OECD Report

I'm taking my lead from Krugman's New York Times column this morning (previewed in his blog), and going straight to the OECD Economic Outlook document. This is a rather bland piece of work. Most of it reads like mainstream intermediate macro textbooks (Mankiw or Abel and Bernanke), and is more or less innocuous for the same reasons. You can quarrel with the basic modeling framework this is based on, but it's some mix of standard Old Keynesian and New Keynesian economics, and is therefore at least internally consistent.

Where the thing actually takes a stand, and gets a reaction from Krugman, is here. There is this:

In this unsettled financial environment, we think governments need to get out ahead of markets, because otherwise they will be hostage to them.

Then there is this:

Moving ahead of markets requires a long term view, that allows all the policy actions to unfold and have an impact. This is expecially true now when markets seem to be returning to a short term view.



On inflation, the issue is not whether it is a risk today—it is not—but whether it will be a risk in two years’ time. Monetary policy needs to be forward looking and, on our projections, things will be rather tighter by then. This means easing up on monetary stimulus. To be clear, we are not arguing for contractionary policy, but for progressively less stimulus. In fact, stimulus should not be withdrawn completely until the economy returns to full employment. But the process should be started fairly soon, to take into account the well known long and variable monetary policy lags. Raising interest rates above zero would also signal a commitment to price stability that would help to prevent inflation expectations from drifting up. If expectations do start to rise, policy will eventually have to tighten more to bring them down again, as we found out in the 1980s.

I think Krugman and I agree here, but for different reasons. It is clear that, when we formulate monetary policy, we have to start in the future, and work backward, in an attempt to weigh the risks of alternative current policies. However, what I think the OECD is recommending here is wrong, for the Fed or the ECB. The large quantity of reserves sitting on the Fed's balance sheet do not represent an inflation threat. Under the current regime, the Fed has all the power it needs to control inflation by setting the interest rate on reserves, which is currently the key policy instrument. There is no reason to raise that rate currently, as inflation is very low, and anticipated inflation is low, as measured by the difference in yields on Treasury securities and Treasury inflation-protected securities (TIPS). There is plenty of time to tighten when we actually start to see more inflation. For me, the key risk is the maturity mismatch on the Fed's balance sheet. The Fed should be selling mortgage-backed securities now to reduce that risk. That would not represent a tightening of monetary policy - it's an asset swap that is essentially irrelevant. For an earlier take on this view of things, applied to the ECB, see this.

Krugman Blog

I may write on this thing called a blog, but I spend little time reading the blogs of other people. I basically read conventional media, often in conventional form. I like to sit for a while in the morning with the actual newspaper and drink my coffee.

Now, being curious, I took a look at Krugman's blog, to see how he does it. The guy writes a lot. He'll have at least one, and maybe two posts per day. They are short thoughts, with typically a strong opinion stated. Of course, I'm not opposed to strong opinions - I certainly have a few of those myself. However, let's take one of these blog posts apart to see how it works. For May 26, here, Krugman has a post called "Reasons to Despair." Certainly a dramatic title - sounds like a Thomas Hardy novel. Here's the first paragraph:

For some reason today’s papers made me feel especially grim about the prospects for economic recovery — not the economic news so much as what one sees about the mindset of policy makers.

So, we are in despair because the policy makers are doing something wrong, or we think they are about to do something wrong. What is it? Next paragraph:

Here’s where we are: growing GDP, but mass unemployment still the law of the land, with only tiny progress so far. What can be done?

Yes, GDP certainly is growing - it's been doing so for three quarters now. The rest is loaded language. Krugman likes the term "mass unemployment." Obviously he thinks the unemployment rate is too high, but relative to what? Does he have some insight as to what an optimal unemployment rate might be at this time? Note that he does not point out that employment is growing, and the unemployment rate did not fall last time around because of an influx of workers into the labor force. There are more people searching because they think the their prospects look a lot better. Let's see what he thinks we should do about the mass unemployment.

Well, we could have more fiscal stimulus — but Congress is balking even at the idea of extending aid for the ever-growing ranks of the long-term unemployed. Fiscal responsibility, you see — hey, and let’s make sure estate taxes stay low!

Even if you were a diehard Keynesian, this is strange talk when you have a recovery well underway - everyone knows that employment lags output, and the unemployment rate takes a long time to fall in a recovery. Our unemployment benefits could certainly be more generous though. As Kartik Athreya would say: "insure people, not firms." Here's what's next:

We could get tough with China, which continues its currency manipulation and, in the face of a world of grossly inadequate demand, is actually tightening monetary policy to avoid an overheating economy — when basic textbook economics says that it should be appreciating its currency instead, which would not only rebalance China’s economy but help the rest of the world. So given China’s outrageous behavior, Geithner went to China, got nothing .. and pronounced himself very pleased.

I did not realize Krugman was a China basher. How unseemly. I'm not sure what textbook Krugman was reading, but it wasn't mine (I know, shameless advertising). I thought notions that a country could somehow "manipulate" it's exchange rate to its advantage, or that economic policy was about "balancing" something were long ago relegated to the garbage dump, but apparently not. On we go:

We could do more through monetary policy. Macro theory suggests that the theoretically right answer, if you can do it, is to get central banks to commit to a higher inflation target. But the Fed and the Bank of Japan say no, because … well, that’s not what central bankers do.

What macro theory? The right answer to what? I don't know what Krugman wants the Fed to be doing. Krugman is a liquidity trap guy, so how does he think we get more inflation from the central bank in the current state of the world? The Fed could reduce the interest rate on reserves to zero, but that won't get us much more inflation. I don't know about the Bank of Japan, but it's hard to characterize the Fed as under the control of a bunch of inflation hawks - Bernanke is decidedly dovish on inflation, for example. And finally:

It’s depressing: shibboleths and conventional wisdom are blocking all routes out of this slump. And I worry that policy makers will just sit there, for years and years, all the while congratulating themselves on the soundness of their policies.

I have seen "shibboleth" before, but I looked it up to make sure I knew what it meant. This is actually a cool word. The strange thing here is that Krugman wants to characterize himself as the outsider, despairing that his obvious truths are falling on the deaf ears of the insiders. But Krugman is the insider. His views are in fact those of the majority of policymakers who have any power in this country. I would not characterize those policymakers as sitting on their thumbs congratulating themselves though. They are actually working hard to figure this thing out.

