Thursday, September 30, 2010

Reserves II

In this post, I was puzzling over the recent behavior of reserve balances. In this chart, if you look at total reserves of private financial institutions plus the reserves held by the Treasury in its General Account, some of the blips, including the most recent one, go away. You see a decline in this total since the beginning of the year (it's weekly data, from the beginning of 2007; I did not mark off the dates), but no rapid recent decline. What is going on is the following. When the Fed holds an auction of Treasury debt, it appears this typically goes temporarily into the Fed's general account with the Fed, until the Treasury spends the funds. In "normal" times, the Fed would typically offset the effects so that you see no effects on reserves or the effective fed funds rate. Currently, the Fed does not bother to offset these things, so a Treasury auction will temporarily increase funds in the Treasury's reserve account, and reduce private sector reserves.

Kocherlakota in London

Narayana gave a speech in London, posted yesterday here. This is a new iteration on the spiel he has been giving for several months. The new and interesting stuff, from my point of view, is in his discussion of quantitative easing (QE). He makes clear that the intervention he is considering is the purchase of long-maturity Treasuries (and not private assets) by the Fed. Kocherlakota breaks down QE into four effects.

1. Commitment: Here, he says:
The first effect of QE is that it represents another form of forward guidance about the path of the fed funds rate. It is a way for the FOMC to signal—in a perhaps more striking way—that it plans to keep the fed funds rate low for an even longer time to come.
The idea here is that purchases of long Treasuries reflects a commitment by the Fed to keep short-term nominal interest rates low. Why? By acquiring a portfolio weighted toward long-maturity Treasuries, the Fed is taking on interest rate risk. If short-term interest rates go up, the Fed will have to pay more interest on reserves, which is essentially revolving short-term debt for the Fed, and will suffer a capital loss on its long-maturity assets. Of course, the Fed can (apparently for a long time) keep the interest rate on reserves (and thus the fed funds rate and all other short rates) at a low level and therefore avoid the capital loss and higher cost of revolving short-term debt. Actually acquiring the long-maturity asset portfolio is then a commitment device. Of course, the problem is that the Fed may be committing to something that it would regret sometime in the future. Should the inflation rate start to take off, the Fed might want to tighten monetary policy by increasing the interest rate on reserves. But it will be deterred from doing so because of its long-maturity asset holdings. As a result, the higher inflation rate could become self-fulfilling.

2. QE creates more outside money: This is just the standard open-market-purchase story. We would get the same effect whether the assets the Fed acquires are T-bills or long-maturity Treasuries. Kocherlakota says:
Second, QE creates more reserves in banks’ accounts with the Fed. The standard intuition is that this kind of reserve creation is inflationary. Banks can only offer checkable deposits in proportion to their reserves. Economists view checkable deposits as a form of money because, like cash, checkable deposits make many transactions easier. In this sense, bank reserves held with the Fed are licenses for banks to create a certain amount of money. By giving out more licenses, the FOMC is allowing banks to create more money. More money chasing the same amount of goods—voila, inflation.

This basic logic isn’t valid in current circumstances, because reserves are paying interest equal to comparable market interest rates.
Kocherlakota's "basic logic" is the standard money multiplier story that can be found in many money and banking and intermediate macro textbooks. If we could pass a law to ban discussion of the money multiplier, I think that would be great. First, even in the context of a banking system with binding reserve requirements, the money multiplier story is of little use for thinking about the causes of inflation. For example, suppose that we had a reserve requirement on apples. If I have a stock of apples for sale, I am required to hold a reserves, say 10% of the value of stock of apples, in a reserve account with the central bank. Suppose this reserve requirement is binding. Now, the central bank doubles the stock of reserves, thus increasing the "licenses" to sell apples. What will happen ultimately is that the nominal stock of apples for sale will double, as will all prices. In the long run, we certainly would not expect the stock of apples for sale to change. There is an apple multiplier at work here: for each unit of reserves there are 10 apples, in nominal terms, and for each extra unit increase in reserves by the central bank, there has to ultimately be an increase of 10 units (in nominal terms) in apples. However, it's not the increase in the nominal quantity of apples that is causing all prices to double ultimately, it's the increase in the quantity of outside money. In practice, even if we have binding reserve requirements, what is causing inflation is growth in the stock of outside money (currency plus reserves). Growth in the stock of the liabilities of private financial intermediaries (the apples) is neither necessary nor sufficient for inflation.

Further, even in the United States, where we still impose reserve requirements on banks, those reserve requirements have become essentially irrelevant. Why we don't do away with them entirely, and improve the efficiency of our financial system, is beyond me. In any event, if we look at pre-financial crisis times, for example 2007, the stock of reserves was hovering around $10 billion, the stock of currency outstanding was about $800 billion, and the stock of M1 was about $1.4 trillion. Thus, reserves are essentially insignificant. Why? Banks have invented ways of getting around the reserve requirements. Business have for a long time had "sweep accounts" with banks. These are transactions accounts that can be used during the day, and then are swept away overnight into interest-earning accounts not subject to reserve requirements. Similar arrangements can be made for consumers, and those types of arrangements are spreading.

I prefer to think of the US banking system as having essentially nonbinding reserve requirements, even in "normal" times. For me, the element of the outside-money-injection aspect of QE is that the reserves can potentially turn into currency. Clearly a swap by the Fed of T-bills for reserves under current circumstances (where the quantity of reserves is in the neighborhood of $1 trillion) has essentially no immediate effect, as there is little difference between T-bills and interest-bearing reserves, at the margin. A key difference between a T-bill and reserves, though, is that the reserves can be withdrawn by banks as currency, just as you can withdraw currency from your transactions account at the ATM. The potential for inflation coming from the overhang of reserves is that, if banks become less willing to hold reserves, prices and interest rates somehow have to adjust to induce consumers and firms to hold the stock of outside money, as currency and reserves. If interest rates are not adjusting (because the Fed does not change the interest rate on reserves), then ultimately the price level has to go up. Kocherlakota and I are coming to the same conclusion here, but the mechanism I have in mind is different.

3. Interest rate risk: As Kocherlakota explains, the idea here is that, by taking long-maturity Treasuries off the hands of the private sector, in return for short-maturity reserves, the Fed is shifting interest rate risk from the private sector to the Fed. This should make the private sector more willing to bear the risk associated with long-maturity assets more generally, and all long-term yields should fall. The Fed can then push down the long end of the yield curve. The problem with this argument is laid out in point 4.

4. Risk shifting: Kocherlakota says:
The Fed cannot literally eliminate the exposure of the economy to the risk of fluctuations in the real interest rate. It can only shift that risk among people in the economy. So, where did that risk go when the Fed bought the long-term bond? The answer is to taxpayers.
What he goes through here is essentially an irrelevance theorem. If we take into account the implications of the Fed's actions for fiscal policy, through the consolidated budget constraint of the Fed and the Treasury, the risk that was taken off the hands of the private sector somehow has to end up there. It could be that we are relieving some people of risk and giving others more. That may even be an optimal thing to do, but as far as I know no one has studied this. Good topic for a PhD dissertation.

One thing left out of Kocherlakota's argument is the basic natural (or fiat) advantage of a central bank. To be doing anything, or indeed to be doing any good, the Fed's intermediation of long-maturity assets must somehow be more efficient than what the private sector does. We have private financial intermediaries that convert long-maturity assets into short-maturity ones. These intermediaries are banks and mutual funds. What advantage does the Fed have in intermediating long-maturity Treasuries? Maybe this is just the ability to issue outside money. The Fed has monopolies on the issue of currency, and of the stuff (reserves) that is used in daytime clearing and settlement among financial institutions. This of course is the principle at work behind the effects of all open market exchanges of assets by the central bank.

Monday, September 27, 2010

Are Reserves Running Off?

I'm not sure if there is anything important going on here. It could just be a blip. However, as you can see in the chart, reserves fell below $1 trillion for the first time since January, and there is a clear downward trend (with a downward blip). The other component of outside money, currency (in the next chart), continues to grow at a steady pace of about 5% per year. If inflation were to increase, this is where it has to come from - reserves are shed by banks as they become relatively less attractive, and currency keeps growing. We need to see more data before attaching more significance to this, but it bears watching.

It's the Housing, Stupid

[In case you weren't old enough in 1992 to get the cultural reference, "it's the economy, stupid," was a phrase used by Bill Clinton's campaign workers in the 1992 election to keep everyone on message.]

Why Krugman keeps beating a dead horse, as he does here this morning, is beyond me. The man is a little slow, he's wedded to a one-good, sticky-price, sticky-wage view of the world, or maybe he just hates Narayana Kocherlakota? You tell me.

