% when the funds could be held as overnight reserves and earn 0.25%? The usual answer for this is "stigma," which actually seemed to be a concern of the Fed during the crisis. The Fed wanted to inject more liquidity into the financial system, and sometimes seemed to think that financial institutions were unwilling to take this as loans from the Fed. Why? There is empirical evidence and theory (in this paper by Huberto Ennis and John Weinberg) that banks are reluctant to borrow from the Fed because this might signal that they are in trouble.

But why would banks face stigma if the Fed keeps the details of its lending programs secret? Apparently there are ways to figure these things out, at least for large institutions. For example, a large quantity of lending in the Richmond Fed district is likely going to Bank of America. So if financial market participants can figure these things out anyway, why should the Fed keep its lending a secret? Why indeed?

Central bank lending is typically rationalized by appealing to the lender-of-last-resort role of a central bank. The conventional view is that there is some temporary market failure that makes the assets of some financial intermediaries temporarily illiquid, or there is an inherent vulnerability of illiquid banks to panics. Thus, it might seem useful for the central bank to lend to financial intermediaries during a crisis. The central bank takes the "illiquid" assets as collateral on its loans, potentially giving the collateral a haircut commensurate with its "true" market value. Central banks are supposedly wary of lending to banks which are actually insolvent rather than just illiquid. It is certainly not economically efficient to prolong the life of a bank that will fail anyway.

But run your mouse over the chart in this Bloomberg post. The three largest borrowers from the Fed during the crisis were Citigroup, the Bank of America, and the Royal Bank of Scotland. It seems widely recognized that the first two were essentially insolvent during the financial crisis, if not now, and the last one essentially failed during the crisis. Lending to these banks certainly does not appear to have been simple liquidity-easing.

I think one could make a case that the details of all of the Fed's activities, including its lending, should be made public, at the time these activities take place. Surely, there is stigma in borrowing from the Fed only if the Fed lends to banks that are essentially insolvent. If the Fed sticks to its appropriate lender-of-last-resort role, then it is only correcting short-term liquidity problems. Indeed, if the Fed is doing its job, then a Fed loan should be a certificate of viability.

In any case, we need more serious research on central bank lending, when it is appropriate and when it is not, what is appropriate collateral for a central bank loan, what are appropriate collateral haircuts, what is the role of central bank lending relative to conventional and unconventional open market operations, etc.

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

2011-11-22T12:35:00.001-08:00

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

2011-11-22T09:11:00.000-08:00

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.

The ECB and Last-Resort Lending

2011-11-20T17:39:00.000-08:00

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.

Mankiw Protest

2011-11-10T09:50:00.000-08:00

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.

Keynesian Economics

2011-11-01T11:45:00.000-07:00

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.

Christina Romer on NGDP Targeting

2011-10-30T10:38:00.001-07:00

Christina Romer thinks that NGDP targeting will solve the world's problems. According to Christina, NGDP targeting will: (i) remove dissent from the FOMC; (ii) improve communication about monetary policy to the public; (iii) improve confidence; (iv) lower borrowing costs; (v) increase private spending. This reminds me of a Tom Waits song, "Step Right Up." Here's an excerpt:

That's right, it filets, it chops, it dices, slices
Never stops, lasts a lifetime, mows your lawn
And it mows your lawn and it picks up the kids from school
It gets rid of unwanted facial hair
it gets rid of embarrassing age spots
It delivers a pizza, and it lengthens, and it strengthens
And it finds that slipper that's been at large under the chaise lounge(2) for several weeks
And it plays a mean Rhythm Master
It makes excuses for unwanted lipstick on your collar
And it's only a dollar, step right up, it's only a dollar, step right up
'Cause it forges your signature
If not completely satisfied, mail back unused portion of product
For complete refund of price of purchase

See my earlier post on NGDP targeting.

Bitcoin Update

2011-10-30T09:45:00.000-07:00

Apparently setting up an alternative monetary system is not so easy. See this update on Bitcoin, and my earlier post.

Note: I had previously linked to David Andolfatto's blog, but it looks like that is defunct.

Tom Sargent

2011-10-30T07:53:00.000-07:00

There is an interview with Tom Sargent in the Sunday NYT. Sargent makes the point that modern macroeconomics is neither political nor inherently un-Keynesian. From the article:

Professor Sargent described himself as a scientist, a “numbers guy” who is “just seeking the truth” as any good researcher does.

“If you go to seminars with guys who are actually doing the work and are trying to figure things out, it’s not ideological,” he said. “Half the people in the room may be Democrats and half may be Republicans. It just doesn’t matter.”

Further,

Today, Professor Sargent says that in some ways he actually is a Keynesian, but he qualified that claim, too. “I’m happy to say I am a Harrison-Kreps-Keynesian,” he said, citing work by two scholars at Stanford, J. Michael Harrison and David M. Kreps. They developed a theory of speculative investor behavior and stock-bubble formation that subtly modifies rational expectations “in a beautiful way” and “captures Keynes’s argument, makes it rigorous, and pushes it further,” he said.

Sargent is kidding us a bit here. What he finds interesting about Keynes is an idea formalized and developed in this paper by Harrison and Kreps. When Sargent says he is "actually a Keynesian," that's not a Hicks IS-LM Keynesian, as a reading of Harrison-Kreps should make clear.

Here's something interesting. Lucas and Sargent once wrote a paper, "After Keynesian Macroeconomics," that you might think, from the title, is an exercise in Keynes-bashing. Actually, not so. Here is the last paragraph:

The objectives of equilibrium business cycle theory are taken, without modification, from the goal which motivated the construction of Keynesian macroeconometric models: to provide a scientifically-based means of assessing, quantitatively, the likely effects of alternative economic policies. Without the econometric successes achieved by the Keynesian models, this goal would be simply inconceivable. However, unless the now-evident limits of these models are frankly acknowledged and radically new directions taken, the real accomplishments of the Keynesian revolution will be lost as surely as those we know to be illusory.

Open Market Operations and Non-Neutralities of Money

2011-10-29T12:51:00.000-07:00

Matt Rognlie and I are having a conversation in the comment thread of this previous post, which I'm sure most of you have lost track of. Here's a summary of the basic issues: One of my complaints with New Keynesian economics is that it skirts around most of what is interesting for me about monetary policy and how it works. In mainstream monetary models, e.g. standard representative agent models with cash-in-advance constraints, non-neutralities of money are restricted to the effects of unanticipated money and inflation. Monetary policy matters due to distortions in intertemporal prices, for example the anticipation of higher money growth and higher inflation acts as a tax on labor supply and reduces output. Further, the nominal interest rate increases due to a Fisher effect. Mike Woodford looked at those effects and thought that they did not matter much in practice, or that they had the wrong signs, and he wrote down models where he could dispense with those types of intertemporal distortions entirely. In basic New Keynesian models we do not worry about the details of monetary exchange, it is assumed that the central bank can choose the short-term nominal interest rate at will, and monetary policy has real effects because of relative price distortions due to sticky prices and wages.

My contention is that one cannot analyze monetary policy without modeling the role of central bank liabilities and other assets in exchange, and the role of the central bank as a financial intermediary. This need not involve substituting for New Keynesian-type effects. One can easily take the approach of being explicit about exchange, the central bank balance sheet, and central bank intermediation activity, and include the sticky prices and wages if one really can't live without them.

In this paper, one of the results I get is a particular non-neutrality of money. Prices are flexible, so it's certainly not a New Keynesian effect, and it's different from what you get in mainstream monetary models. There are essentially two classes of assets - currency and various other assets (government bonds, loans) which may be fundamentally illiquid but are made liquid (though not as liquid as currency) by financial intermediaries. A standard open market purchase (think of this as normal times) will ultimately increase the stock of currency in nominal terms, with no change in the real stock of currency, but the real stock of other assets declines, those assets become more scarce, the real interest rate falls, and lending increases. Essentially, this is an illiquidity effect.

In reply to Matt's last set of comments:

1. [Here he's discussing the effect of the open market operation]

But ultimately I have severe doubts that this channel makes much of a quantitative difference. When the Fed adjusts policy through open market operations, over the short to medium term it's making purchases in the tens of billions of dollars; maybe $100 billion at the very most. Meanwhile, the MZM money stock is $10 trillion, and that's an underestimate of the true size of the universe of liquid assets. Fiscal shocks happen all the time that adjust the quantity of liquid government debt by much more than Fed operations normally do; if you're positing that this an important channel for the effects of Fed policy, it follows that the Fed is at most a minor sideshow next to the Treasury. That doesn't ring empirically true to me.

First, in my model, there is not an increase in the yield spread "between government debt and other liquid securities." To keep things simple, I put assets into two classes. In the second class there is everything that is not currency, and I assumed that all that stuff (government interest-bearing debt and loans) could be intermediated in the same way. In a more elaborate model, one might imagine assets with different degrees of liquidity, but liquidity will be priced according to how assets are intermediated. For example, we might think of a house as highly illiquid, but a mortgage-backed security (MBS) can be highly-liquid, and the MBS is essentially backed by the houses that act as collateral for the mortgage debt that gets chopped up and put into the MBS.

Second, Matt has hit on something interesting in the latter part of the above paragraph, relating to fiscal policy. The Treasury could indeed be more important than the Fed, as it can bring about changes in the total quantity of consolidated government debt outstanding; the Fed can only change the composition. In fact, under current circumstances, the changes in the composition of outstanding debt the Fed can accomplish are irrelevant. Matt seems to think that these things don't "ring empirically true." I say run with the idea.

Matt goes on to discuss how New Keynesian effects work, and how he thinks they are empirically more relevant than what I'm after. You can read the details in the comment thread in the previous post. Two comments:

1. In terms of current events, my model might tell you that our current problem is that liquid assets (the second class of assets - the intermediated non-currency assets) are too scarce, and the real interest rate is too low. New Keynesians tell us the real rate is too high. If we take the New Keynesian line, we have to take a stand on what the "natural" real rate of interest is. That would be the real rate if wages and prices were perfectly flexible. To determine what that rate is we have to determine what the shock was that was driving the recession (and the financial crisis) presumably. I'm not sure what the New Keynesians have in mind there. Also, at first glance, real rates (based on current inflation, current short nominal rates, TIPS yields) look pretty low to me.

2. Some of Matt's arguments are in terms of back-of-the-envelope reasoning about the quantities of government debt and currency relative to other liquid assets. But we know that, through the shadow banking sector, a small quantity of assets, used as collateral, can support a very large quantity of credit activity. This is part of what Gary Gorton has written about. One might not think that things going haywire with a relatively small quantity of mortgage debt could cause such a big problem, but it did. Similarly, small changes in the quantity of interest-bearing government debt outstanding, through the process of rehypothecation, can give potentially very large effects in asset markets. Collateral and rehypothecation are not in my model, but if one were to take it to the data, that might be part of what one would want to include.

Do We Need a New Keynes?

2011-10-26T08:18:00.000-07:00

John Cassidy, a journalist who writes for the New Yorker, wonders where the New Keynes is lurking. Cassidy states:

At the end of the [radio] show, Leonard asked me an interesting question: Has the financial crisis and Great Recession produced any big new economic ideas? My immediate response was that it hasn’t, or, if it has, I wasn’t aware of them.

I seems that what excites journalists is the personal, and the large. A nice, readable story is one that focuses on an individual with a "big" idea, that can be stated crisply in a few lines.

Unfortunately for Cassidy, but fortunately for the rest of us as it turns out, modern economics is not set up to give journalists tasty sound bites. In my generation, and in younger ones, it's hard to identify the "big" people with the "big" ideas, as economic research is a collective effort - much more so than in the days of Keynes, or even in the generation of Lucas, Prescott, Sargent, and Sims. The big idea that is helpful in understanding the financial crisis, its causes, and what should have been done or should be done about it, is the idea that was developed by the information theorists of the 1970s - Akerlof, Stiglitz, Townsend, Rothschild, Holmstrom; by the mechanism designers - Hurwicz, Maskin, Myerson; by the monetary theorists - Wallace, Townsend (again), Kiyotaki, Wright; by the financial intermediation theorists - Diamond, Dybvig, Townsend (again), Prescott, Boyd; by the dynamic contracting theorists - Green, Abreu-Pearce-Stacchetti, Atkeson-Lucas; by general-equilibrium financial-frictions people - Gertler, Bernanke, Smith, Kiyotaki-Moore. That idea is much much bigger, and immensely more solid science than Keynes.

Econometrics, Calibration, and Fights

2011-10-20T07:40:00.000-07:00

Paul Krugman is off on another rant about about dead issues in macroeconomics, in this post and this one, including the usual discussion about "freshwater guys," who currently exist only in Krugman's mind.

Several points here:

1. In current macroeconomic thought, calibration methods and econometrics are both widely accepted as useful approaches to answering quantitative questions, and these approaches are often mixed in particular projects. Kydland and Prescott pioneered calibration methods in macroeconomics, and applied them to a particular class of models, but the methods themselves are more general than that, and various Old Keynesians and New Keynesians have found calibration useful.

2. Part of what the calibration people were reacting to, was a view among econometricians that quantitative work was about "testing" theories. The problem is that any macroeconomic model is going to be wrong on some dimensions. To be useful, a model must be simple, and simplification makes it wrong in some sense. Subjected to standard econometric tests, it will be rejected. Models that are rejected by the data can nevertheless be extremely useful. I think that point is now widely recognized, and you won't find strong objections to it, as you might have in 1982.

3. There was indeed a fight at Minnesota over econometrics. I can't remember exactly when it happened. Maybe I was working at the Minneapolis Fed at the time. Maybe I wasn't. In any case, I think I know most of the details of the fight. The people involved were all fine human beings, and if you talked to them at the time about their sides of the argument, they would all make perfect sense. Fights happen among people who work together, and it's best to let these things rest. I'm sure Krugman could tell us a lot about fights in his own department. This is basically gossip, and is best left for talk in the bar.

4. Krugman tells us:

I’d just add that correspondents tell me that the anti-Keynesians pretty much blockade any hiring of new Keynesians in their departments.

People in academic departments disagree about who to hire. This is news? When an academic hire is made, we think we are making a very long-term commitment, particularly when it's a tenured appointment. We're making risky bets on people. Are they intelligent and creative types? Will they be able to adapt when their current research program goes out of fashion? Will they get along well with their colleagues and make everyone more productive? Sometimes things turn out badly. While James Tobin was alive, he wouldn't tolerate having macroeconomists who were up on contemporary macro in his department. As a result, he set his department back, and they have only recently caught up with where macro has gone. Sometimes things turn out well. In 1991, the University of Minnesota hired Nobu Kiyotaki. Remember that Blanchard and Kiyotaki (1987) was a key innovation in Keynesian economics. The Minnesotans were not doctrinaire about it. They saw a smart and productive guy, hired him, and he went on to do more great things. He now works in the Princeton econ department, with Krugman.

Nominal GDP Targeting

2011-10-19T12:55:00.000-07:00

Nominal GDP (NGDP) targeting seems to be getting a lot of attention. The idea seems to go back at least to the 1980s, when Bennett McCallum talked about it. Scott Sumner and David Beckworth have taken this up as a cause, and Charles Evans has discussed NGDP targeting in a speech. Some of the business media think it matters.

To make sense out of NGDP targeting, start with the original Taylor rule, as specified in Taylor's 1993 paper. Taylor proposed that monetary policy should be conducted according to the following rule:

R(t) = p(t)- p(t-1) + a[y(t) - y*] + b[p(t) - p(t-1) - i*] + r*,

where R is the fed funds rate target, p is the log of the price level, y is the log of real GDP, y* is the target level of real GDP, i* is the target inflation rate, r* is the long-run real interest rate, a > 0 and b > 0. Taylor did not derive his rule using theory, but instead argued that this rule worked well according to some loss criterion in some macroeconometric models. The Taylor rule found its way into New Keynesian (NK) models, and into monetary policy discussions. Taylor rules have been derived in NK models, though the arguments are a little slippery. Generally, an optimal policy rule in a NK model would be some relationship between the policy instrument(s) and exogenous variables, but of course real GDP and the price level are endogenous, so one has to go through some contortions to coax the Taylor rule out of any model. The argument would seem to rely on what is observable to the central bank and what is not.

So, suppose that the central bank adopts a NGDP target. Then, the central bank must also have an approach to implementing such a target. Presumably the advocates of NGDP targeting think that standard central banking practice works, i.e. that a sensible approach to policy over the very short term is to specify an intermediate target for the fed funds rate, with the target set according to the current state of the economy relative to the NGDP target. Thus, we could specify the implementation of the NGDP target as a rule

R(t) = p(t) - p(t-1) + c[y(t) + p(t) - y* - p*] + r*,

where y*p* is the log of the nominal GDP target and c > 0. We can then rewrite this rule as

R(t) = p(t) - p(t-1) + c[y(t) - y*] + c[p(t) - p(t-1) - p* + p(t-1)] + r*

What's the difference between this and the basic Taylor rule? Not much. (i) The coefficients on the terms governing the response of the fed funds rate to the "output gap" and the deviation of the inflation rate from its target are constrained to be the same. (ii) The interpretation of y* may be different. In the NK literature y* is the efficient level of aggregate output ground out in the underlying real business cycle model. The NGDP targeters seem to think of y* as the trend level of output. For practical purposes it does not make much difference, as the people who measure output gaps tend to think of trend GDP as potential GDP. (iii) The target inflation rate is not a constant, but the percentage deviation of the target price level from last period's inflation rate.

In sum, the NGDP rule fits well within the set of Taylor rules that people have considered, which deviate in various ways from the basic rule that Taylor wrote down in 1993. So what's new? Could it be that there is something different about what happens at the zero lower bound, which I have not accounted for thus far? Suppose we are at the zero lower bound, which is essentially the case currently, and the Fed announces, say, a target path for NGDP of 5% per year indefinitely. Could the Fed actually achieve such a target, even if it wanted to? No. Under current circumstances, there are no actions the Fed can take that could necessarily achieve such an outcome. Indeed, it is possible that the Fed could promise to keep the policy rate at 0.25% for five years in the future, and NGDP growth could fall below the target.

There is no magic in a NGDP target. I know people look at the state of the economy, and think that the Fed should keep trying things. Maybe something will work? Well, I'm afraid not. Even the FOMC dissenters, and their supporters are not quite ready to say that there is nothing the Fed can do under the current circumstances that could increase employment. But they should.

Matt Rognlie Needs to Learn Some Monetary Economics

2011-10-18T19:11:00.000-07:00

Matt thinks that monetary frictions don't matter. Mike Woodford made the same mistake, and set a large fraction of macroeconomists off to work on New Keynesian models. Then, the financial crisis hit, and central banks started to engage in some unprecedented interventions, about which standard New Keynesian models had nothing to say.

In a basic Woodford model (see for example Mike's book, Interest and Prices), all monetary frictions are stripped away. In a Woodford world, the only friction comes about because of nominal price stickiness (and perhaps wage stickiness too), which leads to relative price distortions. What does a central bank do in a Woodford world? It sets the price of a bond which is a claim to "money" in the future, but this money is not actually held by anyone, in spite of the fact that all prices and wages are denominated in units of the stuff.

