Monday, August 24, 2015

Summers at Summer's End

Two comments on Larry Summers's piece from yesterday:

1. Summers says:
I doubt that, if rates were now 4 per cent, there would be much pressure to raise them.
I think what Summers means is that, if everything else looked the same, and if the interest rate on reserves were at 4%, then people might be drawing different policy conclusions. But of course, that's an odd counterfactual to be thinking about, as it's hard to imagine how everything else would look the same. So, consider the following counterfactual. The last time the fed funds rate was at 4% was in January of 2008. So, suppose at that time that the Fed had not reduced the fed funds rate target, but had maintained it at 4%. Suppose all other aspects of policy were the same - the interventions during the financial crisis, the Fed's balance sheet expansion etc., and that the Fed commenced paying interest on reserves at 4% in fall 2008, and maintained that until now. What would have been different? A long history of research in monetary economics - theory and empirical work - tells us that the recession would have likely been more painful and perhaps longer. But as of today, six years after the recession actually ended, on the real side of the economy things would not have looked much different. But with nominal interest rates at 4%, standard Irving Fisher economics - which is built into every monetary model that I know about - tells us that the inflation rate would be 4% higher. So in that sense, Summers is absolutely right. If rates were now at 4 per cent, and given the Fed's 2% inflation target, we would be missing the inflation target on the high side, and the pressures would be quite different.

2. Toward the end of his piece, Summers says:
Much more plausible is the view that, for reasons rooted in technological and demographic change and reinforced by greater regulation of the financial sector, the global economy has difficulty generating demand for all that can be produced. This is the “secular stagnation” diagnosis, or the very similar idea that Ben Bernanke, former Fed chairman, has urged of a “savings glut”. - See more at:
As I pointed out to a commenter on this previous post, savings gluts and secular stagnation are actually quite different. Summers and Bernanke are thinking in terms of a simple model of the credit market. There is a demand for loans determined in part by the demand for investment, with demand depending negatively on the real interest rate. There is a supply of loans that depends on savings behavior, and loan supply depends positively on the real interest rate. Secular stagnation is low demand which makes the real interest rate low, savings glut is high supply that makes the real interest rate low. Entirely different. Note further, that the measurements reported here seem to put the kabosh on the secular stagnation idea.

Paul Krugman agrees with Summers:
I’m with Larry here: this attitude has the makings of a big mistake. Think Japan 2000; think ECB 2011; think Sweden. Don’t do it.
I think what he means is that Japan in 2000, the ECB in 2011, and Sweden (presumably 2011 also), did the wrong thing, saw the errors of their ways, and went back to zero or lower nominal interest rates. Currently, the overnight interest rate in Japan is 0.1%, the ECB deposit facility rate (the counterpart of the interest rate on reserves) is -0.2%, and the overnight interest rate in Sweden is -0.35%. It seems that Krugman approves of that, but the Bank of Japan, the ECB, and the Riksbank have certainly not been successful in achieving their goals. All of these central banks would like 2% inflation, but inflation in Japan is currently 0.4%, inflation in the Euro area is at 0.2%, and inflation in Sweden is at -0.1%. I'm sure Krugman (and Summers too) is thinking that a long period with very low nominal interest rates makes the inflation rate go up, but the last 20 years in Japan and this recent experience in other countries might make him want to think twice.

Sunday, August 23, 2015

Gomme, Ravikumar, and Rupert on the Rate of Return to Capital

Paul Gomme, Ravikumar, and Peter Rupert would like to respond to comments on their 2011 RED paper, and St. Louis Fed Economic Synopsis, in blog posts by Noah Smith and Robert Waldmann. Here, I've put in my own words the results of some email conversations with them.

When investment expenditure takes place, the economic measure of the cost of investment is resources foregone, which we measure in the national income accounts as the real value (units of real GDP) of investment expenditure. Then, for example, if there is one unit of investment expenditure, in units of real GDP today, and that unit of investment expenditure becomes usable capital in the future and yields to the owner of the capital a payoff of r in units of real GDP, net of depreciation, we would say that the capital has a rate of return r and, if we've measured depreciation properly, we know how many units of capital we have left, in units of real GDP.

So, note that in defining the rate of return on capital, we don't have to think about market interest rates, discounting, or how the investment is financed. Those things are relevant for the investment decision, but not for calculating the rate of return on investment, or for determining the economic cost of investment. This is just accounting - not corporate finance.