First, it would be nice if discussion of this issue did not revolve around the idea that there are two kinds of unemployment: "structural" and "demand-deficiency" unemployment. Unemployment is unemployment. It's the estimate of the number of people in the economy who are actively searching for work, according to the Bureau of Labor Statistics. Unemployment necessarily involves a friction. If I am unemployed and know that my quest for work on a particular day is going to be fruitless, I will not search. The reason I search is that I expect to eventually come up with something, but it may take some time. Thus, by definition, unemployment (and vacancies, on the other side of the market) is always about mismatch - firms and workers are trying to make good matches, and that takes time.

Now, some people, including Narayana Kocherlakota and yours truly have argued that there is something anomalous going on in the current recession (also see Dave Andolfatto's post). The unemployment rate is unusually high, and we can find good reasons for that in the data, that have to do with the sectoral reallocation of labor, both across sectors of the economy, and across geographical areas. Long-term shifts from manufacturing to services, combined with the housing boom and bust, have acted to make the unemployment rate higher, as have the facts that the long-term shifts and the housing market boom and bust affected different states disproportionately.

However, blind Paul asserts this:
But don’t bother asking for evidence that justifies this bleak view. There isn’t any. On the contrary, all the facts suggest that high unemployment in America is the result of inadequate demand — full stop.
Then, he tries to discredit people who are thinking about sectoral reallocation as an important phenomenon.
Now, the Minneapolis Fed is known for its conservative outlook, and claims that unemployment is mainly structural do tend to come from the right of the political spectrum.
Ah, so those guys are probably just Republican hacks. No need to pay any attention to them. Now, I once worked at the Minneapolis Fed and have had plenty of interaction with the Bank over the years. Some of those people are Republicans, and some are Democrats. One thing I am sure of though, is that you would be thrown out of the seminar room for presenting ideologically-driven research. That place is all about the economics. No chicken models allowed.

Further, here's the Kocherlakota-hating Krugman at work in a blog piece called My Problem with Narayana Kocherlakota.
He has too many characters in his name! I mean, folks, the regular column has to fit into a limited physical space — and every time I mention the president of the Minneapolis Fed, there goes a large chunk of scarce journalistic real estate.

I want a new rule: people who weigh in on policy debates should henceforth all have names like Ng or Ip. Yes, you can call me Kn if necessary.

Or can we just drop all the vowels?
Now, Krugman may have thought of this as good fun, but it certainly looks racist to me. Apparently Narayana should have a nice American name, maybe something like "Paul Krugman." My name has a lot of characters too, but I'm sure Krugman wouldn't be complaining if he had to type it out repeatedly.

Krugman claims that
Well, I’d respectfully suggest that Mr. Clinton [who also thinks sectoral reallocation is important, apparently] talk to researchers at the Roosevelt Institute and the Economic Policy Institute, both of which have recently released important reports completely debunking claims of a surge in structural unemployment.
I looked up the Economic Policy Institute reference, here, and this is what Lawrence Mishel has to say:
A better explanation for high unemployment is that there are simply not enough jobs to go around. The economy is operating far below its potential output because of a shortfall in demand caused by an extreme loss of financial and housing wealth, and the reduced consumption that resulted.
Hmmm. Very helpful. Not enough jobs to go around. Sectoral reallocation thoroughly debunked.

As usual, Krugman also harkens back to the Great Depression.
I’ve been looking at what self-proclaimed experts were saying about unemployment during the Great Depression; it was almost identical to what Very Serious People are saying now.
We've seen this "Very Serious People" reference before. These are apparently those know-it-alls who think they have economics down, but unfortunately fall far short relative to the Truly Wise One. It's pathetic when Mr. Nobel Prize resorts to anti-intellectual Tea-Party rhetoric.

Well, I think that Paul Krugman is a Very Unserious Person. Paul, get off the pot and show us where this demand-deficiency unemployment is coming from. According to you, the right model is IS-LM. In that framework, the demand deficiency is due to sticky prices, but I'll give you sticky wages too, if you want. How does that explain what is going on in the economy currently? Where are the sticky wages and prices? Are unemployed construction workers in Nevada unemployed because the prices of houses in Nevada are sticky, because their nominal wages are sticky, or what? Did firms go out of business during the recession because they could not bear to lower their prices? The IS-LM I was taught did not have sub-prime mortgages and financial crises in it. Maybe Krugman was taught a different IS-LM? Can we employ workers in Nevada by creating government jobs in Washington, D.C.? I'm all ears.

Sunday, September 26, 2010

Plosser: Central Bank Commitment and Interest on Reserves

Charlie Plosser made a speech last week to at the Swiss National Bank Monetary Policy Conference that looks at some recent monetary policy issues. Much of the speech deals with commitment, and for the most part I agree with those ideas. Plosser argues that the unusual credit programs put in place in fall 2008 by the Fed, which were subsequently unwound, create the potential for moral hazard; financial institutions will now have the incentive to take on too much risk given the expectation that the Fed will step in as lender of last resort in the event of trouble. Further the Fed's purchases of mortgage-backed securities (MBS), to the tune of more than $1 trillion, potentially creates the demand for future interventions by the Fed in particular sectors of the economy. If the housing sector is today's problem, to which the Fed should respond by purchasing mortgage-related assets, why shouldn't the Fed respond to perceived problems, for example in the auto sector, by purchasing the debt of Ford, General Motors, and Chrysler? The political pressures, for and against sectoral interventions of this type, threatens the Fed's independence.

Plosser proposes a new Accord between the Fed and the Treasury, which would limit the normal range of monetary policy interventions to standard discount window lending and purchases of Treasury securities. This Accord would put unusual interventions, such as the ones undertaken by the Fed during the financial crisis, under the Treasury's authority. This seems like a useful idea, as it would clearly delimit what is fiscal, and what is monetary policy, in the United States. Over the last two years, those distinctions have become blurred, to the point where it is not clear whether the Fed is taking a particular action because that action is sound monetary policy, or because it is a vehicle for taking some activity off the Treasury's balance sheet. As a case in point, consider the Supplementary Financing Program, which has been in place since September 2008. Currently, the Treasury still holds about $200 billion under this program. The idea is that the Treasury issues T-bills, and deposits the proceeds in its reserve account with the Fed. The Fed's statement makes it seem that this is just a reserve-draining operation - the Treasury is simply moving reserves from the accounts of private financial institutions to its own account. In terms of the consolidated government balance sheet vs. the private sector's consolidated balance sheet, an increase in the Treasury's supplementary reserves reduces outside money outstanding and increases T-bills outstanding. Under current circumstances, the effect is essentially nil, but in any event the Fed could accomplish the same thing by selling T-bills. However, note that the Fed only has about $18 billion in T-bills on its balance sheet currently. It could sell long-maturity Treasuries or MBS though, but apparently it does not want to do that. The clearest explanation for what is going on is that the supplementary financing is not reserve-draining, but an agreement between the Fed and the Treasury to shorten the average maturity of Treasury debt held by the private sector. This has more to do with traditional fiscal policy than with traditional monetary policy.

Now, where Plosser's speech takes an odd turn is in his discussion of interest on reserves. The key section of interest is:
Yet, many overlook that paying IOR ties together the central bank’s balance sheet and the government’s budget constraint, since the interest is financed by government revenues. This may come at the cost of central bank independence.

There are two proposed mechanisms for implementing IOR, 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.
I think this is goofy. First, we know that paying interest on reserves in general increases economic efficiency. The ECB and the central banks of Canada, Australia, and New Zealand, have been paying interest on reserves for some time. Second, the fact that paying interest on reserves has implications for the revenue that the Fed returns to the Treasury makes this element of policy no different from another other dimension of monetary policy. Actions by the Fed consist of changing administered interest rates (the discount rate and the interest rate on reserves) and buying or selling assets. All of these actions will make a difference to the Fed's income statement, and will matter in some way for fiscal policy. Monetary policy and fiscal policy are intertwined, and paying interest on reserves does not make the monetary and fiscal arms of policy any less or more interdependent. Third, the "floor system" that Plosser describes does not have the property that " unlimited amount of reserves are available at the IOR-policy rate." Indeed, the floor system is what we currently have in the U.S. All it takes for the IOR to determine the overnight interbank rate is for the central bank to target a positive quantity of excess overnight reserves. Canada adhered to a floor system through much of the financial crisis period, and is now back on a corridor system. Fourth, being on a floor system or a corridor system has nothing to do with the "footprint" of the central bank. Indeed, we could imagine economies where the central bank accounts for a large fraction of total financial intermediation and there is a corridor system, and other economies where the central bank does not do much financial intermediation but runs a floor system. Indeed, the Bank of Canada operated a floor system with a target of $3 billion in overnight reserves, during the financial crisis. That's hardly a big footprint.

