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tag:blogger.com,1999:blog-24997159099567742292014-12-18T13:11:59.372-08:00Stephen Williamson: New Monetarist EconomicsDisclaimer: Any opinions expressed, potshots taken, or scientific views articulated are mine, and need not represent the opinions, potshots, or scientific views of the Federal Reserve Bank of St. Louis, or the Federal Reserve System. Stephen Williamsonhttp://firstname.lastname@example.com:blogger.com,1999:blog-2499715909956774229.post-39948660961273114492014-12-03T18:56:00.000-08:002014-12-05T08:12:20.333-08:00Economics: The View From SociologySome people (Noah Smith, Paul Krugman) have recently written about The Superiority of Economists by Fourcade et al. This is a paper written by two sociologists and an economist, who give us a sociological perspective on the economics profession. To get my bearings I found the most fitting definition:
Sociology: the scientific analysis of a social institution as a functioning whole and as it relates to the rest of society.
So, that seems very promising. Some scientists, who specialize in the analysis of institutions and the role those institutions play in society, are going to figure out the economics profession.

Here's what I'm thinking. I've never taken a sociology course, but being a social scientist maybe I can guess how a sociologist might think about the institution of economics. What is the social role of the economics profession? First, human beings have a need for pure scientific knowledge - we just want to know what is going on. How do economic systems work? Why are some countries and individuals so poor, and why are some so rich? Why do prices of goods, services, and assets move around over time? Second, human beings have a need for applied science. How do we take what we know about economics and use that knowledge to make human beings collectively better off? Third, we might be interested in where economics came from. Who were the first economists, and how did they put together the seeds of economic knowledge? How is the economics profession organized? How is economics taught? Fourth, what makes economics different from other disciplines? If there are large differences in economics, are the human beings who do economics somehow different, for example do they self-select as economists due to particular skills they possess? Is economics different by chance, or is there something about the nature of things that economists study that makes the field different? Finally, how does the organizational structure of the economics profession help it to perform its key social role? Are there ways we could improve on this organizational structure? This could be pretty interesting, and I'm pleased, in principle, that there are scientists who care about these things, and are willing to help out.

First, I'll tell you some of what I know about the economics profession. Economics is clearly successful - in economic terms. Economics is a high enrollment major in most universities, one can make a decent living selling economics textbooks to undergraduates (as I can attest), an economics undergrad major pays off handsomely, and PhD economists are very well-paid - as academics, in the financial sector, and in government. Economists are also influential. They are called on to run key interational institutions like the IMF and World Bank, they more often than not serve as the chief officers in central banks, and they hold important positions in government. Further - and this must be unique among scientific pursuits - you can become extremely rich as a specialist in bad-mouthing your fellow economists.

Economics is very different from other academic pursuits, as any economist who has had to educate a Dean (of Liberal Arts, Social Sciences, Business, whatever) can tell you. In most academic fields, jobs are scarce, and mobility is low. Not so in economics. It is typically hard work to convince a Dean that one needs to make 8 job offers to fresh PhDs in the hope of getting one or two acceptances, that senior job candidates may be even harder to get, and that departures from your economics department need not mean that good people are fleeing a bad department. Salaries are always an issue. Basically, you need to know some economics (though not much) to understand why the economists are paid much more than the philosophers. Economists have a well-organized fresh-PhD job market that operates under clear rules, and performs the function of matching young economists with employers. Economists are social and love to argue. If you are uninitiated and happen to walk into an economics seminar, you might think you should call the police. Don't worry, it's OK.

Fourcade et al. get some of the facts right, but I came away puzzled. Some data is marshalled, but I wouldn't call this paper science, and it's unclear what we are supposed to learn. The first argument the authors want to make is that economics is "insular." By this they mean that economists don't pay much attention to the other social sciences. The evidence for this is citations - apparently the flow of citations is smaller from economics to the rest of the social sciences than the other way around. Whether this is a good way to measure interaction is not clear. There is a very active area of research in economics - behavioral economics - that uses developments in psychology extensively. There is extensive interaction between economists and political scientists - especially those interested in game theory. But I don't think I have ever encountered a sociologist in an economics seminar, or at a conference. However, suppose that economists totally ignored the other social sciences. Could we then conclude that this is suboptimal? Of course not. Maybe what is going on in the rest of the social sciences is actually of no use to economists. Maybe it is of some use to us. Certainly Fourcade et al. don't give us any specific examples of things we're ignoring that might help us out.

And economists are far from insular, especially if we look beyond the social sciences. Economics is a big tent. To gain admission to an economics PhD program requires some background in mathematics and statistics typically, but we don't necessarily require an undergraduate economics degree. People come into economics from history, engineering, math, psychology, and many other fields. As well, an undergraduate degree in economics is an excellent stepping stone to other things - professional degrees in business and law, or graduate degrees in other social sciences. Economic science did not come out of nowhere. Indeed, it often went by "Political Economy" in the early days, and sometimes still does. Most of our technical tools came from mathematicians and statisticians, though econometricians have developed sophisticated statistical tools designed specifically to deal with inference problems specific to economics, and macroeconomists took the dynamic optimization methods invented by mathematicians and engineers and adapted them to general equilibrium economic problems.