In the 2011 paper by Gomme et al., the idea is to measure average r at a point in time. In this chart, from their Economic Synopsis, they show us before-tax and after tax rates of return on all capital, and on business capital:
For those calcuations, Gomme et al. work with the measurements the Bureau of Economic Analysis (our national income accountants) provide. In particular, from the flow national income accounts - income side - they take the flow income that can be attributed as factor payments to the owners of the relevant component of the capital stock, then divide by the relevant capital stock, which is also measured by the BEA. So, that is an average rate of return on capital, net of depreciation, measured as a ratio of income (in units of real GDP) to capital (in units of real GDP).

Note that the Gomme et al. measure is net of depreciation. On page 2-9 of the BEA manual the BEA shows us how they calculate gross domestic income. The profits measure is net of depreciation, and then the BEA adds depreciation back in to get gross domestic income (that's what "gross" means - GDP and GDI do not net out depreciation). So the Gomme et al. rate of return is not too high because they fail to net out depreciation.

Another complaint (from Waldmann) relates to the fact that, for investment decisions, what we care about is capital's marginal rate of return, not average. Of course, if the production function is Cobb-Douglass, then the marginal product of capital is proportional to the average product of capital, so in that case it does not make any difference whether we're looking at average or marginal. By continuity, anything close to Cobb-Douglass will work as well. In any case, it's hard to imagine why the average return on existing capital would increase as observed without a commensurate increase in the marginal product of capital, or why investment would have increased as it did post-recession unless the marginal product of capital had increased in line with average product.

The main thrust of the Economic Synopsis related to "secular stagnation." Larry Summers holds the view that investment expenditures are stagnant because the rate of return on capital is low. Gomme et al. say that no, as measured, the rate of return on capital is not low and, by the way, investment does not appear to be stagnating. "Stagnation" seems an odd characterization given the data, as Gomme et al. point out. That's not saying that the behavior of of investment is not somehow puzzling, i.e. that we don't have to work hard to explain how it is behaving. Just to repeat, here are Figures 3 and 4 from Gomme et al., which certainly don't look like stagnation in investment spending:

In his post, Noah Smith does in fact express puzzlement that the rates of return in the first chart above are so high currently, while the corporate bond rate is so low. That is, he thinks that investment should be even higher than it is, given those observations, which leads him to conclude:
I suspect that either 1) Gomme et al. have measured the return on capital incorrectly, or 2) basic corporate finance theory doesn't capture what's going on in our economy, or 3) both.
If the recent behavior of investment puzzles Noah, he should also be puzzled as to why there was an investment boom in the 1990s when corporate bonds rates were so high. And if he's worried about the measurement that Gomme et al. report, he should take that up with the Bureau of Economic Analysis.

Friday, August 21, 2015

Krugman Comes Around

I opened up my New York Times (literally - I still retrieve the physical NYT from the curb, the bushes, the mud puddle) and was pleased as could be to see that Paul Krugman has finally picked up on what I think is a key idea for understanding macroeconomic behavior post-financial crisis. The essence of the idea is:
When the housing bubble burst, all that AAA-rated paper turned into sludge. So investors scurried back into the haven provided by the debt of the United States and a few other major economies. In the process they drove interest rates on that debt way down.
I could also add that sovereign debt problems in the world contribute to shortages of safe assets, as do new banking regulations, for example the liquidity coverage ratio requirements in Basel III.

I've written extensively about safe asset shortages, particularly their consequences for monetary policy. You can find that stuff in my blog archive, working papers, and forthcoming and published work, for example:

Scarcity of Safe Assets, Inflation, and the Policy Trap, with David Andolfatto
Scarce Collateral, the Term Premium, and Quantitative Easing
Central Bank Purchases of Private Assets

A safe asset shortage is actually a property of Krugman's own model, though I'm not sure he ever picked up on this. Krugman used his work with Gauti Eggertsson to back up with formal analysis the kinds of things he was saying in blog posts. So, the Eggertsson/Krugman paper focused on a situation in which the nominal interest rate is at the zero lower bound because of tight borrowing constraints, in which case you can get some welfare benefits from increasing government spending. What fixes the problem in his model, in a clean way, is actually an increase in government debt, which serves to relax borrowing constraints and to raise the real interest rate. That is, because of the safe asset shortage the real interest rate is inefficiently low, and fixing the problem raises the real rate.

