Thursday, December 20, 2012


Like most of you, I've been thinking about guns for the last few days. As economists, what do we have to say about gun control? Though this article is not about the economics of the problem, it has something to say about the practicalities of regulation. Regulating guns through the U.S. Consumer and Product Safety Commission is a start, and using some of the strategies that were used against tobacco is another useful step.

What's the problem here? People buy guns for three reasons: (i) they want to shoot animals with them; (ii) they want to shoot people with them; (iii) they want to threaten people with them. There are externalities. Gun manufacturers and retailers profit from the sale of guns. The people who buy the guns and use them seem to enjoy having them. But there are third parties who suffer. People shooting at animals can hit people. People who buy guns intending to protect themselves may shoot people who in fact intend no harm. People may temporarily feel compelled to harm others, and want an efficient instrument to do it with.

There are also information problems. It may be difficult to determine who is a hunter, who is temporarily not in their right mind, and who wants to put a loaded weapon in the bedside table.

What do economists know? We know something about information problems, and we know something about mitigating externalities. Let's think first about the information problems. Here, we know that we can make some headway by regulating the market so that it becomes segmented, with these different types of people self-selecting. This one is pretty obvious, and is a standard part of the conversation. Guns for hunting do not need to be automatic or semi-automatic, they do not need to have large magazines, and they do not have to be small. If hunting weapons do not have these properties, who would want to buy them for other purposes?

On the externality problem, we can be more inventive. A standard tool for dealing with externalities is the Pigouvian tax. Tax the source of the bad externality, and you get less of it. How big should the tax be? An unusual problem here is that the size of the externality is random - every gun is not going to injure or kill someone. There's also an inherent moral hazard problem, in that the size of the externality depends on the care taken by the gunowner. Did he or she properly train himself or herself? Did they store their weapon to decrease the chance of an accident?

What's the value of a life? I think when economists ask that question, lay people are offended. I'm thinking about it now, and I'm offended too. If someone offered me $5 million for my cat, let alone another human being, I wouldn't take it.

In any case, the Pigouvian tax we would need to correct the externality should be a large one, and it could generate a lot of revenue. If there are 300 million guns in the United States, and we impose a tax of $3600 per gun on the current stock, we would eliminate the federal government deficit. But $3600 is coming nowhere close to the potential damage that a single weapon could cause. A potential solution would be to have a gun-purchaser post collateral - several million dollars in assets - that could be confiscated in the event that the gun resulted in injury or loss of life. This has the added benefit of mitigating the moral hazard problem - the collateral is lost whether the damage is "accidental" or caused by, for example, someone who steals the gun.

Of course, once we start thinking about the size of the tax (or collateral) needed to correct the inefficiency that exists here, we'll probably come to the conclusion that it is more efficient just to ban particular weapons and ammunition at the point of manufacture. I think our legislators should take that as far as it goes.

Addendum: See this related piece by Louis Johnston.

The Confused and the Confusing

I don't know why, but I find Paul Krugman's behavior interesting. Here's his reply to my previous post. This is typically the way he does it. For some reason Noah Smith is always the conduit.

The first thing to note is this:
For newbies: saltwater is the kind of macro practiced at MIT, some of Harvard, Princeton, etc., macro that still finds Keynesian ideas useful and argues that monetary and fiscal policy can be effective; freshwater is Chicago, Minnesota, etc. insisting that business cycles are optimal responses to real shocks.
This is not actually a message for newbies. Krugman seems to be hoping that these "newbies" are Rip Van Winkles who have been asleep for 30 years rather than 20. Or maybe he thinks that repeating this enough will make it true. From my previous post:
What are "freshwater" and "saltwater" macro? No idea. In Paul Krugman's own department at Princeton, Richard Rogerson, who was a student of Ed Prescott's, resides with Nobu Kiyotaki, who was a student (or at least a coauthor) of Olivier Blanchard's. There are other macroeconomists there with PhDs from Chicago, Minnesota, and MIT. What school of thought drives that place? Beats me.
If Krugman can't figure out what is going on in his own department, do you think you can trust him to take the pulse of the profession?

A second thing:
So yes, the equations in one of Mike Woodford’s papers look a lot like the equations coming out of Chicago or Minneapolis. And a few years ago it was possible to delude oneself into believing that this represented a true convergence of thought.
There's much more to it than equations. Here's an example. In fall 2008, I went to this conference at the Federal Reserve Bank of Minneapolis. What was it about? Monetary Policy and Financial Frictions. That's in the middle of the crisis, and it was certainly topical. I didn't see anyone there obsessing about TFP shocks. People came from across the country - Princeton, Chicago, MIT, Northwestern, Stanford, Columbia, etc.

One paper I saw was Mike Woodford's work with Curdia. Woodford/Curdia start with a basic NK framework and add a financial friction, in part by introducing some heterogeneity to generate borrowing and lending. When I first saw the program, I was wondering why Andy Atkeson was discussing the paper. I wouldn't have thought that Andy knows much about NK models. Wrong. Actually, what Mike was doing uses some ideas from the market segmentation literature that Andy has done work in. There was basically a set of shared ideas, techniques, and tricks for getting the job done. Cross-fertilization! Market segmentation is about studying the distributional effects of monetary policy - a nonneutrality of money. Mike works in models where the nonneutrality generally comes from price stickiness. Andy was a Sargent student at Stanford. His first job was at Chicago, and he is now at UCLA. Mike at one time also worked at Chicago, and he was at Princeton, then Columbia.

Here's something I could have said:
I’m not saying that the NK approach is necessarily right; but it’s a serious intellectual effort, undertaken by people who thought they were part of an open professional dialogue.
So Krugman and I have something we can agree on.

Krugman seems to want us to be at each others' throats. Only he can tell us why.

Monday, December 17, 2012


I thought I would offer some light entertainment today. This Paul Krugman post struck me as perhaps more deranged than usuual on the topic of macroeconomists.

Here are the two closing paragraphs, to give you the idea:
In fact, the freshwater side wasn’t listening at all, as evidenced by the way 80-year-old fallacies cropped up as soon as an actual policy response to crisis was on the table; and as for changing views in response to facts, well, we all know how that has gone.

The state of macro is, in fact, rotten, and will remain so until the cult that has taken over half the field is somehow dislodged.
Like most of the macroeconomists I know and talk to, I try to keep up with my field, and with what is going on in the rest of economics. That's a hard thing to do of course. It burns all the time that is left after teaching students, trying to do one's own research, and doing whatever else we need to do to get on with life.

It doesn't surprise me that Paul Krugman isn't up on what is going on in macroeconomic research. Why should we expect him to go to macro conferences, spend time in seminars, and talk to his colleagues at Princeton? He has plenty on his plate, what with delivering two NYT columns per week, blogging, talking to pundits, and giving speeches. But if he's not up on the field, what purpose does it serve to make up outlandish stuff for people to read? Maybe this just motivates the Krugman base. I have no idea.

Some of the following ideas you can find in other forms if you search my archive, but these things bear repeating once in a while.

This is actually a relatively tranquil time in the field of macroeconomics. Most of us now speak the same language, and communication is good. I don't see the kind of animosity in the profession that existed, for example, between James Tobin and Milton Friedman in the 1960s, or between the Minnesota school and everyone else in the 1970s and early 1980s. People disagree about issues and science, of course, and they spend their time in seminar rooms and at conferences getting pretty heated about economics. But I think the level of mutual respect is actually relatively high. There seem to be more serious disputes, for example, between structural and astructural labor economists than among macroeconomists.

Back in the day, there was a revolution in macro, beginning with the Phelps volume, and Lucas's "Expectations and the Neutrality of Money." At the time, this revolution was widely-misperceived as a fundamentally conservative movement. It was actually a nerd revolution. The people who led it were an inarticulate and socially awkward bunch who were not let into (or were kicked out of) the Ivy League. They had to persevere outside of the mainstream, in underdog places like Carnegie-Mellon, Rochester, and the University of Minnesota, not to mention the Federal Reserve Bank of Minneapolis.

What these people had on their side were mathematics, econometrics, and most of all the power of economic theory. There was nothing weird about what these nerds were doing - they were simply applying received theory to problems in macroeconomics. Why could that be thought of as offensive?

Since the 1970s, it is hard to identify a field called macroeconomics. People who call themselves macroeconomists have adopted ideas from game theory, mechanism design, general equilibrium theory, finance, information economics, etc. to study problems of interest to policymakers and the public at large. Sometimes it's hard to tell a macroeconomist from a labor economist, from someone working on industrial organization problems. What are "freshwater" and "saltwater" macro? No idea. In Paul Krugman's own department at Princeton, Richard Rogerson, who was a student of Ed Prescott's, resides with Nobu Kiyotaki, who was a student (or at least a coauthor) of Olivier Blanchard's. There are other macroeconomists there with PhDs from Chicago, Minnesota, and MIT. What school of thought drives that place? Beats me.

The truth is that we have all moved on from the macro world of the 1970s. Methods that seemed revolutionary in 1972 are the methods everyone in the profession uses now. The nerds who had trouble getting their papers published in 1972 went on to run journals and professional organizations, and to win Nobel prizes. This isn't some "cult that has taken over half the field," it's the whole ball of wax. Rotten? No way!