Why does central banking matter? It matters because a central bank can engage in intermediation activities that are not replicated in the private sector. A typical central bank has a monopoly on the issue of currency (in the US this is implicit), and on the large-value payments system. Thus, currency and bank reserves are liabilities that cannot be issued by private financial institutions. When the central bank issues its liabilities in order to buy assets, this in general matters. In particular, asset prices move. To understand how that process works, one has to model the frictions that make private intermediation useful, and the frictions that make assets of all kinds (including the ones conventionally called "money") useful in exchange. By "exchange," I mean exchange of all kinds, including retail exchange, and exchange among financial institutions.

Matt, for starters, you can read this blog post, this piece with Randy Wright, our chapter in the Handbook of Monetary Economics, and this forthcoming AER paper. The latter shows you why you need monetary frictions to understand the financial crisis and unconventional monetary policy.

The Two Sides of FOMC

2011-10-18T17:54:00.000-07:00

There were two interesting speeches by Fed Presidents posted yesterday, one by Charles Evans, Chicago Fed President, and one by Jeff Lacker, Richmond Fed President. These are representative, I think, of the two opposing views on the FOMC.

Evans, as is well-known by now, is a hard-core Keynesian. Yesterday's speech is consistent with a previous one he gave, but there are more details in the most recent one. In response to the criticism that he is setting us up to repeat the monetary policy mistakes of the 1970s, he tells us about the 1970s, and also about the policy mistakes of the 1930s. From his point of view, we should be more worried about making the policy mistakes of the 1930s than repeating the 1970s. Why?

Consider another metric for interest rates, the well-known Taylor Rule, which captures how monetary policy typically adjusts to output gaps and deviations in inflation from target. Its prescriptions would call for the federal funds rates to be something like –3.6 percent now, well below the zero lower bound the funds rate is currently stuck at. Our large-scale asset purchases have provided additional stimulus, but by most estimates not enough to bring us down to the Taylor Rule prescriptions.

This is by now a well-worn argument in the Fed system for more monetary policy accommodation. Fit a Taylor rule to the data, without taking into account that it is not feasible to violate the zero lower bound on the fed funds rate. Then, under the assumption that past Fed behavior was optimal, or that we want the Fed to behave consistently with past behavior so as to maintain credibility, plug current observations for the output gap and inflation into the estimated rule. The rule tells us the fed funds rate should be negative. What's the conclusion? You might be thinking that we should re-estimate the Taylor rule taking into account the zero lower bound. Wrong. Some people in the Fed system, including Evans apparently, think that the conclusion is that we are not doing enough, and the Fed should find some other way to ease, such as buying some long Treasury bonds.

This of course is nonsense. In the New Keynesian model underlying Evans's thinking, there are no banks holding reserves, nor a central bank with a balance sheet that includes Treasury bonds, mortgage-backed securities, and Treasury bills. There is nothing that can capture what quantitative easing, of any type, is about. Why would Evans think that his model is telling us anything more than that we are at the zero lower bound and he has nothing more to say about it?

Now, why should we not be worried about making the monetary policy mistakes of the 1970s?

Other critics raise the specter of 1970s-like structural changes in the economy. Such changes, they argue, have reduced our productive potential, in particular the mechanisms by which resources — most notably labor — move from declining to expanding sectors of the economy.[3] I am acutely aware of the costs of making such an error. No central banker wants to repeat the painful experiences of the 1979–83 period. Indeed, the FOMC discussed this issue at great length (see the minutes of our January 2011 meeting).[4] However, I have yet to see empirical evidence based on a modeling framework that successfully captures U.S. business cycle dynamics that shows such supply-side structural factors can come close to explaining the huge shortfalls in actual GDP from trend and the high level of unemployment.

It's good that Evans wants a serious model to explain why unemployment is so high and the recovery is so sluggish. Maybe he could also supply us with a serious model of how quantitative easing works.

Evans has been highly supportive of the two recent policy decisions regarding forward guidance and Operation Twist. But he wants more. In particular, he is calling for conditionality in Fed statements, of the following sort:

I think we should consider committing to keep short-term rates at zero until either the unemployment rate goes below 7 percent or the outlook for inflation over the medium term goes above 3 percent.

Yikes. The Fed should not be making explicit statements that make policy actions contingent on things, such as the unemployment rate, for which we could argue the primary determining factors are not monetary policy. Suppose the Fed made such a commitment, and there were significant sectoral changes in the US economy over the next two years that caused the unemployment rate to increase. What then?

If Evans's views dominated on the FOMC, I would be very worried. Fortunately, there are other voices. Jeff Lacker says:

My reading of the evidence is that the strength of this recovery is going to be relatively independent of our monetary policy choices from here on out. The factors likely to be restraining growth — from empty houses to prospective tax rates — are nonmonetary and largely beyond the power of the central bank to offset through easier monetary conditions. History has repeatedly demonstrated that if a central bank attempts to add monetary stimulus to offset nonmonetary disturbances to growth, the result is higher inflation that can be difficult and costly to eliminate. This is why I opposed the Maturity Extension Program — popularly known as "Operation Twist" — in which the Fed will buy long-term Treasury securities and simultaneously sell short-term Treasury securities. The effect of these operations is uncertain, but likely to be relatively small. My sense is that the main effect will be to raise inflation somewhat rather than increase growth.

I pretty much agree with that, and it's roughly consistent with Plosser's views. The only thing I disagree with here are the prospects for inflation. I don't think that the Operation Twist program has any consequences at all - for quantities or prices.

Lacker also takes a shot at Barney Frank:

The fact that diverse and independent views are brought to bear on important policy questions is attributable in part to the unique federated structure of the Federal Reserve System. When the Fed was founded in 1913, Congress deliberately rejected the monolithic model of the European central banks of the time. By chartering 12 distinct banks, each with a board of directors that appoints their Reserve Bank president (subject to approval by the Board of Governors), they deliberately sought to insulate policymaking from election-induced swings that can distort decision-making by diminishing the focus on long-run considerations. And while the Reserve Bank presidents are subject to oversight from both their own boards of directors and the Board of Governors in Washington, their distinct policy views are informed by both regional economic information and the independent research of Reserve Bank economists. This is why legislation that aims at stifling dissent by removing the presidents from the FOMC would be so harmful. By limiting the diversity of independent views around the table, such measures would undermine the historic strength of the System.

Good for Jeff. One of the strengths of the Fed system relative to other central banks is the semi-independence of the regional Feds from the Board of Governors in Washington, which creates healthy competition in ideas. In recent history, the average level of expertise in economics has been much higher among the regional Fed presidents than among the Governors. It would be too bad to lose that.

Twisting

2011-10-13T09:23:00.000-07:00

There are some things in the minutes of the September 20-21 FOMC meeting that seem worth discussing.

Bernanke and other Fed officials like to tell us about the large toolbox they have available for fixing what ails us, and the meeting began with a discussion of the available tools that could be used to supply more accommodation. The choice was framed as Goldilocks would see it. There is "too cold," "just right," and "too hot," in that order, and you know at the outset that the committee will choose just right.

Too cold would involve a change in how the proceeds from principal payments on its holdings of agency securities would be revinvested. Policy before the last meeting was to hold the size of the Fed's balance sheet constant, and to take the proceeds from agency securities and mortgage-backed securities (MBS) that run off, and reinvest that in Treasury securities with a particular average maturity. The proposal was to simply lengthen that average maturity. Just right was Operation Twist - lengthen the average maturity of the Fed's portfolio by selling short-maturity Treasury bonds and buying long Treasuries, while holding the size of the balance sheet constant. Too hot was a repeat of QE3 - an increase in the size of the Fed's balance sheet through purchases of long Treasuries.

At this point in the meeting, there is some discussion. People on the committee who are in an accommodative mood are thinking they will want to keep trying if whatever the committee decides to do now does not work. Just right is seen as a one-time intervention - clearly you can't keep increasing the average maturity of the Fed's portfolio indefinitely. Some people raise some objections: maybe none of these interventions will have much of an effect, if any; maybe we will get too much inflation. A proposal is introduced which was not heretofore on the table (and which ultimately the committee will go for), which is to reinvest the proceeds from maturing agency securities and MBS in more MBS, rather than in Treasuries.

Then, there is a discussion about transparency. In particular:

Most participants indicated that they favored taking steps to increase further the transparency of monetary policy, including providing more information about the Committee's longer-run policy objectives and about the factors that influence the Committee's policy decisions.

It's hard to know what to make of this without more specifics. Maybe what the committee members had in mind was in line with what Evans talks about here. If so, it's wrongheaded, and some people on the committee seem to think so too:

a number of participants expressed concerns about the conceptual issues associated with establishing and communicating explicit longer-run objectives for the unemployment rate or other measures of labor market conditions, inasmuch as the long-run equilibrium levels of such measures are influenced importantly by nonmonetary factors, are subject to change over time, and are estimated with considerable uncertainty. In contrast, participants noted that the long-run level of inflation is determined primarily by monetary policy.

The committee also considered the possibility of lowering the interest rate on reserves (IOR), presumably to 0% from 0.25%. It is quite important that this discussion appears in the FOMC minutes, as decisions about changes in the IOR actually rest with the Board of Governors, not the FOMC. In discussing this at the FOMC meeting, the Board is recognizing that the committee should have a role in the decision, though that role was not given to it by Congress. In my view, a change in the IOR, or language that tells us about the future path of the IOR, is the only relevant element of Fed decisionmaking currently. None of the quantitative interventions actually matter, under current circumstances.

Here is a useful piece of information from the IOR discussion:

a recent change in deposit insurance assessments had the effect of significantly reducing the net return that many banks receive from holding reserve balances.

There are some seemingly puzzling things going on with respect to the behavior of the fed funds rate relative to the IOR. One might expect that the IOR would place a lower bound on the fed funds rate, much as in any channel system (Canada, Australia, ECB, for example). But this is not the case, as the fed funds rate is currently less than the IOR, and has even decreased since late 2008. The GSEs (Fannie Mae, Freddie Mac) do not receive interest on reserves, and commercial banks do not arbitrage away the difference between zero and 0.25%, for reasons that are in part unexplained. However, a contributing factor to the lack of arbitrage has been the change in deposit insurance assessments. Banks are now charged the assessment based on total assets, not deposits. Thus, if I am a bank and attempt to arbitrage the difference between the fed funds rate and the IOR by borrowing on the fed funds market and holding what I borrow as reserves, I increase what I pay to the FDIC. As well, there seems to be some effect of the total quantity of reserves in the system on the IOR-fed funds rate differential (higher reserves increases the differential), but this is just a correlation with no theory backing it up.

Otherwise, the IOR discussion is a bit murky. For example:

Moreover, many participants voiced concerns that reducing the IOR rate risked costly disruptions to money markets and to the intermediation of credit, and that the magnitude of such effects would be difficult to predict in advance. In addition, the federal funds market could contract as a result and the effective federal funds rate could become less reliably linked to other short-term interest rates.

The "disruptions to money markets" may refer to effects that might arise because of the rules governing money market mutual funds, but I'm not sure. I'm not sure why anyone is concerned with activity on the fed funds market. Most of the activity on this market currently must simply be commercial banks borrowing from GSEs. Why do we care if that goes away?

The FOMC of course settled on a policy involving a swap of $400 billion in short-term Treasuries for an equal quantity of long-term Treasuries ("Operation Twist"), and a policy of reinvesting principal repayments on agency securities and MBS in new MBS. The committee members voting for these measures seem to think this will result in decreases in long-term interest rates, and a reduction in the margin between mortgage rates and other long-term interest rates.

There were of course three dissenting votes. Fisher's objections were:

Mr. Fisher saw a maturity extension program as providing few, if any, benefits in support of job creation or economic growth, while it could potentially constrain or complicate the timely removal of policy accommodation. In his view, any reduction in long-term Treasury rates resulting from this policy action would likely lead to further hoarding by savers, with counterproductive results on business and consumer confidence and spending behaviors. He felt that policymakers should instead focus their attention on improving the monetary policy transmission mechanism, particularly with regard to the activity of community banks, which are vital to small business lending and job creation.

The first sentence makes sense, but I can't decipher the rest. Hoarding by savers and improvements in transmission through community banks? What's that about? We know Fisher is not an economist, but he has economists briefing him. Does he not listen? Does it not sink in? Are the briefers bad at their jobs? Who knows?

Kocherlakota says:

Mr. Kocherlakota's perspective on the policy decision was again shaped by his view that in November 2010, the Committee had chosen a level of accommodation that was well calibrated for the condition of the economy. Since November, inflation, and the one-year-ahead forecast for inflation, had risen, while unemployment, and the one-year-ahead forecast for unemployment, had fallen. He did not believe that providing more monetary accommodation was the appropriate response to those changes in the economy, given the current policy framework.

This is basically identical to Kocherlakota's objection at the previous meeting. Finally, Plosser:

Mr. Plosser felt that a maturity extension program would do little to improve near-term growth or employment, in light of the ongoing structural adjustments and fiscal challenges both in the United States and abroad. Moreover, in his view, with inflation continuing to run above earlier forecasts, such a program could risk adding unwanted inflationary pressures and complicate the eventual exit from the period of extraordinarily accommodative monetary policy.

I think that is basically correct, but the maturity swap is essentially irrelevant for inflation, and does not further complicate exit, given that the size of the balance sheet is being held constant.

So, the majority of voting members on the FOMC seem to think that they can actually do things that are more "accommodative" currently. Even the people who are objecting (particularly Plosser) seem to think that the Operation Twist maturity swap, and the QE2 swap of reserves for long Treasuries, actually matter for long-term interest rates. If the Fed can in fact move long-term interest rates at will, then in fact they should be able to target long-term nominal interest interest rates. Indeed, if we believe what the FOMC says, the Fed should be able to determine the whole nominal term structure of interest rates by intervening sufficiently. Why then are these unusual interventions specified not as interest rate targets but in terms of the quantities of assets purchased? You know why. If they thought they could hit the interest rate targets, they would announce it that way. But they know they cannot; basically it doesn't work.

Red-Letter Day: Krugman Gets Banking

2011-10-10T14:44:00.000-07:00

Miracles happen. Krugman understands a Diamond-Dybvig model (more or less). We can quibble about the banking panic part, but he essentially gets it right, and applies it to thinking about the Murray Rothbard elements of Ron Paul's thinking. It's roughly consistent with #3 in this piece. There is hope.

Sargent Family Tree

2011-10-10T08:23:00.000-07:00

I found this on Sargent's web page. This shows you Sargent's academic children, grandchildren and great-grandchildren.

Krugman is Confused

2011-10-10T06:59:00.000-07:00

I wrote about the 2011 Nobel prize that went to Sargent and Sims, then read what Krugman has to say.

If you have been reading Krugman, you know that he thinks the IS-LM model is great, that bad economists are the ones who use sophisticated mathematics, and that we are in a Dark Age of Macroeconomics that began in the 1970s in "freshwater schools" like the University of Minnesota. Are those views consistent with this?

...before Sargent and Sims came along, econometrics consisted largely of estimating models you had no good reason to believe based on identifying assumptions (if you don’t already know, you don’t want to) that lacked credibility. S and S played a key role in developing methods that let the data speak instead.

Krugman does not seem to understand that the "incredible identifying assumptions" came from Old Keynesian IS-LM economics. 1970s rational expectations macroeconometrics, developed by Sargent and Sims, tells you that the identifying assumptions that went into expanded IS-LM estimated models like the FRB/MIT/Penn model, were incredible, and that we should throw those models out.

Sargent and Sims

2011-10-10T06:07:00.000-07:00

I woke up this morning to Per Krusell's voice on the radio, telling me that Thomas Sargent and Christopher Sims had won the 2011 Nobel Prize in Economics. Excellent!

Sargent, along with Neil Wallace, was among the first macroeconomists to recognize that Robert Lucas had done something important in 1972, and helped the rest of the profession understand that by developing the ideas. Sargent, Wallace, and Sims were instrumental in developing, in the 1970s, a model for cooperation in economic research between academics and central bankers at the Federal Reserve Bank of Minneapolis. Minnesota macro has since had a huge influence on the profession, and on the practice of central banking.

Both Sargent and Sims brought a strong econometric tradition to macroecononomics. Sims's work on vector autoregressions, beginning with Macroeconomics and Reality has been highly influential, and you can see Sims's influence in how people like Marty Eichenbaum, Larry Christiano, and Jordi Gali, for example, do their work. Modern quantitative work in macroeconomics, among New Keynesians and non-Keynesians alike, includes both estimation and calibration (from Prescott), a state of affairs I think Sargent and Sims are pleased with.

Sargent has been a key proponent of the use of mathematics and technical developments in other fields in macroeconomics, from dynamic programming methods to frequency domain techniques to robust control. In part, he has promoted the use of these techniques in several generations of textbooks for economics graduate students. Indeed, Sargent's key influence has been through his students. Any Sargent student can tell you about the "Sargent reading group," how it works, and how much they learned from it.

Both Sargent and Sims are economists with extremely high technical ability, but with brilliant insight into economic ideas and economic modeling. Sims is not only a top econometrician, but has made key contributions to the study of the fiscal theory of the price level and rational inattention.

The Nobel committee chose well this year. I think all of us should be pleased.

Simple-Minded Pseudo-Macroeconomists

2011-10-05T11:22:00.001-07:00

Tyler Cowen does not like the IS/LM model. Excellent. Indeed, when Hicks wrote his 1937 paper "Mr. Keynes and the Classics," which interpreted Keynes's General Theory as the now-familiar IS-LM construct, he finished with this:

The General Theory of Employment is a useful book. But it is neither the beginning nor the end of Dynamic Economics.

Thus, Hicks himself is telling you: "This is my effort to figure out what the heck Keynes was trying to get across. Don't take it too seriously though. I'm sure there is plenty of good research to come that will put all of this into perspective, and indeed may replace it." Hicks would probably have been surprised at what happened to IS-LM. Generations of textbook writers found IS-LM a very convenient model to use in getting basic Keynesian ideas across to undergraduate students. However, frontier macroeconomic researchers did not take IS-LM seriously after the early 1970s. By about 1980, IS-LM had essentially disappeared from the top economics journals and from the top PhD programs in economics. But one could still find some version of IS-LM in undergraduate textbooks.

How is IS-LM used today? You do not see it in published macroeconomic research, as a framework for discussion among policymakers, or in PhD programs in economics. It is certainly not necessary to use it in teaching Keynesian economics to undergraduates. In the third edition of my intermediate macro textbook, you will not find an IS-LM model. I have found what I think are more straightforward and instructive ways to get Keynesian economics across, and to get it across in line with what modern Keynesian researchers actually do. For example, I do a version of a Keynesian coordination failure model that looks like what Roger Farmer did in the early 1990s, and an undergraduate version of a Woodford sticky-price model.

So, given that IS-LM is not used by any serious macroeconomic researchers or practitioners, and that we want to represent in an accessible way for undergraduates what macroeconomic researchers and practitioners are actually up to, why would anyone care about IS-LM? Why indeed? But Brad DeLong and Paul Krugman do. In fact, they are quite passionate about it. Well, the Amish are passionate about what they do as well. While DeLong and Krugman might like to freeze the profession at its state in 1937, the rest of us have moved on. In the words of the great bard:

Your old road is rapidly aging. Please get out of the new one if you can't lend your hand, for the times they are a-changing.