Recognizing the existence of a safe asset shortage can help explain a lot of things. For example, you might think that inflation is puzzlingly high. In most models we work with, a long period of zero nominal interest rates would produce a deflation. But, at the zero lower bound on the nominal interest rate, the tighter are the liquidity constraints that bind because of the safe asset shortage, the higher will be the inflation rate. To see how that works, see the papers I listed above.

Safe asset shortages also have a bearing on how we might think about "secular stagnation," which Larry Summers has been talking about. Eggertsson and Mehrotra's "A Model of Secular Stagnation," is, like Eggertsson/Krugman, actually a model of a safe asset shortage. E-M write down a fairly conventional overlapping generations model with some borrowing and lending and a binding borrowing constraint. This economy wants an outside asset badly - both to permit intergenerational trade and to bypass the borrowing constraint. But that's not something the authors consider.

In any case, there's hope for Paul Krugman. Maybe soon he'll be a committed neo-Fisherite.

Wednesday, August 19, 2015

Tuesday, August 18, 2015

Some Real Interest Rates Are Low, But Some Others Are Not

Observed real interest rates on U.S. government debt are, by any measure, low. For example, here's the 30-day T-bill rate minus the inflation rate:
And this is the yield on 10-year TIPS:
John Cochrane has a post which references a recent Council of Economic Advisors survey on low real interest rates, which contains a useful summary of what is known about this. As well, Ben Bernanke discussed this phenomenon in his blog, and Bernanke and Larry Summers discussed what this might have to do with so-called "secular stagnation."

Some of this discussion seems to work from the assumption that the rate of return on government debt and the rate of return on capital are the same thing. For example, Bernanke shows a chart of the 5-year TIPS yield and then, in addressing what this might have to do with secular stagnation, makes this statement:
First, as I pointed out as a participant on the IMF panel at which Larry first raised the secular stagnation argument, at real interest rates persistently as low as minus 2 percent it’s hard to imagine that there would be a permanent dearth of profitable investment projects. As Larry’s uncle Paul Samuelson taught me in graduate school at MIT, if the real interest rate were expected to be negative indefinitely, almost any investment is profitable. For example, at a negative (or even zero) interest rate, it would pay to level the Rocky Mountains to save even the small amount of fuel expended by trains and cars that currently must climb steep grades. It’s therefore questionable that the economy’s equilibrium real rate can really be negative for an extended period.
So, Bernanke appears to think that low real Treasury yields are associated with low rates of return on capital. As well, Summers's arguments concerning secular stagnation seem to rely on a loanable funds theory of the real interest rate - the demand for investment (i.e. the demand for loanable funds) is low, which makes the real interest rate low. It seems clear that the real interest rate that Summers has in mind is the real rate of return on capital.

John Cochrane also discusses an idea related to low real bond yields, which he attributes to Summers:
One hypothesis that I learned from Larry Summers is that today's production function needs a lot less physical capital to produce the same productivity. A 1930s steel mill is a lot of accumulated savings. Facebook has nothing but a basketball court sized building full of 20-somethings coding while wearing headphones, and a really cool food court. The company is worth billions but it took comparatively little accumulated savings to start it up. If technology moves so that human, rather than physical capital is the heart of the K in F(K,L), productivity growth may determine interest rates in the long run, but there are lower interest rates on the transition path.
Again, this is an explanation for why the real rate of return on capital might be low.

But what if we actually go out and measure rates of return on capital? This work by Paul Gomme, B. Ravikumar, and Peter Rupert, reported in the St. Louis Fed's Economic Synopses, does that exercise. Here's their Figure 2:
So, by any of those measures, the rate of return on capital (this is average, not marginal) is as high or higher than it was before the recession. Conclusion: According to conventional measures, the rate of return on government debt is low, but the rate of return on capital is not.

In many standard economic models, there is no difference between the real interest rate faced by consumers and the marginal product of capital. But that will not be the case in models in which, for example, government debt plays some special role, for example as collateral, and therefore bears a liquidity premium. There is work by Kiyotaki and Moore that studies this type of effect, and I've worked on models in which government debt can bear liquidity premia, for example in this paper with David Andolfatto, and this paper of mine on QE. The ideas in those papers are related to Caballero's ideas on "safe asset shortages."

I think that the measurements in the work by Gomme/Ravkumar/Rupert are key to thinking about issues related to low real interest rates, so this deserves attention.

Saturday, August 15, 2015

The State of the Labor Market in the U.S.