If we take the good parts of Plosser's speech, we could construct the following two elements that could be a basis for a new Accord between the Treasury and the Fed. These would be:

1. Restrict the Fed's monetary policy actions to discount window lending to member financial institutions and the purchase of Treasury securities, except under special authorization from the Treasury.

2. Establish explicit inflation targets. Much as in the countries where inflation targets are already a reality (Australia, Brazil, Canada, Chile, Israel, Mexico, and New Zealand), the Fed and the Treasury would periodically negotiate a new inflation target, and there could even be explicit penalties for the Chairman for deviating from the target. Adopting inflation targeting would mean abandoning the old Humphrey-Hawkins Act.

Now is a good time to get this proposal on the table, as it is important to lay the groundwork for how monetary policy will proceed.

Tuesday, September 21, 2010

FOMC Statement, 9/21/10

There is some news in today's FOMC statement. A key change in the statement from the August 10 statement is this:
Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.
The FOMC is registering concern that the measured inflation rate is below its target, typically thought to be in the neighborhood of 2%. Of course the FOMC is careful to state this in terms of its dual mandate, as laid out in the Full Employment and Balanced Growth Act, otherwise known as the Humphrey-Hawkins Act. The Fed is supposed to care not only about inflation, but about real aggregate economic activity, as specified (somewhat vaguely) in the Act. I have always viewed the Phillips-curve language in the FOMC statement (language like "...substantial resource slack continuing to restrain cost pressures...") as the Fed attempting to have its cake and eat it too. If we accept that the Phillips curve is a structural relationship (of course a highly dubious notion, ever since Friedman wrote about it in the 1960s), then there is no conflict implicit in the Humphrey-Hawkins dual mandate. When there is resource slack we will then expect low inflation, and therefore both the inflation hawks and the Keynesians can be happy with a more accommodating monetary policy. If we're doubtful about the Phillips curve, we are going to have a harder time getting these two groups to agree.

The FOMC is signaling that it is concerned about the low level of inflation. They either hope that this will induce expectations of higher future inflation that will actually produce higher inflation today, or they are thinking that their previously announced policy of holding constant the size of the Fed's balance sheet as mortgage-backed securities (MBS) run off will produce results, or both. One policy they might have pursued is to actually increase the size of the Fed's balance sheet, perhaps by purchasing more long-term Treasury securities, as Jim Bullard seems to be considering here.

The actual change in policy, announced in the FOMC's August 10 statement was:
To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve's holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.1 The Committee will continue to roll over the Federal Reserve's holdings of Treasury securities as they mature.
Now, it is not entirely clear why this matters. This is essentially the same as what would happen if the Fed exchanged MBS for long-term Treasury securities. What's actually happening is that some people are prepaying their mortgages and refinancing, so that a mortgage that was effectively on the balance sheet of the Fed is now on some private balance sheet, and the Fed is holding a Treasury security instead. Why should this matter? MBS on the Fed's balance sheet are effectively loans to the private sector; Treasury securities are loans to the Federal government which are going to be paid off with future taxes, so these are also effectively the liabilities of the private sector. What's the difference? It could be that the Treasury debt is not in fact backed by future taxes; maybe the private sector perceives that Treasury debt will just be rolled over by the Federal government, and some of it will be monetized. Then, we might think of the Fed's policy action as telling us to expect more future inflation, as MBS and Treasury securities are "backed" differently. The MBS were financed by issuing outside money that will be retired in the future, but Treasury securities are purchased with outside money that will be outstanding indefinitely, and will therefore be inflationary.

Of course, all of this depends on public perceptions about how outside money (currency and reserves) issued by the Fed is backed on the asset side of the Fed's balance sheet. But I think that most people are currently in the dark about what the Fed intends for the future. There is some clarification in the current FOMC statement - we know that the Fed thinks inflation is too low - but we have no information about, for example, what the Fed intends to do with the large stock of MBS it holds. Does it intend to let this run off due to prepayments, defaults, and natural maturing of the debt, or does it plan to sell these assets and, if so, at what rate? I think a clearer statement of intentions (even if contingent) would be helpful.

Wednesday, September 15, 2010

Sectoral Reallocation and Housing

I'm going to attempt to make a case that we could explain some of the anomalies in labor market behavior and in the current sluggishness in real GDP growth by thinking about the housing sector and some of the implications of the financial crisis and the recession for the sectoral reallocation of resources.

The phenomenon of a shifting Beveridge curve has drawn a lot of attention. I first learned about this from a talk Bob Hall gave in early July, and Rob Shimer has for some time featured this on his web page. Basically, the idea is that, given the current vacancy rate in the labor market, the unemployment rate would be much lower if we thought that the Beveridge curve (the observed negative relationship between the unemployment rate and the vacancy rate) were stable. Dave Altig has written about this, and Tasci and Lidner have claimed that the shift in the Beveridge curve we are seeing typically happens in the recovery phase of recessions. However, they are relying on pre-2000 vacancy rate data, which is notoriously poor. Altig's conclusion is that we have to wait and see more data before we can say much about this.

In any event, even if we thought that the Beveridge curve always shifts in this fashion during a recession, that could still indicate that mismatch in the labor market is important. During a recession, and maybe particularly this one, an important element of the recovery is that job vacancies and unemployment may not be well matched, in terms of the skills firms want and the skills workers have, and in terms of where the vacancies and unemployment are located. Further, in another post, I illustrated another way to look at the vacancies/unemployment data. Suppose we think about a standard Cobb-Douglas matching function, of the kind that researchers use when fitting Mortensen-Pissarides search models to the data, and include a "productivity" coefficient that measures the efficiency of the matching process. Then, measure matching efficiency as you would a Solow residual. I did that, in a crude fashion, and found a huge drop in matching efficiency, beginning in early 2008.

Why not look at some other data, to see if we can get more information about what is going on? Wikipedia, my favorite in-depth source of information, actually has a nice summary of BLS unemployment rate data by states, complete with color-coded maps. There is clearly a lot of dispersion, though I have no idea whether this is unusual or not. Unemployment rates differ from a high of 14.3% in Nevada to a low of 3.6% in North Dakota. The states where the housing market crashed are doing particularly poorly (California, Nevada, Oregon, Florida), as are states where manufacturing is in long-run decline (Indiana, Illinois, Michigan, Ohio). States west of the Mississippi and east of the Rockies are faring relatively well, but some of those states are not so populous. However, centers of population such as New York, Texas, Virginia, and to a certain extent Minnesota and Wisconsin, are doing better than average. We would presumably be safe in assuming that a Beveridge curve relationship holds at the state level so that, for example, North Dakota should have a very high vacancy rate and Nevada a very low one. However, we don't know for sure what the state-level vacancy rates are, as that data does not seem to be available.

In any event, it seems safe to say that, if I live in Las Vegas and am seeking employment, I would be much better off looking for work in Fargo, Minneapolis, New York City, Austin, or Washington, D.C., than in Las Vegas. However, there may be unusual factors that are impeding migration. For example, I may be unemployed in Las Vegas and own a house, which is currently underwater, and I do not want to default on my mortgage. Maybe the house is not underwater, but it is very difficult to sell.

Now, what about the general characteristics of the unemployed? From this table, we can see that they are more likely to be men, more likely to be black, and more likely to be less educated, than for the population as a whole. Again, I have no idea what this pattern looks like relative to the typical recession. However, it is certainly consistent with mismatch in terms of skills, i.e. the vacancies are for high-skill workers but the unemployed have relatively low skills. We need the other side of the story though, so we need to look at what has been happening across sectors.

The chart shows employment by sector beginning in 2000, with everything normalized to 100 for the first observation. We see a large and steady decline in durables and nondurables manufacturing, and a steady increase in services and government. Construction booms until sometime in 2007, then tanks. The shift from manufacturing to services has been happening for a long time. This, along with observations on the skill premium in wages, indicate a fundamental shift from low-skill to high-skill jobs. However, the housing boom we experienced, in part due to incentive problems in the mortgage market, which you can see reflected in construction employment in the chart, soaked up some low-skill labor that was being shed by the manufacturing sector. Thus, the housing boom effectively slowed down or negated the long-term adjustment that was occurring in labor markets. Once the housing sector collapsed, the need for sectoral reallocation of labor hit with a vengeance and, we could argue, contributed to the very high unemployment rate we are seeing.