The World Supply of Liquid Assets

I found this piece by Ricardo Caballero, which is a useful starting point for a discussion of the role of safe assets in the financial crisis and in the recent European sovereign debt crisis. An important feature of post-2000 financial markets in the United States was the multi-layered role of housing in somehow "lubricating" financial markets. Housing played a direct role as collateral for mortgage debt that was used to finance consumption expenditure, and mortgage-backed securities were very important as collateral in financial market arrangements. However, when everyone realized that incentive problems had caused us to vastly overvalue the direct mortgage debt, and the securities built up from it, we then had much less of what we consider to be safe, liquid assets. With less liquid assets, there has to be less trade on financial markets, as was, and still is, the case.

What can governments do about this? Well, if we think there are less liquid assets than is socially optimal, the government can step in and supply more. One way to do this would be through fiscal policy. In order not to deal with issues related to public goods and government spending on goods and services, consider a policy where the government increases the deficit by reducing current taxes. Now, we have to ask why this would accomplish anything. As my undergraduate students know, (see Chapters 8 and 9 of my intermediate macro book) in a world where credit markets are perfect, changes in the timing of taxes are irrelevant, and so by implication is the level of government debt. Given that the government always pays off its debt eventually (another important assumption), Ricardian equivalence holds, and everyone simply saves their tax cut so as to pay off the higher taxes they will owe in the future to pay off the government debt.

Of course, we know we are not in a Ricardian equivalence world. The financial crisis was about frictions - the frictions that make studying financial and monetary arrangements interesting. However, even standard ways of thinking about financial frictions do not necessarily lead us to any obvious role for the government in "lubricating" financial markets. Suppose we think about standard private information and limited commitment problems. If private lenders face private information problems that make lending costly or might shut it down altogether, or there is limited commitment which makes collateral useful in mitigating the resulting incentive problems, then borrowers may be constrained and shut out of credit markets altogether. Further, spreads emerge - there are significant margins between borrowing and lending rates of interest, and there are risk and default premia.

But the government is faced with the same private information problems and limited commitment problems as is the private sector. In order to somehow make credit markets work more efficiently, the government has to have an informational advantage - it has to somehow be a better banker than private bankers - or it must have an advantage in collecting on its debts. For example, if we imagine a world where the limited commitment problem is so severe that lending shuts down entirely, we might imagine the government stepping in and cutting taxes, issuing debt in the present, and collecting taxes in the future to pay off the government debt, thus essentially making loans to the private sector. However, if the government is no better than the private sector at collecting on its debts, private sector economic agents will run away from their tax liabilities just as they run away from their private debts. If that is the case, this government fiscal program will not even get off the ground.

The point is that the correct type of fiscal intervention for the government in a world with significant financial frictions (which is the world we live in, and always have) is far from obvious. If anyone tries to tell you it is, you should not listen.

Now, what about monetary policy intervention? If we view a financial crisis as temporary, this gives a natural advantage to monetary policy intervention, which can in principle be reversed quickly. Milton Friedman of course recognized the unwieldy nature of the fiscal decision-making process - tax policy is hard to turn on and off. How can the Fed create more liquid assets? You might think the answer would be open market purchases and reductions in short-term market interest rates. However, note that we think of the recent reductions in long-maturity Treasury yields as reflecting an increase in the demand for Treasuries - a flight to safety. The low yields on Treasury securities at all maturities reflects a liquidity premium, or a scarcity of safe and liquid, assets. Thus, if we eliminate the scarcity, we would be increasing yields at all maturities, not lowering them. Perhaps we are thinking of this problem in exactly the wrong way.

Now, I'll address more specifically what is in Caballero's piece. He starts off this way:

While the focus of commentators and policymakers is on secondary (although still important) regulatory and corporate governance issues, the fundamental problem in the current global macroeconomic and financial equilibrium is one of asset shortages. In particular, there is a shortage of safe “AAA” assets. The world seems to need more US Treasury-like instruments than are available.

The part of this I don't like is the notion that the regulatory issues are somehow secondary. This is at the heart of what has led to what Caballero is calling a "shortage." The regulation was bad, which created the incentive problems, which ultimately created the shortage of privately supplied liquid assets. To get these privately-supplied assets back, you need proper regulation.

As Caballero seems to recognize, "producing" AAA assets is not like producing good shoes as opposed to bad ones. Whether US debt is AAA or something worse depends on self-fulfilling expectations. If the world began to think tomorrow that the United States was not creditworthy, then it would not be. We are currently in a fortunate position, as the world treats us as highly creditworthy - so much so that the yields on US Treasuries are incredibly low, in spite of our high deficit and accumulating debt. But we should not push our luck. Higher US deficits might give our creditors pause, and cause them to seek safe haven elsewhere. Further, we don't want a large quantity of debt outstanding when credit markets get back to normal and safe private liquid assets flood the market to compete with US Treasury debt.

Where Caballero loses me is here:

We should separate the production of micro- and macro-AAA assets. The private sector is much more efficient than the government in producing micro-AAA assets, but the opposite is true for macro-AAA asset production.

What's this about micro-AAA and macro-AAA? Maybe what he means is that there was aggregate risk hiding on the balance sheets of various financial institutions - as a result the liabilities of those institutions seemed a lot safer than they actually were. But this gets back to the regulatory reforms that Caballero dismisses at the beginning of his piece. It seems to me that we can make the private sector very good at producing macro-AAA assets if we regulate the financial institutions properly - that's the basic problem.

Financial Reform

In some respects I have been dreading writing about this. For example, to do a proper analysis of the Senate version of the financial reform bill (currently passed in House and Senate versions) I would have to read the bill carefully, which would take more time than I have available. Thus, I'm relying on what I have read in the mainstream press, and on this summary of the Senate's financial reform bill.

I am going to pick and choose some features I find interesting:

1. Implications for the Fed: Some early legislative proposals involved taking power away from the Fed, particularly its regulatory power over small banks. The Fed does lose some of that (banks with less than $50 billion in assets will be regulated by either the FDIC or the Comptroller - OCC), but it gains some power as a consumer watchdog, and as a "systemic regulator." Something I did not see reported was this:

The president of the New York Federal Reserve Bank will be appointed by the President of the United States, with the advice and consent of the Senate. The New York Federal Reserve president is a permanent member of the Federal Open Market Committee, the Bank executes open market operations and is an important source of information on capital markets, and the Bank supervises many important bank holding companies. However, the president of the New York Federal Reserve Bank is currently chosen by the Bank’s directors, 6 of whom are elected by member banks in that district.