Economic science does an excellent job of displacing bad ideas with good ones. It's happening every day. For every person who places obstacles in the way of good science to protect his or her turf, there are five more who are willing to publish innovative papers in good journals, and to promote revolutionary ideas that might be destructive for the powers-that-be. The state of macro is sound - not that we have solved all the problems in the world, or don't need a good revolution.

Wednesday, December 12, 2012

Why We Shouldn't Feel Well-Guided

Today's FOMC statement was as expected on the quantitative easing (QE) side of policy. The Fed will continue to purchase $40 billion in mortgage-backed securities (MBS) per month, and will be purchasing $45 billion per month in long Treasury securities outright, rather than swapping short Treasuries for long ones.

There were some surprises (for me) in the change in forward guidance. Let's see what the statement says, so we can parse it:
the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. The Committee views these thresholds as consistent with its earlier date-based guidance. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.
The first part of this, is a trigger at at a 6.5% unemployment rate. Actually, it's not a trigger, as the 6.5% unemployment rate is just a necessary condition for tightening. The second part - the inflation trigger - is pretty weird. A second necessary condition for tightening is an inflation forecast -one to two years ahead - that exceeds 2.5%. Note the following:

(i) The FOMC is going to ignore actual inflation. Apparently that's irrelevant.
(ii) Whose forecast is this? You know whose. It's the Fed's own forecast. If you're paying attention to the Fed's forecasts, you'll understand that they basically make it up so that it's consistent with their own policy.

We're also told that inflation expectations becoming unanchored would be grounds for tightening. What is that supposed to mean? Then we're told that, of course, the Fed will look at everything, just as it always does.

If the goal was to provide a more precise statement about what will trigger a tightening of policy in the future, the FOMC has failed dismally. This statement is more vague than the last one, in October, which contained a calendar date.

What about policy after liftoff? We're told that the committee"...will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent." I'm worried that this is balanced like Fox News. The last reference to "balanced approach" I saw was in a speech by Janet Yellen. The balanced approach, as far as I can tell, represents a marked change in monetary policy, toward an activist approach rooted in the belief that short-run non-neutralities of money are a very big deal. The Fed has just told us that they care a lot less about inflation. They're losing sight of what their job is.

Tuesday, December 11, 2012

Fed Update

The FOMC is meeting today and tomorrow. What is on its collective mind? There are two issues which are likely to be on the agenda relating, respectively, to the two legs of the Fed's current unconventional policy actions: quantitative easing and forward guidance.

Quantitative Easing
The Fed's "operation twist" will end at the end of this month. Recall that this asset swap program began in September 2011, and was extended in June of this year. The program involves sales of Treasury securities with remaining maturities of 3 years and less in exchange for Treasury securities with remaining maturities 6 years or more. Those swaps have been proceeding at a rate of $45 billion per month. Even if the Fed wanted to continue that program, it would not be feasible, as the short-term Treasury securities on the Fed's balance sheet are all but depleted.

Since September, the Fed has been purchasing $40 billion in mortgage-backed securities (MBS) per month - the "QE3" program. This is also an asset swap, but in this case a swap of reserves for MBS. QE3 is an open-ended program, which will continue under conditions stated, for example, in the last FOMC statement:
If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.
My best guess is that the committee will not think of the new information received since the last meeting as indicating "substantial" improvement in the labor market, and they will be looking to keep their policy stance the "same" as it was at the last meeting. But they can't do that, as it's impossible to continue the twist asset swap. What's the next best thing? Well, if you believe that QE works to actually ease something, as the FOMC certainly does, then you should also think that there is little difference between swapping short Treasuries for long Treasuries and swapping reserves for long Treasuries. What you should expect to see is a QE4 program involving purchases of $40 billion in MBS per month and $45 billion in long Treasuries per month. In terms of total purchases, that's a little larger than QE2, which involved purchases of about $75 billion per month (all Treasuries). The Fed could of course buy more than $40 billion in MBS per month, but that would signal a change, and they're not likely to do it (I'm not sure about the feasibility either - how big is that market?).

Some concerns:
1)The Treasury and the Fed are clearly thinking about debt management in completely different ways. As for example James Hamilton and David Beckworth have pointed out, the Treasury has been systematically increasing the average maturity of the outstanding government debt in the hands of the public, while the Fed is systematically reducing it. The Treasury might be thinking that it can save a huge amount on debt service in the future by, for example, locking in a 30-year borrowing rate of 2.84%. The Treasury seems to think it is looking after us by lengthening the average maturity of government debt, lowering borrowing costs, and presumably lowering our future tax burden. But the Fed thinks that we get more real economic activity (temporarily, permanently?) if the average maturity of government debt is lower. The Fed also thinks it is looking out for us. Maybe Ben Bernanke should walk down the street and try to sort this out with Tim Geithner (or his successor).
2)Short of a theory of QE - or more generally a serious theory of the term structure of interest rates - no one has a clue what the effects are, if any. Until someone suggests something better, the best guess is that QE is irrelevant. Any effects you think you are seeing are either coming from somewhere else, or have to do with what QE signals for the future policy rate. The good news is that, if it's irrelevant, it doesn't do any harm. But if the FOMC thinks it works when it doesn't, that could be a problem, in that negative QE does not tighten, just as positive QE does not ease.

Forward Guidance
This is where the big change in policy is likely to occur. In public statements, various Fed presidents have been honing a policy rule that involves quantitative triggers. Until now, the FOMC's forward guidance statements have included a calendar date for "liftoff" - the date at which the Fed's policy rate (the interest rate on reserves currently, given the large stock of reserves outstanding) rises above 0.25%. The last FOMC statement says that date is "likely" to be mid-2015.

After living with calendar dates in the forward guidance language since August 2011, FOMC members now appear to think they are a bad idea. Why? The Fed generally likes the idea of forward guidance, as it is another tool the Fed thinks it can use when it is up against the zero lower bound. Support for the idea comes from New Keynesians - Woodford et al. - and New Keynesian models. But Woodford is on record as thinking that a calendar date is a bad idea. One may think that extending the liftoff date will be more accommodative, as this increases anticipated inflation and lowers the real rate of interest, but extending the liftoff date also conveys pessimism.

The triggers for liftoff typically take the following form. The policy rate should stay at 0.25% until one of two things happen: (i) the inflation rate rises above x%; (ii) the unemployment rate falls below y%. Most of the public debate currently seems to be over what x and y should be. x is typically in the range 2.5 to 3.0, and y is typically 5.5 to 7.0. The argument for triggers is that a calendar date can lead to policy errors, or negates the intent of the policy. If the Fed commits to the calendar date, it risks waiting too long to tighten, or it tightens too soon. But if the Fed appears willing to move the calendar date in response to new information, the forward guidance becomes meaningless. With triggers, the FOMC can state the policy once, commit to it, and move forward.

Here are the problems with triggers:
(1)To be well-understood, the triggers need to be specified in a very simple form. As such it seems as likely that the Fed will make a policy error if it commits to a trigger as if it commits to a calendar date. The unemployment rate seems as good a variable as any to capture what is going on in the real economy, but as such it's pretty bad. It's hardly a sufficient statistic for everything the Fed should be concerned with.
(2)This is a bad precedent to set, for two reasons. First, the Fed should not be setting numerical targets for anything related to the real side of the dual mandate. As is well-known, the effect of monetary policy on real economic activity is transient, and the transmission process poorly understood. It would be foolish to pretend that we know what the level of aggregate economic activity should be, or that the Fed knows how to get there. Second, once you convince people that triggers are a good idea in this "unusual" circumstance, those same people will wonder what makes other circumstances "normal." Why not just write down a Taylor rule for the Fed, and send the FOMC home? Again, our knowledge of how the economy works, and what future contingencies await us, is so bad that it seems optimal, at least to me, that the Fed make it up as it goes along.

My overriding concern is that the Fed's unconventional policy moves - one on top of the other - are digging a deep hole that it will find it difficult to get out of. Of course, Ben Bernanke seems likely to leave at the end of his term in about a year's time, so it won't be his problem.

Sunday, December 9, 2012

Gaps and Triangles

James Tobin once said:
It takes a heap of Harberger triangles to fill an Okun gap.
Gregory Mankiw once discussed gaps versus triangles in the context of fiscal policy issues (the 2009 stimulus package). According to Mankiw, Keynesians think of Harberger triangles as small potatoes, and output gaps as large potatoes; non-Keynesians think the opposite. That's certainly consistent with Paul Krugman's view of the world. Krugman quotes Tobin in his post, and states:’s a more general observation that even bad microeconomic policies, which lead to substantial distortions in the use of resources, have a hard time doing remotely as much damage as a severe economic slump, which doesn’t misallocate resources — it simply wastes them.

What's a Harberger triangle? It's a partial equilibrium measure of the welfare loss from a distortion - a tax or monopoly power for example. Total welfare from the production and consumption of a given good or service can be measured as consumer surplus plus producer surplus, which is the area under the demand curve minus the area under the supply curve, calculated given the quantity traded in the market. Total welfare is maximized at the competitive equilibrium quantity and price, but a proportional tax, for example, reduces the quantity traded, and the welfare loss (when we include the revenue generated from the tax) is a triangle - indeed a Harberger triangle.