The crash in housing market construction is phenomenal, as you can see in the housing starts time series in the chart. Housing starts fall beginning in 2007, and are currently at a lower level than at any point since 1959. Basically, the incentive problems in the mortgage market caused the US economy to build a large quantity of houses and other structures on false pretenses. Think of what would happen if you take an economy that is on a steady state growth path and drop a large stock of houses on it. That is essentially the state we are in now. This reduces the relative price of housing, and people stop building houses - for a long time. Notice in the chart that housing starts typically bounce back quickly in a recession - housing starts is typically a leading variable. That will not be the pattern in this recession. It will take a considerable time before depreciation and growth in the demand for houses take up the slack, housing prices increase, and new construction starts to pick up. In the meantime, workers formerly employed in the housing sector will be looking for work in other sectors, where their skills may match poorly with what employers are looking for, and the job vacancies may be in other parts of the country.

As further evidence for sectoral reallocation in explaining current labor market behavior in the US, consider what is going on in Canada, as I do here. Canada had none of the US problems in its mortgage market, it experienced a similar pattern of GDP growth during the recession (though their recovery is stronger - further evidence for my claims), and housing construction in Canada has followed a typical cyclical pattern. Indeed, Canada is currently experiencing something of a real estate boom. However, the change in the unemployment rate in Canada during the recession was considerably smaller, to the point where the Canadian unemployment rate is currently lower, whereas the unemployment rate in Canada tends historically to be much higher than in the US.

Finally, the next chart shows a crude measure of average labor productivity - household survey employment divided by real GDP - for the US. An important anomaly here is the large increase in average labor productivity during the recession. Historically, average labor productivity is procyclical - if it was behaving is it would normally, it would have gone down. One view is that this is the silver lining of the recession. We are shedding inefficient firms, and some Schumpeterian process is making the US economy much more productive and setting the stage for future growth. However, we might also view this as a composition effect. The dramatic fall in housing construction, which is a low-productivity industry, is increasing aggregate average labor productivity, and the other sectors aren't really considerably more productive at all. Maybe there is no silver lining, or it's not so shiny.

It seems to me that there is a good case for what Kocherlakota says here, that there is little or nothing the Fed can do about the currently-high unemployment rate. This is due to wide dispersion in geographical and sectoral unemployment and vacancies. There is a sense in which the Fed can move resources from once sector to another - indeed, that is part of what it did when it purchased a large portfolio of mortgage-backed securities. That moved resources from other sectors into the housing sector. But the resources moved in the wrong direction, working against the adjustment that needs to happen. I don't see a particular fiscal role that comes out of the sectoral reallocation story, other than a long-term re-evaluation of the adequacy of our unemployment insurance system and our system of public education.

Monday, September 13, 2010

Can the Nobel Prize be Revoked?

The answer to the question is no (see here.). Alfred Nobel originally set up five Nobel prizes: Physics, Chemistry, Medicine, Literature, and the Peace Prize. How Literature fit in, it's not clear (maybe Alfred liked to read by the fire in the evenings), and I'm not sure what stories lie behind the omission of Mathematics and Biology, for example. However, at some point, the Swedish Central Bank saw fit to fund the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, often referred to as the Nobel Prize in Economics. The natural scientists, writers, and peacemakers may not feel comfortable with us economists, but there we are.

Now, in 2008, Paul Krugman was granted the Nobel Prize in Economics. In giving the prize, the Nobel Prize committee always cites some specific work or body of work that justifies what they are doing. In Krugman's case, he got it "for his analysis of trade patterns and location of economic activity." Krugman is a recognized expert in the field of international trade, and the Committee, after input from members of the economics profession and deliberation, decided to award Krugman the prize.

The Nobel Prize recognizes important and influential contributions to our knowledge. To pass the bar for the Nobel prize, we have to think of these contributions as truly pathbreaking. The prize-winner must somehow have made us all better off in a significant way. I don't think that anyone imagines that conferring the prize on an individual will make that individual work harder for humanity. What we are thinking is that young economists might see the recognition of a Nobel Prize (and the million bucks too) at the end of the rainbow. In spite of the fact that the chances of getting a Nobel are tiny, perhaps young economists at the top of the profession will all work just a little harder, and the benefits for society will be worth what the Swedish Central Bank spends on the thing every year.

Now, I asked a question in my title, and I mentioned Krugman, so you know what is coming now. We might forgive Paul for his lapses in macroeconomics. He's a trade guy after all, and we don't expect him to be up to speed in modern macro. However, the prize he got was for his work in international trade, and if he is writing about issues in that field, we expect a lot. That's what makes today's NYT column so disturbing. Part of what we do in undergraduate economics classes is to dispel myths, and to show how some basic tools from economic science can shatter ideas that can seem intuitively plausible. Krugman's column takes economic knowledge backward. This is not an attempt to enlighten lay readers by showing them how some simple economics works. It's an exercise in bad economics put forward as mainstream thought, and beyond reproach. If it were in my power, I would love to take the guy's prize away. Of course I can't, and unfortunately no one else can, either.

First, Krugman says this:
China is deliberately keeping its currency artificially weak.

The consequences of this policy are also stark and simple: in effect, China is taxing imports while subsidizing exports, feeding a huge trade surplus.
First, of course there is nothing "artificial" about China's exchange rate policy. The Chinese government and its central bank are free to intervene as they see fit in financial markets, and those actions are going to have an effect on the exchange rate of the renminbi against the US dollar. Currently, though the Chinese claim that the renminbi/US dollar exchange rate is flexible and market determined, they appear to be essentially pegging it. But so what? A basic principle of international economics is that a country cannot "subsidize" its exports through what are essentially monetary policies determining its nominal exchange rate. The prices of goods sold by China on world markets are determined in world markets in US dollars. There is nothing that Chinese exchange rate policy can do to affect those prices.

As to the claim that China's nominal exchange rate policy is "feeding a huge trade surplus," the state of China's current account balance has little to do with exchange rate policy. In China, financial intermediation is very inefficient. Banking in China is dominated by a few large state-owned banks, and those banks are not very good at channeling domestic savings into high-return domestic investment projects. The savings of Chinese households is huge. What happens to that savings? Much of it leaves the country in the form of US Treasury securities and other foreign assets, resulting in lower real interest rates in the rest of the world (than would otherwise exist), as compared to the high domestic real interest rates in China. Some of the savings that flows out of China comes back in as foreign direct investment, but there are barriers to that flow. The result is a current account surplus in China - Chinese national savings exceeds investment. The primary cause has nothing to do with the nominal exchange rate. The Chinese current account surplus would be much smaller if domestic financial intermediation in China were much more efficient - and our interest rates would be higher.

Now, Krugman perhaps is anticipating this criticism:
You may see claims that China’s trade surplus has nothing to do with its currency policy; if so, that would be a first in world economic history. An undervalued currency always promotes trade surpluses, and China is no different.
The big question here is what "undervalued" means. Relative to what? If I can decide what undervalued is, I guess I could make that statement true. The point is, Krugman's last sentence here is not the statement of an empirical fact, so it does not count as evidence.

Then there is this:
And in a depressed world economy, any country running an artificial trade surplus is depriving other nations of much-needed sales and jobs. Again, anyone who asserts otherwise is claiming that China is somehow exempt from the economic logic that has always applied to everyone else.
Give me a break. Even if what Krugman claims earlier in the piece is true, China could only be accused of selling us stuff cheap, and lending us the funds to do so at a very low interest rate. Somehow this does not look like deprivation.

So what does Krugman want us to do about this "problem?" Well, apparently he wants a trade war. Great idea. Also,
One answer, as I’ve already suggested, is fear of what would happen if the Chinese stopped buying American bonds. But this fear is completely misplaced: in a world awash with excess savings, we don’t need China’s money — especially because the Federal Reserve could and should buy up any bonds the Chinese sell.
The world currently has a healthy appetite for US Treasury securities, which in part is why yields to maturity on all these assets are so low now. What happens if the Chinese, or anyone else for that matter, loses interest in our government's debt? Clearly, absent anything else happening, those yields will have to rise. But Krugman suggests that the Fed can buy the Treasuries that the rest of the world is unloading, thus monetizing the debt. This would of course result in more inflation, which would amount to an implicit default on our nominal debt, which I assume is what Krugman wants. This of course would make the world even more skittish about holding our Treasury securities.

Krugman either believes this stuff or he doesn't. In either case it is disturbing. If he doesn't believe it, then what's his agenda? Why the China-bashing? I expect this from politicians, but not from a Nobel-Prize winning trade theorist.