This is very interesting, and I'm not sure whether this is good or bad. On the one hand, under the current rules, whereby the New York Fed President is appointed by the Board of Directors of the New York Fed, the possibility exists that the New York Fed President could be unduly influenced by Wall Street interests. Indeed, this New York Times piece calls into question Treasury Secretary Geithner's behavior as New Fed President in this respect. On the other hand, do we think we can trust the President of the United States (current, past, or future) not to be intimidated by Wall Street? I don't think so.

2. Consolidation and clarification of regulatory authority: I like this line from the summary:

Experts agree that no one would have designed a system that looked like this.

Yes, but the problem is that we did. The proposal here is for a clear demarcation of regulatory responsibility among the FDIC, OCC, and the Fed. The FDIC and OCC get the small banks, the Fed the large ones. The legislation would get rid of the Office of Thrift Supervision (OTS) which appears to have been a culprit during the demise of Washington Mutual. This is clearly a step forward, though it would have been nice if OCC had met its demise as well. Unfortunately, though the legislation would do away with one regulator, it creates another - the Office of National Insurance. This seems like a bad idea. The legislation needs to recognize that it is difficult, and will become more difficult, to distinguish between banks and other financial intermediaries. A comprehensive approach to regulating all financial intermediaries is needed. Why not put the insurers under the Fed's supervision, and give them access to the discount window?

3. Glass-Steagall restrictions: Some features of the bill represent moves to put Glass-Steagall-type restrictions back in place, to separate banking from other elements of what goes on in financial markets. These have to do with the "Volcker rule," and Blanche Lincoln's proposal that bank's spin off derivatives activity. First, banks are quite innovative in getting around restrictions imposed in terms of specific financial instruments and activities. It is better to write the restrictions in terms of risk-taking, to give the regulators more flexibility and discretion in deciding what individual financial institutions can or cannot do. Second (and this relates to point 2 above), there is no point in sticking to obsolete notions of what a "bank" is. Canadian banks, for example, perform some standard banking functions along with investment banking, and this does not appear to cause problems.

4. Too-Big-to-Fail: Here the legislation gets somewhat murky. Apparently there will be a Financial Stability Oversight Council with some vague mandate to monitor systemic risk (hard to define at the best of times). Large financial institutions are supposed to design their own "funeral plans," and there is to be a liquidation procedure for large financial institutions that

requires Treasury, FDIC and the Federal Reserve all agree to put a company into the orderly liquidation process. A panel of 3 bankruptcy judges must convene and agree - within 24 hours - that a company is insolvent.

We have to get 3 regulators to agree to put liquidation into motion? Good luck. However, at least there is some orderly procedure in place, though I'm not sure we can trust any of these institutions to come up with socially optimal "funeral arrangements."

5. Retail payments: This was not in the summary document, but other sources report that there will be changes that will affect the pricing of credit card and debit card services. Over the years, credit card issuers in particular have developed clever mechanisms to extract monopoly rents. For example, a typical credit card contract written by the credit card company (Visa for example) with a retailer specifies that the retailer must accept the card even for very small transactions, and must charge the same price for credit card and cash transactions. Thus, Visa can extract surplus from the retailer, but not in a way that reduces the quantity of credit card services sold - indeed this does just the opposite. Elements in the legislation would make these contractual arrangements illegal. I'm sure retailers like these proposals, but it is not clear they would be better off if their customers use cash with greater frequency. This implies that the retailer will have a higher stock of cash on hand, and thus be a more lucrative target for thieves. We seem to have an inconsistent policy concerning retail payments in general. We seem to have come to the conclusion that the issue of circulating currency should be a monopoly given to the central bank, but the credit card and debit card business appears to have essentially free entry. Historically, some private monetary systems (e.g. the one in Scotland in the early nineteenth century, or Canada until 1935) worked quite well, but were certainly not unregulated. Maybe there are lessons from how these monetary systems were regulated that we can use in thinking about the optimal regulation of credit card and debit card systems.

There He Goes Again

I shouldn't read Krugman's New York Times column, as sloppy thinking irritates me. I made that mistake this morning though. Krugman is in doom-and-gloom mode again. Apparently Paul thinks that we're potentially headed for the Japanese 1990s experience. Here's his take on the latest CPI report:

This isn’t really surprising: you expect inflation to fall in the face of mass unemployment and excess capacity. But it is nonetheless really bad news. Low inflation, or worse yet deflation, tends to perpetuate an economic slump, because it encourages people to hoard cash rather than spend, which keeps the economy depressed, which leads to more deflation. That vicious circle isn’t hypothetical: just ask the Japanese, who entered a deflationary trap in the 1990s and, despite occasional episodes of growth, still can’t get out. And it could happen here.

We're in the midst of what's looking like a strong recovery, and Krugman makes it sound like the midst of the Great Depression. At the moment, we should be anticipating that the returns on lending are going to start to look very good for banks, and they will lose interest in holding reserves, at which point we get some more serious inflation. This will necessitate some monetary tightening, i.e. an increase in the interest rate on reserves. At this point, though, the Fed should just hang tight, and sell their MBS and agency securities while the prices are high.

There is certainly reason to be concerned about what is going on in Europe. There is panic at large, and we don't need to be reminded that panics don't just happen in some of our models. In this case though, I think the Greek crisis is not a big deal on a world scale. Hopefully in a few weeks everyone will regain their senses, and asset prices will be back where they were - I could be wrong though.

FOMC Minutes

FOMC minutes from April 27-28 were just published here. I think I should take back some of my previous statements about the vague nature of FOMC statements. While there is vagueness in these minutes (of course, this is the Fed speaking), they are also revealing.