The authors of "The Superiority of Economists" see us as hierarchical, with a power elite that controls the profession. PhD programs are indistinguishable, and publication and recruiting are regimented. Seems more like the army than an institution that is supposed to foster economic science. Well, baloney. People of course recognize a quality ranking in academic institutions, journals, and individual economists, but I don't think that's much different from what you see in other fields. Powerful people can dominate particular subfields, but good ideas win out ultimately, I think. In the 1970s, there was a revolution in macroeconomics. That did not happen because the research of the people involved was supported by the Ivy League - far from it. But modern macro research found supporters in lesser-known places like Carnegie-Mellon University, the University of Minnesota, and the University of Rochester. People like Bob Lucas and Ed Prescott got their papers published in good places - eventually - and then got their share of Nobel Prizes in Economics. The economics profession, though it could do better in attracting women, is very heterogeneous. I have no hard evidence for this, but my impression is that the fraction of foreigners teaching economics in American universities is among the highest across academic disciplines. I don't think you would see that in a rigid profession.

Ultimately, Fourcade et al. think that our biggest problem is our self-regard. Of course, people with high self-regard are very visible, by definition, so outsiders are bound to get a distorted picture. We're not all Larry Summers clones. But if we do, on average, have a high level of self-regard, maybe that's just defensive. Economists typically get little sympathy from any direction. In universities, people in the humanities hate us, the other social scientists (like Fourcade et al.) think we're assholes, and if we have to live in business schools we're thought to be impractical. Natural scientists seem to think we're pretending to be physicists. In the St. Louis Fed, where I currently reside, I think the non-economists just think we're weird. Oh well. It's a dirty job. Someone has to do it.Stephen Williamsonhttp://email@example.com:blogger.com,1999:blog-2499715909956774229.post-39747987985836798102014-11-24T14:41:00.001-08:002014-11-24T17:37:22.293-08:00Piketty/PovertySo you've all forgotten who Thomas Piketty is, right? Recall that he is the author of the 685-page tome, Capital in the Twentieth Century, a bestseller of the summer of 2014, but perhaps also the least-read bestseller of the summer of 2014. I was determined, however, not to be like the mass of lazy readers who bought Capital. I have slogged on, through boredom, puzzlement, and occasional outrage, and am proud to say I have reached the end. Free at last! Hopefully you have indeed forgotten Piketty, and are not so sick of him you could scream. Perhaps you're even ready for a Piketty revival.

Capital is about the distribution of income and wealth. For the most part, this is a distillation of Piketty's published academic work, which includes the collection and analysis of a large quantity of historical data on income and wealth distribution in a number of countries of the world. Of course, data cannot speak for itself - we need theory to organize how we think about the data, and Piketty indeed has a theory, and uses that theory and the data to arrive at predictions about the future. He also comes to some policy conclusions.

Here's the theory. Piketty starts with the First Fundamental Law of Capitalism, otherwise known as the definition of capital's share in national income, or

(1) a = r(K/Y),

where a is the capital share, r is the real rate of return on capital, K is the capital stock, and Y is national income. Note that, when we calculate national income we deduct depreciation of capital from GDP. That will prove to be important. The Second Fundamental Law of Capitalism states what has to be true in a steady state in which K/Y is constant:

(2) K/Y = s/g,

where s is the savings rate, and g is the growth rate of Y. So where did that come from? If k is the time derivative of K, and y is the time derivative of Y, then in a steady state in which K/Y is constant,

(3) k/K = y/Y.

Then, equation (3) gives

(4) K/Y = k/y = (k/Y)/(y/Y) = s/g,

or equation (2). It's important to note that, since Y is national income (i.e. output net of depreciation), the savings rate is also defined as net of depreciation.

So, thus far, we don't have a theory, only two equations, (1) and (2). The first is a definition, and the second has to hold if the capital/output ratio is constant over time. Typically, in the types of growth models we write down, there are good reasons to look at the characteristics of steady states. That is, we feel a need to justify focusing on the steady state by arguing that the steady state is something the model will converge to in the long run. Of course, Piketty is shooting for a broad audience here, so he doesn't want to supply the details, for fear of scaring people away.

Proceeding, (1) and (2) imply

(5) a = r(s/g)

in the steady state. If we assume that the net savings rate s is constant, then if r/g rises, a must rise as well. This then constitutes a theory. Something is assumed constant, which implies that, if this happens, then that must happen. But what does this have to do with the distribution of income and wealth? Piketty argues as follows:

(i) Historically, r > g typically holds in the data.
(ii) There are good reasons to think that, in the 21st century, g will fall, and r/g will rise.
(iii) Capital income is more more concentrated among high-income earners than is labor income.