I thought this would be a good time to look at a range of labor market data, to see what we can learn. How does labor market performance look relative to performance before the Great Recession? What's different, and why?

We'll start with standard time series. Payroll employment growth (year-over-year) looks like this:
Employment growth is currently in excess of 2%, which is as high as anything we have seen since 2001, though you can find periods of higher employment growth in the 1990s, for example (and in 2000 in the chart). Next, we can look at the employment/population ratio, and the labor force participation rate:
As is well-known, the drop in the employment/population ratio, in percentage points, is larger than anything that occurred in the whole post-World War II time series. Further, the large drop in the labor force participation rate, and the fact that labor force participation has continued to fall well after the recession is over, is unusual. Labor force participation appears to typically be driven primarily by long-run factors, so either there was something about the Great Recession that affected participation in an unusual way, or we are just seeing the effects of long run forces here.

In terms of unemployment rates, let's look at the standard measure - what the BLS calls U3 - and the broadest possible measure, U6, which includes persons marginally attached to the labor force and those who report that they are employed part time for economic reasons:
In terms of U3, the current unemployment rate is 5.3%, which we last saw in January 2005, in the midst of the housing boom. So, by the standard measure, the labor market appears to be fairly tight. But U6 is higher than at any time since 2000, which might indicate a labor market that is not tight. Here, we might appeal to other evidence. The U6 measure indicates that there exists an unusually large fraction of labor force participants who report that they are working part-time, would like to work full-time, but cannot, for "economic reasons." But if we look at hours worked per employee on nonfarm payrolls, this is what we see:
So, by this measure, the average worker is working more hours per month than at any time since the 2001-2002 recession. This perhaps reflects the pitfalls of taking the CPS data too seriously. As economists we would like good measures of what economic agents are actually doing. In the labor market, we would like to know exactly how labor force participants use their time - how much time is spent searching for a job, what exactly this search entails, how much search employed workers do, how non-participants spend their time, etc. The CPS actually tells us little about what we really want to know.

Another way to slice the unemployment data is to look at unemployment rates by duration. The BLS reports the number of unemployed less than 5 weeks, 5-14 weeks, 15-26 weeks, and 27 weeks and over, so we can take these numbers and express them as rates, relative to the labor force. Here's what we get:
When unemployment is low, as before the recession, most of the unemployed are short-term unemployed - less than 15 weeks. For example, in 2007, it appears that short-term unemployment is about 2/3, and long-term unemployment is about 1/3, of total unemployment. At peak unemployment, following the Great Recession, that situation roughly reversed itself, with about 2/3 of unemployment being long-term. Since then, as you can see in the chart, short term unemployment rates have returned to pre-recession levels or lower. Even the unemployment rate of those unemployed 15-26 weeks is about where it was in 2007. But, though the unemployment rate of those unemployed 27 weeks or more has fallen substantially, this rate is still higher than at any time since 2000.

One feature of how the labor market looks different from before the Great Recession is captured in the Beveridge curve relationship, as shown here (vacancy rate vs. unemployment rate):
We're interested in the Beveridge curve, in part because the relationship falls out of conventional Mortensen-Pissarides search models of the labor market. In that model, we think of low unemployment and high vacancies as capturing a tight labor market, and high unemployment and low vacancies a slack labor market. In the figure, the line joins points in the scatter plot sequentially in time, moving to the southeast as the recession worsens, then up and toward the northwest as the recovery proceeds. Early in the post-recession period, people were speculating as to whether the rightward shift in the Beveridge curve was due to cyclical factors (the Beveridge curve always shifts rightward in a recession) or some phenomenon related to mismatch in the labor market (the unemployed don't have skills that match well with the posted vacancies). Perhaps surprisingly, the Beveridge curve has not shifted back, with the end of the Great Recession now more than 6 years in the rearview mirror. That would seem to put the kabosh on cyclical explanations for the phenomenon. But it's not clear that mismatch fares any better in explaining the Beveridge curve shift. If that's the explanation, why doesn't the mismatch between the searchers and the searched-for go away?

Other interesting, and unusual, observations relate to initial claims for unemployment insurance. If we plot initial claims relative to the size of the labor force (a weekly flow rate, in percentage terms), we get this:
That's quite remarkable, as this measure is at its lowest level in the sample considered in the chart. To receive unemployment insurance (UI), one has to be eligible, and the eligibility requirements include having been sufficiently employed during the recent past. Thus, if I am out of the labor force, and search unsuccessfully for work, I can't collect UI. So, initial claims can be missing something, in terms of capturing labor market tightness. Further, the "takeup rate," which is the fraction of eligible unemployed who actually apply for UI, is known to be countercyclical - people tend not to apply for UI if they anticipate that they will get a job soon, for example. But, this works in our favor as, if we're interested in capturing the tightness of the labor market, initial claims will in part reflect forecasts of the unemployed about their probabilities of finding work.