In case you were wondering why there was no mention in the FOMC statement for April 28 of decisions concerning the sales of mortgage-backed securities (MBS) and agency securities (Fannie Mae and Freddie Mac debt) currently on the Fed's balance sheet, that's because the FOMC did not make any. As you can see, there was a long discussion of asset sales, and opinions on the committee were all over the map. Some people want to simply let the assets mature (which will take a very long time - these are all mortgage related assets of course, so we are talking upwards of 30 years), others want to start selling the assets now, others want to wait until short-term interest rates start to increase, some want to sell all of the MBS and agency securities within 3 years, others want to take much longer, etc. Possibly Greece and credit market problems attracted most of the committee's attention, and they did not have time to resolve the issue.

There is still confusion on the committee about how monetary policy works, and what determines inflation, when the quantity of excess reserves in the system is positive. For example:

A couple of participants thought faster sales, conducted over about three years, would be appropriate and felt that such a pace would not put undue strain on financial markets. In their view, a relatively brisk pace of sales would reduce the chance that the elevated size of the Federal Reserve's balance sheet and the associated high level of reserve balances could raise inflation expectations and inflation beyond levels consistent with price stability or could generate excessive growth of credit when the economy and banking system recover more fully.

The participants clearly do not understand that a high level of excess reserves cannot in itself cause inflation. With a large quantity of positive excess reserves, asset purchases or sales are essentially neutral, and have no implications for inflation. The only issue has to do with the maturity mismatch on the Fed's balance sheet, which would dictate selling the MBS and agency securities sooner rather than later.

It is apparent from the minutes that the Fed is proceeding with plans to use term deposits and reverse repurchase agreements as tools of monetary policy. Note this passage:

The staff also briefed the Committee on recent progress in the development of reserve draining tools. The Desk was preparing to conduct small-scale reverse repurchase operations to ensure its ability to use agency MBS collateral. It also continued to work toward expansion of the set of counterparties for reverse repurchase operations. The staff noted that the Board had recently approved changes to Regulation D that would be necessary for the establishment of a term deposit facility.

This tells us how the Fed views these new tools, i.e. they "drain reserves." The Fed seems to be reluctant to part with its MBS and agency securities, and needs to finance this with reserves, but it seems worried that the reserves will somehow escape and cause inflation. Now, this is very confused thinking. First, reverse repos can only be more costly than actually selling MBS outright. I'm sure securities dealers will be quite happy to get the Fed's business to roll over reverse repos in MBS every day, but the Fed would be much better off if it just unloads the MBS. With regard to term deposits, this is just going to work in a perverse way. For example, suppose the Fed wants to induce the banks to hold a $1 trillion in excess reserves. How do they do it? First, the Fed could set the interest rate on reserves to induce the banks to hold $1 trillion in their usual reserve accounts, and these reserves can be used during the day to make interbank transactions. Second suppose the Fed auctions off $500 billion in term deposits, and sets the interest rate on reserves so that the banks will hold the other $500 billion in their reserve accounts. Now, note that the term deposits cannot be used in interbank transactions - they are essentially locked up for a month, or whatever. Clearly, in the second case the Fed has made the total quantity of excess reserves less desirable for the banks to hold, and on average it will be paying a higher interest rate on the whole $1 trillion in the second case than in the first. The result is exactly the same, as the banks hold the reserves, but in the second case the Fed pays more for the reserves. How can this be useful? Indeed, think about this another way. Suppose we fix the average interest rate on reserves (including regular reserves and term deposits), and increase the fraction of reserves held as term deposits. What happens? Well, the price level goes up. The reserves are as desirable in terms of their payoff to the banks, but are less desirable, as less of them can be used in transactions. The banks want to hold less total excess reserves, i.e. the demand for outside money falls, and the price level must rise. I think the usual Old Monetarist logic is that term deposits are deflationary, which is obviously wrong!

Finally there are some issues in the minutes related to recent inflation. Note this passage:

Consumer price inflation was low in recent months; both headline and core personal consumption expenditures (PCE) prices were estimated to have risen slightly in March after remaining unchanged in February. On a 12-month change basis, core PCE prices slowed over the year ending in March, with deceleration widespread across categories of expenditures. In contrast, the corresponding change in the headline index moved up noticeably, as energy prices rebounded.

Ever since the 1970s, apparently, we have been paying some attention to price measures which leave out prices that are viewed to be volatile. Why this practice persists, I have no idea. We might argue similarly that there are some highly-volatile components of GDP that we would be better off ignoring. Then, the recession does not look so bad, if we take out the volatile components, principally investment and consumer durables. Indeed, we might justify just looking at "core GDP," which might be consumer expenditure on services and non-durables. Of course this would be silly, but it's the same silliness that tells us we should ignore volatile components of the CPI.

Now, for anyone who thinks that preemptive tightening in monetary policy (i.e. increases in the interest rate on reserves) is appropriate now, the recent CPI numbers would give one pause. Since January 2009, the seasonally adjusted CPI has increased on average at about 2.1% per annum, and this CPI measure was essentially flat between March and April 2010. Here's something interesting that I noticed. If you look at the seasonally unadjusted CPI, it increased on average at about 2.6% per annum since January 2009, and the last monthly increase was about 2% at an annual rate. Now, there was a large drop in the implicit anticipated inflation rate that I can read from TIPS bond yields, that occurred on the day of the most recent CPI release. This may have had something to do with Europe as well, but the timing would make us think that the bond traders are looking at the seasonally adjusted CPI, and thought this was important news that the monthly inflation rate was down to zero.

The CPI must be pretty messed-up seasonally. Think about how the basket of goods purchased by the average consumer varies over the seasons, and how prices vary. There aren't any Christmas trees sold in August, fresh blueberries are very expensive (and the quantity sold very low) in the winter, and beach houses are not being rented out in Cape Cod in the winter. But the basket used to calculate the CPI is fixed year-round, as far as I know. How can we attach any significance to a one-month change in the CPI, whether it is seasonally adjusted or not? The most recent data might indeed reflect actual inflation of 2% or more - there could easily be an anomaly created by how the seasonal adjustment was done.

Now, suppose that we think that recent inflation measures (say seasonally adjusted CPI inflation) are accurate. How do we explain the recent inflation experience? Consider the following possibilities.

1. Certainly an Old Monetarist approach will not help. For example, if I am an Old Monetarist and my measure of money is the monetary base, I would not be able to make sense out of the first figure.

This shows the log of the real monetary base - given the huge recent increase, this certainly doesn't look like a time series that could have been generated by some stable demand function for base money.