In the 1950s, Harberger measured the welfare loss from monopoly in the United States, essentially by adding up these triangles for monopolized industries. He came up with a small number - about 0.1% of GDP. Thus, if we were to use Harberger's methods to add up the heap of Harberger triangles arising from tax distortions, monopoly, various trade restrictions, and other synthetic obstacles to exchange, the welfare loss we obtain should be small.

Are output gaps large? Certainly Paul Krugman thinks so.
Right now the U.S. economy is operating something like 6 percent below capacity.
A 6% output gap is what you get if you use the Congressional Budget Office's (CBO's) measure of potential output. The chart shows this measure, along with actual real GDP. Suppose we take the CBO output gap of 6% of GDP as an accurate measure of what could be achieved if the fiscal and monetary authorities in the United States behaved appropriately. Also suppose that 0.1% is a good part of the heap of Harberger triangles in existence in the US economy. Then, indeed, the heap of triangles looks trivial relative to the gap.

But this isn't as obvious as it might look to some of you. Let's go back to Tobin's article ("How Dead is Keynes?"), where the quote comes from, and try to figure out what he was trying to say. Perhaps surprisingly, he wasn't comparing the welfare cost of business cycles to the welfare costs of "micro" distortions. In his article, Tobin said that 1977 policymakers were between the rock and the hard place. To achieve disinflation would require some sacrifice in terms of lost output. But further monetary accommodation would just lead to self-fulfilling increases in inflation. According to Tobin, "the way out, the only way out, is incomes policy." Then he states:
Most of you will, I'm sure, have no idea what "incomes policy" is, and that's a wonderful thing. "Incomes policy" sounds innocuous. What could be wrong with a government policy that looks after our incomes, presumably making them larger? Well, incomes policy is actually wage and price controls. In the pre-Volcker era, wage-price controls were very much on the table as a means for controlling inflation. Wage and price controls were introduced by the Nixon administration, and were in effect from 1971 to 1974 in the United States. I had the misfortune to live through the era of the Anti-Inflation Board in Canada, 1975-1978. The key achievement of Milton Friedman and the Old Monetarists was to convince everyone that inflation control is the job of the central bank. It's hard to find anyone today who disagrees with that view, and I think that's a good.

The funny, and I think key, point comes out of Tobin's confusion about gaps and triangles. Relative to what he's discussing, the gap and the triangles are actually exactly the same thing. Early in his paper, Tobin discusses the "central propositions" of Keynes's General Theory. To start:
So, inefficiencies arise because prices and wages are not at their market-clearing values, and quantities traded are demand-determined. In this context, how would we measure the efficiency loss in a particular market? Guess what, it's a Harberger triangle. The inefficiencies Tobin envisions arising from wage and price controls arise from what? From wages and prices that deviate from their market clearing values. What's the efficiency loss? It's a Harberger triangle. It takes a heap of Harberger triangles to fill a heap of Harberger triangles.

If I were a hardcore Keynesian - New, Old, whatever - how would I measure the costs of business cycles? Well, to start, I would accept Tobin's first central proposition from the General Theory. Inefficiencies arise because wages and prices are misaligned. To calculate welfare losses I would add up Harberger triangles across markets. The inefficiencies that arise in New Keynesian models are indeed identical to the ones which would be generated by a set of good-specific taxes.

What's the conclusion? Keynesians - Paul Krugman in particular - can't have it both ways. Macro does not "trump" micro. This is a no-trump world. If I argue that Keynesian sticky wage/price distortions are large, and that tax distortions are small, that's a contradiction.

But it's not a contradiction to say that sticky wage/price distortions are small, and other inefficiencies that we face are large. Is 6% of GDP a serious measure of the current effects of sticky wage/price distortions? Of course not. Read this document and see if you think the CBO measures potential output the way any sensible macroeconomist would measure it. Yikes. I don't think so.

There are of course plenty of models around now that take wage and price stickiness seriously, and also contain a multitude of shocks that allow those models to fit the data. Christiano/Eichenbaum/Evans is one of those. It seems straightforward to take a model like that, turn off the wage/price rigidity, compare business cycles without the wage/price rigidity to those with it, and ask what the agents in the model would pay to live without the wage-price rigidity (this is with monetary and fiscal policies that are not correcting the inefficiencies). I don't know if that has ever been done.

We could think of such an experiment as giving us an upper bound on the welfare loss from wage/price rigidity. There are plenty of reasons to think that standard New Keynesian models exaggerate the effects of wage/price stickiness. For example, Calvo pricing is suspect. If the losses from wage/price rigidity are such a big deal, there are large surpluses left on the table that inventive buyers and sellers of labor, goods, and services, would be happy to have.

So, there are good reasons to think that the welfare losses from wage/price rigidity are small. There is also plenty of evidence that other inefficiencies matter a great deal. This paper by Hsieh and Klenow shows how the misallocation of resources in China and India is a big deal - for aggregate TFP (total factor productivity) and GDP. There is an upcoming special issue of the Review of Economic Dynamics on misallocation and productivity. This includes a paper by Greenwood, Sanchez, and Wang, showing that financial misallocation can be big-time. In the United States, we have experienced a decade where resources were apparently reallocated, inefficiently, to the housing and mortgage markets, with disastrous results. We understand more about that episode than we used to, but we have a lot to learn. What people should come to terms with, is that wage and price rigidity likely had little to do with that experience, and the sooner economists recognize that, the more progress we'll make.

Monday, November 26, 2012

SED Newsletter: Lucas Interview

The November 2012 SED Newsletter has some useful information on upcoming meetings. There is also an interview with Robert Lucas, which is a gem. Some excerpts:

On the Lucas Critique:
But the term "Lucas critique" has survived, long after that original context has disappeared. It has a life of its own and means different things to different people. Sometimes it is used like a cross you are supposed to use to hold off vampires: Just waving it it an opponent defeats him. Too much of this, no matter what side you are on, becomes just name calling.

Business cycles are all alike?
As I have written elsewhere, I now believe that the evidence on post-war recessions (up to but not including the one we are now in) overwhelmingly supports the dominant importance of real shocks. But I remain convinced of the importance of financial shocks in the 1930s and the years after 2008. Of course, this means I have to renounce the view that business cycles are all alike!

ED: If the economy is currently in an unusual state, do micro-foundations still have a role to play?
RL: "Micro-foundations"? We know we can write down internally consistent equilibrium models where people have risk aversion parameters of 200 or where a 20% decrease in the monetary base results in a 20% decline in all prices and has no other effects. The "foundations" of these models don't guarantee empirical success or policy usefulness.
What is important---and this is straight out of Kydland and Prescott---is that if a model is formulated so that its parameters are economically-interpretable they will have implications for many different data sets. An aggregate theory of consumption and income movements over time should be consistent with cross-section and panel evidence (Friedman and Modigliani). An estimate of risk aversion should fit the wide variety of situations involving uncertainty that we can observe (Mehra and Prescott). Estimates of labor supply should be consistent aggregate employment movements over time as well as cross-section, panel, and lifecycle evidence (Rogerson). This kind of cross-validation (or invalidation!) is only possible with models that have clear underlying economics: micro-foundations, if you like.

This is bread-and-butter stuff in the hard sciences. You try to estimate a given parameter in as many ways as you can, consistent with the same theory. If you can reduce a 3 orders of magnitude discrepancy to 1 order of magnitude you are making progress. Real science is hard work and you take what you can get.

"Unusual state"? Is that what we call it when our favorite models don't deliver what we had hoped? I would call that our usual state.

Wednesday, November 21, 2012

What the Economics Profession Looks Like to Yglesias

It took three weeks for Matt Yglesias to figure out that I was having fun at his expense. As my mother would have said, better late than never.

Yglesias tries to get my goat by arguing that people who talk about economic science are full of it. But here is something interesting:
Here's what I think about ambition. I think that if I were an ambitious monetary economist who believed in good faith that the current course being pursued by the FOMC will be ineffective in boosting employment and is likely to produce a troubling level of inflation, I'd be shouting that from the rooftops.
Why? Because when we're mired in inflation, all the whores and politicians will look up and shout "save us!" and they'll be shouting at the people who called it right. When Milton Friedman warned that the naive Phillips Curve economics being pursued by the Federal Reserve in the late-60s and 70s would lead to ruinous inflation, nobody listened to him. Until suddenly they did listen to him and low and behold Milton Friedman was super-famous. Developing a correct analysis of the situation and then explain it is obviously no guarantee of success in your career. But all else being equal, it tends to help. That said, sometimes things aren't equal. But I wonder what it is Williamson thinks isn't equal here? What job is Kocherlakota angling for? And how will pretending to believe something he knows is wrong help him get it?
This, I think, is a strange view of the economics profession, but possibly not so far away from how the average non-economist thinks. If you're an economist, you might be anticipating that Uncle Billy is going to ask you for a forecast tomorrow over Thanksgiving dinner, and you probably won't know what to tell him. Probably his forecast is as good as yours. Some economists are indeed forecasters, but most of us hardly think about the forecasting problem.