Plosser Speech

2011-09-30T10:47:00.000-07:00

I tend to like Charles Plosser's speeches, and this recent one is no exception. Plosser has an excellent understanding of why central bank commitment to a policy rule is a good thing, and communicates the idea well to a lay audience.

Here is one of the interesting parts:

The ills we currently face are not readily resolved through ever more accommodative monetary policy. If we act as if the Fed has the ability to solve all our economic problems, the credibility of the institution is undermined. The loss of that credibility and confidence could be costly to the economy because it will make it much harder for the Fed to implement effective monetary policy in the future.

We do indeed face ills. A large fraction of the population is significantly worse off than they were in 2007. But there are no monetary policy actions available currently that will make them better off. However, by continuing to engage in unconventional policy actions - QE1, QE2, "forward guidance," and Operation Twist, the Fed is acting as if it knows what it is doing, and can actually reduce unemployment by taking those actions. Further, public statements by some Fed officials, particularly Bernanke, express confidence that these actions actually work. Bernanke, and like-minded people such as Charles Evans, Chicago Fed President, are unfortunately engaged in wishful thinking.

In commenting on his dissent at the August FOMC meeting, Plosser states:

Credibility was also at the center of my opposition to changing the forward policy guidance in August. I was concerned that tying monetary policy to calendar time could be misinterpreted by the public as suggesting that monetary policy is no longer contingent on how the economic outlook evolves. This could also lead to a loss of credibility should economic conditions develop in a way that requires the federal funds rate to be adjusted prior to mid-2013. And in my view, given the outlook, economic conditions will likely warrant that the Fed begin to raise rates before that time.

This is essentially identical to Kocherlakota's justification for his dissent at the same meeting, and it makes sense. While the August FOMC decision may look like it implies more commitment, it actually gives less, as Plosser points out. If inflation happens to be much higher than the Fed forecasts (in fact a serious possibility, given the policy) then there are two possibilities. First, the Fed could choose not to tighten, in which case it loses its credibility for controlling inflation. Second, the Fed could choose to tighten, in which case it violates the promise it made in August. Either way credibility is lost and we are actually worse off than if the FOMC had not made the announcement it did in August.

Finally, Plosser discusses inflation targeting:

An important first step in that direction is for the Federal Reserve to adopt an explicit numerical objective for inflation. The explicit inflation goal would help to anchor inflation expectations, raise policy transparency, and increase the central bank’s accountability for its actions. There is considerable evidence that countries that have adopted such an objective as a cornerstone of their monetary policy decision-making have had more success at achieving price stability without any deterioration in the stability of real activity. In the United States, Congress has given the Fed a mandate to promote the goals of maximum employment, stable prices, and moderate long-term interest rates. Price stability is the most effective way for monetary policy to promote the other two goals. Thus, by helping the Fed achieve and maintain price stability, an explicit inflation objective would help the Fed promote all three of the goals set forth by Congress.

Some people think that the Humphrey Hawkins Act constrains the Fed in such a way that it must speak directly to the second part of the dual mandate, typically in terms of specific goals for the labor market. However, Plosser gives us a way out. Just as many other central banks in the world do, the Fed could announce specific inflation targets (or a price level target, if you like that better). This need not require any authorization from Congress, as the Fed can argue that this actually speaks to the dual mandate. And that is not a lie, as indeed a wide class of economic models tells us just that. In general, the long-run costs of inflation are reflected in real GDP and employment. Further, there are models of short-run nonneutralities of money in which price stability implies that real GDP and employment are maximized. For example, some New Keynesian models work that way.

Owls, Hawks, and Doves

2011-09-30T07:32:00.000-07:00

This speech by Fed Governor Sarah Bloom Raskin is mostly a recitation of majority FOMC views, but I thought this was interesting:

Indeed, some commentators assign a label of "hawk" or "dove" to the various FOMC participants in an attempt to characterize how we prioritize the goals of maximum employment and price stability. In my view, such labels are ill conceived and misleading because everyone on the Committee is fully committed to promoting both of these goals. Incidentally, since my kids now love describing everyone as a hawk or a dove or some other kind of bird, I have taken to reminding them of this conviction I have: When my colleagues and I are doing our job correctly, we are neither hawks nor doves but owls--that is, we are trying to be as wise as possible in deploying all the tools we have to fulfill our legal mandate.

I've never thought the labels "hawks" and "doves" were particularly useful. Some people seem to be stuck on the notion that views on the FOMC are simply a matter of choosing a point on the Phillips curve. Hawks and doves in this view are simply individuals with different preferences over inflation and unemployment, with the doves being much more willing to tolerate higher inflation to achieve lower unemployment. Of course since the 1970s we all know that central bankers should not be thinking about Phillips curve tradeoffs, right?

Here is something interesting I learned today. Apparently the average layperson (in this case meaning non-biologist) grossly mischaracterizes the behavior of birds. Sarah Bloom Raskin falls in line with standard mischaracterizations by thinking of the owl as a wise, and presumably "nice", bird. Actually, the owl is as much a predator as the hawk, and typically survives on a diet that includes mice, rats, and hares. The owl's beak is much like a hawk's, allowing it to kill its prey before eating it whole. Further, the owl is very sneaky, having evolved to be extremely quiet so that it can surprise its dinner. Owls are also loners, and not known for getting along in groups.

Further, in terms of vision, the hawk appears to dominate the owl. A hawk can have about 1 million photoreceptors per square mm in the retina as opposed to 200,000 for humans. The owl, however, is noted for being farsighted, perhaps a good quality in central bankers, but basically it can't read the General Theory (or Recursive Methods in Economic Dynamics) up close. As well, the owl is backward-looking, a definite drawback. Though its eyes face forward (making it look human, and therefore "wise"), the eyes don't move in their sockets. The owl compensates for this by turning its whole head. In fact, it can swivel its head 270 degrees, i.e. it can essentially look backward.

According to Louis Lefebvre, a biologist at McGill University, hawks are well up there on the bird IQ scale. No mention of owls unfortunately. They look smart but are apparently dummies.

Here's another interesting tidbit from Dr. Lefebvre. Apparently doves can be nasty.

Cole and Ohanian Reply

2011-09-28T04:47:00.000-07:00

Here is a clarification of Cole and Ohanian's WSJ piece, sent to me by Hal and Lee.

Paul Krugman claims our economic history is in "incredibly bad faith" by showing that industrial output is positively correlated with the wholesale price index. The main point of our op-ed, as well as our earlier work, is that most of the increase in per-capita output that occurred after 1933 was due to higher productivity – not higher labor input. The figure shows total hours worked per adult for the 1930s. There is little recovery in labor, as hours are about 27 percent down in 1933 relative to 1929, and remain about 21 percent down in 1939. But increasing aggregate demand is supposed to increase output by increasing labor, not by increasing productivity, which is typically considered to be outside the scope of short-run spending/monetary policies.

The facts that labor doesn’t recover very much, and that wages in some sectors of the economy are well above trend, is why we have analyzed the impact of New Deal cartelization policies. And the slow recovery from the Depression has been known for decades, including work by Armen Alchian, Milton Friedman and Anna Schwartz, and Robert Lucas, all of whom point to New Deal policies that depressed competition in labor and product markets.

In terms of the relationship between changes in prices and changes in industrial production, our piece examined the 1932-34 period because that was a period cited by Bernanke for strong growth related to eliminating deflation. And the growth that occurred in industrial production during that period occurred while the CPI was falling (1932-1933). Between 1933-34, the CPI rose, but industrial production didn’t.

In any case, growth during the New Deal was due primarily to productivity – not labor.

Ugghh

2011-09-27T15:41:00.000-07:00

Sorry to bother you with more of this drivel, but you might as well know. Here is Krugman, spouting off again about how useless we all are.

I looked up a definition of "science," and came up with this:

The intellectual and practical activity encompassing the systematic study of the structure and behavior of the physical and natural world through observation and experiment.

So, as economists we are systematic, we study the structure of the economy and the behavior of individuals in it, and we observe and experiment. Thus, apparently, we are a science. But Krugman does not think so:

I’ve never liked the notion of talking about economic “science” — it’s much too raw and imperfect a discipline to be paired casually with things like chemistry or biology, and in general when someone talks about economics as a science I immediately suspect that I’m hearing someone who doesn’t know that models are only models.

Of course the chemists and biologists also have models, and those models are only models as well. What is it we do, if not science?

Here's what Krugman closes with:

...liberal economists by and large do seem to be genuinely wrestling with what has happened, but conservative economists don’t.

Apparently Krugman has not been to a macro seminar or serious economics conference for a long time. But maybe all the people writing those papers on the financial crisis are all liberals? I didn't ask. Maybe Krugman has in mind a particular definition of "wrestling," i.e. he/she who actually wrestles uses an IS-LM model.

Hal Cole and Lee Ohanian Are Bad Guys

2011-09-27T11:03:00.000-07:00

In case you haven't noticed, Hal and Lee have joined the Paul Krugman bad guy club. Writing about Cole and Ohanian's WSJ piece, Krugman says:

This goes beyond holding views I disagree with (as does much of what happens in this debate). This is a deliberate attempt to fool readers, demonstrating that there is no good faith here.

Hal and Lee are two thoughtful and careful economists. I don't agree with everything they have ever said, but to call them liars is appalling.

Lucas and Krugman

2011-09-26T08:00:00.000-07:00

I thought that this post by Paul Krugman required a response. It's related to a Lucas interview in the WSJ which, if nothing else, tells you why Krugman's assertions about the "moral failure" of non-Keynesian macroeconomists are absurd.

Krugman's blog post mainly tells us that his deficit in macro-knowledge persists. First, Krugman appears to think that Lucas's only contribution to 20th-century macroeconomics was "Expectations and the Neutrality of Money," in particular the signal-extraction money-surprise story about the non-neutrality of money. Then, Krugman states:

In the 1980s, the Lucas project failed — pure and simple. It became obvious that recessions last too long, and there are too many sources of information, for rational confusion to explain business cycles. Nice try, with a lot of clever modeling, but it just didn’t work.

Money surprises were a tiny part of the "Lucas project." While I think a widely-held view now is that the money-surprise mechanism is unimportant in explaining aggregate fluctuations, the lasting contribution from "Expectations and the Neutrality of Money" is a methodological one. And that methodological contribution is not only the use of rational expectations in a general equilibrium context - very useful in itself - but the use of explicit and consistent economic theory in a macroeconomic context. Further, the "Lucas project" also involved pathbreaking work in asset pricing, monetary economics, economic growth, and dynamic contracts under private information, among other things. Some failure!

Krugman seems to like New Keynesian economics, but:

I find NK economics useful, if only as a way to check my logic, although it’s not really clear if it’s any better than old-fashioned Keynesianism.

Judging from the output, I'm not sure there are any serious checks on Krugman's logic, but we'll give him the benefit of the doubt and assume that he actually grinds through Eggertsson and Krugman whenever he writes a blog post. However, if we take "old-fashioned Keynesianism" to be what is in the General Theory, or in an IS-LM model, then it is hard to argue that Woodford-style New Keynesian economics does not dominate. In its explicit form, New Keynesian economics in fact adheres to the "Lucas project." You can see exactly what is going on - there are optimizing agents, explicit preferences, endowments, and technology, and a well-defined equilibrium concept, in a dynamic context. The General Theory is close to impossible to decipher, and IS-LM is static, with a load of hidden assumptions.

Krugman does not like Prescott economics, and thinks that was a failure too. And he states:

But the math was impressive, and RBC became a self-contained, self-replicating intellectual world.

This is quite a mischaracterization, as RBC was ultimately neither self-contained, nor self-replicating. People built on the basic neoclassical growth model in work in monetary economics, economic growth, optimal taxation, commitment to economic policy, heterogeneous-agent incomplete markets models, etc. Indeed, New Keynesian economics, which is Krugman's logic-checker, evolved directly from RBC models - basic Woodford is RBC + Dixit-Stiglitz + Calvo pricing.

Krugman finishes with this:

But the descendants of the Lucas project know that Keynes was wrong — it’s what their teachers and their teachers’ teachers have been saying all these years. They cannot accept anything resembling a Keynesian explanation without devaluing everything they’ve done with their intellectual lives.

Actually, the descendants of the "Lucas project" are serious economic scientists, who would not say anything so outlandish as "Keynes was wrong." I think modern macroeconomists in general think of Keynesian economics as a small part of macroeconomics - just another friction. Whether Keynesian ideas are useful or not is an open question. There are many holes in Keynesian economics that need to be filled before serious macroeconomists can in fact take Keynesianism seriously. But I don't think anyone finds Keynes threatening. That's just silly.

Cole and Ohanian

2011-09-26T07:28:00.000-07:00

Some interesting reading for today is Cole and Ohanian's piece in the WSJ. At the minimum, this is a reminder that there is more to life than aggregate demand. Here's the conclusion:

Policy can also improve today. The bipartisan Joint Select Committee on Deficit Reduction will make a recommendation by Nov. 23 to deal with future deficits. It has an outstanding opportunity to initiate broad-based tax reform that adopts the recommendations of most bipartisan tax reform commissions of the last 20 years: a simpler tax code that improves the incentives to hire and invest, broadens the tax base, lowers the corporate income tax, and also eliminates loopholes to equalize tax treatment of capital income. Sensibly addressing our long-run challenges will do more for the economy than continuing the stop-gap measures that have dominated policy-making for the last three years.

The Joint Select Committee on Deficit Reduction has an opportunity to tackle tax reform in a serious way - to make the tax code much more efficient while also closing the gap between tax revenue and outlays. Likely the Committee will be dysfunctional, but hoping does not hurt.

Post-FOMC: What Does the Fed Think It Is Up To?

2011-09-22T07:47:00.000-07:00

I'll try to dissect the FOMC statement from yesterday.

The primary policy change is:

The Committee intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less.

While some people want to interpret this as different from QE2, which was a swap of $600 billion in reserves for long-maturity Treasury bonds over a period of about 8 months, a swap of short-maturity Treasury bonds for long-maturity Treasury bonds amounts to essentially the same thing under current conditions. The only differences are that the purchase is 2/3 of QE2, and takes place over a longer period of time.

While this asset swap was widely anticipated, the other policy change was not:

To help support conditions in mortgage markets, the Committee will now reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities.

Since mid-2010, Fed policy had been to reinvest these principal payments in long Treasury bonds.

My contention is that both of these interventions are irrelevant, and will have no effect on current or future prices and real activity. First, as I argue here, the asset swaps cannot matter. Second, while the QE1 purchases of mortgage-backed securities (MBS) may have mattered (possibly in some bad ways), under current conditions MBS purchases by the Fed cannot make any difference unless the Fed purchases dominate the market, which they will not.

So what does the FOMC think it is doing? First, it justifies the interventions in terms of its dual mandate:

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee continues to expect some pickup in the pace of recovery over coming quarters but anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets. The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee's dual mandate as the effects of past energy and other commodity price increases dissipate further.

As we know, FOMC statements post-financial crisis now are much more explicit about the dual mandate, in including the "maximum employment" language. Further, note the emphasis on future inflation here. The FOMC is telling us that what matters is the Fed's forecast of future inflation (which is low) not current inflation (which is high). This is quite different from what we saw in Bernanke's justification for QE2:

Today, most measures of underlying inflation are running somewhat below 2 percent, or a bit lower than the rate most Fed policymakers see as being most consistent with healthy economic growth in the long run.

Thus, in November 2010, Bernanke wanted to convince us that QE2 was reasonable by appealing to current inflation observations; now he wants to convince us based on the inflation rate that we have not yet seen. My interpretation of this is that he does not actually care that much about inflation, but is focused on the second part of the mandate (real activity), as Charles Evans (one of the members who voted for the policy) certainly is.

Now, an interesting part of Bernanke's Washington Post piece that justified QE2 was this:

This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

Maybe Bernanke can explain to us why the Fed's announcement this time coincided with a large drop in stock prices and a narrowing of the spread between nominal Treasury bond yields and TIPS yields (the break-even inflation rate).

I am collecting a set of rules for central bankers. Here are some of them:

1. Don't claim credit for things you cannot control.
2. Don't claim property rights over things you cannot control.
3. Don't engage in interventions when you have no idea what the consequences are.

Bernanke and company have broken all three of those rules.

1. It is dangerous to claim credit for stock price appreciation.
2. The FOMC claims it is intervening to lower the unemployment rate. Under current conditions, it cannot do that.
3. The FOMC does not understand the effects of its policies.

Fisher, Plosser, and Kocherlakota are on the right side of the fence in dissenting on this decision, and I think we should support them.

Chuckle of the Day

2011-09-20T15:47:00.000-07:00

Krugman describes himself, once again:

A lot of the blame goes to the economists ... many of whom are giving bad advice now, I firmly believe, based more on ego and political affiliation than on analysis.

Pre-FOMC: Trying to look decisive when there are no decisions to make

2011-09-19T13:33:00.000-07:00

Some people have been weighing in with some interesting commentary prior to the FOMC meeting on Tuesday/Wednesday. John Taylor thinks that the Fed's dual mandate is a bad idea, and that the Fed should focus only on price stability. Of course, this is standard practice for the ECB, and for central banks with explicit inflation targets, e.g. the Bank of Canada, the Reserve Bank of Australia, the Bank of England, and the Reserve Bank of New Zealand. Taylor cites a paper by Dan Thornton (St. Louis Fed), who looks at the language in Fed policy statements, and finds a recent inclination of the Fed to get much more specific about the second part of the dual mandate. For example, the last FOMC statement says:

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.

This is much stronger than the vague pre-financial crisis language about "sustainable economic growth," for example.

This trend, and public statements like those of Charles Evans, Chicago Fed President, have Paul Volcker worried. The key part of Volcker's NYT op-ed is this:

My point is not that we are on the edge today of serious inflation, which is unlikely if the Fed remains vigilant. Rather, the danger is that if, in desperation, we turn to deliberately seeking inflation to solve real problems — our economic imbalances, sluggish productivity, and excessive leverage — we would soon find that a little inflation doesn’t work. Then the instinct will be to do a little more — a seemingly temporary and “reasonable” 4 percent becomes 5, and then 6 and so on.

What we know, or should know, from the past is that once inflation becomes anticipated and ingrained — as it eventually would — then the stimulating effects are lost. Once an independent central bank does not simply tolerate a low level of inflation as consistent with “stability,” but invokes inflation as a policy, it becomes very difficult to eliminate.

Volcker, as you remember, was the Fed Chairman faced with the task of eliminating the inflation caused by the well-intentioned Fed officials of the 1970s - the Ben Bernankes and Charles Evans of their day. Thus, his opinion should carry some weight, though Paul Krugman of course does not think so.

This WSJ piece suggests that Charles Evans and Charles Plosser (Philadelphia Fed President) have been assigned the task of working out explicit dual mandate targets, as envisioned by Evans. Of course, this leans further in a bad direction. It seems particularly dangerous to be making explicit statements about targets for the unemployment rate, for example. The Fed certainly has no control over the unemployment rate in the long run, and how much influence it can have even over short periods at the best of times is debatable. Further, right now there is absolutely nothing further the Fed can do to move the unemployment rate down.

Essentially, the Fed is faced with a non-decision. Under the current circumstances, with a large positive stock of reserves, all that can matter is a change in the interest rate on reserves (IROR). The Fed will not likely move the IROR to zero, for technical reasons that have to do with money market mutual funds. It will not move the IROR up, as it is not ready to tighten yet. It has already committed to to keeping the IROR at 0.25% for close to two years in the future, and extending that period is not only unlikely, but foolish (as indeed was the commitment made at the last meeting).