2. Alternatively, consider Phillips curve explanations. Now, suppose that I forecast inflation next quarter as inflation in the current quarter. New Keynesian Phillips curve logic tells me that the forecast error I make should be positively correlated with the output gap. In the next two figures, I plot this forecast error against the output gap (measured as the Hodrick Prescott deviation from trend in real GDP) for the 1947-2010 data (up to first quarter 2010) and for 2007-2010. In both figures, my eyeball tells me the correlation is zero. So much for the Phillips curve. By the way, it does not particularly matter how I measure the output gap here, though I'm sure a dishonest Keynesian could find a positive correlation.





3. Now, if you think like I do, you would say that inflation is determined, basically, by the supply and demand for currency. In the next figure, I show the log of the real currency component of M1. You can see that the quantity of currency in real terms dropped substantially beginning in the late 1960s, and then stabilized in the mid-1990s. Other than one small recent downward blip, the behavior of this time series is anything but anomalous.



My point here is that the data is entirely consistent with the story I have been telling. The price level is determined by the demand and supply for currency - currency is where the rubber hits the road, basically. When there is a positive supply of excess reserves, and the demand for reserves falls, the nominal supply of currency has to rise, and the price level rises. Now, in spite of the fact that there may be a stable demand for U.S. currency, this is not going to help me forecast inflation. I don't know where in the world the currency resides, and I will have a very hard time estimating a demand function for the stuff. Given the realities of measurement, the Fed is better off setting an inflation target and then (under the current circumstances) manipulating the interest rate on reserves to hit the target.

ECB, Part II

These are replies to comments on my previous post.

In reply to anonymous: I read the Ennis/Wolman Richmond Fed piece, and found it confused. This relies on Old Monetarist money-multiplier thinking, which I think is wrongheaded. People need to understand that, when there is a positive quantity of reserves in the system, the interest rate on reserves (IROR) becomes the relevant policy rate. Rather than, as in normal times, conducting open market operations to target the fed funds rate, what is going on now is that IROR is set by the Fed, and all the other short rates follow. If holding other assets starts looking more attractive to banks, then the price level will rise if IROR stays constant. To prevent the price level from rising, the Fed has to increase IROR to induce the banks to hold the reserves. Term deposits accomplish absolutely nothing. If there is any marginal liquidity value to the reserves in interbank transactions, then the Fed has to pay more for the reserves in the form of term deposits (the term deposit rate has to be higher than the IROR). At best, the reserves have zero marginal liquidity value and the term deposit rate is the same as IROR - but then it does not matter at all whether the outside money is reserves or time deposits. This old piece, that Ennis/Wolman cite, is even more confused.

In reply to Andolfatto: A key point is that the ECB is not "monetizing" the Greek debt. They are intermediating the debt, and what comes out the other end is interest bearing reserves, which under the current circumstances looks just like T-bills (or whatever you call a short-term riskless Euro-denominated security). The EMU may not have understood this, but when they acquired Greece as a member, they were committing to a long term policy where they have to take responsibility for Greece's debt. Right now, the ECB is hoping that it can acquire Greek debt, finance this with interest bearing reserves, and that Greece will ultimately get its act together, in which case the ECB makes a profit on the deal. If Greece ultimately defaults on its debt, then it looks like you are correct - there are inflationary implications, as the ECB somehow has to make up for the losses on its asset portfolio. Otherwise, I think we are agreed that there are no inflationary implications. Now, can the purchase of Greek bonds matter for the market prices of those bonds? That's the debatable part. I think the Fed thinks that its acquisitions of long-maturity Treasuries and MBS changed the term structure of interest rates, even though they were just swapping short maturity interest bearing reserves (i.e. T bills) for long-maturity treasuries. One might think that arbitrage would dictate that this is neutral. Maybe financial markets are somehow segmented, and this segmentation is even more acute for something like Greek debt? In that case, the acquisition of Greek debt by the ECB increases the prices of Greek bonds, and this benefits the Greeks. I'm not sure how this market segmentation might work, but if it does it is at the heart of some recent central bank interventions.

The ECB and Inflation Control

Earlier this week, the ECB announced that it would be buying more euro-denominated government bonds. Presumably the ECB will do what it typically does with government debt purchases, which is to buy the debt of EMU members in proportion to their sizes. However, this is clearly aimed at bailing out Greece. The EMU has decided that it wants to keep Greece as a member, and the central bank is therefore going to take on Greek debt.

Some people, including Jean-Claude Trichet's interviewer seem worried that the additional injection of outside money by the ECB will be inflationary. As I have argued previously, with respect to Fed policy, these fears are unwarranted.

To understand this, we'll need to review ECB policy institutions and recent developments on the ECB balance sheet. The ECB operates on a channel system, which has some similarities to the Canadian system. There is a marginal lending facility, for central bank overnight lending to financial institutions, and a deposit facility allowing for the holding of reserves. Current interest rates are 1.75% at the marginal lending facility, and 0.25% on the deposit facility, and these interest rates bound the overnight interbank lending rate. As well, there is additional lending through refinancing operations, at maturities of 1 week, 1 month, and 3 months. The current 1-week lending rate is 1% (see here for details).

Now, if we look at the most recent ECB balance sheet, note that, as in the US, the ECB is holding a large quantity of reserves, though not as much as a fraction of liabilities as the US. With a roughly 2 trillion Euro balance sheet, the ECB holds 282 billion Euros in its deposit facility. Consistent with this, in the May 2010 monthly bulletin, Chart 11, page 34, you can see that the overnight interbank rate is essentially being determined by the interest rate on the deposit facility (just as in the US).

Now, with a positive quantity of reserves in the financial system, and the overnight interest rate determined by the interest rate on reserves, purchases of government debt by the ECB are essentially irrelevant. The ECB is simply swapping reserves for government debt, and this will have little effect on anything, including the inflation rate. The only issue is the maturity mismatch on the ECB balance sheet - the ECB is borrowing short and lending long.

Now, in Trichet's interview, he seems a little confused about this. Like Ben Bernanke, he seems to think that he has to "lock up" the reserves in the deposit facility so that they will not escape and cause inflation. He says:

The additional liquidity that we are providing through the purchase of government bonds will be withdrawn again. Interest-bearing time deposits are an appropriate way to withdraw this liquidity.