Saturday, September 11, 2010

Monetary Policy Issues

A key policy question facing us is: Should the Fed, based either on concerns about the inflation rate, the level of real aggregate economic activity, or both, engage in a more accommodating policy? If the answer to that question is yes, the next question is: Does such a policy exist and, if so, what is it?

Two days ago, the Wall Street Journal published a "symposium," titled "What Should the Federal Reserve Do Next," with short pieces by John Taylor, Richard Fisher (Dallas Fed President), Frederic Mishkin, Ronald McKinnon, Vincent Reinhart, and Allan Meltzer. The WSJ picked a group of conservative economists with a considerable amount of accumulated policy experience among them, and including one sitting Federal Reserve Bank President (Fisher). One would think we could get something useful out of these guys. Well, apparently not.

Let's start with the low point. Fisher should win the bad analogy contest with this:
One might assume that with more than $1 trillion in excess bank reserves and significant amounts of cash held by businesses, the gas tank of those who have the capacity to hire is reasonably full. One might also conclude that the Fed, having cut the cost of interbank overnight lending to near zero and used quantitative easing to coax the entire yield curve downward, has driven the cost of gas to virtually nil for businesses that are creditworthy. And yet businesses still aren't hiring.
So, the gas is in the tank, the Fed has done all it can by making the cost of gas zero. So why won't the car go? Fisher says:
If businesses are more certain about future policy, they'll release the liquidity they're now hoarding.
He's talking about fiscal policy:
Fiscal and regulatory authorities share significant responsibility for incentivizing economic behavior through taxes, spending and rule making.
So, apparently the person driving the car, which is full of cheap gas, is paralyzed with fear - he or she might get stopped at the toll both, have to obey speed limits, etc. If Fisher is worried about policy uncertainty, he should probably clean his own house first (to use another analogy). What does the Fed intend to do with the more than $1 trillion in mortgage-backed securities (MBS) on its balance sheet. Will it hold those forever? Will they be sold off slowly? If so, when, and at what rate? What's with that "extended period" language in the FOMC policy statement? How long is that period? How do we know when it is time for the Fed to tighten? When the time comes to tighten, how does the Fed intend to do it - raise the interest rate on reserves, sell Treasuries, sell MBS?

There is some talk among the WSJ Symposium guys about Taylor rules. The funny part of this is having Taylor discuss his rule, which of course he makes reference to as the "Taylor rule." Taylor warms up with this:
To establish Fed policy going forward, the best place to start is to consider what has worked in the past.
That sounds great. Here we are in an unprecedented situation. On the liabilites side, the Fed is holding an enormous quantity of excess reserves, which it did not have in the past, and those reserves are earning interest, like they never did in the past. The nominal interest rate has been close to zero since late 2008, as has never been the case in past. On the asset side of the Fed's balance sheet, the Fed is holding in excess of $1 trillion in essentially private assets (MBS - see above, again uprecedented), and its Treasury holdings are mainly long-maturity, which again is a novelty. Taylor has a lot of explaining to do to get me to understand how what appears to have worked in the past is going to help here.

Taylor's argument is summarized here:
Get back to the rule-based policy that was working before the crisis. To get there without causing more market disruption, announce and follow a clear exit rule, in which the Fed's bloated balance sheet is gradually pared back by predictable amounts as the economic recovery picks up.
First, it's not clear what "working" means. Taylor seems to want to tell us that periods where the Taylor rule fit actual Fed behavior in the past were good times, and periods where it did not fit were bad. We could certainly debate that. If you tell me the Taylor rule worked well, my question is "relative to what?" To give Taylor some credit, he's asking the Fed to map out an exit strategy, seemingly for reasons that I discussed above in connection with Fisher's comments. However, now he's discussing things in the context of the quantities (the "bloated balance sheet"), which is inconsistent with the Taylor rule concept (what "worked in the past") which ignores the quantities on the Fed balance sheet.

Allan Meltzer discusses the Taylor rule as well:
Adopting and following a rule, like the Taylor rule, is an effective way to regain independence [for the Fed].
It's not clear exactly what he has in mind here. "Adopting" could mean that you write the Taylor rule into the Federal Reserve Act, or I suppose it could be an amendment to the Constitution (I know little about the law, maybe someone can help me out here). In any case, he seems to have in mind that the Fed be explicit about the rule, agree with the branches of government on what it is, and follow it. Then, for example, if there is a public outcry for the Fed to buy more MBS to stimulate the housing market, the Fed can say: "sorry, can't do that, my rule says no."

The Taylor rule specifies how the target fed funds rate should be determined in response to the deviation of the current inflation rate from its target, and in response to the "output gap," which is the difference between some measure of aggregate real economic activity, and what that measure "should" be. What is the argument against the Taylor rule as a formal rule for the Fed to follow?

1. The role of the output gap in the Taylor rule is problematic. First, we could never get agreement among economists on how we should measure this object. At one extreme is the Old Keynesian view that essentially all of the deviation of aggregate economic activity from trend is inefficient, and so that is the output gap. At the other extreme is a Prescott view of the world, under which monetary policy is close to irrelevant for the output gap, and reducing the gap is a matter of getting rid of all of the inefficient fiscal interventions. Some people measure output gaps in terms of real GDP, others in terms of the unemployment rate. Second, even if we could agree on what the output gap is, we would not be able to measure it well in real time, or communicate that information well to the public.

2. There are several things that are treated as invariant in the Taylor rule, which may not be in practice. First, the rule is typically written with the nominal fed funds rate as the relevant policy target. However, the currently relevant policy rate is the interest rate on reserves which, with a positive quantity of excess reserves in the system, determines short-term interest rates. Currently, the fed funds target is irrelevant. There is an important governance issue as well. The fiction is that the FOMC determines monetary policy, but it is the Board of Governors that determines the interest rate on reserves. Second, there is no good reason to think that the long-run real interest rate, or the optimal long-run inflation rate, should be constants. The savings behavior of Chinese households may matter for the world real interest rate, for example, and there are good reasons to think that the optimal inflation rate can fluctuate over time.

However, there is a special case of the Taylor rule that is in fact in use by other central banks - the Bank of Canada, for example - and that is an explicit inflation target. This ignores the output gap as a criterion for setting monetary policy, and makes no mention of how the instruments available to the central bank are to be used in achieving the goal. Bernanke is on record as supporting inflation targeting in the past, and the question is why this does not appear to be part of the current agenda. Is the Fed too distracted by unconventional monetary policy, is it too difficult to negotiate this with Congress, or what?

Now, suppose that we accept that the optimal inflation rate is a constant, 2%, as the Fed seems to believe. For me, it's hard to make the case that 2% is better than -1%, 0%, or 4%, but let's go with 2% anyway. Now, what should be the Fed's measure of the price level? Many central banks focus on "core" measures of inflation. I think that's nonsense. The idea is that we should ignore volatile prices when we think about inflation targeting, which seems akin to ignoring investment and consumer durables expenditures during recessions. Some people draw distinctions between prices that are "sticky" and those that are not, which seems like a related, and equally bad, idea. Since the costs of inflation are related to the fact that we write contracts in nominal terms, which makes inflation uncertainty bad, it seems we should aim for predictability in the rate of change in the broadest possible measure of the price level, which for me is the implicit GDP price deflator. Now, by that measure (see the chart), we are well below the target. Year-over-year, the inflation rate is below 1% (though increasing).

What should the Fed do about an inflation rate that appears to be too low? Possibly it has already done the trick. The last FOMC statement specified that the Fed would essentially hold the size of its balance sheet constant as MBS run off through prepayments on the underlying mortgages. This is perhaps a bigger policy move than it seems. MBS are private sector assets backing a portion of the stock of outside money. Tom Sargent might think of these as "real bills" which under some conditions we could think of as having no inflationary consequences. For example, if the Fed bought $100 billion in MBS today, with the promise that they would sell them one year from now, thus retiring the outside money that was issued to finance the original purchases, that could have no consequences for prices. Interventions like this were studied extensively, both in theory and empirically, in the 1980s. You see some of this in Sargent and Wallace's "Unpleasant Monetarist Arithmetic" paper, in Sargent's "Four Big Inflations" paper, and in Bruce Smith's work on colonial money. Now, once the Fed makes a promise to replace MBS as they run off with Treasury securities, they are promising that the outside money issued to finance the MBS will be held by the private sector indefinitely, and that then has consequences for inflation. Possibly it increases the current inflation rate enough to get us up to 2%.