What will the Fed do? I think it unlikely that they will actually buy more long-maturity Treasury bonds - i.e. embark on QE3. The most likely outcome will be to lengthen the average maturity of assets in the Fed's portfolio through swaps of short-maturity for long-maturity Treasuries. This of course will accomplish absolutely nothing. However, I think most of the FOMC is convinced that it will.

Barro: Investment and Taxation

2011-09-14T08:26:00.000-07:00

On the weekend, in the New York Times, Barro proposed a program of fiscal reform to deal with our current ills. Paul Krugman, still struggling to understand how a dynamic economy behaves by using an obsolete static model from 1937, can't seem to figure out what Barro is trying to say, but Tyler Cowen does a pretty good job.

Krugman puzzles:

I would have expected Barro to offer some kind of argument based on real business cycle theory or whatever he believes about macro these days.

Here's what Barro says about the determinants of investment:

What drives investment? Stable expectations of a sound economic environment, including the long-run path of tax rates, regulations and so on.

Barro is of course dressing this up for lay people reading the NYT, but what he says seems consistent with the standard neoclassical growth model. You have to add some details, of course, to the basic model - distorting taxes and regulation. However, the basic idea is that investment decisions are made based on long-run factors. Given time-to-build for new capital, and the long life of the capital after it is put in place, any firm contemplating an investment decision will be looking far into the future. Even if one thinks that sticky prices and wages matter for some of a firm's decisions - employment and utilization - stickiness has to be irrelevant over the investment-decision horizon.

Old-fashioned accelerator theories, to the extent there is any serious theory backing them up, appear to rely on the idea that output is demand-determined. Then, since capital is required to produce output, and investment is the change in the capital stock, investment depends on the change in output, i.e. the change in "demand." But for this to work requires that wages and prices be stuck for very long periods of time, which is not consistent with empirical evidence. This seems to be why New Keynesians do not get into accelerator discussions (except for the financial accelerator, but that's entirely different).

Barro goes on with this:

And employment is akin to investment in that hiring decisions take into account the long-run economic climate.

The lesson is that effective incentives for investment and employment require permanence and transparency. Measures that are transient or uncertain will be ineffective.

The first point is a useful one, and I don't think anyone has been discussing this in the context of the current recession. Employment decisions by a firm are indeed investment decisions, though of course this varies across different types of jobs. In some cases, the firm makes a substantial investment in specific human capital when hiring a worker (shared with the worker in some fashion, as determined by the labor contract), and in other cases the primary human capital input in the job is general human capital that can be used at any firm. Thus, to some extent, employment decisions are governed by the same long-run factors that determine investment. Therefore, if we can understand what is holding investment down, we can understand part of what is holding back employment. Interesting idea.

Here are the components of Barro's tax reform proposal:

1. Bowles-Simpson proposals. Barro says:

reforming Social Security and Medicare by increasing ages of eligibility and shifting to an appropriate formula for indexing benefits to inflation; phasing out “tax expenditures” like the deductions for mortgage interest, state and local taxes and employer-provided health care; and lowering the marginal income-tax rates for individuals.

These all seem fine. Politically, changes in Social Security and Medicare seem difficult to obtain, and elimination of mortgage interest deductibility impossible, except perhaps as part of a larger package - i.e. we take this away from you but give you this in return.

2. A value-added tax. This is common in Western Europe, and Canada has a federal value-added tax. Taxation is not something I work on, so I'm not familiar with the economic arguments in favor of the value-added tax. In the long run, you get the same distortion on the consumption/leisure margin as with the income tax. Maybe the tax base is larger than for the income tax, so you can lower the tax rate and reduce the distortion, but you lose the progressivity you get from the income tax.

3. Eliminate corporate taxation. Optimal dynamic taxation tells us that taxing capital income is a bad idea, though I'm sure there are plenty of qualifications in the taxation literature. In any case, there are at least some sound economic arguments for this one.

4. Other stuff. Barro wants to (i) reverse spending increases that have occurred since 2000; (ii) eliminate estate taxes. For us to evaluate (i), Barro would have to be more specific (Bush's prescription drug plan?), and there seems no particular economic rationale for (ii).

So, Barro has given us a few things to think about. What he wrote is certainly much more useful than this, from Krugman:

So the best thing we could do to spur business investment would be to get a recovery going by whatever means necessary, including fiscal stimulus.

That conclusion is based on an accelerator idea - another obsolete piece of economics.

Evans Speaks

2011-09-09T06:08:00.000-07:00

If you think the FOMC is confused, this speech by Charles Evans, Chicago Fed President, might tell you why.

First, Evans wants to take the Fed's dual mandate very seriously - never a good idea. The so-called Humphrey-Hawkins Act of 1978 mandates, in somewhat vague language, that the Fed foster price stability and also pursue policies that promote growth and employment. There is a problem, though. It is essentially universally-accepted among economists that a central bank can control the rate of inflation under most circumstances, though there may be particular circumstances, such as exist currently, under which that is not entirely true. It is also widely-accepted that money is neutral in the long run, and there is much disagreement about the nature and quantitative significance of short-run nonneutralities of money. Thus, any group of economists and non-economists finding themselves sitting in an FOMC meeting will have a hard time interpreting what the dual mandate dictates they should do, and they certainly will not agree on what the Humphrey-Hawkins prescription is.

The Fed has found creative ways of getting around this problem however. First, in speeches by Fed officials and in FOMC statements, lip service is paid to the dual mandate, but the Fed could actually be more-or-less ignoring the real side of the economy. Second, the Fed often uses Phillips curve language, in spite of the fact that the Phillips curve is a problematic object with a sordid history, and output gaps and unemployment rates are of demonstrably little use in forecasting inflation. Why does the Fed do this? Because this is a convenient way to get agreement among FOMC members - if real GDP growth is expected to be high (low) then the Phillips curve tells us that inflation will be high (low), and all the FOMC members vote to tighten (ease), whether they are Keynesians or not. Third, it can be convenient for Fed officials to speak in public about how a low and stable inflation rate actually fosters economic growth. By this logic, in fulfilling one part of the mandate, the Fed can fulfill both, and kill two birds with one stone. The logic is also correct, though we could argue about the quantitative effect of inflation on economic growth.

None of this namby-pamby vague central-bank-speak for Evans, though. He wants to interpret the dual mandate in terms of hard numbers. According to him, the "natural rate" of unemployment is 6%, and price stability means an inflation rate of 2%, so the bliss point for the US economy is a 6% rate of unemployment and a 2% rate of inflation, and the Fed's performance should be measured in terms of a quadratic loss function. Why? Mike Woodford told him it was OK.

What should the Fed do under the current circumstances? Evans anticipates that the inflation rate will fall below 2% and the unemployment rate is of course well above 6%, so the choice is clear for him: there should be more monetary accommodation. Implicit in this argument of course is the Phillips curve - more monetary accommodation implies more inflation and less unemployment. But how much accommodation? For Evans, this is just a matter of what coefficients go into the quadratic loss function. He clearly puts a low weight on the losses from high inflation and a high weight on the losses from high unemployment, so he is willing to bear a much higher inflation rate so as to bring unemployment down.

There are three problems here.

1. Evans is forgetting the lessons of the 1970s. What Evans is proposing is a change in the policy rule - a change in how the state of the economy maps into actions by the Fed. What economists understand today that they did not in 1975, is that commitment by the Fed to a policy rule is critical for its success in fulfilling its mandate. Once the public understands that the Fed intends to exploit a short-run Phillips curve relationship (and the problem is worse if the short-run inflation/unemployment tradeoff in fact does not exist), then all bets are off. High inflation can become well-entrenched and we have to go through an episode like the policy-induced "Volcker recession," followed by a long period where the Fed re-establishes its credibility. This is exactly the logic, I think, behind Kocherlakota's dissent at the last FOMC meeting. In the 1970s, the Fed was dominated by many well-intentioned people much like Charles Evans, and they got us into trouble.

2. What is the economic inefficiency that Evans thinks he is trying to correct? By efficient, I think we mean a state of affairs that is optimal from the point of view of a policymaker - there is nothing that a policymaker can do given that state of affairs to increase aggregate economic welfare. Evans seems convinced that the state we are in is not efficient. In this quote, he comments on "the story" that interprets our bad state of affairs as intractable, from a policymaker's point of view:

I suppose it is natural to believe that some elements of the story are true. But for me, the evidence for this is minimal, and the implications for productive capacity are exceedingly pessimistic. And even if it is true, the market mechanism should cause wages and prices to adjust in order to reemploy unused resources. For example, there should be some lower real wage that would make it profitable for firms to fund the necessary on-the-job training for workers who need some modest acquisition of skills. According to this pessimistic hypothesis, something is preventing the market’s pricing mechanism from achieving such results within a satisfactory time frame.

This seems confused. What he seems to be saying is that theories that attribute a rise in the unemployment rate to frictions associated with sectoral reallocation must rely on price or wage distortions. However, the sectoral reallocation frictions that typically come into play in these discussions involve the time and effort associated with acquiring sector-specific human capital, information frictions, and the costs of moving labor across geographical regions. One would think that wage and price distortions might be key to Evans's argument - he's clearly a hardcore Keynesian, and one would not think he would be appealing to wage and price flexibility to shoot down the alternative case.

So what is our key macroeconomic problem, from Evans's point of view?

...I think the evidence favors the belief that aggregate demand is simply much too low today.

Arrrgghhh. If all economists could take a pledge never to use the words "aggregate demand" again, the world would be a better place. What Evans is saying is that he does not know what is going on. Aggregate demand is Keynesian language. When the language is used, what it means is that there is an inefficiency that the monetary and/or fiscal authority might be able to correct. In Keynesian theory, the inefficiency can come from two sources: (i) sticky wages and prices or (ii) multiple equilibria. The specifics of the inefficiency actually matters for what the optimal policy response is. Which prices are sticky and which are not? Are the prices sticky, are the wages sticky, or both? If the problem is not sticky wages and prices but the fact that we are just in a bad equilibrium, the solution to getting to the good equilibrium might be quite different than solving the price/wage distortion problem.

Further, Evans tells us about Reinhart and Rogoff, the debt overhang, and how this prolongs our economic recovery. How does he know that the "unused resources" he is seeing are not unused because of the financial problems created by the recent crisis? Debt overhang in the economy may create conditions under which those resources will go unused, no matter what the Fed does. Did debt overhang actually go into Evans's 6% "natural rate of unemployment" calculation?

3. How can the Fed actually be more accommodative under current conditions? As I have discussed before, the Fed has only one policy instrument given the large quantity of excess reserves in the financial system: the interest rate on reserves (IROR). Quantitative easing, or changes in the maturity structure of the assets on the Fed's balance sheet will accomplish nothing. Thus, to be more accommodative through current actions is impossible, unless the IROR goes to 0%. Bernanke told us a year ago that this was not on the table, but maybe he has changed his mind. In any case, setting the IROR at 0% will not change anything much. However, the Fed can change its statements about the future path of the IROR, and that can matter.

Evans suggest three types of "forward guidance," that the Fed could contemplate. The first is a policy rule explicitly contingent on the unemployment rate. The second is contingent price-level targeting, and the third is nominal GDP targeting. The first policy is quite ill-advised, partly for reasons discussed above, but in particular because the "natural rate of unemployment," whatever it is (there are many definitions) is a moving object, and it moves in unpredictable ways. The other two proposals actually do not imply anything especially new about how we formulate policy, as you ultimately have to reformulate those things in terms of a rule for the policy interest rate.

Some of what Evans contemplates would open up the possibility of a future with high and sustained inflation. Evans should think carefully about which he prefers - some heat from Krugmaniacs and the unemployed about unused resources, or a lot of heat from everyone about the high rate of inflation.

Zombie Economics, Redux

2011-09-08T11:44:00.000-07:00

For all of you who are dying to know more about John Quiggin's Zombie Economics, here is a review essay I have written. This is somewhat formal and un-bloggy, complete with references, and is not the Journal of Economic Literature review on Quiggin's book that I wrote, which is quite short. I do more in this essay than just critique Zombie Economics. It is in part a defense of contemporary economics, in response to various rabble-rousing, including Paul Krugman's 2009 NYT piece, or this more recent critique. There are also some financial crisis ideas in there.

If you find errors, please let me know, and I'm interested in your comments.

Mark Thoma Went to the Wrong Conference

2011-08-30T11:50:00.000-07:00

Mark Thoma went to the Lindau Nobel Laureates meetings and wonders why he did not learn anything new. No offense to these people, many of whom I admire and have learned a great deal from, but this is the geriatric set, mostly. One should not expect to be enlightened about the causes and consequences of the financial crisis by showing up at Lindau. For enlightenment, Mark should have gone to the SED meetings in July, to see what the sharpest young economists in the world are doing. I'm sure Ed Prescott would agree.

Let's deal with some of Mark's specific complaints about what he thinks practicing macroeconomists have been up to:

Macroeconomic models have not fared well in recent years – the models didn’t predict the financial crisis...

I'm so sick of hearing that one I could scream. The economic agents living in a model in which a financial crisis can occur know that there is a possibility that this event can happen. But they cannot predict it, otherwise there would be an unexploited profit opportunity. Similarly, a real human being could not have used such a model to predict the financial crisis. Economists may have been unaware of some of the things that were going on in financial markets that contributed to the crisis, and some of that was not their fault, as some of those things involved obfuscation by the financial market participants involved. Failure to predict the financial crisis does not in itself condemn all existing macroeconomic theory.

How can some of the best economists in the profession come to such different conclusions? A big part of the problem is that macroeconomists have not settled on a single model of the economy, and the various models often deliver very different, contradictory advice on how to solve economic problems.

Mark obviously finds disagreement disagreeable, but that's what makes life interesting. If we all agreed, we could pack up, go home, and watch TV. There will never be a "single model" that solves all macroeconomic problems, nor should there be. We use different models for different problems, and all of those models are going to be wrong on some dimension. Intelligent economists are going to disagree about the details of what goes into the models. Science marches on.

Finally, here's an extra bit from Mark's blog post

I have little faith that the older generation will ever acknowledge the models they spent their lives building are fundamentally flawed.

Of course, every model is flawed in some sense, i.e. it is going to be wrong on some dimensions. A model is necessarily an abstraction - a simplification that helps us to organize our thinking about the world. It cannot do its job unless it leaves stuff out, and it therefore can't be right about everything.

The idea that we are surrounded by "fundamentally flawed" models is so gloomy. Look on the positive side, Mark, and recognize what the important contributions are, and how economists have built on those contributions in the last 40 years. Pay attention to the good work that young economists are doing right now, under your nose, if you care to look.

Alan Krueger

2011-08-29T11:29:00.000-07:00

Is Alan Krueger a good person to head the Council of Economic Advisors? Here's his CV. Krueger is a successful applied microeconomist who has worked on problems in labor economics and education. I may be wrong, but I think we can characterize him as astructural, vs. structural along the lines of Heckman, Wolpin, or Pakes. Krueger would certainly have a grip on the ailments of US labor markets and US education, which certainly seem central to what the CEA should be thinking about. How any individual will behave in a policy job is hard to predict, but this seems as good a choice as any to me. Maybe you know something I don't though. I do know that this paper was a little weird.

Regular and Irregular Economics, Continued

2011-08-29T08:59:00.001-07:00

I was pointed to this Richmond Fed article, which relates to Barro and Krugman.

Conversations with Brad

2011-08-28T10:37:00.000-07:00

Tyler Cowen linked to one of my posts and seems to find something in there to like. Brad DeLong does not like it.

Cowen wanted to think of what I do as "neoclassical economics." Some people like to call it "micro-founded macreconomics," and Barro recently called it "regular economics." The people I have learned from, work with, and talk to do economics - they take theory developed by other people, build on it, match the theory to data, and attempt to evaluate macroeconomic policies in a sensible way. Some of those people are sympathetic to Keynesian ideas; some of those people are critical of those ideas.

Here's what Brad has to say:

From my perspective this "neoclassical macroeconomics" is merely Hicks (1937) (or perhaps Wicksell (1898)) "plus", as Rüdi Dornbusch liked to say, "original errors".

This will be a theme. The pristine ideas are apparently in the classics - Hicks, Wicksell - and we have just thrown sand into the gears.

I said something in my piece about how the inefficiency I wanted to isolate was not a Keynesian inefficiency. The Keynesian inefficiency is a too-high safe real rate of interest; my inefficiency was a too-low safe real rate of interest. Here's Brad again:

In the Keynesian-or perhaps it would be better to say Wicksellian--framework, when you say that real rates of return are "too high" you are saying that the market rate of interest is above the interest rate consistent with full employment, and with savings equal to investment at full employment. Wicksell called that interest rate the "natural rate of interest" and it is relative to that natural rate of interest that Wicksellian (and Keynesians) speak of interest rates being "too high" and "too low". Thus Williamson is wrong when he say that what we have now--when the natural rate of interest on relatively safe securities is negative and the market rate of interest is not--is "not a Keynesian [or Wicksellian] inefficiency". It is precisely such an inefficiency. To claim that it is not misinterprets Keynes (and Hicks, and Wicksell), and misleads readers trying to understand what they did and did not say.

I'm taking my cue here from Mike Woodford, for example "Interest and Prices." Woodford certainly thinks that he is channeling Wicksell, though maybe Brad thinks he's not. In a Woodford New Keynesian model, monetary policy is about moving the market nominal interest rate around, and the transmission mechanism for monetary policy works through the real rate. Once you hit the zero lower bound on the nominal rate, the real rate can't go lower. That's the way New Keynesian economists inside the Fed system frame the monetary policy problem in the current circumstances. The real rate is too high, you want it to be lower, but monetary policy can't do that in the conventional manner.

Here's the interesting part. Brad is characterizing the current state of affairs and says "the natural rate of interest on relatively safe securities is negative and the market rate of interest is not." What I think he is saying is that the safe real rate of interest is low, but the relevant "market rate of interest" is in fact high. I don't think you can find that feature in any "Keynesian" framework where you would be able to correct the problem through some kind of policy Brad might want to prescribe in the current circumstances.

But whether you can find it in the General Theory or not, Brad has brought up something very useful. The fact that the safe real rate is low is intimately related to the fact that the "market rate of interest" is high. In fact, you can find this in this paper. The effect is more pronounced in the financial crisis, but I think it persists. The idea is that greater uncertainty and higher costs associated with evaluating collateral and unwinding debt acted to increase interest rate spreads - the spreads between the safe rate of interest and "market rates of interest" - reducing the quantity of privately-produced liquid assets, creating the asset scarcity that lowered the safe real rate of interest. To understand that idea, you don't need to go digging in Wicksell, Hicks, Fisher, or the General Theory. It's elucidated much more precisely in the work of Rob Townsend, Doug Diamond, and other people who worked on modern information theory, contract theory, and the theory of financial intermediation.

Brad goes on:

A second thing I think is wrong is Williamson's claim that while things could be (or perhaps should be) improved by shifting the IS curve out and to the right...

Don't go there Brad. As I said, it's not in Hicks.

The relevant question he asks is this one:

Why does pulling spending forward into the present fail while pushing taxes back into the future works?