Yglesias has a story in his head about how Milton Friedman became "super-famous." Actually, Friedman was super-famous long before he made his 1968 address as President of the American Economic Association, and long long before the importance of that address was widely understood. Further, in terms of research impact, Friedman's influence today has more to do with the Friedman rule, the permanent income hypothesis, and the Monetary History.

Yglesias thinks that the way to get ahead in the economics profession is to make an outlier forecast, make a big noise about it, and hope that you're right. There's certainly a cynical view out there that says this works - Nouriel Roubini comes to mind. I guess Yglesias and I are very different. He puts himself in the shoes of an "ambitious monetary economist" and asks what he'd do. Maybe I'm not ambitious, or too old for it, but I think of everything I do as learning and teaching. I want to learn, and I enjoy passing the knowledge on to other people. Fame is for Yglesias and Lady Gaga.

On the particular questions at hand: First, it is indeed accurate that I think what the Fed has done recently (QE, Twist, forward guidance) matters little for US labor markets. Second, it is not accurate to say that I think a "troubling level of inflation" is "likely." Given current and planned monetary policy actions, and how I think the Fed will behave in the future, I can see an equilibrium path on which the inflation rate is higher than it should be. I can't say anything sensible about "likely." Actually, my hope is not that this comes to pass and people think I am remarkably prescient, but that I have some influence and it doesn't happen. That would be better for everyone, don't you think?

Second, there are plenty of economists for whom Narayana Kocherlakota is a puzzle. He may yet redeem himself, but my current thinking is the following. Nerds are valuable members of society. I think we should give them resources and room to work. But we should think twice about letting a nerd run anything.

Shameless Advertising

The fourth Canadian edition of my intermediate macro book is now out, though the Pearson web page claims you can't actually buy it yet. I have a physical copy of the thing, so you should be able to get it soon.

One innovation in this edition is a version of the Mortensen-Pissarides search model of unemployment, for undergraduates. This model has been with us for a very long time, and has been responsible for some Nobel prizes, so I thought its introduction to undergads was long overdue.

Some people ask me what the difference is between my Canadian and US books. The straight answer is that some Canadian institutions are different, as is the data, and examples. I usually make a joke out of it, though, and tell people that I have to translate into Canadian.


US English: My friend and I were going to the hockey game. I hadn't put the snow tires on my car, and perhaps I had had too many beers, and I ran into a moose. Boy, am I a loser.

Canadian English: Well, me and my buddy were goin to da hockey game, eh. No snow tires on the car, so she was slidin around a bit, not to mention we had been at the hotel playing shuffleboard and had got plowed. A big moose in the road, eh, and we hit her. What a hoser.

Monday, November 19, 2012

The Future of Federal Reserve Policy

If the rumors are correct, Ben Bernanke is likely to leave his post when his term ends on January 31, 2014. Bernanke's likely successor is Janet Yellen, who is currently Vice-Chairman (official title - not sure why they haven't dropped the "man") of the Federal Reserve Board, and former President of the San Francisco Fed. How does Janet Yellen think? We can get some ideas about that from her most recent speech.

Yellen's speech is primarily a defense of mainstream views on the FOMC, and I find some of those views troubling. Yellen argues that, in contrast to the bad old days of central bank secrecy, we are now in an age of Fed transparency. What the Fed says matters, and she is on board with policies that use Fed statements about its future policy actions - forward guidance - to influence the behavior of private economic agents. With regard to policy goals, Yellen favors a "balanced approach," whereby unemployment matters as much as inflation to Fed decision-makers. But what would that mean for policy decisions? This gives you an idea:
Put differently, the purpose of providing greater clarity about the FOMC's longer-run inflation goal is to anchor inflation expectations more firmly. These more firmly anchored expectations in turn free the Committee's hand to more actively and effectively stabilize short-run fluctuations in economic activity. The Committee can act in this way because the FOMC can tolerate transitory deviations of inflation from its objective in order to more forcefully stabilize employment without needing to worry that the public will mistake these actions as the pursuit of a higher or lower long-run inflation objective.
So given that the Fed is now so transparent and able to speak directly and honestly to the public about its goals for long run inflation, it is free to do almost anything in the short run to influence real economic activity. This seems like an excuse for perpetual postponement of decisions to come to terms with inflation.

For Yellen, the Phillips curve is alive and well:
...the essence of the balanced approach, is that reducing the deviation of one variable from its objective must at times involve allowing the other variable to move away from its objective. In particular, reducing inflation may sometimes require a monetary tightening that will lead to a temporary rise in unemployment. And a policy that reduces unemployment may, at times, result in inflation that could temporarily rise above its target.
We know where those ideas led us.

What would Yellen's "balanced approach" imply for economic policy over the foreseeable future? She's quite specific, particularly in how she evaluates policies:
...I need to rely, as I noted, on a specific macroeconomic model, and, for this purpose, I will employ the FRB/US model, one of the economic models commonly used at the Board.
That the FRB/US model is "commonly used at the Board," and that Yellen takes its policy implications seriously, is shocking. We don't know exactly what is in the FRB/US model, but my best guess from this 1996 publication (and it's pretty poor that the latest documentation on this thing is 16 years old) is that the FRB/US model looks much like the large-scale macroeconometric models that existed in 1970. These are basically elaborate, pseudo-dynamic IS/LM models, which were debunked as policy tools by the mid-1970s.

What does the FRB/US model have to tell us?
The optimal policy to implement this "balanced approach" to minimizing deviations from the inflation and unemployment goals involves keeping the federal funds rate close to zero until early 2016...
I should note here that, in addition to being a poor policy tool at any time, FRB/US knows absolutely nothing about quantitative easing, interest on reserves, how the world works when the Fed holds a very large stock of long-maturity Treasury bonds and mortgage-backed securities, what happens when there is a very large stock of reserves outstanding, or how a financial crisis matters. But Janet Yellen wants us to take this model seriously.

With regard to forward guidance, Yellen is all for publishing more detailed Fed forecasts, and being more explicit about the "liftoff" date.
the Committee might eliminate the calendar date entirely and replace it with guidance on the economic conditions that would need to prevail before liftoff of the federal funds rate might be judged appropriate. Several of my FOMC colleagues have advocated such an approach, and I am also strongly supportive. The idea is to define a zone of combinations of the unemployment rate and inflation within which the FOMC would continue to hold the federal funds rate in its current, near-zero range. For example, Charles Evans, president of the Chicago Fed, suggests that the FOMC should commit to hold the federal funds rate in its current low range at least until unemployment has declined below 7 percent, provided that inflation over the medium term remains below 3 percent. Narayana Kocherlakota, president of the Minneapolis Fed, suggests thresholds of 5.5 percent for unemployment and 2.25 percent for the medium-term inflation outlook. Under such an approach, liftoff would not be automatic once a threshold is reached; that decision would require further Committee deliberation and judgment.
This is a rather foolish idea. To be well understood, a liftoff rule has to be simple. It has to contain specific numerical goals, in terms of a few economic variables. But that is the liftoff rule's fatal flaw. Sensible central banking policy requires that policymakers look at everything. Unforeseen contingencies arise that would make it obvious that the liftoff rule should be abandoned, with an ensuing loss of credibility for the Fed. As well, the unemployment rate is a poor summary statistic for economic welfare, and the unemployment rate fluctuates for many reasons that the Fed should want to ignore.

To bring us down to earth, this speech by Charles Plosser, President of the Philadelphia Fed, is helpful. Janet Yellen thinks that monetary policy is a powerful tool for influencing real economic activity, but Plosser reminds us that modern economics tells us that it ain't so:
The ability of monetary policy to influence employment has long been recognized as tenuous at best. Indeed, the current workhorse models in macroeconomics rely on some form of wage or price stickiness to generate real effects of monetary policy. As wages and prices adjust, the effects of monetary policy on the real economy dissipate; in other words, the effects are transitory. In addition, the experience of the 1970s clearly demonstrated that attempts to use monetary policy to pursue an employment or unemployment target can lead to extremely poor economic outcomes, jeopardizing both employment and inflation.
People seem to forget this simple point. Outside of multiple-equilibrium models, which are not the "current workhorse models" taken seriously by central bankers, all models of short-run monetary non-neutrality involve transient real effects from monetary policy actions. Further, those real effects become smaller the more sophisticated economic agents become at seeing through central banking policy. Janet Yellen would like you to think that economic agents are so unsophisticated that they can't figure out how to adjust wages and prices in response to an announced future monetary policy, yet so sophisticated that they can predict the effects of the announced future monetary policy - for wages and prices. Further, she wants us to believe that the financial crisis - which happened in 2008 - will have lingering effects that need to be corrected by monetary policy, until 2016!

Plosser goes on in his speech to discuss the risks associated with current accommodative Fed policies. He sees those risks as associated with "moral hazard, future inflation, and loss of institutional credibility." On moral hazard, here's an interesting point:
By engaging in targeted purchases of housing-related securities, the Fed has affected expectations about what monetary policy will do in the future should the housing market take a sharp downturn. Will market participants price housing-related assets with the expectation that the Fed will protect the market from significant losses? Will investors in other markets expect similar treatment and therefore be encouraged to take excessive risk?
Those are useful points. Whether the Fed can move mortgage rates more - if at all - by purchasing mortgage-backed securities than long-maturity Treasuries, the perception is that it can. If firms and consumers take into account that the Fed will bail out their sector in the event of adverse events, this causes problems. Those firms and consumers will take on more risk than is socially desirable, and in the event that the Fed does not act as expected, the damage will be worse.