This is the same type of term-deposit facility that the Fed appears to be going ahead with. The idea is quite lame. When there is a positive quantity of reserves in the system, the central bank can control inflation by setting the interest rate on reserves. There is no need for a term-deposit facility - the central bank just has to pay more for the reserves this way.

Here is another point of confusion:

HB: Do you now start the same what the central banks in the United States and the United Kingdom have already been doing for a while?

Trichet: That is not comparable. What the Federal Reserve and the Bank of England have done was “quantitative easing”. They were injecting liquidity into the markets and that with the explicit goal of augmenting the overall liquidity. As I said already what we are doing through the Securities Market Programme is not quantitative easing.

Trichet seems to think that he's different because of the term deposit facility. Baloney. Behind the smoke and mirrors, the ECB program is intended to subsidize Greece, just as the Fed's MBS purchases subsidize the housing market.

Fed Swap Facilities

On May 9, the Fed reopened its swap facilities with the Bank of Canada, the Bank of England, the European Central Bank, and took similar action with respect to the Bank of Japan on May 10.

This New York Fed piece explains how the swap facilities work. The swap facility is a line of credit extended to a foreign central bank. Here's what happens when the foreign central bank uses its line of credit. The foreign central bank receives a loan as a credit to its account with the Fed (essentially a non-interest-bearing reserve account), in US dollars, and a loan appears on the asset side of the Fed's balance sheet. As collateral on the loan, the Fed receives a credit to its account at the foreign central bank of an equivalent amount in foreign currency, at the current exchange rate. The foreign central bank then, in turn, makes loans in US dollars to foreign financial institutions. When these loans are repaid to the foreign central bank, the balances in the Fed's account at the foreign central bank and in the foreign central bank's account at the Fed go to zero. It is as if the foreign central bank repurchased the foreign exchange (the collateral) from the Fed at the original exchange rate, so there is no exchange rate risk for the Fed. Further, any interest (earned in US dollars) that the foreign central bank earned on its lending to financial institutions goes to the Fed.

What's going on here? Essentially this is a roundabout way for the Fed to extend discount window loans, as US dollar lender-of-last-resort, to financial institutions in foreign countries which are holding US dollar-denominated assets. This is a perhaps under-emphasized feature of the Fed's interventions during the financial crisis. Lending through the swap facility began in earnest in fall 2008, and peaked at a whopping $583 billion in December 2008. The majority of this lending was to the ECB.

Reading between the lines here, the reopening of the swap facilities was likely done at the request of the ECB as part of the bailout package for Greece. The extension of the credit lines to central banks in England, Canada, and Japan, is likely just for show. Most of the actual lending - and even more so than in the financial crisis - will go the ECB.

Are the swap facilities a good idea at this time? There is some reporting on this here. Clearly the Greek crisis has increased the demand for US dollar denominated assets substantially in Europe, and this is reflected in recent drops in Treasury yields at all maturities. It makes sense to inject US dollar liquidity where it is scarce, and we could argue that this is in the interest of US residents. Two things puzzle me though:

1. The line of credit to the ECB appears to be open-ended. I don't see any limits. I assume the Fed would not write a blank check and would want to exercise some discretion here, but I don't see it.

2. Why doesn't the Fed charge the discount rate on these loans? This is the correct price to put on the lending. The Fed should not accept whatever rate the ECB chooses to lend the funds at.

Fannie Mae

Fannie Mae's financial report for the first quarter (see here) was published today, with much the same story as for Freddie Mac (see here). Both Fannie Mae and Freddie Mac have reported losses, and will need more bailout money from the Treasury. An interesting feature of the reports from both agencies, is that some of the losses are due to changes in accounting. I am interested in learning more about this. Were Fannie and Freddie engaged in accounting practices that hid the extent of the risks they were taking?

Fannie Mae and Freddie Mac

This piece in the Sunday New York Times draws attention to Freddie Mac's first-quarter 2010 financial report, and raises questions about the unaddressed problems related to Freddie Mac and Fannie Mae vis-a-vis the proposed Congressional financial reform package.

As background, recall that Fannie Mae (Federal National Mortgage Association) has been with us since 1938. Originally created as part of the federal government, it was moved off the government's balance sheet in 1968 and made a private corporation. Freddie Mac (Federal Home Loan Mortgage Corporation) was created in 1970 with a structure and role very similar (if not identical) to Fannie Mae's. In September 2008, Fannie Mae and Freddie Mac became wards of the government, under the "conservatorship" of their regulator, the Federal Housing Finance Agency (FHFA). The FHFA was in turn created in July 2008, with the powers it needed to subsequently take over Fannie Mae and Freddie Mac as conservator.

What do Fannie Mae and Freddie Mac do? First, they securitize mortgages. Mortgage loan originators sell loans to Fannie and Freddie, and they repackage these loans as mortgage-backed securities (MBS), which they then sell. This does not create any assets and liabilities on Fannnie or Freddie's balance sheets, except for the short-term financing required while these agencies are packaging the MBS. Second, Fannie and Freddie have a mandate to buy and hold mortgages and mortgage-related assets. These assets could be mortgages purchased directly from the orginators, or on the secondary market, MBS issued by other financial intermediaries, or mortgage-related derivatives. In order to buy mortgages and mortgage-related assets, Fannie and Freddie issue agency securities - i.e. long-maturity debt.

Fannie Mae and Freddie Mac are huge. Fannie reports that, in September 2009, 27.5% of U.S. residential mortgage debt was either held directly by Fannie, or was somehow incorporated in Fannie MBS. Assuming Freddie is of comparable size (and I'm pretty sure it is), these two agencies have something to do with about half of the residential mortgage debt in the US.

Now, it has been known for a long time that the agency debt issued by Fannie Mae and Freddie Mac enjoys the implicit backing of the federal government. I first learned this as a teaching assistant in Don Hester's University of Wisconsin-Madison undergraduate money and banking class in 1980. The implicit backing was made explicit in September 2008, and the two agencies have subsequently received capital infusions from the US government, to the tune of $59.9 billion for Fannie and $52 billion for Freddie.