In my post, I was arguing that the problem was a shortage of safe assets, monetary policy could not solve the problem, and we could think of an otherwise Ricardian fiscal experiment that would do the trick. I wanted to avoid talking about government expenditures on goods and services, as that would open up a whole set of issues I did not want to get into - redistribution, alternative types of spending and the government's advantages relative to the private sector, political economy, etc.

Then, Brad says:

And yet a third thing I think is wrong is Williamson's claim that "the Fed is powerless" because "swap[s of] reserves for T-bills or reserves for long-maturity Treasuries… essentially amounts to intermediation activities the private sector can accomplish as well, this will have no effect". But such swaps take various forms of duration and default risk onto (or off of) the Fed's and thus taxpayers' balance sheets and off of the private market and thus investors' balance sheets. These are different (but overlapping) groups who perceive risks differently, have different resources, and react to risks differently. The fact that the private market could undo any particular Federal Reserve policy intervention does not mean that it will.

This is a key part of my argument - i.e. under the current circumstances, quantitative easing is irrelevant. In order for asset swaps to have any effect the Fed has to have some advantage in the intermediation activity it is engaging in relative to what the private sector can accomplish. Currently the Fed has no advantage in turning long-maturity Treasury debt into overnight assets, so QE is irrelevant.

Finally,

I would say go back to Hicks, Keynes, Fisher, and Wicksell, and think about them carefully: they were smart. A "neoclassical macro" that does not start from them has little chance of getting much of anywhere.

Yes, Hicks, Keynes, Fisher, and Wicksell were smart, but Keynes did not spend all of his time with his nose in Adam Smith, otherwise he would not have got any work done. Maybe someone got something wrong, and there are nuggets of insight in early work that were not passed on through the economic writings that succeeded it. However, most of what is useful from Hicks, Keynes, Fisher, and Wicksell is baked in the cake. Modern students of macroeconomics are much better off reading Lucas, Woodford, Prescott, Gertler, Gali, Farmer, Rogerson, Kehoe, Wright, Christiao, Kiyotaki, etc. from the older generations, or any number of excellent young macroeconomists. However, here is what I read the other day in Hicks's 1937 paper:

The General Theory of Employment is a useful book; but it is neither the beginning nor the end of Dynamic Economics.

Hicks was smart.

Economics Reporting

2011-08-28T08:14:00.000-07:00

This comes from Dissecting the Mind of the Fed, by David Leonhardt, in the Sunday NYT:

But you would also find a sizable group of economists who thought the Fed could and should do far more than it was doing. This group, known as doves, tilts liberal, though it includes conservatives as well. If anything, it can probably claim a larger number of big-name economists — J. Bradford DeLong, Paul Krugman (an Op-Ed columnist for The New York Times), Christina D. Romer, Scott Sumner and Mark Thoma, among others — than the camp that believes the Fed has done too much.

Seems like he's taking a poll, and then calculating some weighted average to come up with a conclusion, with the weights determined by numbers of blog-readers.

Stiglitz

2011-08-26T18:28:00.000-07:00

Here is a Stiglitz talk at the Lindau meetings. He gets going, and you think it is just going to be Krugman ideas - kibitzing about modern macro in general. He makes the common error of finding fault with models that did not predict the crisis. If you build a good model of a financial crisis, the people living in that artificial environment know that a crisis can happen, but they won't be able to predict it. And you won't be able to use the model to predict a crisis in the real world either.

However, the talk then gets more interesting. It becomes clear that, when he's finding fault with models that are in common use, he has actually talked to people and tried to figure this out. The models he finds fault with are apparently New Keynesian models. He thinks that wage rigidity is unimportant, that the distortions that New Keynesians worry about don't matter much, and that we should be more concerned with financial frictions and credit. Excellent! A central banker tells him that the model used in his or her central bank has no banks in it. Stiglitz is flabbergasted. Stiglitz is now my hero.

Prescott Talk

2011-08-26T15:25:00.001-07:00

If you have never seen an Ed Prescott talk, here is your chance. Don't pay attention to how he's saying it, just listen closely. This is interesting, just to hear how he thinks about what he does.

Woodford in the Financial Times

2011-08-26T14:55:00.000-07:00

I agree with some of Woodford's conclusions, but was having a little trouble with his argument. First, he states

The economic theory behind QE has always been flimsy.

Yes, exactly. But then he states:

The original argument, essentially, was that the absolute level of prices in an economy is determined only by a central bank’s supply of base money.

The way Bernanke and others typically made the argument was to state that they could manipulate the relative supplies of short and long-maturity debt, and with the short end of the term structure of interest rates essentially pegged at zero, long rates would go down.

Woodford goes on to discuss how it matters whether the reserves are increased permanently or not. There is a sense in which that is correct, but I think it's also true that quantitative easing could take place in such a way that the reserves are out there forever, and it would not matter.

Woodford also states:

Uncertainty about the economic outlook is likely now the most important obstacle to a more robust recovery. The problem is not just uncertainty about Fed policy, but the fact that the Fed has become harder to “read” does not help.

I agree with that. The policy change in the August FOMC statement indeed makes the Fed harder to read, and adds to uncertainty, which is not good.

Bernanke's Jackson Hole Speech

2011-08-26T12:06:00.000-07:00

Bernanke's speech seemed mostly on target and sensible, leaning toward growth issues, given the thrust of the conference apparently, but touching on some short-run policy issues.

Of particular note is the discussion of the August FOMC policy statement.

In light of its current outlook, the Committee recently decided to provide more specific forward guidance about its expectations for the future path of the federal funds rate. In particular, in the statement following our meeting earlier this month, we indicated that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013. That is, in what the Committee judges to be the most likely scenarios for resource utilization and inflation in the medium term, the target for the federal funds rate would be held at its current low levels for at least two more years.

The important message here is that the majority of the Committee is quite certain that there will be "low rates of resource utilization and a subdued outlook for inflation ..." for an extended period of time, in particular two years. That view seems hard to reconcile with some of the other parts of the speech, which seem to emphasize the uncertain state in which we are in. We can infer that this is the key element of contention on the committee. The dissenters may just be more uncertain than the majority.

Another key tidbit is this:

In addition to refining our forward guidance, the Federal Reserve has a range of tools that could be used to provide additional monetary stimulus. We discussed the relative merits and costs of such tools at our August meeting.

This makes it sound like there are some tools in the box that we have not tried yet, and that some of these tools will actually do something. One tool that has been used, and could be used again, is quantitative easing. As I argued here, under the current circumstances more QE is futile. The only tool the Fed currently has that will do anything is the interest rate on reserves. As Bernanke told us last year, lowering that from 0.25% is not an option, so it can only go up.

In the growth discussion, there is this:

Normally, monetary or fiscal policies aimed primarily at promoting a faster pace of economic recovery in the near term would not be expected to significantly affect the longer-term performance of the economy. However, current circumstances may be an exception to that standard view--the exception to which I alluded earlier. Our economy is suffering today from an extraordinarily high level of long-term unemployment, with nearly half of the unemployed having been out of work for more than six months. Under these unusual circumstances, policies that promote a stronger recovery in the near term may serve longer-term objectives as well. In the short term, putting people back to work reduces the hardships inflicted by difficult economic times and helps ensure that our economy is producing at its full potential rather than leaving productive resources fallow. In the longer term, minimizing the duration of unemployment supports a healthy economy by avoiding some of the erosion of skills and loss of attachment to the labor force that is often associated with long-term unemployment.

What is not clear from this is whether Bernanke thinks that, at this point in time, the Fed can do anything to bring about a faster recovery. Maybe (actually almost certainly) the FOMC is conflicted about this, and we'll have to wait for the next meeting to find out what they are thinking.

Finally, the federal government is told to get its act together:

Finally, and perhaps most challenging, the country would be well served by a better process for making fiscal decisions. The negotiations that took place over the summer disrupted financial markets and probably the economy as well, and similar events in the future could, over time, seriously jeopardize the willingness of investors around the world to hold U.S. financial assets or to make direct investments in job-creating U.S. businesses. Although details would have to be negotiated, fiscal policymakers could consider developing a more effective process that sets clear and transparent budget goals, together with budget mechanisms to establish the credibility of those goals. Of course, formal budget goals and mechanisms do not replace the need for fiscal policymakers to make the difficult choices that are needed to put the country's fiscal house in order, which means that public understanding of and support for the goals of fiscal policy are crucial.

Good. That needed to be said.

Has Politics Paralyzed the Fed?

2011-08-26T06:54:00.000-07:00

Actually, no. But Paul Krugman says yes. This morning's NYT Krugman column starts by focusing us on Rick Perry. Perry is of course an excellent foil, and genuinely scary. But does Perry actually influence Ben Bernanke's behavior? Well, not really.

O.K., I don’t mean that Mr. Perry, the governor of Texas, is personally standing in the way of effective monetary policy. Not yet, anyway. Instead, I’m using Mr. Perry — who has famously threatened Mr. Bernanke with dire personal consequences if he pursues expansionary monetary policy before the 2012 election — as a symbol of the political intimidation that is killing our last remaining hope for economic recovery.

So, since Perry is only "symbolic," what exactly is the substantive nature of the political pressure on the Fed? Krugman mentions two things: (i) the dissent by three members of the FOMC on the last policy decision; (ii) some public statements by Paul Ryan about dollar debasement and such. Now, (i) Dissent within the FOMC is certainly not political; that has to do with the internal workings of the Fed. I don't think you can make a case that Plosser, Kocherlakota, or Fisher were motivated by political pressure (see this, this, and this). (ii) There is nothing much new about members of the House criticizing the Fed. Ron Paul has for a long time been arguing that we should abolish the Fed, which seems to make even members of his own party want to run the other way. I don't see any evidence that monetary cranks have altered Fed behavior.

So much for the politics. The heart of Krugman's post actually has to do with how Bernanke's behavior as Fed chairman matches up to what Bernanke was proposing in 2000, as a recipe for Japan's problems at the time.

Mr. Bernanke suggested that the Bank of Japan could get Japan’s economy moving with a variety of unconventional policies. These could include: purchases of long-term government debt (to push interest rates, and hence private borrowing costs, down); an announcement that short-term interest rates would stay near zero for an extended period, to further reduce long-term rates; an announcement that the bank was seeking moderate inflation, “setting a target in the 3-4% range for inflation, to be maintained for a number of years,” which would encourage borrowing and discourage people from hoarding cash; and “an attempt to achieve substantial depreciation of the yen,” that is, to reduce the yen’s value in terms of other currencies.

Then, Krugman states:

So why isn’t the Fed pursuing the agenda its own chairman once recommended for Japan?

Let's just deal with the accuracy of that statement for now. Of course, if you have been watching what the Fed has been doing since late 2008, you know that the Fed has been following Bernanke's 2000 Japan agenda remarkably closely. The Fed has tripled the size of its balance sheet, purchasing large quantities of long-term government debt, as well as mortgage-backed securities and agency securities. The Fed's policy rate (the interest rate on reserves) has been set at 0.25% since late 2008, and the FOMC has just announced that, barring some extreme and unexpected circumstances, that will continue for almost two years. How much more extended can you get? The only piece of policy that differs from the Japanese agenda is the 3-4% inflation target. Bernanke and other Fed officials are on record as stating that their inflation target is 2%. While one could find sound reasons why this target could be higher, there is nothing the Fed could be doing that it has not already done that could actually increase the inflation rate in the United States.

Krugman argues that the Fed is paralyzed and politically intimidated. Neither is the case. The question we want to ask under the current circumstances is the following. Are there actions the Fed could be taking that would make us better off? Krugman would like you to believe that there are things the Fed could be doing, Bernanke knows what they are, but wrongheaded politicians and some dissenters on the FOMC are preventing him from executing the agenda. I don't think that's right. Under the current circumstances, the Fed is powerless, and the dissenters are right.

Understanding Irregular Economics

2011-08-25T19:05:00.000-07:00

Paul Krugman has written a post that encapsulates his thinking on macroeconomics - how he thinks other people do it, and how he thinks it should be done. His post is a comment on Barro's WSJ article that I discussed here.

Let's take this apart. First paragraph:

As Glasner says, there’s something deeply weird about asking “where’s the market failure?” in the face of massive unemployment, huge unused capacity, an economy producing less than it did three and a half years ago despite population growth and advancing technology. Of course there’s some kind of market failure, which means that there’s nothing at all odd about asserting that better policy can yield free lunches.

We cannot observe a market failure. To deduce that a market failure exists, one needs a model. Given that we cannot observe market failure by looking at the state of the economy, we also can't say what a "better policy" is. Again, for that we need a model.

Second paragraph:

More generally, the existence of business cycles is hardly a trivial feature of real economies. You can try to explain those cycles in terms of “regular economics” — that’s what real business cycle theory is all about — but that effort has been a dismal failure, even if the practitioners refuse to admit it. The desperate efforts to find something Obama has done that explains why the economy plunged are in effect a demonstration of the hollowness of that whole approach.

Yes, real business cycle theory uses regular economics. But so does all of modern Keynesian theory. The people who worked on coordination failures - Bryant, Diamond, Cooper, Farmer, Benhabib - all used regular economics. So do the New Keynesians - Woodford, Gali, Gertler, etc. Krugman himself uses regular economics. But what was the "dismal failure" of real business cycle theory? Kydland and Prescott introduced a quantitative methodology that is still in wide use. The basic theoretical framework (due as much to Solow, Cass, Koopmans, Brock and Mirman, as to Kydland and Prescott) was expanded upon and used widely in the study of optimal taxation, time consistency, and other things. Further, Woodford adapted it to produce New Keynesian theory. Seems there is plenty of success in there.

Third paragraph:

But I want to add something more: why, exactly, are we supposed to have such faith in “regular economics”? What is the compelling evidence that the vision of a competitive, efficient economy allocating resources to the right uses is actually a good description of the world we live in?

Regular economics is not restricted to the study of competitive and efficient economies. Much of modern macroeconomics deals with externalities and the distortions caused by taxation and information frictions, among other things. The study of efficient economies is only a tiny part of what macroeconomists actually do.

Fourth paragraph:

I mean, it’s a lovely model, and one I, like everyone else in economics, use a lot. But I would not have said that it’s a model backed by lots of evidence. We do know that demand curves generally slope down; it’s a lot harder to give good examples of supply curves that slope up (as a textbook author, believe me, I’ve looked); and it’s a very long way from there to the vision of Pareto efficiency and all that which Barro wants us to take as the true economics. Realistically, imperfect competition, market failure, and more are everywhere.

1. "It's a lovely model" clearly means basic RBC, e.g. Kydland and Prescott. Why the focus on this particular model? Even if we focus on that model in particular, you can't say it's not backed by evidence. That was the whole idea. Go back and read Kydland and Prescott.
2. "it’s a very long way from there to the vision of Pareto efficiency and all that which Barro wants us to take as the true economics." Where does Barro say in his piece that everything is Pareto efficient?
3. Yes, we can find plenty of imperfect competition, market failure, and more. But regular economics can and does deal with all of that stuff. What is the problem here?

Fifth paragraph:

Meanwhile, there’s actually a lot of evidence for a broadly Keynesian view of the world. Not, to be fair, for fiscal policy, mainly because clean fiscal experiments are rare. But there’s huge evidence for sticky prices, lots of evidence that monetary shocks have real effects — and it’s hard to produce a coherent model in which that’s true that doesn’t also leave room for fiscal policy.

We have a fairly good characterization now of how prices behave - the frequency of price changes for particular goods and services. That evidence does not entirely square with modern Keynesian models, and we have search models which can deliver the features of price behavior we observe, but where money is in fact neutral. It does not follow obviously from the observed behavior of prices that the short run non-neutralities of money actually result from the pricing behavior of firms. The big gap in Keynesian theory is that it does not deliver on the elements that are key to how it works: Why are contracts set in nominal terms? Why are prices changed infrequently for some goods and services? What would make a firm unwilling to change its price but more than willing to incur the costs of changing output and employment?

Last paragraph:

In short, there’s no reason at all to consider microeconomics the “real” economics and macroeconomics some kind of flaky impostor. Yes, micro is a lot more rigorous — but if it’s rigorously wrong, who cares?

Note how he uses "macroeconomics." He means the macroeconomics that is spooned out to poor unsuspecting undergraduates in many undergraduate principles and intermediate macro books, which is indeed flaky. This is not the macroeconomics of most practicing macroeconomic researchers, the macroeconomics taught in PhD programs or the macroeconomics of the economists who advise many policymakers. It's not too much to expect that macroeconomists be rigorous - just like everyone else.

Regular Economics

2011-08-25T08:15:00.000-07:00

Barro has a piece in the WSJ which appears to be part of a series of critical opinon pieces on Keynesian economics. It's better than the last one.

I like the idea of emphasizing "regular economics" vs. Keynesian economics. The 1970s revolution that Lucas started was principally a drive to make macroeconomics regular, by using tools developed in other fields in economics to make sense out of macroeconomic problems. This was initially hard for Keynesians to swallow, but it did not take long for them to catch on, and by the 1980s they were doing the same thing.

Modern Keynesian coordination failure models (not so popular today) and New Keynesian models (very popular) are in fact regular economics - most of the time. Everything is explicit, you can see how it works, and you can quantify things, such as the effects of government policies. Then, we can go about evaluating these models. Why is this assumption there and not another one? Is this parameter measured correctly? How well do these models fit the data?

Much blogosphere Keynesian economics is not regular economics, though. What is driving much of this are the misleading notions that come from some undergraduate textbook macro - the free lunches that Barro is complaining about. Arguments are typically couched in terms of "deficient aggregate demand," by which an irregular Keynesian means "output is below trend." Not all of the blogosphere is like this though. Paul Krugman, who often engages in irregular Keynesian economics, can on occasion be regular, in which case you can actually take it apart and see how it works.

Now, since Barro is regular, you can also take his arguments apart and see what makes them tick. For example, Barro states the following:

Ironically, the administration created one informative data point by dramatically raising unemployment insurance eligibility to 99 weeks in 2009—a much bigger expansion than in previous recessions. Interestingly, the fraction of the unemployed who are long term (more than 26 weeks) has jumped since 2009—to over 44% today, whereas the previous peak had been only 26% during the 1982-83 recession. This pattern suggests that the dramatically longer unemployment-insurance eligibility period adversely affected the labor market. All we need now to get reliable estimates are a hundred more of these experiments.

We know that unemployment insurance (UI) has incentive effects. Any serious model of unemployment will deliver the result that an increase in UI benefits - working through a reduction in search effort by the unemployed, or a tendency of the unemployed to become more picky about the jobs they will accept - will imply a higher unemployment rate and longer average duration of unemployment spells. The key question is how large the effect is. We might also be interested in how the size of benefits matters relative to the duration of benefits, for example.

Barro is too careful to stick his neck out, but he certainly seems to be indicating that he thinks the effect could help in a significant way in explaining what we are observing in the data - i.e. he thinks the effect is large. He also indicates that we should have to see more data to sort this out, but I don't think that is true. We actually have a lot of cross-country data for countries with very different UI systems, for example, and some previous experience with the extension of benefits in the US. Indeed, I would be surprised if there were not many published papers that address the question directly. Anyone know?

P.S. Here is some work on this, arguing the effect is small. The source of the citation also makes the point that it is important to look at the recent data.