Here are Plosser's fundamental principles:
The first principle is to be clear and explicit about the goals and objectives of policy. And in so doing, policymakers must acknowledge what policy can and cannot achieve.

The second principle is for policymakers to make a credible commitment to their goals by describing how they will conduct policy in a way that is consistent with those goals. One way to do this is for the central bank to articulate a reaction function or rule that will guide policy decisions.

The third principle is to be clear and transparent in communicating to the public the policy actions that are taken.

The fourth principle is to strive to ensure central bank independence.
It's important to note that those principles aren't so different from Yellen's. That's important. A given statement of principles can lead you in entirely different directions.

In contrast to Yellen's "balanced approach," Plosser favors a "systematic approach," which again does not differ so much from what Yellen has in mind. Plosser likes "robust rules," which includes the class of Taylor rules. The Taylor rule of course takes account of both sides of the dual mandate. I'm not sure exactly what Plosser wants. He could mean a public announcement of a specific policy rule, or he could mean simply clear statements about the reasons for Fed policy decisions, which allow the private sector to deduce what the FOMC is up to. It matters which. The former type of systematic policy seems prone to the risks that Plosser is worried about.

Finally, Plosser appears to have no sympathy for liftoff targets.
In my view, this threshold approach could cause some long-lasting confusion, especially if the thresholds are misinterpreted as the FOMC’s longer-run policy goals. But how do you decide on the right numerical values? Moreover, if numerical thresholds were provided as a way to convey forward guidance for the fed funds rate, a numerical stopping rule would also be needed to convey when QE3 asset purchases could be expected to end. This means we may have multiple thresholds associated with multiple tools. It would be difficult to describe all the various conditions necessary for this multi-faceted strategy and communicate them to the public in a comprehensible and credible fashion. I am concerned that we would create more confusion than clarity.
This is an important point. In the Fed's attempt to be more transparent about the future, it may have only sown confusion. There are now multiple facets to the Fed's forward guidance. If even the most sophisticated financial market participants have figured this out, I would be very surprised.

Tuesday, November 6, 2012

Monday, November 5, 2012

Managing a Liqudity Trap: Monetary and Fiscal Policy

Ivan Werning's paper on liquidity traps is getting attention in the Federal Reserve System. For example, Narayana Kocherlakota cited the paper in a recent speech. Ivan presented a version of the paper at the 2011 St. Louis Fed Policy conference, which was where I saw it.

What's the paper about, and why would the FOMC be interested in it? The basic model Werning uses is a well-worked-over linearized New Keynesian sticky price model, much like what can be found, for example, in Clarida, Gali, and Gertler's survey paper. The key differences here are that Werning works in continuous time with no aggregate uncertainty, which is going to lend tractability to the problem. Further, he's going to solve an optimal policy problem. Perhaps surprisingly, New Keynesians do not often do that. The typical approach is to assume a Taylor rule for monetary policy, and go from there.

Here's the basic model(changing notation a bit):

(1) dx/dt = a[i(t)-r(t)-p(t)]
(2) dp/dt = bp(t)-kx(t)
(3) i(t) >= 0

x is the output gap, i is the nominal interest rate, r is the natural real rate of interest, and p is the inflation rate. a, b, and k are positive parameters. Equation (1) is an inverted Euler equation, equation (2) is a Phillips curve, and (3) imposes the zero lower bound on the nominal interest rate. Given an exogenous path r(t), the central bank determines i(t), and this determines a solution p(t) and x(t). Werning assumes a typical quadratic loss function, where bliss is taken to be a zero output gap and zero inflation.

What is an optimal monetary policy in this environment? If r(t)>=0 for all t, then the answer is easy. Bliss is attainable for all t. An optimal monetary policy is i(t)=r(t), which implies x(t)=p(t)=0.

The interesting question is what happens if r(t)<0 for some t. A simple example is r(t)=r1 for t<=T and r(t)=r2 for t>T, where r1<0 and r2>0. This will imply that bliss is not feasible for all t, and the zero lower bound (3) must bind at some dates. This is intended to look like the type of monetary policy problem that the Fed is currently faced with, as we'll see.

It will make a big difference whether or not the central bank is able to commit to a policy. With no commitment, we know that the central bank chooses i(t)=r(t) from date T on, with x(t)=p(t)=0 for t>T. Then we can work back to find the dynamic path up to time T. Before time T, we are in a liquidity trap, with i(t)=0, and things can be very bad. The output gap and the inflation rate are increasing, but until the time of liftoff there is a negative output gap and deflation. The problem gets worse the larger is T, i.e. the longer the liquidity trap scenario lasts.

Basically, the problem is that the real rate of interest is too high, and there is nothing the central bank can do about it, being constrained by the zero lower bound on the nominal interest rate. Further, the problem is compounded because of deflation during the liquidity trap period.

But, the central bank can do better if it can commit to a policy different from i(t)=r(t) after date T. After date T, the optimal policy with commitment is for the central bank to generate inflation above zero and an output boom (i.e. a positive output gap) after date T, which feeds back to the liquidity trap period, increasing inflation and output before period T.

You can see why people looking for a rationale for the FOMC's recent policy decisions like this paper. If you buy Werning's results, you might write something like the following in an FOMC statement:
To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.
The Fed is under a lot of pressure to "do something" about the weak labor market, and that pressure has been fed (no wordplay intended) by the Fed's confident statements about the efficacy of its policies. Apparently they are looking for serious research that will support what they are doing.

But how seriously do we want to take Werning's paper? Is this a basis for sound monetary policy in the circumstances we find ourselves in? I don't think so.

What's the shock that is driving the policy? As in much recent Keynesian analysis, the reason for being in a prolonged state with a binding zero lower bound on the nominal interest interest rate is that the "natural real rate of interest" is low (negative, in the model). In the underlying model, the natural interest rate is the real rate of interest under flexible prices. What would cause the real rate to be low? The underlying model is a standard neoclassical growth model, in which the natural rate of interest depends (with a constant relative risk aversion utility function) on the discount factor (from preferences) and consumption growth. The natural real rate goes down if the discount factor rises (people care more about the future) or if efficient consumption growth falls. We're supposed to think that the financial crisis was about everyone simultaneously taking a greater interest in the future? At the optimum, this would make them want to save more. Or maybe the financial crisis shock - whatever it was - should have resulted in lower than average consumption growth coming out of the recession? These things are inconsistent with the Keynesian ideas about intervention that I have been hearing.

In terms of the logic of the model, and what we know about the recent recession, the negative natural real rate shock does not make any sense. More fundamentally, this is a model which does not incorporate any financial factors. There is no credit, no banks, and in fact no money. Monetary policy is about setting a market nominal interest rate, and that's it. The model has nothing to say about quantitative easing, why it may or may not work, and how that policy fits into the forward guidance policy that Werning's paper is about. It seems particularly bizarre to be attempting to address monetary policy in the wake of the financial crisis in a model that can exhibit nothing that looks like a financial crisis.

Approximations. There are at least a couple of papers in which it is argued that nonlinearities are important at the zero lower bound, one by Villaverde and coauthors, the other by Braun and coauthors. Sometimes accounting properly for the nonlinearities doesn't just change the results quantitatively, but gives you qualitatively different results. It's a big deal. Werning uses the standard approach of linearizing around zero inflation, and then using a quadratic loss function to approximate welfare loss. I think the latter is suspect as well. As evidence that approximation may be leading Werning astray, look at his results on the effects of allowing for more price flexibility. Monetary policy in this model is all about correcting the price distortions that arise from price stickiness. Thus, one would expect that any monetary policy problems become less foreboding as prices get less sticky. That's not true in Werning's linearized model. In fact, in the economy without commitment, the output gap goes to minus infinity as price stickiness goes away in the limit. Something wrong there, I'm afraid.

Basic New Keynesian problems. I've come to think of the standard New Keynesian framework as a model of fiscal policy. The basic sticky price (or sticky wage) inefficiency comes from relative price distortions. Particularly given the zero lower bound on the nominal interest rate, monetary policy is the wrong vehicle for addressing the problem. Indeed, in Werning's model we can always get an efficient allocation with appropriately-set consumption taxes (see Correia et al., for example). I don't think the New Keynesians have captured what monetary policy is about.

Commitment. The original idea about monetary policy and commitment came from an example in Kydland and Prescott's paper. In that model, in the absence of commitment the central bank is always tempted to use inflation to increase the output gap. The result is a bad equilibrium with high inflation. That model was used to justify commitment to policy rules that would lower long-run inflation with no cost in terms of output. The Werning paper, and related work, is being used to turn that argument on its head. Now, we are supposed to think that committing to high inflation in the future, when the central bank would otherwise choose low inflation, will be a good thing. Whether Kydland and Prescott's monetary policy model was any good (it has its problems), the idea certainly played out well in the policy realm, beginning with the Volcker disinflation.