Suppose that the announced change in policy does not work. The inflation rate stays below 2%. Maybe it even falls - maybe into the negative range that Paul Krugman seems to be terrified of. What can the Fed do then? Some people, including Krugman, argue that we're trapped and we turn into Japan. I don't think so. If the Fed buys Treasury securities at a rate sufficient to induce growth in the size of its balance sheet, I think this has to ultimately induce more inflation in the present. Why? Given opportunities for lending, and positive yields on long-term Treasuries, the willingness of banks to hold reserves is not unlimited. But outside money can also be held as currency. However, in turn, the willingness of the public to hold currency is not unlimited. For reasons of safekeeping, people are not going to put it in the mattress. It seems that, if the Fed floods the system with enough outside money, they can create all the inflation they might want. I don't think it matters whether they Fed buys T-bills or T-bonds in order to do this. Indeed, buying T-bills may reduce the yields on long-maturity bonds in the circumstances we now find ourselves in, simply by altering the liquidity premia in Treasury yields.

Monday, September 6, 2010


We have important monetary policy issues to think about, but Krugman's NYT column this morning was too much to resist, as it feeds directly into what I was addressing in my last post.

Krugman wants to draw lessons from 1938 and World War II for current fiscal policy in the United States. This encapsulates his argument:
But it’s both instructive and discouraging to look at the state of America circa 1938 — instructive because the nature of the recovery that followed refutes the arguments dominating today’s public debate, discouraging because it’s hard to see anything like the miracle of the 1940s happening again.
He thinks he has it nailed. Note the reference to the "miracle of the 1940s." I'll take that literally, as referring to the whole decade, and that seems to be part of the argument. Apparently we're to think of World War II as some kind of miracle.

The 1938 recession is a key part of the Great Depression experience. It has long been part of our macroeconomic policy narrative, and has been used before in support of Keynesian-style responses to the financial crisis, in particular by Christina Romer. The FDR administration took the budget deficit from 5.5% of GDP in 1936 to a state (roughly) of budget balance in 1938. A Keynesian interpretation of that is that the contraction in fiscal policy helped cause the 1938 recession. Milton Friedman and Anna Schwartz, in their Monetary History of the United States argued that monetary policy was important - principally the doubling in reserve requirements from 1936 to 1937. Hal Cole and Lee Ohanian argue here that you can explain a lot of the features of the latter Great Depression years as coming from FDR's labor market policies. This is far from an open and shut case. I think you could convince me that the state of the government deficit at the time had little to do with the 1938 recession.

Now, the most egregious part of Krugman's argument is the following. Here, he is talking about World War II:
Deficit spending created an economic boom — and the boom laid the foundation for long-run prosperity.
Now, let's have a look at the time series, which I show in the chart. What I show here are real GDP, consumption (cons), investment (inv) and total government spending (gov) for 1929-1950.* What you see is a massive increase in government spending coupled with a large increase in GDP. What happens to the private sector? Note the dips in private consumption expenditure and investment expenditure during World War II. Where are the multipliers and accelerators? If this were a Keynesian phenomenon we would see the free lunch here. Private sector spending should have gone up. Of course, we know what was going on. This was a war, damn it. The US government implemented a massive shift in domestic production. Young men went off to Europe and the Pacific to become hamburger, women went to work, and everyone worked long hours. The labor force was not building houses and highways, and people were not buying Cadillacs. The resource reallocation was in part accomplished through non-market mechanisms. There were price controls and rationing. No one I ever talked to thought of World War II as good times. I think a lot of them would have been happy to trade 1943 for 1933. A key lesson here is that the level of employment, or the unemployment rate, may be a very bad measure of economic welfare.

Now, the incredible thing is that, after World War II, the US economy picked itself up and went on its way. In spite of the reallocation of resources for the war effort, production reoriented itself to private uses. Krugman seems to want to tell us that the government spending in World War II somehow put us back on the right track. To me this just looks like evidence in favor of the view that the private economy, left on its own, is remarkably resilient. Obviously the GI Bill - a government intervention - helped in the transition from a wartime to a peacetime economy, but it is nuts to say that World War II "laid the foundation for long-run prosperity."

Krugman sees the economy as an uruly child. You have to shut her in her room and tell her what to do, or she will mess up badly. From my point of view, what the child needs is a framework of rules, and I know that there are some things I will have to do for her. I need to defend her against powerful bullies, and I need to write some checks to provide for her education and keep her healthy. But part of my job is to cut her loose and get out of the way. If I keep her locked in her room, she might get her homework done today, but she won't prosper in the long run. And I'll be writing checks forever.

*Note that the components of GDP do not add up in the picture, i.e. it looks like GDP is smaller than the sum of consumption, investment, and government spending. Given the chain-weighting procedure used to calculate the components of real GDP, the real GDP components never, in fact, add up. This problem shows up with a vengeance in this instance.

Saturday, September 4, 2010

Economic Policy and Politics

My roots are in Canada where, as far as I can tell, we are all socialists, with the exception of a few oddballs, including this guy and his spouse. In Canada, liberal is not a pejorative. Indeed, we capitalize that word, apply it to a political party, and sometimes have those people run the country. When I was growing up, the Williamsons were Liberals. My parents were active in the local Liberal Association. My mother worked as an enumerator (like a census worker - in Canada they actually make an effort to find you and put you on the voters' list), and my father got good Liberals out to the polls on election day. In the 1968 election, to their chagrin, this Tory was elected Member of Parliament for our constituency, but they were ecstatic over Pierre Trudeau's landslide victory and majority in the House of Commons. Trudeau of course had a long run in Canadian politics, and the man was very appealing. He was an intellectual; he had taught law at the Universite de Montreal; he was fluent and articulate in both English and French; he could evoke behavior similar to what would happen if Elvis or Paul McCartney were in town.

Trudeau's legacy was tolerance (official bilingualism, getting the government "out of the bedrooms of the nation"), toughness (controversially, he invoked the War Measures Act, suspending civil liberties in response to violent acts - including kidnapping and murder - by a radical wing of Quebec separatists), and constitutional reform. He was fiercely principled, and not afraid to speak his mind, to the point of apparently telling an opposition member to "f*** off" during question period in the House of Commons (though whether Trudeau said this, mouthed it, or thought it, is subject to debate). Trudeau is not the type who could be elected to anything in the United States. In particular, his preference for a flower (rather than a large flag pin) on his lapel would not go over well.

Now, here's where I come in. In 1975 I was an undergraduate at Queen's University, Kingston, Ontario. I was a math major, and most of what I knew was math, statistics, natural sciences, and computer science. I couldn't see myself (just) proving theorems for the rest of my life, or being an actuary, and someone suggested I take economics. I ended up in an Introduction to Economics class taught by Neil Bruce. This was a full-year course, using Dick Lipsey's book. The first half was micro, taught by Neil.

One day, late in the fall of 1975, Neil Bruce walked into class, and announced that he wasn't going to teach the lesson he had planned. He told us that he and his colleagues had watched Trudeau on the television the evening before, they had discussed Trudeau's new policy initiative, and he (Neil) was going to spend the next 90 minutes talking about it. That policy initiative was the Anti-Inflation Board (AIB), a government agency that was to spend the next 3 years overseeing collective wage agreements and price-setting in Canada. One story behind the AIB is that Trudeau was influenced by another Canadian, John Kenneth Galbraith, at that time a professor at Harvard. Trudeau apparently didn't buy Milton Friedman's notion that "inflation is always and everywhere a monetary phenomenon," but instead went with Galbraith, whose ideas on inflation control seemed to have been shaped by his service with the Office of Price Administration during World War II. The solution to high inflation? Legislate it out of existence.

Neil Bruce had been busy teaching us the standard basics of microeconomics. By then we had covered price theory, consumer and firm behavior, and the effects of taxes and subsidies, etc. Neil could show us, using some basic tools, how the AIB would introduce distortions and would misallocate resources, and we could add that welfare loss to the waste from the creation of a new government bureaucracy. There were three important lessons here. (i) Smart and well-intentioned politicians (in this case, one I admired, Pierre Trudeau) could be misled by smart and well-intentioned, but nevertheless misguided, economists. (ii) The Ivy League is capable of harboring bad ideas. (iii) A guy (Neil Bruce) who received his PhD from the University of Chicago Economics Department, which some people thought was full of right-wing bad guys (and the bad-guy image hasn't gone away), was making more sense than the Prime Minister and the economist from Harvard.