Common Sense and Macroeconomics

2011-08-23T17:58:00.000-07:00

This WSJ article by Stephen Moore was ridiculed by Paul Krugman and David Glasner as anti-intellectual, and Noah Smith used the article in an attempt to ridicule Ed Prescott.

Moore's basic argument is that Keynesian economics does not satisfy the rules of common sense, whatever that is, and he gives some specific examples. Moore's discussion is somewhat confused. In particular, he seems to think that modern macroeconomics and Keynesian economics are synonymous. He also argues that, in analyzing unemployment insurance we should only be thinking about the incentive effects, and apparently not about why the government should be supplying the insurance, the role of UI as a transfer, or how the financing of the transfer could matter. However, it's not surprising to me that Moore is confused, and I have some sympathy for the poor guy.

Indeed, one could get the idea from reading the blogosphere that modern macro is dominated by the legacy of Keynes, when the truth is that most practicing macroeconomic researchers are not spending their time thinking about multipliers and the paradox of thrift. There are indeed ways in which Old Keynesian economics - basic Keynesian cross and IS/LM - defies common sense, i.e. the common sense that comes from standard microeconomics.

What is common sense anyway? It has to be something most of us possess, clearly. Don't put your hand in a fire. Don't cross the street without looking both ways. The latter piece of information came to me along with: Don't run out between parked cars. There were no parked cars where I lived. Everyone parked in the driveway or the garage. Therefore, that did not apply to me. Looking both ways before crossing the street must also not apply to me. When I was 8 years old, I crossed a highway without looking and was run over by a car. I have looked carefully ever since.

When I first took economics, here is what common sense was for me. It was the tail end of the hippy era and I thought that people in suits were greedy bad people out to steal from the poor. Rent control was a good thing as it took money from greedy landlords and gave it to poor apartment-renters. Wage and price controls seemed like a good way to control inflation, though I did not quite understand what it was that was inflating. And so on.

In microeconomics, my professor convinced me that a simple supply/demand apparatus determining equilibrium prices was a useful way to think about price determination, and he showed us how this apparatus could be used to make sense out of actual prices and quantities that I could observe. Greedy people could actually be getting rich and performing a useful social function. Rent controls could actually harm everyone - rich and poor - in the long run. Wage and price controls could screw up the allocation of resources in a severe way. There is no free lunch. Everything comes at a cost.

Then I took macroeconomics which, in terms of the machinery I had built up in taking micro, made little sense. If competitive equilibrium with market-clearing prices was so useful in microeconomics, why couldn't we do that in macro? What is this paradox of thrift? What's this nonsense about the multiplier free lunch? Why did I have to un-learn all the micro I had learned in order to do macro? It took another 6 or 8 years and many readings and re-readings of work by Lucas, Wallace, Prescott, and others, before everything finally made sense.

There is nothing easy, natural, obvious, or common-sensical about Keynesian economics. If you try to do it properly, or try to turn it into a story, you come up with more questions than you can answer. Why would we think that firms would shut their doors or would-be workers would remain unemployed because of an unwillingness to lower their prices and wages, respectively? Why would a firm, faced with an increase in customers, increase its output and not its price? Why would many economists, faced with phenomena that appear very un-Keynesian, and with plenty of sophisticated tools available, revert to the rustiest old contraption in the shop?

Liquidity Traps, Money, Inflation, and Bond Yields

2011-08-19T14:08:00.000-07:00

What is a liquidity trap? This is really two questions: (i) What is the "liquidity" that is getting trapped and (ii) What is the "trap" all about? In Old Keynesian economics and Old Monetarism, we think of the financial world in terms of two assets: interest-bearing assets and money. Money is the stuff that is used in transactions - liquidity - and private sector economic agents are willing to substitute money for interest-bearing assets in response to changes in the nominal interest rate. The nominal interest rate is essentially a measure of the scarcity of money as a medium of exchange. Monetary policy is about swaps by the central bank of money for interest bearing assets, or the reverse, and the attendant effects of those actions. One of those effects is a short-run liquidity effect. A central bank swap of money for interest bearing assets tends to make money less scarce as a medium of exchange in the short run, and the nominal interest rate falls.

But what if the nominal interest rate were zero? In that case, money is not scarce as a medium of exchange, so that money and "interest-bearing" assets are essentially identical, in which case central bank swaps of money for other assets are irrelevant. That's Grandma's liquidity trap.

Now, as Hicks said,

The General Theory of Employment is a useful book, but it is neither the beginning nor the end of Dynamic Economics.

Modern economists have expanded on Old Keynesian and Old Monetarist ideas and made them more precise. For example Ricardo Lagos, building on earlier work by Charles Wilson, tells you exactly what Grandma's liquidity trap is. It's basically a Friedman rule idea. There are many ways for policy to support a Friedman rule, i.e. a zero nominal interest rate forever. If there are many policies that support a zero nominal interest rate forever, that's also saying that there is a subset of monetary policies, among which the choice is irrelevant, i.e. if the central bank conducts certain kinds of asset swaps, then nothing changes, i.e. there is a liquidity trap.

Why am I calling this Grandma's liquidity trap? During the National Banking era, there were recurrent banking panic episodes, and it is most useful to think of these as currency shortages, i.e. "liquidity" shortages. The way to correct a currency shortage is through conventional central bank actions - open market purchases of interest-bearing assets and discount window lending. This is just the logical extension of standard day-to-day central banking practice: Target a "degree of liquidity scarcity," i.e. a nominal interest rate, and then accommodate shocks to the private sector's demand for liquidity. This view of the world is consistent with how Friedman and Schwartz thought about the Great Depression. Basically, in Grandma's world, the idea is that the central bank does not need to be worried about the sources of fluctuations in the demand for currency. All that matters is that these fluctuations be accommodated appropriately with the standard tools available to central bankers.

I am convinced that this is not the way we want to think about the recent financial crisis, or about how monetary policy should be conducted given current circumstances. We are not in Grandma's liquidity trap.

Here's a better way to think about it. Think of the world as having two kinds of liquidity: currency and other liquid assets. The other liquid assets include bank reserves, Treasury bills, long maturity government debt, asset-backed securities, bank loans, etc. - all the assets that are somehow useful in some form of exchange (retail, wholesale, financial) either directly, or because they can be transformed by financial intermediaries into some asset that can be used in exchange. The "other liquid assets" of course have different characteristics, and are used in different ways in exchange. Risk, including maturity risk, is important in determining the prices of these assets (relative to each other), and different liquid assets will have different liquidity properties, reflected in how they are used in exchange. An important concept here is the "liquidity premium" which we can measure as the difference between an asset's market price, and its "fundamental," i.e. the price it would trade at, based on the stream of future payoffs the asset is a claim to, if the asset were not useful in exchange.

Bank reserves - the accounts of financial institutions with the Fed - are a key liquid asset, as reserves are used daily in the clearing and settlement of a very large volume of transactions. However, it takes a very small quantity of reserves to support this extremely large volume of financial trade - the velocity of circulation of reserves within a day (pre-financial crisis) is typically humongous. Currently, the financial system is awash with reserves, to the point where the marginal value of reserves in financial transactions is essentially zero. The interest rate on reserves (IROR), which is currently 0.25%, is higher than the interest rate on 3-month T-bills, which is currently 0%. Thus, T-bills command a higher liquidity premium than do reserves, as they are actually more useful in financial exchange (inside and outside the US).

The key liquidity trap - the contemporary liquidity trap - the Fed is faced with currently is that all of the other liquid assets are now essentially identical, from the point of view of Fed asset swaps. The Fed cannot make reserves more or less scarce as a liquid asset through swaps of reserves for other assets, and therefore has no hope of moving asset prices. The Fed can swap reserves for T-bills or reserves for long-maturity Treasuries all it wants, but because this essentially amounts to intermediation activities the private sector can accomplish as well, this will have no effect.

An important point to note is that the contemporary liquidity trap, in contrast to Grandma's liquidity trap, has nothing to do with the zero lower bound on the nominal interest rate. Remember that the short-term safe nominal interest rate tells you how scarce currency is relative to other liquid assets. The IROR could be 2%, 5%, or 8%, so that currency is scarce, but there would still be a contemporary liquidity trap if reserves were not scarce relative to other liquid assets.

As I have discussed in earlier posts, the only relevant policy instrument the Fed has, so long as the stock of excess reserves is positive, is the IROR. Thus, the only lever the Fed has is the ability to make currency more or less scarce relative to other liquid assets, and that is the avenue by which the Fed can control the prices of goods and services. Here is where the zero lower bound on the IROR comes in of course. At the zero lower bound, the Fed cannot achieve a higher price level, except through talk about the future.

Now, to put this in context, let's look at some traditional monetary measures. The first chart shows the stock of currency over the last five years. You can see that the currency supply grew significantly during the financial crisis; this is likely driven by overseas demand, but it is hard to know - we don't know exactly where US currency resides or what it is doing. Over the last two years, and particularly this year, currency has been growing at a reasonably brisk pace (more on growth rates later).

The key thing to note here is that, under the current regime (positive stock of excess reserves), the currency stock is not directly under the Fed's control. The Fed determines the total stock of outside money (currency + reserves) and financial institutions, firms, and consumers determine how that is split between currency and reserves. The stock of currency could be rising because the demand for it is rising, or because reserves are looking less desirable for financial institutions. This of course matters - in the latter case this would be inflationary, in the former case not.

The next two charts show M1 and M2, again for the last 5 years. These charts are very interesting. Both M1 and M2 show recent large spikes. Further, if we look at year-over-year growth rates in currency, M1, and M2, these are all getting large, as we see in the next chart. The twelve-month growth rate in M1 now exceeds 20%, and growth rates in M2 and currency are at or close to 10%. Allan Meltzer should be having a cow.

Of course, this is where Grandma's liquidity trap comes in. Monetary aggregates are constructed to include private and public liabilities that are widely used in exchange by firms and consumers, under "normal" circumstances. But circumstances are not normal - a checking account is now a convenient short-term store of value with no associated opportunity cost. Thus, these spikes in M1 and M2 need not be associated with more inflation. However, I don't think we know enough to tell.

But why the spikes in M1 and M2 in the last weeks? That may have something to do with what you see in the last chart. This one shows, again for the last five years, nominal and real (i.e. TIPS) yields on 10-year Treasuries. These yields have also fallen significantly in the last weeks. This reflects a scarcity of other liquid assets, presumably because of a general "flight to quality" in world asset markets.

Now, if other liquid assets are becoming more scarce, it would make sense that we should see growth in financial intermediation, reflected in growth in M1 and M2, as the private sector creates more assets in the "other liquid assets" category. However, it could also be that there has been a decrease in financial intermediation not reflected in M1 and M2. For example, there could have been a shift out of "shadow banking" into conventional commercial banking, but unfortunately we do not measure shadow banking activity.

The scarcity we are observing is not a traditional currency scarcity. As such, we can't correct the scarcity by using conventional central banking tools - open market operations in short-term government debt and discount window lending. Neither can we correct it through "quantitative easing." We cannot ease anything through swaps of reserves for long-maturity debt, as that cannot make reserves relatively less scarce under the current circumstances. But the inability of monetary policy to correct the liquidity scarcity problem has nothing to do with the zero lower bound on short-term nominal interest rates, as the key problem is a contemporary liquidity trap, not Grandma's liquidity trap.

How can government action mitigate the liquidity scarcity? If monetary policy cannot do it, that leaves fiscal policy. But there is a tendency, particularly in the blogosphere, to frame the problem in Old Keynesian terms. In this view, we are facing Grandma's liquidity trap, the LM curve is flat, monetary policy doesn't work, so shift the IS curve instead. Further, unemployment is very high and persistent, so it might seem natural to have the government employ people directly by spending more. But the problem here is financial, and it's not a Keynesian inefficiency associated with real rates of return being too high; in fact real rates of return are too low given the scarcity of liquid assets, which produces large liquidity premia.

One way to solve the problem would be to have the Treasury conduct a Ricardian intervention, i.e. issue more debt with the explicit promise to retire it at some date in the future. If the future arrives, and we still have a scarcity, then do it again. This requires a transfer, or a tax cut in the present, and leaves the present value of taxes unchanged, but the result is not Ricardian because of the exchange value of the government debt issued.

What's the difficulty here? Well, the US government apparently has a very difficult time making decisions on fiscal matters, and seems not to like commitment, so what I am proposing is just not feasible politically. You might think it convenient if the Fed could conduct limited types of fiscal policy, but that requires giving the power to tax to unelected officials, and that seems a bad idea.

So where does that leave us? The key financial problem facing us is a scarcity of other liquid assets, not a traditional currency scarcity. The Fed is powerless to solve that problem; the Treasury could in principle solve it but cannot. For now, the Fed can only monitor the economy for signs of a more serious inflation. Some of those signs may already be there, for example in currency growth, though it is hard to tell what is driving that.

Plosser Elaboration

2011-08-18T14:56:00.000-07:00

You can see Charles Plosser explaining himself here. He is quite thoughtful, and I did not hear him say anything I disagreed with. There's a funny part where his interviewer asks him if the Fed is getting too "mathy." See what you think.

Rick Perry and Texas Research Universities

2011-08-16T16:20:00.001-07:00

This story is interesting on two dimensions. It deals with incentives in academia, and with someone who tells us he wants to be President of the United States. The first I heard of this was from one of my friends, who moved from a well-regarded public university in Texas to a similarly well-regarded public university in another state, and this issue seemed to play a role in the move.

This article in the Washington Post lays out the details of the story, which involves Texas Governor Rick Perry, his friends/contributors in the business community, the Board of Regents of the Texas State University System, and the University system itself. You can also find information in this Huffington post piece. Basically, the Texas Public Policy Foundation (TPPF), working in part through Jeff Sandefer, a Texan with personal and financial connections to Governor Perry, proposed Seven Solutions to what they perceive to be problems with the Texas State University System. It appears that the Governor shares the opinions of the TPPF and Sandefer on this matter.

In Texas (as in other states) the Governor can exercise a lot of power, if he or she chooses to, over how the state's public universities are run. In particular, Governor Perry appoints the Board of Regents. The media articles I link to above tell us that Perry is indeed excercising the power granted him. He has bought into the ideas of the TPPF, he is a man of action, and he wants the ideas implemented.

Indeed, officials at Texas A&M took the first step in implementing the first of the Seven Solutions, which essentially involves creating a bottom line for each professor in the university. Teaching a lot of students is a good thing. That brings in tuition dollars and enters as a plus. Earning a big salary is a bad thing. That enters as a negative. A grant is a good thing. That brings money into the university and enters as a plus. Not surprisingly, as you can see in the resulting spreadsheet, most of the Texas A&M Professors end up in the red.

A university that followed the Seven Solutions would look like the following. There would be a small number of adjunct faculty with low salaries, teaching a large number of students, and with salaries determined by scores on student evaluations. Research might be done at this university but, if so, it would be funded externally, and the research operation would be completely separated from the teaching operation. Indeed there is no reason for research and teaching to be conducted in the same physical location. One could imagine a Texas "university" system with separate teaching institutions and research institutions, though if the research institutions were totally dependent on external funding, it's hard to see why the state of Texas needs to be involved with those.

This is a particularly bad model for higher education. First, teaching and research are in fact complementary activities, both for the individual professors who work in research universities, and for the institutions themselves. It is important to have teachers in the classroom who are at the cutting edge of research in their respective fields, as those are the people with the best knowledge of what students should be learning, and who can best guide the curriculum in general. Further, one role of a university is to fund research directly - for example, the university may have better information about the individual researcher than does an outside funding agency.

Second, while students are perceptive and can pick up on some forms of misbehavior by professors - poor preparation, tardiness, lack of respect for students - in other ways students can be fooled. A student may find a course easy because they have an aptitude for the work. A course may also be easy because the professor is not challenging the students, and therefore not teaching them much. The student may find it hard to tell the difference, so the professor is rewarded for being unambitious. The student is none the wiser until he or she tries to apply what was learned in class, which may be years later. Thus, student evaluations, while they convey some information, need to be treated with a grain of salt.

A key problem with the Seven Solutions, and the top-down approach coming from the Texas Board of Regents, is micromanagement. In a university system, management starts at the department level. A good department chair understands who is good at teaching, who is good at research, allocates people accordingly to the correct tasks, and provides them incentives in terms of salary, teaching load, and other benefits. Deans set broad goals for departments. Provosts set broad goals for Deans. Presidents of universities set even broader goals and raise money, and in a state university system the Board of Regents oversees the whole thing. It is a very bad idea to have the Board of Regents - the people at the top of the system with little information about what is happening at the lowest level - trying to manage the faculty directly.

Now, the troubling part of this, with regard to Governor Perry, is that this episode reveals something of an impulsive nature. Some of your friends tell you something, and you act on it, apparently without much regard for the views of experts in the field. In this case, the friends seem to be zealots, whose ideas run counter to accepted practice among university administrators. Governor Perry is also on record as supporting the teaching of "intelligent design" in public schools, and appears to appoint people to the State Board of Education who are favorable to that. We might read into this a disregard for science in general.

In any case, we need to know more about Rick Perry. If we look at the current Republican Presidential field, and follow the money, this person is the likely nominee. Obama is currently looking weak, so Perry stands a good chance of being President of the United States. Right now, that looks pretty scary.

Commitment, the State of the World, and Dissent

2011-08-15T09:43:00.001-07:00

Here are some more thoughts with regard to my previous three posts (this one, this one, and this one.)

As academics, our policy arguments take place in the following way. We agree on what the state of the world is, but we may disagree on what model we should use to guide policy. Typically our arguments are in terms of the merits of the models at hand. Which model is better? Once we agree on that, then we can determine an operating rule for policy that tells the policymaker what action to take given any possible state of the world.

Policymaking on the FOMC seems not to work like that. Some of the non-economists on the committee are not aware of all the models available and how they work. The trained economists may have very different views concerning the merits of the models at hand. Over time, what seems to make the decision-making process work is to have the argument over the state of the world rather than over the theory. Pre-financial crisis, the question would be framed as follows. The FOMC members took as given that they did the right thing at the last FOMC meeting. The question for the current meeting was whether the state of the world was worse, better, or about the same relative to the last meeting. If things were worse, they would move the target for the fed funds rate down 1/4 point; if things were better, they would move up 1/4 point; if things were about the same they wouldn't do anything. Easy.

Post-financial crisis, things are not quite so easy, as now we supposedly have some more tools (I say supposedly because this is Bernanke's claim; I actually don't think so). Primarily, quantitative easing is on the table, and so is "extended period" language. But the policy decision is still framed in the same way. Is the state better or worse? Based on the answer to that question, the FOMC either tightens or eases. Then the question is how to do the tightening or easing.

Now, go to Bernanke's explanation for why the FOMC voted for the QE2 program in November 2010, i.e. this piece in the Washington Post. He discusses the dual mandate and some broader issues associated with the state of the world. Here is the important part:

The FOMC decided this week that, with unemployment high and inflation very low, further support to the economy is needed.