The forward guidance idea in FOMC policy, backed up by Werning's work (and Woodford's), may prove to be harmless. But maybe not. Some FOMC members, particularly Evans and Kocherlakota, seem bent on writing down explicit numerical criteria for future policy tightening. I hope they run up against resistance.

Friday, November 2, 2012

Dave Altig: Has Fed Behavior Changed?

I never thought I would be reporting regression results in public, let alone having people comment on those results. Life is full of surprises. Dave Altig has written a response to this blog post.

1. Dave points out that, given my crappy model, the current fed funds rate is well within a standard error of a predicted value of 1.1%. I am of course no Taylor rule fanatic, and am willing to blame Taylor for any shortcomings of his rule. Dave could also have pointed out that the relevant policy rate is the interest rate on reserves, which is the overnight nominal rate of return faced by most of the financial institutions in the system. The current fed funds rate is only relevant to the GSEs, who now do most of the lending in the fed funds market. 0.25% is even closer to 1.1% than the current fed funds rate, which makes Altig's case stronger. But hold on. Given past behavior, the FOMC should at least be considering that they will be increasing the policy rate soon. But they are promising to keep it where it is until mid-2015. Seems like a break with previous behavior, don't you think?

2. Here's Dave's dual mandate analogy:
Consider a homeowner with the dual mandate of keeping both the roof of the house and the driveway in good repair. If the roof isn't leaking but there are cracks in the driveway, I think you would expect to see the owner out on the weekend patching the concrete. I don't think you would conclude as a result that he or she had ceased caring as much about the condition of the roof. I do think you would conclude that attention is being focused where the problem exists.
I see it more like this. Suppose the homeowner has a husband. The dual mandate is: Keep the roof in good repair, and make sure the husband behaves well. Keeping the roof in good repair is a task with a well-defined goal, and the homeowner knows how to do it. Getting the husband to behave well is ill-defined, and at best the homeowner knows that she can only move him temporarily toward what she might see as well-behaved. She would be foolish to think otherwise.

Fed Speculation

Mark Thoma wonders what will happen at the Fed after the election. Bernanke's job must be unpleasant. This one is more interesting, and the salary is much better.

Wednesday, October 31, 2012

When is it Time to Take a Vacation?

Answer: When Matt Yglesias calls you a "hero of rigor."

Kocherlakota Joins the COGCB

What's the COGCB? Club of Goofy Central Bankers. Case in point: his speech yesterday. Kocherlakota tells us, if we didn't already know, that
...the Fed’s policy stance is considerably more accommodative than it was five years ago.
Of course, in terms of what the Fed says it cares about (the twelve-month rate of increase in the pce deflator and the unemployment rate), the Fed has been considerably more accommodative than it would have been, pre-2008, if the same state of the world had occurred, as I pointed out here. Thus, the behavior of the FOMC has changed. Either it cares about some things it did not care about before (and in a particular way), or it cares about the same things in different ways - in particular it is less concerned about its price stability mandate.

The Fed may have good reasons for changing its behavior. If so, Fed officials should articulate those reasons in public, so that we can debate the issues. That seems to be what Kocherlakota is attempting here, and he goes even further than you might expect. His conclusion is:
...monetary policy is, if anything, too tight, not too easy.
If you have not fainted and fallen on the floor, take a couple of deep breaths, and we'll figure out what Narayana has on his mind. His argument is:

1. We had a big shock, and this calls for extreme measures.
2. The current inflation rate is too low.
3. Forecast inflation is too low:
Current monetary policy is typically thought to affect inflation with a one- to two-year lag. This means that we should always judge the appropriateness of current monetary policy using our best possible forecast of inflation, not current inflation. Along those lines, most FOMC participants expect that inflation will remain at or below 2 percent over the next one to two years.

Big shock: Of course we had the big shock - four years ago. Now, in 2012, what is it about that big shock that creates macroeconomic inefficiency that can be corrected by central bank action - and by central bank action that has not already been executed? Prices and wages are so sticky they have not adjusted? We are in the midst of some coordination failure that Ben Bernanke (or Narayana Kocherlakota for that matter) can fix? What? There has been massive intervention on an unprecedented scale, and the Fed was in the midst of a transformation of the maturity structure of its asset holdings when it embarked on its most recent asset purchase program. How much is enough? I'm sure you don't have any idea, and I'm afraid the Fed, in spite of its brave front, really has no idea either.

Is the inflation rate too low? It depends how you measure it. The Fed's inflation target is 2%, as measured by the pce deflator. The inflation rate, August 2011 to August 2012, is 1.5%, which is the number Kocherlakota uses. From September 2011 to September 2012, the number is 1.7%. If we look at a shorter horizon, the annualized percentage increase in August was 5.0%, and in September was 4.7%. If we look at a longer horizon, as I did here, from the beginning of 2007 or the beginning of 2009, you'll get something a little higher than 2.0% (I didn't have the most recent observation in the chart in the previous post). Too low? I don't think so.

Monetary policy should respond to forecast inflation, not actual inflation. You would think Kocheralakota would know better. Does a forecast give us any more information than what is in the currently available data? Of course not. It's the currently available data that we use to make the forecast. Further, the "best possible forecast of inflation" is not very good, in general, and the Fed's forecast of inflation is suspect. Any economic forecast is 90% judgement and 10% model, and the judgement of Fed forecasters is going to drive the forecast to something that justifies current policy actions. Arguing that the the Fed's forecasts could justify a more accommodative policy than what we already have is nonsense.

On April 8, 2010, Kocherlakota said this:
Deposit institutions are holding over a trillion dollars in excess reserves (that is, over 15 times what they are required to hold given their deposits). These excess reserves create the potential for high inflation. Suppose that households believe that prices will rise. They would then demand more deposits to use for transactions. Banks can readily accommodate this extra demand, because they are holding so many excess reserves. These extra deposits become extra money chasing the same amount of goods and so generate upward pressure on prices. The households’ inflationary expectations would, in fact, become self-fulfilling.
So the Kocherlakota of 2 1/2 years ago had some worries about the potential for inflation. Maybe he changed his mind for good reason? I don't think so. The new Kocheralakota seems to be a flimsy-excuse guy.

Addendum: Kocherlakota goes on in the same speech I quote from in the last paragraph to say this:
I hasten to say—and I want to stress—that I view this scenario as unlikely. For it to transpire, the country would need a combination of bad monetary policy and poor fiscal management. I do not foresee this combination as likely to occur.
That's important. We now have bad monetary policy and poor fiscal management (whoever is elected President next week - worse if it's Romney). The stunning thing here is that the old Kocherlakota didn't imagine that he would be the source of the bad monetary policy.

Thursday, October 25, 2012

FOMC Behavior and the Dual Mandate

In the most recent FOMC statement, we are told the following:
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee remains concerned that, without sufficient policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that inflation over the medium term likely would run at or below its 2 percent objective.
The argument is that we need more accommodative policy because: (i) the FOMC expects that, without such policy, there would be insufficient improvement in the state of the labor market and (ii) inflation is expected to continue below the FOMC's target of 2%. Thus, the FOMC anticipates that it will be missing on both sides of its dual mandate in the immediate future unless it does something about it.

Does the FOMC have it right? I have no idea whether the Fed is confident in its forecasts, whether we would think those forecasts are any good if we knew how they were done, etc., so all I can do is look at actual data. With respect to the "price stability" part of the dual mandate, the Fed has decided that the rate of increase in the PCE deflator is the appropriate measure of inflation. The first chart shows the twelve-month percentage increase in the PCE deflator.
As you can see, by this measure inflation is well below the 2% target - it's about 1.5% currently. But it was also well above the target for much of 2011 and early 2012. At that time, for example in the June 2011 policy statement, the FOMC was inclined to discount what it was seeing:
Inflation has moved up recently, but the Committee anticipates that inflation will subside to levels at or below those consistent with the Committee's dual mandate as the effects of past energy and other commodity price increases dissipate.
When the FOMC highlights the volatile nature of inflation on the upside and fails to mention it on the downside, one can't help but be suspicious. Further, suppose that we look at the price data in another way, as in the next chart.
In this chart, I show the pce deflator, and a 2% trend, beginning in January 2007. If we were judging the Fed's performance according to a price level target, as in the chart, we would think it was doing phenomenally well. Since early 2009, the actual PCE deflator has not strayed far from its target path, and is currently right on target, particularly with the large increase in the last month.

What about the other part of the Fed's mandate? We can argue about what an economically efficient level of aggregate economic activity is currently in the United States and what influence the Fed can have over it. But what if we take a standard central-banker-New-or-Old-Keynesian approach - something like what I describe in this post? The Congressional Budget Office (CBO) thinks that the current "short-term natural rate of unemployment" is 6%. I have no idea what they think that means, or if it makes any sense at all, but we'll use that number. The actual rate of unemployment is 7.8%, so by the CBO's criterion, the Fed is missing on this side of the mandate.