Fannie and Freddie, like all other large US financial institutions (except Lehman Brothers, apparently), have been treated as too big to fail. I don't know how the antecedents of the FHFA regulated Fannie and Freddie, but it is abundantly clear that they were doing a bad job. Fannie and Freddie, with the benefit of undue political influence, became bloated, inefficient, and corrupt institutions that took on too much risk.

The New York Times article points to recent losses on Freddie's portfolio, and asks an interesting question, which is: "How do Freddie and Fannie determine what they pay for the mortgages they buy?" The answer is the following:

Michael L. Cosgrove, a Freddie spokesman, declined to discuss what the company pays for the mortgages it buys. “We are supporting the market by providing liquidity,” he said. “And we have longstanding relationships with all the major mortgage lenders across the country. We’re in the business of buying loans, and we are one of the few sources of liquidity available.”

If we read between the lines here, the answer seems to be that, since Fannie and Freddie are essentially the only game in town now, they buy mortgages at whatever price they want.

Thus, though Fannie and Freddie account for roughly half of the stock of mortgage activity, they account for most of the recent flow. Further, the Fed was in turn financing most of that activity, until its purchase programs of Fannie and Freddie MBS and Fannie and Freddie agency securities ended in March. Thus, we currently have three-tiered intermediation in the mortgage market, whereby mortgage loans ultimately end up on the asset side of the Fed's balance sheet. How did the Fed determine the prices at which it bought MBS from Fannie and Freddie? Must be the same way Fannie and Freddie determines the prices it pays for mortgages - the prices are whatever the Fed wants.

Now, the MBS currently on the Fed's balance sheet are not junk, but nevertheless the Fed could have paid more than the "market price" for this stuff, and would thus take a loss if it sold these assets now or later. The difference between the price at which these assets are carried on the Fed's balance sheet, and the market value of the assets, is the implicit subsidy the Fed is granting to Fannie and Freddie, and to the housing market.

What should we do with Fannie and Freddie? These institutions suffer from the same moral hazard problems as other too-big-to-fail financial institutions. Without appropriate regulation, Fannie and Freddie will take on too much risk, and they further suffer from the usual bureaucratic bloat of government-owned or government-insured institutions. And what do we get for all this pain? I have argued elsewhere that we should embrace large financial institutions. In spite of the costs of regulation and industry concentration, economies of scale generally win out in the financial industry. However, the same argument does not apply to Fannie and Freddie. These institutions are nothing more than inefficient vehicles for subsidizing the housing market in the United States. If Fannie and Freddie were not there, well-regulated private financial institutions could take over their activities and do it better.

Fed Independence

The Fed has of course attracted a lot more attention than usual since 2008. Plenty of people, including Eliot Spitzer, are asking for the Fed's head on a plate. Here is the core of his reasoning:

In monetary policy—controlling the supply of money—the Fed is constrained by reasonably well-understood policy levers that have a macro impact, and its decisions are rather evident in short order. Now, in contrast, the Fed is engaging in fiscal policy—spending money—and in fact has become the single largest fiscal actor in the U.S. economy, dispensing hundreds of billions of dollars to private parties. In doing so, the Fed is picking winners and losers. Why Goldman but not Lehman? Why guarantee the debt of some companies but not others?

It looks like the Fed will escape relatively unscathed though. Legislation wending its way through Congress (see here) appears to have been toned down, to the point where the Fed will see some auditing only of its market activities during the financial crisis.

Now, the Spitzer quote above is quite confused, but in an interesting way. First, by definition, the Fed is not engaged in fiscal policy. All of the Fed's recent activities are permitted under the Federal Reserve Act, which prescribes what monetary policy is (though we could debate whether the Act gives the Fed too much power). Second, the Fed is not "dispensing money," it is acquiring assets, and so far making a profit in doing so. Most importantly, Spitzer seems to think that the Fed is typically not up to much - it moves the money supply around, announces fed funds rate targets, publishes its statements and minutes, and everything is fine. Well, not really. Central bankers are practiced at laying low, keeping secrets, and saying as little as possible in public. First, the Fed typically moves its fed funds rate target up or down by 1/4% at any FOMC meeting, and they do that for a reason. This is part of laying low. Monetary policy could be having very big effects - changing the level of GDP, reallocating credit across sectors, etc. But the average Congressperson, Joe Schmoe, or Jane Doe, is not going to notice this much in real time. Second, we all know how central bankers (Alan Greenspan being the classic example) can drone on for hours, sound authoritative and confident, say absolutely nothing of importance, and get away with it. Third, while the Fed publishes the minutes of FOMC meetings (see here), it does this with a lag, and in a very vague manner. We don't know the actual words, and who said what until five years later. By then, this information has only historical interest, and it is hard to hold anyone accountable. Having this information on a timely basis (i.e. immediately) is of course key to understanding exactly what the Fed is up to.

Now, in intervening in such a massive way, the Fed is being called to account, and rightly so. The Fed is enormously powerful, and able to reallocate resources in important ways, even in normal times. If and when the Fed gets its balance sheet back to "normal," maybe we should be thinking seriously about more transparency in central banking as well as in private banking.

April Employment Numbers

The Bureau of Labor Statistics published April employment data this morning. A good source is the Federal Reserve Bank of St. Louis FRED facility. Employment has been growing, both in the establishment data and in the household survey data since December 2009, as you can see in the charts. But average growth since December in establishment employment has been about 1.3% at an annual rate, while average growth in household survey employment has been about 3.6% at an annual rate (both somewhat higher recently).

Now, I am not a labor economist, but I understand that there is some notion that the establishment survey number is more trustworthy than the household survey number. However, there are good reasons (and different reasons) to worry about measurement error in both numbers. First, though the establishment number is trustworthy in the sense that it is easy for establishments to report the number of people on their payrolls, the establishment survey misses agriculture and self-employment. Second, though the household survey can have problems due to respondents not understanding what they are being asked, it actually covers everyone.

Are there any regularities in the behavior of the establishment survey relative to the household survey? I have attached my plot of the log of each employment series, normalized to log(100) in January 1980. What you see here is that the behavior of the two series was not so different up to the early 1990s (with a sharper downturn in establishment employment in the business cycle downturn in the early 1980s). Then, establishment employment grows at a higher rate until 2000, and after that the behavior of the two series is not so different. The exception to this is that the "jobless recovery" people talk about after the 2001 recession is mainly a feature of the establishment survey series. Household survey employment recovers fairly quickly after the 2001 recession, though growth is rather low.