What Bernanke is telling you is that the FOMC has a decision rule, and for purposes of communicating with you, that decision rule takes account of inflation and unemployment. Unemployment is bad, and more inflation is good in this case. That's not the unemployment or inflation that he or someone else is forecasting, that's the unemployment and inflation we are actually observing. Then, he is telling you that the state of the world dictates that the FOMC should ease, following which he lays out the QE2 plan:

With short-term interest rates already about as low as they can go, the FOMC agreed to deliver that support by purchasing additional longer-term securities, as it did in 2008 and 2009. The FOMC intends to buy an additional $600 billion of longer-term Treasury securities by mid-2011 and will continue to reinvest repayments of principal on its holdings of securities, as it has been doing since August.

So, it's possible that the FOMC might now think that QE2 did not work, in which case maybe they want to try something else. However, Bernanke seems to think it worked, at least that's what he said in this speech in February. As of the end of the QE2 program, Jim Bullard certainly thought the program worked, as did other Fed officials.

Thus, in terms of Bernanke's own publicly-stated criteria for what directs easing and tightening, Kocherlakota tells us the state is worse. In November 2010, the FOMC agreed that the state of the world directed them to ease. They eased, and according to them the easing worked. The state of the world is now better, so why ease further?

I think macroeconomists agree broadly on issues of commitment. The decision rules of policymakers need to be simple enough for the public to understand, and policymakers need to behave in ways that are consistent with their publicly-stated policy rules. If there is a change in a decision rule, that needs to be clearly-communicated.

In the case of last week's FOMC decision, there was certainly no statement that the FOMC was thinking about the world in a different way. Thus, presumably the decision rule has not changed. If that is true, than the FOMC's decisions should be consistent with what it has been doing. But Kocherlakota argues that is not the case, and I think he is right. A decision that may appear to make the Fed's behavior more predictable actually makes it less so. Instead of asking why the dissenters on the FOMC voted the way they did, we should be asking why the other people on the committee voted the way they did. And we should not have to ask that. We are now more confused, and that is not good.

Kocherlakota Elaboration: An Update

2011-08-13T08:17:00.000-07:00

As you might expect, Mark Thoma and Paul Krugman are criticizing Kocherlakota's dissent on the recent FOMC statement, and his subsequent elaboration.

Thoma accuses Kocherlakota of cherry-picking the data, then proceeds to cherry-pick. Krugman points out that the employment/population ratio is still low, but it's not so different from where it was in November 2010, which seems consistent with Kocherlakota's argument. Thoma thinks the Fed has not really committed:

Finally, this is not a rock solid commitment from the Fed. This is their view of the most likely path for the federal funds rate, they have not said this is what they will do independent of how the data evolve. All they have said is that economic conditions are likely to warrant this outcome.

I'm afraid not, Mark. As I argued here, something very dramatic will have to happen for them to go back on their word.

Finally, Krugman states this:

So this isn’t fact-based policy. The Fed dissenters are obviously looking for excuses to pursue tight policies; they’re looking at the facts only in search of support for their prejudices. As the old line goes, they’re using evidence the way a drunk uses a lamppost: for support, not illumination.

This is of course grossly insulting. He's not accusing Kocherlakota of faulty reasoning. Apparently his crime is that he has an unstated agenda, and he's picking the data to support his narrative. Actually, that's Krugman's crime. Narayana, as long as I have known him, has been honest and straightforward, even when it hurts. Whatever it is that he is thinking, he'll let you know, as I think he has done here.

Kocherlakota Elaborates

2011-08-12T11:40:00.000-07:00

Here is Narayana Kocherlakota's explanation for his dissent with respect to the most recent FOMC decision. As I mentioned in the comment section of my previous post, Kocherlakota actually has some New Keynesian (NK) leanings, and his dissent is entirely consistent with an NK view of the world. In this view, a Taylor rule dictates monetary policy. In Taylor-rule land, only the current state of the world, defined by the current inflation rate and the current unemployment rate, matters (though some Taylor rules have anticipated inflation on the right-hand side). On those terms, the current state actually looks better than the state in November 2010. Inflation is higher and unemployment is lower, which should dictate a less accommodative policy, not a more accommodative one.

Thus, if we buy NK, Kocherlakota's dissent makes sense. However, this guy, for example, seems to think that Kocherlakota is ridiculously hawkish and callous toward the unemployed. Seems he just wants to enforce New Keynesian consistency though.

I live in non-NK land (or willing-to-be-convinced-but-still-unconvinced-NK-land), so if Kocherlakota's dissent makes sense to me, and it can make sense in NK-land, it must be good, right?

The FOMC: There is good commitment, and there is...

2011-08-10T07:22:00.000-07:00

Yesterday's FOMC statement came with some unexpected news, but in retrospect I think we should have seen it coming. Here is the key change in policy:

The Committee currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.

Thus, the key change is applying a date to the "extended period" language that has been in the statement since late 2008. "Likely to warrant" is about as clear a commitment as I think will ever come from the FOMC. Compare this to what was in the November 2010 statement where QE2 was laid out:

...the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.

That program was executed exactly as planned. There was some language in there to hedge against wild unforeseen circumstances, but once the FOMC gets this specific it has to stick to its guns or risk destroying its credibility.

A key problem here, of course, is that not everyone is on board, and the dissenting group - Fisher, Kocherlakota, Plosser - includes two of the most capable economists on the committee. Outside of Dudley, the New York Fed President, only one of the voting regional Fed Presidents, Evans (Chicago), voted in favor of the policy change. I think the dissenters are on the right side of this issue.

Given the current operating regime the Fed is in, with very large quantity of excess reserves in the financial system, and the interest rate on reserves (IROR) determining short-term nominal interest rates, the experience is not there, nor is there agreement on what theory to apply, for the Fed to understand well what it is doing. It is also very difficult for people trying to understand what the Fed understands, to know what is going on. In this context, how can the FOMC be so certain of itself as to commit two years in advance?

Further, it seems the outcome the Fed would hope for is one where inflation increases, the interest rate on reserves increases commensurately, and the Fed proceeds to sell off assets so as to normalize the state of its balance sheet, with zero exess reserves. Committing to IROR = 0.25 for two years risks two outcomes that seem equally bad (if we believe that 2% inflation is optimal). One is the too-high-inflation outcome: People anticipate high inflation, reserves start to look much less desirable, and the high inflation is self-fulfilling. The other is too-low-inflation: People anticipate low inflation, the reserves look more desirable, and low inflation is self-fulfilling. The first scenario is something that I have been worried about. The second scenario was a concern of Jim Bullard, and Narayana Kocherlakota. I think both are possibilities, i.e. there are multiple equilibria.

Fed officials like to talk about "anchoring expectations." In this circumstance, the kind of FOMC statement that would anchor expectations would be something like: "We anticipate raising the fed funds rate target (actually the IROR target, but what the heck) as observed and anticipated inflation warrants. Currently, we think we are on a path on which inflation will increase."

Pre-FOMC: A Guide to What's on the Table This Week

2011-08-07T08:58:00.000-07:00

The upcoming FOMC meeting this week is a critical one, and an important test for Ben Bernanke. In terms of something we can agree the Fed should be concerned with - inflation - here is what is going on. The figure shows the cpi, the core cpi (cpix in the figure) the pce deflator, and core pce deflator (pcex in the figure). I've taken January 2005 as a base period here. This is obviously arbitrary, but that choice is instructive in this context. The figure also shows a 2% trend path, which represents the Fed's quasi-explicit target. I'm not defending the 2% inflation target, and I don't think the Fed can defend it either, relative to 0%, 1%, 3%, or 4%, for example.

In June, the headline cpi was 3.1% above the 2% trend, the pce 1.6% above, the core cpi 0.4% below, and the core pce 0.6% below. Now, if the FOMC wanted to be consistent with previous FOMC statments and public minutes, and if it were looking only at that picture, there would be grounds for tightening. While core price indexes are a little below where they should be, an increase in the relative price of food and energy has persisted since 2005, and there is no good reason to expect that relative price shift to go away. As I noted here, the FOMC is on record as being focused on headline inflation, and rightly so.

Of course, the FOMC is not looking just at that picture. Indeed, unless you have been living in an isolation tank for the last several weeks, you know that all hell appears to be breaking loose. The Fed is bound by law to speak to its dual mandate, and I think there is little dispute about the role of a central bank in promoting financial stability.

On the real side, the last quarterly GDP numbers were weak, and there is nothing very promising in the monthly data. Things could be worse, but residential construction is still in the toilet, with no pickup in housing starts; consumption expenditure is weak; employment is growing but at a slow pace; the employment/population ratio is also still in the toilet.

In financial markets real and nominal yields on US government debt have recently dropped significantly. Stock prices are falling. Sovereign debt problems in Europe are going unsolved. Our federal government's inability to develop a coherent fiscal plan has the potential to get us into trouble.

How do we make sense out of this, and what should the Fed be doing about it? First, suppose that the turmoil in financial markets is only temporary, but nevertheless forecasts indicate that real growth (absent Fed action) will continue to be more sluggish than we had expected. Should the Fed be doing something? No, there is nothing it can do. The interest rate on reserves has been at 0.25% since fall 2008, and the "extended period" language could be in the FOMC statement until eternity. The Fed could do QE3, but QE2 was irrelevant, so another round would have no effect either. Even if you thought quantitative easing worked as the Fed claims, long-maturity Treasury yields are already low. The problem is not that safe long bond yields are too high.

On the financial front, the big story is uncertainty. One story you hear is that firms are not investing because they are uncertain about future government behavior. While we appear to have a weak executive branch and a goofy legislative branch, I think the uncertainty people are concerned with is rooted in debt problems - in this case sovereign debt. Europe's sovereign debt problems have the potential to produce calamity on the order of what we saw in fall 2008. Mitigating that is our previous experience, and the fact that policymakers have had more time to figure out where the vulnerabilities lie.

A key problem is that low US Treasury yields reflect a scarcity of safe assets in the world. US debt, in spite of our recent fiscal fracas and S&P downgrade, is still viewed as a safe haven. I mentioned above that inflation, if anything, is currently too high in the US, but a continuation of the current financial conditions, or a worsening of the situation in Europe, would ultimately lead to a downward price level adjustment in the US, due to the increase in demand for the liabilities of our consolidated government. Effectively, there is a liquidity problem, but it is not one that can be solved through standard open market operations - this is not a currency shortage (as for example in the Great Depression) but a shortage of consolidated-government debt (i.e. the net debt of the central bank and federal government combined).

What to do about the liquidity shortage? The Fed can of course use conventional discount window lending, but currently the liquidity problem is mainly in Europe, not in the US. There is another tool, though, which is the Fed's swap facilities with foreign central banks. These played an important role during the financial crisis, were discontinued, and then renewed again in May 2010. As far as I can tell, these swap lines are still open, but are currently not being used, and I don't know why. Maybe someone has information on this.

In any event, I'm very curious to see what comes out of this FOMC meeting. Reassuring words? Something big? There is certainly a lot at stake, including the credibility of the institution.

Repy to Krugman Part II

2011-08-06T10:59:00.000-07:00

A few more words on the fracas associated with this, before we move on to the serious problems facing the world. I was mulling over Krugman's comments, in particular this one:

It’s funny in this case, because Quiggin is in fact a prominent economist, Williamson not so much.

So, it seems that, in Krugman's mind, prominence is a good thing, I have not so much of this thing, and therefore I must be some kind of lesser being, who should not be so uppity.

Now, prominence actually might be bad. I could have a prominent zit on the end of my nose, in which case I'm just hoping it will go away quickly. Prominence can also be good. Ed Prescott is a prominent person in the profession in part because of the students he has trained, and the students that were trained by the students of students, etc. On that dimension, Prescott is prominent, Krugman not so much.

Lady Gaga is prominent. A few weeks ago I actually shared an airplane with this person, on the way back from Sydney. The security guy at the Sydney airport clued us into this fact, though he seemed to be somewhat embarrassed by what she had on. Lady Gaga then left my mind, until we landed in LA. My wife and I were walking the 20 miles to US immigration, and there she was. Conservatively dressed, this time (for Lady Gaga), but with 5-inch heels and a funny hat. Not sure how she walked the 20 miles without breaking an ankle. Now, you might think being prominent in the sense of Lady Gaga would be a bad thing (for her) in an airport, but she actually seemed to be quite into it. Even the walk to immigration was a performance, and she seemed to like the attention.

Now, Lady-Gaga-prominence is a particular kind of prominence. Many people know her name, but most of us could not say much about her music or what ideas are floating around in her head. Krugman has some Lady-Gaga-prominence, but of course there's more depth to it than that. People who know who he is are aware of the ideas in his head, and he has followers. We can say that he is influential. But what of that influence? People can be prominent and propagate bad ideas, as Krugman does on a regular basis. John Quiggin is apparently prominent - he has written many words, and there is obviously a market for that stuff. On the basis of my reading of "Zombie Economics," I would argue that he is also propagating bad ideas. So much for prominence.

Now, here's the core of Krugman's idea here:

...if you look at how many freshwater macroeconomists have responded to Keynesian arguments in this crisis, you find over and over again that they resort to assertions of privilege — basically, I am a famous macroeconomic expert and you aren’t — rather than really addressing the issues...But in any case, this is never an appropriate way to argue — least of all at a time like this, when events have strongly suggested that a lot of work in economics these past few decades, very much including the work on which these guys’ reputations are based, was on the wrong track.

The problem with this, as with Quiggin's book, is that it is so vague and general as to be vacuous. There was "a lot of work," done by "these guys." It was on the "wrong track." "These guys" are apparently "freshwater economists," but guys like that are very hard to identify these days. 1970s ideas have evolved to the point where the labels "fresh" and "salt" don't apply to anyone in particular.

Krugman is badly confused. The ideas of some of "those guys" are in fact in the core of some of the work that he is so proud of. His liquidity trap paper uses a cash-in-advance construct, popularized by Lucas. His paper with Eggertsson is a direct descendant of Kydland and Prescott (1982), by way of Rotemberg and Woodford.

This kind of criticism is just misguided flailing-about, and it certainly can't accomplish anything useful.

Reply to Paul Krugman and other Rabble-Rousers

2011-08-05T11:59:00.000-07:00

Well, the blogosphere is a strange place, full of funny people. Sometimes people ignore me. Sometimes I hit a nerve and an organized mob goes to work. I wrote this, John Quiggin replied with this, and Paul Krugman felt the need to stand up for his comrade with this.

Like everything I've done in this blog, I've learned from this. People have come back with interesting comments, and we've worked through some ideas. I learned something about some work that exists out there, and about some interesting people.

Krugman seems to think that I'm somehow "pulling rank" on John Quiggin. Well, the story of my life is being misunderstood, so I'm accustomed to this. In my original post, I'm just giving you a factual account of how I happened to be reading Quiggin's book. If I tell you that, previous to getting the book in the mail, I had never heard of John Quiggin, that's certainly not his fault, nor does that mean that I think the guy is a dope, or that I'm somehow better than he is. Holy crap! Who am I anyway? I have not worked at any institution (save perhaps the Minneapolis Fed) that anyone would rank in the top 20 in the world. I typically work on things that people find somewhat esoteric and cultish. I grew up in small-town Ontario and was educated in public schools. My parents were well-educated, but basically lived hand-to-mouth.

Quiggin is a very interesting case. He has a strong technical background, and has an enormous number of citations for a paper published in 1982 that seems to have been written when he was an undergraduate. That paper is in decision theory, which I find hard, and he has published other work in that vein. The man writes, and has written, an enormous amount. His keyboard must be on fire.

The bone I have to pick is with his damn book. There are some theorists that see modern macroeconomics and like it. It fits together like things they already know, the language is similar, and one can see how standard economics can be put to work to understand aggregate phenomena. Quiggin is not like that though. If you read Zombie Economics and this paper, with names redacted, you would not know it was the same person, as Zombie Economics reads like fringe economics (Austrians, Post-Keynesians, etc.). In fringe economics, the game is dismissing things you know little about, and offering little that is actually constructive.

Quiggin and Krugman indeed have a lot in common. They are smart people, with demonstrated success in particular branches of economics, but with little or no knowledge of what makes modern macroeconomics tick. In part, they seem to think that modern macro is a tool of right wing conservatives and therefore needs to be destroyed. Let me assure you that modern macro is not inherently a tool of any particular ideology. It just forces you to work harder to find the appropriate role for government. But the result is better policy.

The Great Divide is Between Thoma's View of Reality and Reality

2011-08-03T18:30:00.000-07:00

I saw this piece by Mark Thoma a while back, yawned, and went on to something else. When I got back from vacation, in the course of catching up and following links to my posts, I discovered that there is actually a reference to one of my posts hiding in there (more on that later), so I thought it was worthwhile to rebut his nonsense.

We'll skip the bad analogy at the beginning of the piece. Mark's point is essentially a standard one. Academics are out of touch with the "real world" and basically spend their time staring out the window thinking deep thoughts for their own entertainment.

Apparently, as we keep hearing from the usual rabble-rousers, academics failed to predict the financial crisis, so what are they good for anyway? Further,

...a few practitioners saw the housing bubble coming.

Who were those people anyway? They must have made a killing! Did they predict the turning point in housing prices in 2006? Did they predict that prices would fall from their peak by about 35% (or whatever)? What exactly is a bubble anyway? Do those practitioners have a good definition of this phenomenon? What do they think caused it? Do they know when the housing market will turn around if they are so smart?

What's at the root of the problem?

Economics has lost the connection between the practitioners and the academics. This may have something to do with the desire among economists to become more of a science – a heavy focus on theory and math is the result.

So, we would do much better if we did not use the tools that Newton, Pontryagin, Bertsekas, Arrow, Debreu, Samuelson, Solow, Nash, Harsanyi, Selten, Hurwicz, Maskin, Myerson, etc., gave us. Then we could better communicate with those in the trenches and the world would be a better place.

There is no great divide between academics and practitioners in economics. When I go to conferences and go out to give seminars I meet people working in many different fields in economics. Plenty of them move around among institutions where people think about policy and advise policy makers, institutions where the main job is doing frontier research and educating students, and consulting work. Go to any business school and you will find loads of applied economics that people find useful not only as an organizing tool to make sense of the world but for making money. In business schools applied economics sometimes is called finance, accounting, or marketing.

One of the great successes in economics is auction theory. This started off in a quite abstract, mathematical fashion, and ultimately expanded into empirical work in the hands of people like Robert Porter, Ken Hendricks, and Harry Paarsch, for example. Auction theory has been used successfully in the design of auctions of bandwidth and oil leases, and there are currently economists working for Yahoo and Google who use their knowledge of auctions to contribute in important ways to making those companies profitable.

Closer to home, there are plenty of high-level academics who are willing to get their hands dirty at regional Federal Reserve Banks and at the Board of Governors in Washington. In this respect, there is far more interaction between academics and the Federal Reserve System than was the case 10, 20, or 30 years ago, thanks in part to the pathbreaking work done by people like John Kareken, Art Rolnick, Tom Sargent, Gary Stern, and Neil Wallace at the Federal Reserve Bank of Minneapolis in the 1970s.

Now, here's where Thoma mentions me:

Academic economists do evaluate policy proposals theoretically and empirically, and they do provide forecasts of the economy. But forecasting in particular is not the main focus of their efforts, , and they’ve all but ignored – even looked down their noses upon – forecasters and practitioners in the government and business communities. They are often viewed as data grubbers who use old-fashioned models and techniques, and are thus unworthy of attention from high-minded academics.