New Keynesians like to think about monetary policy in terms of a Taylor rule, which specifies a target for the federal funds rate as a function of the "output gap" and the deviation of the actual inflation rate from its target value. According to standard Taylor rules, the fed funds target should go down when the output gap rises and up when the inflation rate rises. You can even fit Taylor rules to the data. I fit one to quarterly data for 1987-2007, and obtained the following:

R = 2.02 - 1.48(U-U*) + 1.17P,

where R is the fed funds rate, U is the unemployment rate, U* is the CBO natural rate of unemployment (so U-U* is my measure of the output gap) and P is the year-over-year percentage increase in the PCE deflator. You can see how it fits the historical data in the next chart.
So that's how the Fed behaved in the past. If it were behaving in the same way today, what would it be doing? Given that U = 7.8, U* = 6.0, and P = 1.5, my Taylor rule predicts R = 1.1%.

Thus, the FOMC may see itself as missing on both sides of its mandate, but if it had been missing in the same way in 1997, the fed funds rate target would be at 1.1%, and the Fed would certainly not have been considering large-scale asset purchase programs, let alone making promises to keep the fed funds rate at 0-0.25% for almost three years into the future.

So, the Fed's behavior seems to have changed. Maybe change is good. Who is to say that behavior from 1987-2007 was optimal? One argument for an extended period of low nominal interest rates comes from Eggertsson and Woodford, and I raise some doubts about that here. Even if you buy Eggertsson Woodford, their extended-period arguments are a matter of fulfilling a commitment, not getting some extra accommodative mileage currently. People who use the Eggertsson-Woodford argument are imagining the extended period to be well off in the future, not where we are now.

But one view of the Fed's behavior could be that it has simply lost its inflation resolve. If that view catches on, look out.

More on Bubbles

This will perturb David Andolfatto, who has heard enough about bubbles. But Andolfatto perturbation is enjoyable, for some reason, so here goes. Ben Lester told me about this 1993 paper by Allen, Morris, and Postlewaite on bubbles. Here's the relevant quote:
I think that corresponds quite closely to what I had in mind here (and see this post as well). I'll leave you to judge whether Allen, Morris, and Postlewaite are better or worse economic theorists than Paul Krugman or Noah Smith.

Monday, October 22, 2012

Money and Bubbles

Money. Bubble. Liquidity. Fire sale. Those words are used a lot, particularly with reference to the recent financial crisis. Sometimes the words are used as if we all agree on what they mean, but if you engage anyone in a discussion about any of them, you'll find a distinct lack of agreement. I've seen several shouting matches in seminar rooms over what "bubble" means. Thus, it's not surprising that Noah Smith, Paul Krugman, and I don't think about bubbles in the same way.

From my previous post, here's my bubble definition, with examples:
What is a bubble? You certainly can't know it's a bubble by just looking at it. You need a model. (i) Write down a model that determines asset prices. (ii) Determine what the actual underlying payoffs are on each asset. (iii) Calculate each asset's "fundamental," which is the expected present value of these underlying payoffs, using the appropriate discount factors. (iv) The difference between the asset's actual price and the fundamental is the bubble. Money, for example, is a pure bubble, as its fundamental is zero. There is a bubble component to government debt, due to the fact that it is used in financial transactions (just as money is used in retail transactions) and as collateral. Thus bubbles can be a good thing. We would not compare an economy with money to one without money and argue that the people in the monetary economy are "spending too much," would we?

Noah Smith and I once had a conversation along these lines, and I thought we were making progress, but apparently not. Noah says the above paragraph is nonsense, since most payoffs on assets in monetary economies (like the one we live in) are denominated in terms of money. Thus, Noah reasons, if money is a bubble, then all assets are bubbles. How dumb could I be?

The payoffs on my stocks and bonds, and the sale of my house, may be denominated in dollars, but that does not mean that the value of those assets is somehow derived from the value of money. It's useful to ask what would happen if the monetary bubble "bursts." Think about an identical economy where money is not valued (that's always an equilibrium) and ask what happens. Everything changes of course, as now it's more difficult to carry out transactions - but not impossible. People will find other means to get the job done. Private financial intermediaries will issue substitutes for government money; people might engage in barter; people might use commodity monies. There is no reason why stocks and bonds and houses can't exist and be traded, with payoffs denominated in terms of something other than government-issued liabilities. Indeed, because private assets are substituting for government liabilities in exchange, some of those assets will have larger bubble components than in the monetary economy.

To give a practical example, think about monetary arrangements in the United States during the free banking era before the civil war. There was no fiat money or central bank. Transactions were executed primarily using the paper notes issued by private, state-chartered, banks, and using commodity money. Think of the role that gold played in that era. The price of gold had a bubble component as the stuff was used in exchange. It's not used in exchange today, so the bubble has gone away.

Here's Krugman's bubble definition:
I’d start by asking, what do we mean when we talk about bubbles? Basically, I’d argue, we mean that people are basing their decisions on beliefs about the future that are based on recent experience but can’t be fulfilled. E.g., people buy houses because they expect home prices to keep rising at a pace that would eventually leave nobody able to buy a first home...This sounds a lot like what happens in a Ponzi scheme...
It's different, right? My definition was based on rationality, and bubbles can be sustained forever. The crucial elements of a Krugman bubble are irrationality, and lack of sustainability. That's pretty much where the discussion ends. Krugman finds his notion of a bubble useful. I find mine useful. Krugman is in the Shiller bubble camp. I'm in the monetary theorist bubble camp.

Here's something interesting, though. Toward the end of his post, Krugman discusses fiat money, and Samuelson's overlapping generations (OG) model, which is one framework for thinking about money and what it does. No one took this model seriously as a model of money for a long time, perhaps because the tone of Samuelson's article is half-serious. However, Lucas used it in his 1972 paper, and this inspired Neil Wallace and his Minnesota students in the early 1980s to develop it further. The OG model captures Jevons's absence-of-double-coincidence problem in a nice way, it's easy to work with, and it admits complications like credit arrangements in a simple manner. Indeed, this book by Champ/Freeman/Haslag is essentially OG models for undergraduates.

One interesting feature of an equilibrium with valued money in the OG model, is that it looks like a Ponzi scheme - i.e. it has a feature Krugman associates with his bubble. And it's sustained forever. In each period, the young transfer goods to the old in the belief that they will receive goods when old from the next generation. Indeed, that arrangement looks just like social security, which is also a Ponzi scheme, though Krugman doesn't want to admit it. There's nothing wrong with it of course. Under the right conditions, social security can be an efficient and sustainable Ponzi scheme.

Saturday, October 20, 2012

The State of the World

There is some stuff in this Krugman blog post that is worth discussing. It's hard to get past his usual self-aggrandizement (I am a remarkably prescient forecaster; I am an island of clarity in an ocean of confusion; blah blah blah), but I'll try. We need to be tolerant, even when it's hard.

Here's what Krugman thinks is the key effect of the financial crisis:
Here’s how I interpret what we see in the historical data: financial crises leave an overhang of private-sector problems, principally excessive debt on the part of some subset of economic agents — households, in the case of the United States. Because these agents are either forced or strongly induced to slash spending, the “natural” rate of interest, the interest rate consistent with full employment, falls sharply — and in the case of a severe crisis, falls well below zero.
He's got the sign wrong. Suppose that for various reasons debt constraints bind more severely. That's in Eggertsson-Krugman for example. They just impose debt limits exogenously, but you could do something more sophisticated and tie the debt limits to the value of collateral, or what a would-be borrower stands to lose from default. In any case, what you get is more severe credit frictions, which make safe assets - government debt and safe private liabilities - more valuable. Why? These assets are now more useful at the margin in financial trade and as collateral. The safe market rate of interest is now too low, relative to where it should, or could, be. The "natural rate of interest" has not fallen. For more detail, see this post, point #1.

Krugman thinks economists and policymakers (past and present) are subject to "conceptual confusion." According to him, there are three facets to this:

1. Krugman is worried that people think he is being inconsistent (see my previous post for example). How can the Reinhart-Rogoff regularity (extended recovery after a financial crisis) be a regularity, and also represent an opportunity for Keynesian policy? Here's the heart of Krugman's argument:
...there are simple policy actions that could quickly end this depression now, there were simple policy actions that could have quickly ended depressions past. The problem is that now and then policy makers tend not to take these actions — which is why some of us write books.
A simple and quick solution is at hand. Easy. To buy this argument, you have to think that Krugman is really really smart, and the remainder of the human race is really really stupid. There are plenty of economists - with and without Nobel prizes - who don't think the solutions are easy.

2. Demand/supply and bubbles:
Over and over again one hears that we can’t expect to return to 2007 levels of employment, because there was a bubble back then. But what is a bubble? It’s a situation in which some people are spending too much — and we can’t expect those people to return to past spending habits.
What is a bubble? You certainly can't know it's a bubble by just looking at it. You need a model. (i) Write down a model that determines asset prices. (ii) Determine what the actual underlying payoffs are on each asset. (iii) Calculate each asset's "fundamental," which is the expected present value of these underlying payoffs, using the appropriate discount factors. (iv) The difference between the asset's actual price and the fundamental is the bubble. Money, for example, is a pure bubble, as its fundamental is zero. There is a bubble component to government debt, due to the fact that it is used in financial transactions (just as money is used in retail transactions) and as collateral. Thus bubbles can be a good thing. We would not compare an economy with money to one without money and argue that the people in the monetary economy are "spending too much," would we?