Now, for a person with an urge to fix what is wrong with the world, a course in microeconomics might be quite discouraging. Mostly (and this of course depends very much on how it is taught), conventional micro is a series of exercises in how governments can screw things up. Rent controls end up hurting the people they were intended to help. Various subsidies, inappropriate taxation, tariffs, and quotas reduce welfare in general and cut down on the gains from exchange. If we want to fix things, this will involve undoing stuff, and that stuff may be the pet projects of our well-intentioned but misguided friends, who will only give us grief. There are, however, ways out for good-deed-doers. There are externalities (positive and negative), market failures, and monopoly power. Working out how to fix the externalities, complete the markets, or regulate the monopolies requires work, though. It may be the case that one can fix the externality through a clever market mechanism - cap and trade for pollution for example. However, the government may actually be no better at supplying some item the private market fails to provide or monopoly power might actually not be so bad - it may actually promote innovation. The answers are not clear at the outset. One has to weigh alternatives, and carefully measure the costs and benefits of government intervention.

However, there may be a refuge for the good-deed-doer in that other branch of economics - macroeconomics. There is a large body of work - Keynesian economics - that tells us that intervention is the name of the game, and it looks easy. According to Keynesians, the government can, and should, act to make things better. Doing nothing in a recession, when unemployment is high and real GDP is low, would be cruel as well as inefficient. That is what I was taught in the macro portion of my Intro course. At the time, it didn't occur to me that what I learned in the fall semester should have something to do with what I learned in the spring.

I have had plenty of opportunities to talk to Keynesians and learn from them over the years. Mark Gertler, for example, has strong Keynesian leanings, and I learned a lot from in him in graduate school. However, both Mark and I were learning a lot from someone else - Rao Aiyagari, who had been a Neil Wallace student at Minnesota and, in 1981, had the complete tool basket together, i.e. everything we now know as modern macro. Rao, and the writings of Lucas, Wallace, Sargent, and Prescott, made sense to me, and I caught the Minnesota bug.

There seems to be a view among some people that interest in Minnesota macro is all about the aesthetics of mathematics. I certainly think that a functional equation is an object of beauty. I also think that the average North American has a bad attitude toward mathematics. Indeed, some people seem quite proud, rather than ashamed, of the fact that they don't know it. Mathematics is a language that, in some circumstances, is simply an efficient tool for getting the job done. I could be like Adam Smith, and write it in words, or I could be like Bob Lucas and write down an economic model and analyze it using some mathematics. I can walk 8 miles from the University to the Fed (and maybe get lost on the way), or I can get there on the train.

There are many things about the recent financial crisis that have surprised me. One of those surprises was the wide support for Keynesian-style fiscal programs, in particular the American Recovery and Reinvestment Act of 2009 (or stimulus package). Why did I think that policymakers might at least stop and think before jumping into something like that? First, New Keynesians, led by Mike Woodford, with their renewed popularity in central banks and among academics, were primarily interested in monetary policy. I took this as some sign that they had recognized that Milton Friedman was right in his analysis of policy lags. Even if fiscal policy works as Lipsey said it did in his book, the legislative process is too cumbersome, the effects are so uncertain, and the lags are so long that you just should not bother. Further, there seemed to be something different going on here. By calling this a "financial crisis," we were recognizing that the key forces at work were financial. It wouldn't seem that the economics of sticky wages and prices would have much to say about that, so why would we be following some simple Keynesian policy prescription?

Now, Christina Romer, in her farewell speech is quite unrepentant. She argues that the stimulus package worked, and her interpretation of what is going on in the economy would have fit right into the second semester of my 1975-76 Intro to Economics course. Indeed, Christina could have showed up in class and said the following, and everyone would have understood her:
The … United States still faces a substantial shortfall of aggregate demand. GDP by most estimates is still about 6 percent below trend. This shortfall in demand, rather than structural changes in the composition of our output or a mismatch between worker skills and jobs, is the fundamental cause of our continued high unemployment….

This represents the extreme end of Keynesian economics. She seems pretty sure about this. GDP is not where it should be. She knows where it should be, and she knows how to get us there. Y = C + I + G + NX. We don't have enough Y because of too little C, I, and NX, so we just replace that with some more G. Easy. As Brad DeLong says here, "the government's money is as good as anyone else's."

New Keynesian Economics is less extreme, in that it makes a clear assumption about what the friction is in the economy - typically the distortions from sticky prices, in an otherwise-standard modern macro model. In a Woodford model, we're at least recognizing that what we think of as the efficient level of GDP can fluctuate - it's a moving target, and we're going to be uncertain about what it is in real time. You can quarrel (as I do, and others as well) about how New Keynesian models are put together, and whether they fit the empirical evidence, but at least there is something recognizable here as economics.

Unfortunately, what Romer says in the quote above, and what DeLong says here in the debate with my friend Boldrin, is mostly bilge. Let me explain. Why does an increase in spending by the government on goods and services matter in basic Keynesian models? Expenditure on goods and services is income for consumers; when consumers get more income, they spend more; that is also income for consumers, so they spend more, etc. That's the multiplier. This is a wonderful thing - it's essentially a free lunch. For every $1 the government spends we get more than $1 in GDP. How much more? Here, Christina claims we get about $1.60 more, and she argues that that's probably a lower bound. This is great! Followed to it's logical conclusion, of course, this should make us want an infinite-sized government so that we can all be infinitely rich. Keynesians aren't that stupid of course. Typically the argument would be that this only applies when there is "resource slack" in the economy. Like now.

Now, what is left out of the typical textbook Keynesian analysis or, put another way, what implicit assumptions are they making?

No Ricardian equivalence. Ricardian equivalence is the notion that forward-looking consumers take account of the implications of current government policy for future taxation. Suppose the government increases spending on goods and services today. It must finance this by increasing taxes, or by borrowing. If it borrows, it is going to have to increase taxes in the future to pay off the debt. What difference does the financing make to me as a consumer? Either way I'm stuck with the tax bill - it's just deferred if the government borrows to finance its higher deficit. Now, a Keynesian would then say that there are two problems here. One is that credit markets are not perfect. Indeed, if some consumers are credit constrained, Ricardian equivalence does not work. But if the problem is in credit markets, why not address that directly? Government intervention by way of spending directly on goods and services seems rather roundabout. A second Keynesian response might be that consumers are not as sophisticated as Ricardian equivalence requires them to be. Who has the knowledge to see through the government's behavior and understand the future tax implications of current policies? The answer to this is that it is never good to fool people. By saying people are too stupid to get it, we are just saying that we can make them do something that is not in their interest - spending more today when they should be saving.

There are resources lying around that can be put to use to produce the goods and services the government wants to buy. If the government wants to build a bridge, this requires labor, materials, and capital equipment. If the government wants to fight a war, that also requires labor, materials, and capital equipment. Typically, we would think of these inputs to production as having an opportunity cost, which is what we could have done with them in the best available alternative. In the most basic kind of Keynesian model, the opportunity cost of government spending is zero - it's literally a free lunch. The notion is that, with a 9.6% unemployment rate, for example, and given the quantity of existing empty buildings and idle machinery, we just take all the idle resources we have and put them to work. Of course it's not that simple. Do the unemployed workers have the skills that the government needs to produce things that are actually useful for society? Are the unemployed workers living in the places where these government goods and services are going to be useful? What if the increased government spending actually uses labor skills that are in high demand, and soaks up resources that would actually be more useful in the private sector? What if the government's intervention actually slows down the adjustment that needs to take place in the economy, i.e. moving jobs and resources across industries and from one geographical location to another? In the excerpts here, from Christina Romer's farewell speech, she is quite proud of the speed with which the stimulus package was passed and implemented. Do you think that much thought went into how that money was spent, or that anyone attempted to seriously answer questions like the ones I just asked?

When I do a class in intermediate macroeconomics, the first thing we do is to see how far we can go with conventional microeconomic tools in understanding how the macroeconomy works. Basically, this is the analog of what Neil Bruce was doing in our micro intro class - he was using conventional micro tools to think about a policy that was addressed to a macro issue - inflation. This past spring, as fiscal policy was very much on the agenda, one exercise my class did was to think about all the ways that government spending could matter, without bringing sticky wages and prices onto the table. This is essentially extending what I do in Chapter 5 of my book. There, I start with a basic case, which is government purchases as pure waste. This is a good model for spending on a war. The spending (hopefully) is for a good purpose, but the benefits will not be reflected in the National Income Accounts. Standard microeconomics tells you that GDP will in fact increase as a result. Under the assumption that consumption and leisure are normal goods, consumers will work harder to support the larger government, as higher taxes have caused their after-tax incomes to fall. The multiplier, however, is less than 1, since consumption decreases. Consumption is crowded out by the larger government. The opportunity cost of government spending here is lost leisure and consumption. One can now think about many other types of government purchases. There are government-provided goods and services, for example those associated with National Parks, that provide consumers with direct benefits. There are items like roads and bridges that make private sector production (e.g. trucking) more profitable. For some of these types of spending (e.g. government-provided goods and services are perfect substitutes for private goods and services), the multiplier can be zero. In other cases (complementarities), we can get substantial multipliers. This boils down to the issue of whether the government is more efficient than the private sector at providing particular goods and services, or particular kinds of capital inputs. We have a whole field of economics that deals with this: public economics. Actually, that's Neil Bruce's department.