Notice what he's up to. Mark fancies himself as a very high-minded and fair individual who would never stoop to name calling, but he's essentially calling me an arrogant twit. If you go back and read my post, you'll see that it was a response to some interview comments by Larry Meyer that included this:

My views would be considered outrageous in the academic community, but I feel very strongly about them. Those models [modern macro models] are a diversion. They haven’t been helpful at all at understanding anything that would be relevant to a monetary policymaker or fiscal policymaker. So we’d better come back to, and begin with as our base, these classic macro-econometric models.

Meyer essentially disparages post-1980 modern macroeconomics as a waste of time, and I thought that deserved a response. The gulf there is not a problem for modern macro, it's a problem for Meyer, who has not taken the time and trouble to understand what macroeconomists are doing and how he can make use of it. Why Mark Thoma can't see that is beyond me.

John Quiggin

2011-08-03T07:40:00.000-07:00

[For an expanded (and published) update on this post, see this.]

John Quiggin is an Australian economist who some of you might be familiar with as the author of "Zombie Economics: How Dead Ideas Still Walk Among Us." Currently he is having a bit of a dustup with the Australian wing of the Rupert Murdoch empire.

I knew absolutely nothing about John Quiggin, until someone asked me to write a short review of Zombie Economics for the Journal of Economic Literature. The timing was good, as I was about to leave for Australia to give a plenary talk at the Australian Conference of Economists in Canberra in July. I could read the book on the plane (though a trip from St. Louis to Chicago would actually be sufficient) and might actually come across the man himself, or news of him, at the conference.

By the time I got to Canberra, I had read Zombie Economics, and had written a draft of my review which panned the damn thing (more on that later). I was a little lost at the conference as none of the Australian economists I know showed up, but Pete Klenow was there, and I sat down at dinner with Max Corden, who is one of the most engaging people I have run into in my life. Between courses at dinner, various awards were presented, and at one point we got to an the annual award of Distinguished Fellow of the Economic Society of Australia. Previous recipients included my dinner companion Max Corden, Trevor Swan (he of the "Solow-Swan model"), and Murray Kemp. Who did the 2011 award go to? John Quiggin.

What is Quiggin's claim to fame? His early work is an odd mix of agricultural economics and decision theory, but he seems to have distinguished himself mainly in public policy. He writes regularly in the mainstream media, writes a blog, and Zombie Economics appears to have sold well.

Now, what is Quiggin up to in Zombie Economics? Roughly, Quiggin is the Australian farm team in the Krugman/Thoma/DeLong league. Quiggin argues that there are five key "zombie ideas" that have been used by conservative economists for ideological purposes. The financial crisis has showed us that, without question, these ideas are wrong. Nevertheless the ideas, like zombies, continue to walk. If you read the book, you'll see why it could sell well in airports. However, I would recommend Life by Keith Richards (which is the last book I bought in an airport) over Zombie Economics any day. Keith is much more interesting, and the economics is better.

So, what are the zombie ideas? They are:

1. The Great Moderation.
2. The Efficient Markets Hypothesis.
3. Dynamic Stochastic General Equilibrium
4. Trickle-down economics
5. Privatization

The Great Moderation: Quiggin is a little confused on this one, as the Great Moderation simply characterizes a set of properties of US aggregate time series. From about 1985-2007, inflation was lower and less variable, and real GDP was less variable about trend than had been the case previously. Quiggin is certainly correct, though, in finding fault with those (Ben Bernanke included) who wanted to argue that the Great Moderation was due to a regime change in economic policy. If policy was so great, it should have done a better job over the last four years.

The Efficient Markets Hypothesis: For Quiggin this is "the idea that prices generated by financial markets represent the best possible estimate of the value of any investment." Here, Quiggin is badly confused, but maybe the finance practitioners are not helping him out much. Market efficiency is simply an assumption of rationality. As such it has no implications. If it has no implications, it can't be wrong.

Dynamic Stochastic General Equilibrium: Quiggin claims that this is "the idea that macroeconomic analysis should not concern itself with economic aggregates like trade balances or debt levels, but should be rigorously derived from macroeconomic models of individual behavior." I can hear you snorting with laughter. Why is "but" in that sentence? Like the "efficient markets hypothesis," DSGE has no implications, and therefore can't be wrong. Indeed DSGE encompasses essentially all of modern macroeconomics. Which of our models is not dynamic, with uncertainty (and therefore stochastic), and with some equilibrium concept. Indeed, many of them incorporate trade balances and public and private debt. Granted, some of our models were not so helpful in making sense of the financial crisis. But others were, and some of the models that were not helpful could be (and are being) modified so that they are.

Trickle-down economics: This one puzzled me. For the previous three zombie ideas, Quiggin is confused, but I could see where the confusion might come from. However, while the words "trickle-down economics" are familiar to me, I have a hard time associating that idea with the mainstream ideas of any academic economists. On some level, it seems obvious that economic growth benefits all residents of a country. Whatever my skill set, I would rather ply my trade in the United States than in Malawi. While there may exist serious barriers to economic mobility in the United States that we should be addressing, the financial crisis does not somehow point out some serious deficiencies in how economists think about the income and wealth distributions.

Privatization: Here, Quiggin offers a litany of government privatization efforts gone awry. If I wanted to, I could take this evidence as supporting the hypothesis that government is really bad - so bad that it can even screw up privatization.

So, the heart of economic thought is a set of zombie ideas that should die a miserable death. But to be replaced by what? Quiggin is pretty vague about this. He thinks that "heuristics and unconsidered assumptions inevitably play a crucial role," and that economics should focus "more on realism, less on rigor." Eureka. We need some sloppy, realistic, heuristic models with unconsidered assumptions.

It's unfortunate that some of the people who write so much about economics for the general public spend so little time reading about what economists actually do, and attempting to understand it. No wonder people are confused.

Krugman and Keynes, Part II

2011-07-20T14:38:00.000-07:00

I am currently on vacation in the back woods west of Ottawa, but my brother just had internet service put in, and I made the mistake of catching up on my email. Someone was urging me to write something about this emission by Paul Krugman, who is writing about a piece he read by Ezra Klein in the Washington Post. Let's just work from the last paragraph:

Klein suggests that what went wrong in the Great Depression was that people hadn’t read Keynes yet; well, what went wrong and continues to go wrong in the Lesser Depression is that eminent economists, or at those so judged by their peers, turned their back on everything Keynes learned.

First, what do you think Keynes actually learned? No one really seems clear on this. In what profession are people still arguing about the meaning of a book written in 1936? As best we can make out, there are two more-or-less coherent modern versions of Keynesianism. One model is the multiple-equilibrium coordination failure version of Keynes, that comes to us by way of John Bryant, Peter Diamond, Russ Cooper, Andy John, Roger Farmer, Jess Benhabib, etc. A calibrated version of this type of model was fit to the data by Farmer and Guo. A second model is that developed by Mike Woodford, and subsequently (with many bells and whistles) fit to data by Smets/Wouters and Christiano/Eichenbaum/Evans.

Both of these modern Keynesian models are actually versions of a basic Cass-Koopmans-Brock-Mirman-Kydland-Prescott neoclassical growth model - the basic framwork we teach to graduate students as a starting point in all serious contemporary macroeconomics core courses for PhD students. As such, modern Keynesianism is just another tweak. Add some increasing returns and you get multiple equilibria, and maybe some role for government in coordinating on good equilibria. Add some sticky prices and wages, and you get some role for government in correcting relative price distortions.

Of course, these are not the only tweaks we might want to think about. Search frictions are useful for thinking about the dynamics of the labor market and unemployment. Private information and limited commitment are useful for thinking about the role of assets in exchange, monetary policy, and how credit markets work (or do not work).

Now, if you were to choose your tweaks in order to make sense of the financial crisis and the recent recession, what would those tweaks be? Well, I am not a betting person, but if you forced me to put up some cash, it would not be riding on sticky wages and prices. I've thought about that (go back and search my posts) and I can't force it to make sense. As for multiple equilibria, maybe one could get some mileage out of that, but I don't see anyone trying. Want to learn about financial crises and what governments should do about them? Want to understand unemployment and why it so high? Turn your back on Keynes.

FOMC Minutes

2011-07-13T15:35:00.000-07:00

FOMC minutes from the June 21-22 meeting are posted here. There are a few interesting things in there. First, there is a discussion, continued from the previous meeting, on the exit strategy. Basically, the FOMC plans to first stop reinvesting principal payments on the securities it holds, and will then begin increasing the fed funds target rate. Mortgage-backed securities (MBS) and agency securities will then be sold off over a three-to-five-year period. The minutes say:

In particular, the size of the securities portfolio and the associated quantity of bank reserves are expected to be reduced to the smallest levels that would be consistent with the efficient implementation of monetary policy.

That's vague, but I take it to mean that, after three to five years, excess reserves will be zero.

There is a bit of funny stuff:

When economic conditions warrant, the Committee's next step in the process of policy normalization will be to begin raising its target for the federal funds rate, and from that point on, changing the level or range of the federal funds rate target will be the primary means of adjusting the stance of monetary policy. During the normalization process, adjustments to the interest rate on excess reserves and to the level of reserves in the banking system will be used to bring the funds rate toward its target.

The truth of the matter is that, over the period discussed here, where excess reserves are positive, the FOMC actually has no control over the fed funds rate, as that is determined by the interest rate on reserves (IROR), which is set by the Board of Governors. Further, in this regime, "adjustments...to the level of reserves" are irrelevant for the fed funds rate.

On the current policy stance, there seems to be a divergence of opinion on the committee:

On the one hand, a few members noted that, depending on how economic conditions evolve, the Committee might have to consider providing additional monetary policy stimulus, especially if economic growth remained too slow to meaningfully reduce the unemployment rate in the medium run. On the other hand, a few members viewed the increase in inflation risks as suggesting that economic conditions might well evolve in a way that would warrant the Committee taking steps to begin removing policy accommodation sooner than currently anticipated.

Thus, some people on the FOMC think that we should be considering QE3. Obviously, they think QE2 worked, which I think is incorrect. Others are actually more worried about inflation than at the last meeting, and think that the Fed will have to start executing its exit strategy sooner rather than later.

Here's another interesting tidbit:

In the discussion of inflation in the statement, members decided to reference inflation--meaning overall inflation--rather than underlying inflation or inflation trends, in order to be clear that the Committee's objective is the level of overall inflation in the medium term.

Thus, the FOMC wants it to be known that it cares about headline inflation, not core inflation.

John Cochrane and the Krugmaniacs

2011-07-13T02:02:00.001-07:00

John Cochrane has apparently created a stir among the usual blogosphere types, not so much for what he writes about, but for who he eats dinner with and how much they pay for the wine. This has caused Krugman to come unhinged.

To sort out the players here, remember that Cochrane wrote this in response to Krugman's 2009 New York Times Magazine piece. It's likely that, in the absence of his Krugman-critique, Cochrane would never have appeared on Krugman's radar screen, much like the rest of the the economics profession or, indeed, economics in general. However, Cochrane now has a place of honor on Krugman's list of bad guys, and serves as a convenient foil, particularly given his University of Chicago affiliation.

Krugman's blog piece gives us the usual message. In Krugman's mind there is a Chicago school of arrogant freshwater economists who can't bear the humiliation of facing up to the fact that Old Keynesians are oh-so-right. Since this is more of the same, I'll refer you to my earlier post, and this one.

Now, to get to something more constructive, this reminded me that I had not looked at this paper by Cochrane, which someone recommended to me. The paper was written almost a year ago, and it's Cochrane's attempt to make sense of the financial crisis and policy in the context of the crisis, looking through a fiscal-theory-of-the-price-level lens.

Cochrane claims that he can make a model-free argument based on two equations. The first is a "valuation equation for government debt," which states that the current real value of the debt (money plus bonds) is equal to the expected discounted value of future primary government surpluses. Essentially, the total consolidated-government debt is valued according to "fundamentals." The second equation is an old-fashioned money-demand function, of the sort that would fall out of a cash-in-advance environment, for example.

There are two ideas in the paper that I like. First, Cochrane points out that the "flight to quality" during the financial crisis represented an increase in the demand for all consolidated-government liabilities, not just currency, as occurred for example during the banking crisis in the Great Depression and in National Banking era banking panics. You'll find that idea in these slides as well, and in the associated paper.

Second, I liked the emphasis on the relationship between fiscal policy and monetary policy. As Cochrane points out, those ideas go back to the 1980s, and can be found in Sargent and Wallace's "Unpleasant Monetarist Arithmetic" paper, and other work by Tom Sargent.

What I do not buy into are the ideas that come from the fiscal-theory-of-the-price-level literature, which Cochrane contributed to, along with Sims and Woodford. This is where Cochrane gets his conclusions about the relationship between anticipated government deficits and inflation. Cochrane is incorrect in stating that he can get results from two equations, without fleshing out a complete model. Indeed, I can think of models where his equation (1) on page 2 of the paper does not hold, and this actually has an important bearing on how we think about the financial crisis.

Here's a counterexample. Take any pure-currency monetary model where we derive a role for money from first principles. There is just one asset, fiat money, in fixed supply, and the environment is stationary. The deficit is zero forever, so that the right-hand side of equation (1) is zero. But there exists an equilibrium where the price level is constant, money is valued, and the left-hand side of equation (1) is greater than zero, so the equation does not hold. That's if the money is an endowment for economic agents in the first period. But what if money is injected initially by way of lump sum transfers? Then the right-hand side of the equation is negative, so it still does not hold.

What is going on? Money is a bubble. It deviates from its fundamental value, which is zero. In general, any asset can exhibit such bubbly properties if it is used in exchange and is sufficiently scarce. For example, there can be a liquidity premium on Treasury bills due to their value in exchange. During the financial crisis, it seems clear that all government liabilities were scarce, real rates of return on safe assets were low, and the marginal liquidity value of government debt in financial exchange was high.

In principle, one could construct a model of the runup in house prices after 2000 and the subsequent bust, based on incentive problems leading to lending to the wrong people, and the use of mortgage-backed securities (MBS) in financial exchange, which not only creates a liquidity premium for MBS, but a liquidity premium on the underlying assets - houses. The key question is whether the theory could produce a liquidity premium large enough to match the data. Note that this has nothing to do with the way that Robert Shiller, for example, thinks about bubbles.

On another Cochrane matter, I ran across this piece from last month, which I thought was pretty good. Cochrane looks at the bond yield data and argues that QE2 was a failure, and goes on with this:

Both sides ignore an inescapable conclusion: With near-zero short-term interest rates, and bank reserves paying interest, money is exactly the same thing as short-term government debt. A bank doesn't care whether it owns reserves or three-month Treasury bills that currently pay less than 0.1 percent.

This is what drove the Fed to QE2 in the first place. Conventional easing -- buying short-term Treasuries in exchange for reserves -– obviously has no effect now. Taking away your green M&Ms and giving you red M&Ms instead won't help your diet.

But if exchanging money for short-term debt has no effect, it follows inescapably that giving banks more money is exactly the same as giving them short-term debt. All QE2 does is to slightly restructure the maturity of U.S. government debt in private hands.

Now, of all the stories we've heard to explain our sluggish recovery, how plausible is this one: “Our big problem is the maturity structure of Treasury debt. If only those goofballs at Treasury had issued $600 billion more three-month bills instead of all these five-year notes, unemployment wouldn’t be so high. It’s a good thing the Fed can undo this tragic mistake.” That makes no sense.

I like that, and it's consistent with what I wrote here.

Cochrane finishes with this comment on QE2:

Mostly, it is dangerous for the Fed to claim immense power, and for us to trust that power, when it is basically helpless. If Bernanke had admitted to Congress, “there’s nothing the Fed can do. You’d better clean this mess up fast,” he might have had a much more salutary effect.

Excellent.

Now, I'm reading Cochrane's stuff, and I'm finding it useful. I don't agree with everything, but he is using the economics he knows to effectively make some very useful points. I don't see any connection between what Krugman and friends are writing about the guy and what the guy actually writes.

Economic Welfare

2011-07-11T22:00:00.001-07:00

I saw an interesting talk yesterday by Pete Klenow (Stanford) on this paper by Klenow and Jones. The basic idea is to use standard economic theory to come up with measures of economic welfare by country. The paper is quite nice, as the measure allows us to account for how each of the four factors considered contribute to the welfare measure. In general, welfare is increasing in consumption, increasing in leisure, increasing in life expectancy, and decreasing in a measure of inequality. As Klenow showed, while the US and Australia currently have about the same level of per-capita real GDP, the Australians are about 16% (this is the number I remember) better off, in units of consumption. The Australians in the audience certainly seemed to like this result. Australians are doing better as they live longer, enjoy more leisure, and have less income inequality than do Americans.

Comparisons between Western Europe and the US often focus on per-capita GDP, and some researchers, including Ed Prescott, attribute much of the income gap to taxation. But of course the Western Europeans are buying something with their taxes. They are on average healthier than Americans, they live longer, they do not work as hard, and they are better-insured against low-income states. In the year 2000, while Western European per-capita real GDP was 71% of what it was in the US, the Jones/Klenow Western European welfare measure was 87% of the US measure.

Now, a question came up in Klenow's talk about unemployment. Someone was upset that the welfare measure essentially treated not-in-the-labor-force and unemployment as identical states, i.e. leisure. I think Klenow viewed this as the cleanest way to think about this, but do we think there is something to be gained from treating unemployment differently? Certainly many people want us to think about the currently high rate of unemployment in the US as a tragedy, but do they have in mind that we should somehow independently take account of unemployment in a measure of aggregate welfare? Maybe all these people are thinking is that there is a set of policies that could make unemployment lower, and that this would simultaneously make average consumption higher and reduce inequality, thus giving us a welfare improvement by the Jones/Klenow measure?

What does theory tell us about the cost of being unemployed? In some search models, it is costly to look for a job, in terms of effort and the opportunity cost of time. Unemployed people are willing to bear these search costs as they perceive that their potential welfare from being employed is sufficiently high relative to their welfare from being unemployed, given the probability of obtaining work. Thus, costs of search contribute negatively to economic welfare, independent of the factors that go into the Jones/Klenow welfare measure. Of course the measurement here is problematic - the unobservability of search effort is in fact the key problem in designing unemployment insurance systems.

Do we want to think of the unemployment state as somehow more painful than not-in-the-labor-force, i.e. does the average person obtain fewer utils from an hour spent unemployed as opposed to an hour spent not-in-the-labor-force, everything else held constant? An unemployed person may face higher uncertainty, which makes him/her worse off, but is a day spent playing golf less satisfying if I am unemployed than if I am not actively searching for work? But maybe the unemployed person can't afford to play golf, i.e. there are complements to leisure time that we need to take into account.

Sometimes excessive focus on the levels of employment and unemployment as welfare measures can get us in trouble. For example, some people looked at the report of the Council of Economic Advisors on the effects of the stimulus package, which told us that $666 billion was spent to obtain 2.4 million jobs, put the first number in the numerator and the second in the denominator, and determined that each job cost $280,000. Seems like a bad deal. Of course, we know that this is a poor way to evaluate the stimulus program, as we need to take account of the effects on incomes, both now and in the future, among other things. I would be more worried about that 2.4 million number and where it came from.

However, you can't fault the people who made that $280,000 calculation for making it, as people like Paul Krugman are encouraging them to do it. The labor market is important, but if you focus on it too much it can come back to bite you.