We can also look at the insured unemployment rate, which is the number of people collecting UI as a percentage of the labor force. Here, I'll show that along with the standard unemployment rate (U3):
As with the initial claims rate, the insured unemployment rate is currently at its lowest level in the whole sample. Further, note that before the recession, about 40% of the unemployed were receiving UI, this rose to about 50% at the peak of the recession, and has fallen to about 30%. This reflects the relatively large fraction of longer-term unemployed, who typically cannot receive UI for more than 26 weeks.

Here's something interesting. If we plot a Beveridge curve, replacing the standard unemployment rate (U3) with the insured unemployment rate, this is what it looks like:
That looks quite stable. Further, currently we're about as far to the northwest in that chart as we have been since the vacancy rate data has been collected, i.e. if we measure labor market tightness as the ratio of vacancies to insured unemployed, the labor market is as tight as it's ever been, post-2000.

There are also interesting details in the labor market flows, as measured in the CPS. We'll look at flow rates, as a percentage of working age population, among the three labor market states: employed, unemployed, and not-in-the-labor-force (NILF). First, flow rates into employment:
Note here, that the flow into employment from NILF is always larger than the flow from unemployment. Maybe you knew this, but it's news to me. Maybe this comes from thinking too much in terms of Mortensen-Pissarides, where there are only two labor force states (employed and unemployed), and a spell of employment is always preceded by a spell of unemployment. Perhaps people should be thinking more about the NILF state. In any case, both of these rates have returned roughly to where they were before the recession.

Second, consider flows into unemployment:
Before the recession, note that flows to unemployment from NILF and from employment are roughly the same, but this changed with the recession. Currently, more of the flow into unemployment comes from NILF. Consistent with what we observed in the initial claims and insured unemployed data, the flow from employment to unemployment is lower than before the recession, and the flow from NILF is higher. This can be interpreted as reflecting a tight labor market - separations from employment are low, and people are entering the labor force to search for work at a high rate.

Finally, we'll look at flows into NILF:
This one is pretty interesting. Note that, before the recession, the flow into NILF directly from employment was typically more than twice the flow from unemployment to NILF. So, in good times, people typically drop out of the labor force due to retirement, illness, for fertility reasons, to go back to school, etc., rather than because they could not find work. Of course, that changes during the recession, when far more people search for work, then drop out of the labor force. An interesting feature of the data is that, in the Great Recession, in contrast to the 2001-02 recession, the flow from employment to NILF drops instead of increasing. Possibly far fewer people were retiring because of large drops in the value of retirement accounts. While the flow of people from unemployment to NILF remains high - presumably this is the long-term unemployed dropping out of the labor force - the flow to NILF from employment has increased to pre-recession levels. You can see why the labor force participation rate continues to decline (in terms of accounting).

Finally, we can look at the behavior of market wages. We'll look at year-over-year increases in average hourly earnings and the employment cost index:
Here, the main story is a drop in nominal wage growth from the neighborhood of 3.5% per year before the recession, to the neighborhood of 2% currently. What to make of this? The next chart shows the real wage, measured as average hourly earnings divided by the PCE deflator (headline), and average labor productivity, measured as real GDP per hour of payroll employment.
You can see that from the beginning to the end of the sample, wage and productivity growth are almost identical, as standard theory would tell us. The anomaly here is in the behavior of productivity and wages during the Great Recession. Typically the real wage is acyclical (depending on how you measure it), and average labor productivity is procyclical, but obviously this recession was very different, with large increases in both productivity and real wages. A concern here, of course, is the anemic post-recession growth in productivity.

What are the key conclusions we should draw from this? Employment growth is currently strong, and by most measures the labor market is currently somewhat tight to very tight. While labor force participation is low and falling, and there is an unusually large number of long-term unemployed relative to pre-recession times, those observations are tempered by observed flow rates from NILF to the labor force that are comparable to pre-recession times. Given the currently elevated number of long-term unemployed, the unemployment rate could drop much lower than it is now - possibly as low as 4.5-4.8%.