Now, this analysis does not say much in particular about the cyclical nature of government intervention. In general, this type of analysis is concerned with the long run. What do we want the government to do? How large should it be? We can, however, make the case that, if we have some project we think it would be socially advantageous for the government to undertake, the opportunity cost of doing it in a recession is lower. Recently, some forces in my school district convinced me that a new middle school was needed. Some other forces wanted to argue that this wasn't the time to do it, as we are in a recession. My answer to that was that this is indeed exactly the right time. The school could be built quickly and at low cost, and I was pleased to vote in favor of floating a school bond at a low interest rate. However, I did not notice arguments like that being used in favor of the stimulus package. This appeared to be a set of new initiatives that we would otherwise not have been contemplating.

Is there some case for a fiscal policy initiative that we could construct based on the particulars of the financial crisis? If we think that a key source of our recent problems is a temporary increase in credit market frictions, one approach might be a pure Ricardian one. When there are credit-constrained economic agents, a temporary tax cut for everyone, with a promise to pay off the resulting debt with higher future taxes, is effectively a large government credit program. It does not require any new government bureaucracy, and just works through the existing income tax mechanism. Those who are credit constrained spend the tax cut as if they were getting a loan, and work harder or consume less in the future so as to pay the higher future taxes, as if they were paying off the loan. Those who are not credit-constrained save the tax cut so as to pay their future taxes. There are no long-run implications for the government budget. Why didn't we just do that?

By now, we are well past the financial crisis. The financial system is not entirely out of the woods, but we're well beyond the need for emergency measures. However, the recovery has been weaker than expected, and there is some shouting, particular from you-know-who that we need to do more, and "more" appears to mean more spending by the federal government on goods and services. Krugman does not seem to be particular about the specific goods and services that comprise this extra spending. Here's Krugman:
As I pointed out in February 2009, the Congressional Budget Office was predicting a $2.9 trillion hole in the economy over the next two years; an $800 billion program, partly consisting of tax cuts that would have happened anyway, just wasn’t up to the task of filling that hole.
Interpretation: Krugman knows, and he's using the CBO for support, what the "right" or efficient level of GDP is, and he's telling us how to get there. It's easy - like filling a hole. And who wants a hole anyway?

What I was taught in Intro to Economics was that the role of an economist in society is to give advice. I think this was in Dick Lipsey's introduction, where he talks about positive and normative economics. Learning and practicing economics can be a purely intellectual and selfish exercise. We want to understand how the world works, and having that knowledge makes us feel better, and perhaps more in control. However (and some people I know disagree with me here), we also want to make the world a better place. Now, that's a delicate thing. Economists like to think about efficiency, but there are few, if any, practical policy interventions that imply Pareto improvements - making everyone better off. Someone always loses. What we can do however, is to analyze the effects of particular policies, and then give a rundown of who wins and loses. Alternatively, if you give me a particular objective, I should be able to design a policy that accomplishes the objective efficiently.

What does Paul Krugman want? He may want money and power, but that's not saying much. The quest for that stuff seems universal. What he says he wants, given the current circumstances, is for fewer people to be unemployed and more people to be employed. Why does he want that? It appears that he is concerned with equity. For him, it is criminal that some people are doing well and won't help out the unemployed, who are in dire straits.

What Krugman appears to be arguing for is insurance. Some people who are unemployed today never expected to be, and some of the currently employed (maybe me) will be unemployed in the future. Bad stuff happens to everyone, the private market for some reason does not insure us against all these bad events, and we accept that there is a role for government in providing insurance. Lucas, in his 1987 book Models of Business Cycles conducts a thought experiment, where he asks what the representative consumer would pay to get rid of business cycle risk, and the answer is "not much." Of course, we knew that had to be wrong on some level, as business cycle risk is borne disproportionately by the poor and less-educated. But why would you insure these people by having the government employ them during recessions? If we think our unemployment insurance system is badly designed, as I think we can argue it is, why not fix that?

Krugman has good intentions, as did John Kenneth Galbraith. However, just as Galbraith was selling a flawed policy to Pierre Trudeau, Krugman is selling snake oil to the American public. And man, he is selling it in a nasty way. The second Bush administration included people who were masters of deception, and the art of pandering to fear and ignorance. Krugman acts like someone who has studied those methods and put them into practice, and this does not serve anyone well.

The Republican party does not seem to have much to offer us. They seem to be about further pandering to fear and ignorance, with no constructive economic ideas. The Democrats do better on the fear and ignorance front, though there could be many improvements. On economic policy, there is clearly room for either political party to push forward an agenda of sound fiscal policy, driven by careful economic research and good economic principles. In Canada, a Liberal government (those characters would be far to the left of the Democratic Party, remember) actually turned deficits in the neighborhood of 8% of GDP into surpluses in the mid-to-late 1990s. If Krugman wanted to, he could lead a revolution in the Democratic party that would give the party a fiscally-responsible image. But that would mean talking sense for a change.

Wednesday, September 1, 2010

Liquidity Traps and Deflation Traps

Krugman posted a 1998 paper here., which goes some way to explaining what he might be thinking about here. The 1998 Krugman and I apparently think alike. The example he used in his paper is exactly the same one I used here. If anyone doubts the existence of liquidity traps, it is clear that we can produce these in essentially any mainstream, precise, dynamic general equilibrium monetary model. The liquidity trap that Krugman produces is one where you fix monetary policy in the future, ask what it takes in terms of monetary policy to drive the nominal interest rate to zero in the present, then ask what happens if you go further. Once the nominal interest rate is at zero in the present, if the central bank injects more money at the margin, this is irrelevant. In an earlier version of a paper I am currently revising, I included an example that looked almost identical, in a Lagos-Wright construct, but you can do the same with cash-in-advance, as Krugman does. Krugman's 1998 paper then gets into some hand-waving about insufficient demand, real interest rates that are too low (he's describing Japan at the time), etc., that I did not find so useful, but we'll leave that aside for now.

Krugman's 1998 example, which is a temporary liquidity trap, works in exactly the same fashion as phenomena that occur in essentially all monetary models at the Friedman rule. The Friedman rule is a rule for monetary policy that implies a zero nominal interest rate forever. At the Friedman rule, there is always a liquidity trap. Another way to think of this is that there are many paths for the money stock that are consistent with having a zero nominal interest rate forever. If, for example, negative money growth of -4% per year with an initial money stock M implies that the nominal interest rate is zero forever, then -4% per year money growth with an initial money stock xM also implies the nominal interest rate is zero forever, where x > 1. Further, the path for price level in the first case is also an equilibrium in the second case. Note that this is not just standard neutrality of money as the quantities and the prices are the same in both cases. However, it's not any money stock path that will support the Friedman rule. What Ricardo Lagos shows here (and this is related to work done long ago by Charles Wilson) is that, roughly, the money stock has to go to zero in the limit. This is all about the long run, and the forward looking behavior of economic agents. If we do not anticipate that the money stock will be decreasing at a sufficient rate indefinitely, this cannot happen.

Now, Krugman and others seem to associate liquidity traps with deflation. That is certainly the standard Friedman-rule logic, and it could be that when Krugman says "deflation trap" he means "liquidity trap." In the paper I'm revising (see these slides) you can show that liquidity traps can occur for any inflation rate, with monetary policy set appropriately, and the trap can persist forever. The liquidity trap arises in taking full account of the role of banks. What happens is that, if private assets used in financial exchange are sufficiently scarce (e.g. in a financial crisis), and cash is sufficiently plentiful, then the nominal interest rate can be zero, potentially even with a positive rate of inflation. There is nothing particularly weird going on here - no funny equilibria or disequilibria.

Note that there are other liquidity trap phenomena, related to current policy. For example, under current conditions with a positive level of excess reserves, and interest paid on those reserves, a swap by the central bank of reserves for T-bills is essentially irrelevant, for the same reasons you get a standard liquidity trap. The central bank is just swapping one interest bearing asset for another that is essentially identical.

What's the bottom line? First, the conditions required to support sustained deflation in standard models seem hard to fulfill in practice given what we understand about commitment by the Fed to future policy. Second, it is possible to have a sustained liquidity trap without sustained deflation. These are just more reasons why we should not be too worried about deflation.