I don't see any particular reason to discount what I see in the recent household survey numbers, which is reasonably vigorous growth in employment. I'm not sure why people focus solely on the somewhat anemic establishment survey employment numbers. Obviously it makes a big difference if we simply extrapolate based on the recent behavior of establishment employment or household employment. With the working-age population growing at about 1.25% per year, annual growth in employment of 1.3% per year (establishment survey) won't put much of a dent in the employment/population ratio, even over a very long period of time. However, 3.6% employment growth per year (household survey) would get us a long way in a short time.

Consider this. Suppose that the employment population ratio increased from where it is now (58.8%) to its previous peak (about 63%) over a five-year period. This would imply employment growth of about 2.7% per year, which translates into a contribution of the labor input to growth in real GDP of about 2% per year. If we add contributions of about 1% per year from productivity growth and 1% per year from growth in the capital stock, we get 4%, which is well above the average real GDP growth rate of about 3%. The conclusion? Given how highly productive the US economy currently is, it has a huge capacity for growth. The current slack in the labor market is good news, in that we can get a lot of growth just from growth in the aggregate labor input over the next few years. As I commented in this post, I see no reason to see doom and gloom around the corner (aside from Europe's sovereign debt problems).

First Quarter 2010 National Income Accounts

Gross Domestic Product data for first quarter of 2010 for the US were published Friday, April 30. Here is a mainstream news report, and the actual data can be found here.

There is a dominant narrative of doom-and-gloom from economy-watchers, and it comes from both ends of the political and economic policy spectrum. People who want more fiscal and monetary policy intervention, like Paul Krugman and Janet Yellen, preach doom-and-gloom. People who want you to think the Obama administration is doing a horrible job also preach doom-and-gloom. For example, this piece put out by the American Enterprise Institute has a somewhat uplifting title, but predicts 2.5%-3% growth for 2010, which is short of what a typical recovery looks like (average US annual real GDP growth is about 3% per year). Doom and gloom is not the only narrative of course. Kocherlakota is not doomy-gloomy, and neither is Daniel Gross. However, this quote, from the above New York Times piece, shows you the pervasiveness of doom-and-gloom:

Output would need to grow at least 5 percent annually for several years to get back on track — and perhaps what is more important, to stimulate enough job creation to employ the 15 million Americans already out of work and the 100,000 new workers joining the labor force each month.

Right now, many economists expect the nation’s output to expand 2.5 to 3.5 percent this year.

“Unless the pace of growth picks up significantly, we will see high unemployment rates for years to come,” said Josh Bivens, an economist at the Economic Policy Institute, a liberal research organization in Washington.

Of course, what we want to do here is to settle down a bit and be objective scientists. First, what is actually in the first quarter 2010 National Income Accounts data? Real GDP grew at 3.2% (seasonally adjusted at annual rates) in the first quarter. What sectors did the growth come from? Personal consumption expenditures were very strong, with 3.6% growth (and particular strength in durable goods with 11.3% growth), and investment in equipment and software (13.4%) and exports (5.8%) were both strong. This all looks pretty good, and along with the fact that inventory stocks are increasing a bit, is not atypical of how the US economy typically looks in the midst of a strong recovery. Note here that we are getting 3.2% growth at an annual rate in spite of strong negative growth in investment in residential and nonresidential structures, negative growth in state and local government expenditures, and strong growth in imports.

Why are we in a recession? First, since about 2000, we built a lot of houses, and non-residential structures as well, under false pretenses. Given incentive problems at all levels of the financial market, many people received loans to buy structures who would not have received these loans if Adam Smith's fictitious social planner had been checking. Of course, once we figured this out, the demand for residential and nonresidential structures adjusted to something closer to what is socially optimal, construction became unprofitable, and a big chunk of GDP went away. This, combined with the ensuing credit market shock that we are only beginning to understand, gave rise to the recession.

Now, what is unusual about this recession is that the drop in employment has been much larger, proportionally, than the drop in real GDP (think that our typical experience is that the percentage drop in employment is about 2/3 of that for real GDP). What's going on here? Well, some of this is just long-run sectoral change in the US economy - more services and less manufacturing, a shift in auto manufacturing from the north to the south, for example. As well, the sectors that are currently doing well - e.g. health services and information technology - use very different skills from residential and non-residential construction.

I'm beginning to think that some of the policy interventions during this recession were appropriate. While the Fed could be chastised for going into panic mode after the demise of Lehman Brothers, probably their early lending interventions were appropriate, though we still need to sort that out - hard to criticize, though, when no one knew what was going on. I don't like the Fed's massive purchases of mortgage-backed securities though - this is just working against the appropriate sectoral reallocation of resources that needs to happen right now. On the fiscal front, it is probably helpful that the federal government made transfers to constrained state governments and made unemployment insurance more generous, but most of the new expenditures on goods and services were put in place too quickly to be well-thought-out.

At this point in time, it's hard to say that things are not evolving in the US economy as the social planner would want it. The social planner would look at the stock of housing and non-residential structures in the United States and tell us to give construction a rest for a couple of years. In the meantime, she would be telling us to take the workers who were toiling as roofers and carpet-layers and send them to school so they can be nurses, doctors, and software specialists. The social planner would be packing up families in Detroit and Rochester NY and sending them elsewhere to look for work. And that's what's happening. Where's the output gap? I don't see one.

Now, there is plenty to be optimistic about. We have not had a severe recession since 1981-82. As is well-known, the silver lining in recessions is that we clean out a lot of crap - weak firms meet their demise and strong ones survive - all very Darwinian. Unfortunately we didn't clean out all the crap, as we kept General Motors and Chrysler alive (with the help of the Canadians, I might add). But productivity is growing at a high rate, and this is promising in terms of our ability to compete internationally and sell stuff to the rest of the world. Good news! Forget the doom and gloom.

One last thought. The American obsession with houses and cars is a weakness, and has lead to plenty of bad economic policy - Fannie Mae, Freddie Mac, the mortgage interest tax deduction, auto company bailouts. Sometimes people try to argue that there is some kind of positive externality associated with home ownership - what baloney! If there is some logic that says we should be bailing out GM and Chrysler, the same logic says we should bail out every potentially insolvent firm - get real!