But the bubble component of housing prices after, say, 2000, does not appear to have been entirely a good thing, as it was built on false pretenses. Various kinds of deception resulted in housing prices - and prices of mortgage-related assets - that, by anyone's measure, exceeded what was socially optimal. As a result, I think we can make the case that pre-2008 real GDP in the US was higher than it would have been otherwise. Further, the housing-market and mortgage-market boom could have masked underlying changes taking place in US labor markets - for example David Autor's "hollowing out" phenomenon. One could argue that there was a cumulative effect in terms of the labor market adjustments needed, and that these adjustments took place during the recent recession, and are still taking place. See for example this paper by Jaimovich and Siu. That's why all the long-term unemployed. So that's not some confusion. People are talking about alternative ideas that have some legs, and may have quantitative significance. Why dismiss them?

3. Sectoral shifts:
One last point: we still keep hearing the “structural” argument, that we have to expect prolonged high unemployment because it takes time to turn construction workers into manufacturing workers or whatever. One answer is that this portrait of the economy is factually wrong: job losses have not been concentrated in a few sectors or professions, they have been broadly spread across the economy. But there’s also a conceptual answer: if shifting workers across sectors requires mass unemployment, how come the bubble years — when we were moving out of manufacturing into housing — weren’t high-unemployment years? Why does moving into the bubble sectors mean more jobs, but moving out into other sectors mean fewer jobs? I’ve never heard a coherent answer.
Answer: If you're not listening, you can't hear. There is plenty of unusual behavior in the recent labor market data: (i) the jobless recoveries that Krugman highlights here; (ii) the large drop in employment relative to output in the recent recession; (iii) the abnormally large fraction of long-term unemployed. One element of unusual behavior is the failure of residential construction to lead the recovery. David Autor and others (as mentioned above) have highlighted the recent shift out of middle-skill occupations. There is plenty here for any labor economist or macroeconomist to sink their teeth into. How do you tie together the financial crisis, the shifts in employment across sectors, and the changes in the skill mix? It's well-known that sectoral changes have macroeconomic consequences - economists have been discussing this at least since the early 1980s.

So, there is a lot going on. If we want to think of our current predicament as an aggregate demand management problem, we're missing all or most of what is important. It's certainly not simple, but it's a lot more interesting than an IS-LM model.

Friday, October 19, 2012

Financial Crises

I just received Gary Gorton's new book, Misunderstanding Financial Crises in the mail. This is as good an account of the financial crisis as any I have seen, and adds to Gary's previous book, Slapped by the Invisible Hand. Gary has an unusually broad grasp of banking history, modern banking theory, financial theory, and the practical aspects of modern finance and institutions. Indeed, some of his consulting work placed him at the center of the financial crisis. In the late 1980s, Gary taught me that securitization was important, long before most economists had any idea what that was about. I don't agree with everything he writes, but you can learn a lot from his new book.

Lucas once said that business cycles are all alike. Gorton wants to focus on what makes financial crises all alike. His key point seems to be that, in any financial crisis, we can find a run. In the United States, bank runs were a key feature of panic episodes during the National Banking era (1863-1913) and the Great Depression. Bank runs were certainly not a feature of the recent financial crisis, but Gorton thinks that "repo runs" were essentially the same phenomenon.

Gorton's idea is that any financial entity that intermediates across maturities can be subject to a run. The Diamond-Dybvig view is that bank runs are inherent to the liquidity transformation carried out by banks. A well-diversified bank transforms illiquid assets into liquid liabilities, subject to withdrawal. Everything is fine unless depositors anticipate that others will run on the bank, in which case we find ourselves in a bad equilibrium - a bank run. In the run equilibrium, it is optimal for each depositor to run to the bank to withdraw his or her deposit, since their best hope in this equilibrium is to get to the bank before the assets are exhausted.

A shadow bank is not quite like a Diamond-Dybvig bank. A typical shadow bank holds long-maturity liquid assets and finances its portfolio by rolling over short-term repos (repurchase agreements), using the underlying assets as collateral. One might think that, because the shadow bank's assets are liquid, a run could never occur. If financial market participants are reluctant to roll over the shadow bank's repos, it can sell assets to pay off its debts. The problem arises if there is a systemic revaluation of shadow bank assets. Then, an individual shadow bank could default because new repo holders are demanding large haircuts in their repo contracts. Worse, since all shadow banks are selling assets simultaneously, the prices of assets are further depressed (a fire sale), which amplifies the repo run.

A debt contract is an efficient arrangement that works extremely well in good times. The payments required under a debt contract are non-contingent, and there is no fuss about what it means to fulfill the terms of the contract. Problems occur in default states, however, particularly when there are multiple creditors. For a bank, the coordination problem that arises in the event of default is particularly severe, given the large number of small depositors. However, coordination can be very costly even if a financial institution's creditors consist of a few other financial institutions. In a Diamond-Dybvig model, coordination is formalized as "sequential service," which inhibits communication among the bank's depositors in a rather brutal fashion. Of course, a shadow bank run really has nothing to do with creditors "lining up" at the shadow bank, so we can't take sequential service literally if we want to think of repo runs as akin to Diamond-Dybvig runs.

Coordination costs that arise in a default involving multiple creditors are reflected in legal costs, and the time that assets are tied up in litigation. In the case of banking, deposit insurance minimizes those costs in a nice way. The FDIC stands in for all creditors, thus eliminating the replication of default costs among creditors and doing away with disputes among creditors. Further, resolution occurs quickly. Of course, we all know about the fallout from insuring the liabilities of financial intermediaries. Absent constraints on risk-taking, insurance creates a moral hazard problem, whereby intermediaries take on more risk than is socially optimal.

So if, as Gorton suggests, a financial crisis is defined by widespread runs on financial intermediaries, how is that helpful?

1. Does this mean that central banks should respond to every financial crisis in the same way? Probably not. Banking panics in the National Banking era and the Great Depression were essentially currency shortages. The recent financial crisis involved a shortage of safe assets, more broadly. A currency shortage can be solved with a central bank open market purchase of government debt. A shortage of safe assets may be a problem for fiscal policy - as asset swaps by the central bank will not change the net supply of safe assets. Further, central bank lending policies may depend on the particulars of the crisis.

2. If we think of a financial crisis as a run problem, and draw an analogy to banking and deposit insurance, this must mean we should insure everything that looks vaguely like banking. Moral hazard everywhere. Great.

3. One of the lessons of the financial crisis is that financial factors are important. Surprisingly, many people once thought otherwise, and some continue to think so. But the importance of financial factors is not confined to the events we want to call "financial crises." It seems wrongheaded to take episodes in history and put them in "crisis" and "non-crisis" bins.

You can see how fussing over what is a financial crisis and what is not can be unproductive. Case in point:

1. Reinhart and Rogoff define a financial crisis in a particular way, and argue that there is a regularity in the data. Recoveries after financial crises are protracted. People use that "fact" in different ways. Jim Bullard wants to argue that the Reinhart-Rogoff regularity tells us that the Fed should not held responsible for the slow recovery. Paul Krugman wants to use the Reinhart-Rogoff regularity to absolve the Obama administration. Of course, he is walking a fine line here as, in contrast to Bullard (apparently) he seems to think that appropriate monetary and fiscal policy would have left Reinhart and Rogoff with no regularity to talk about.

2. Mike Bordo and Joe Haubrich define a financial crisis differently (from Reinhart and Rogoff) and argue that, in the United States, it's hard to argue that the Reinhart/Rogoff regularity is in the data. Sometimes we see it. Sometimes we don't. John Taylor picks up on this. Like Krugman, he has an ax to grind - different ax though. According to Taylor, things are worse than they should be because of you-know-who.

Taylor does point out something useful, though, and quotes Bordo:
The mistaken view comes largely from the 2009 book “This Time Is Different,” by economists Carmen Reinhart and Kenneth Rogoff, and other studies based on the experience of several countries in recent decades. The problem with these studies is that they lump together countries with diverse institutions, financial structures and economic policies.
That's important. The U.S. financial system is unique in many ways. It still has many small banks; U.S. financial regulation is unusually complicated, with a confusing patchwork of overlapping regulatory authority; the U.S. supplies the world's reserve currency; the Fed intervenes in different ways because of peculiarities in our financial markets. The comparison with Canada is useful. Canada and the U.S. are similar in many ways, but it is difficult or impossible to find anything that Reinhart-Rogoff or Bordo-Haubrich would call a financial crisis, in all of Canadian history. How come? They have debt contracts, banking, and financial intermediation across maturities in Canada. Why no panics?

Why indeed. Definitions and data give us something, but they can't substitute for theories that can help us organize our thinking about the data. The immediate question is whether or not the monetary and fiscal authorities in the United States are doing the appropriate things. There are good reasons to think that recessions are not alike, and that the most recent recession has features that are different from previous ones in the United States - and different in important ways from episodes where we think that there was some element of "financial crisis." Even if we could figure out the Great Depression, and understood completely the policies that would have been appropriate at the time, that would be no guarantee of success under current conditions.