Conclusion: Given (5) and (i)-(iii), we should expect a to rise in the 21st century, which will lead to an increasing concentration of income at the high end. But why should we care? Piketty argues that this will ultimately lead to social unrest and instability, as the poor become increasingly offended by the filthy rich, to the point where they just won't take it any more. Thus, like Marx, Piketty thinks that capitalism is inherently unstable. But, while Marx thought that capitalism would destroy itself, as a necessary step on the path to communist nirvana, Piketty thinks we should do something to save capitalism before it is too late. Rather than allow the capitalist Beast to destroy itself, we should just tax it into submission. Piketty favors marginal tax rates at the high end in excess of 80%, and a global tax on wealth.

Capital is certainly provocative, and the r > g logic has intuitive appeal, but how do we square Piketty's ideas with the rest of our economic knowledge? One puzzling aspect of Piketty's analysis is his use of net savings rates, and national income instead of GDP. In the typical growth models economists are accustomed to working with, we work with gross quantities and rates - before depreciation. Per Krusell and Tony Smith do a nice job of straightening this out. A key issue is what happens in equation (2) as g goes to zero in the limit. Basically, given what we know about consumption/savings behavior, Piketty's argument that this leads to a large increase in a is questionable.

Further, there is nothing unusual about r > g, in standard economic growth models that have no implications at all for the distribution of income and wealth. For example, take a standard representative-agent neoclassical growth model with inelastic labor supply and a constant relative risk aversion utility function. Then, in a steady state,

(6) r = q + bg,

where q is the subjective discount rate and b is the coefficient of relative risk aversion. So, (6) implies that r > g unless g > q and b is small. And, if g is small, then we must have r > g. But, of course, the type of model we are dealing with is a representative-agent construct. This could be a model with many identical agents, but markets are complete, and income and wealth would be uniformly distributed across the population in equilibrium. So, if we want to write down a model that can give us predictions about the income and wealth distribution, we are going to need heterogeneity. Further, we know that some types of heterogeneity won't work. For example, with idiosyncratic risk, under some conditions the model will essentially be identical to the representative agent model, given complete insurance markets. Thus, it's generally understood that, for standard dynamic growth models to have any hope of replicating the distribution of income and wealth that we observe, these models need to include sufficient heterogeneity and sufficient financial market frictions.

Convenient summaries of incomplete markets models with heterogeneous agents are in this book chapter by Krusell and Smith, and this paper by Heathcote et al. In some configurations, these models can have difficulty in accounting for the very rich and very poor. This may have something to do with financial market participation. In practice, the very poor do not hold stocks, bonds, and mutual fund shares, or even have transcations accounts with banks in some circumstances. As well, access to high-variance, high-expected return projects, for example entrepreneurial projects, is limited to very high-income individuals. So, to understand the dynamics of the wealth and income distributions, we need to understand the complexities of financial markets, and market participation. That's not what Piketty is up to in Capital.

How might this matter? Well suppose, as Piketty suggests, that g declines during the coming century. Given our understanding of how economic growth works, this would have to come about due to a decline in the rate of technological innovation. But it appears that technological innovation is what produces extremely large incomes and extremely large pots of wealth. To see this, look at who the richest people in America are. For example, the top 20 includes the people who got rich on Microsoft, Facebook, Amazon, and Google. As Piketty points out, the top 1% is also well-represented by high-priced CEOs. If Piketty is right, these people are compensated in a way that is absurdly out of line with their marginal productivities. But, in a competitive world, companies that throw resources away on executive compensation would surely go out of business. Conclusion: The world is not perfectly competitive. Indeed, we have theories where technological innovation produces temporary monopoly profits, and we might imagine that CEOs are in good positions to skim off some of the rents. For these and other reasons, we might imagine that a lower rate of growth, and a lower level of innovation, might lead to less concentration in wealth at the upper end, not more.

Capital is certainly not a completely dispassionate work of science. Piketty seems quite willing to embrace ideas about what is "just" and what is not, and he can be dismissive of his fellow economists. He says:
...the discipline of economics has yet to get over its childish passion for mathematics and for purely theoretical and often highly ideological speculation, at the expense of historical research and collaboration with the other social sciences.
Not only are economists ignoring the important problems of the world, the American ones are in league with the top 1%:
Among the members of these upper income groups are US academic economists, many of whom believe that the economy of the United States is working fairly well and, in particular, that it rewards talent and merit accurately and precisely. This is a very comprehensible human reaction.
Sales of Capital have now put Piketty himself in the "upper income group." Economists are certainly easy targets, and it didn't hurt Piketty's sales to distance himself from these egghead ivory-tower types. This is a very comprehensible human reaction.

To think about the distribution of income and wealth, to address problems of misallocation and poverty, we need good economic models - ones that capture how people make choices about occupations, interhousehold allocation and bequests, labor supply, and innovation. Economists have certainly constructed good models that incorporate these things, but our knowledge is far from perfect - we need to know more. We need to carefully analyze the important incentive effects of taxation that Piketty either dismisses or sweeps under the rug. Indeed, Piketty would not be the first person who thought of the top 1% as possessing a pot of resources that could be freely redistributed with little or no long-term consequences. It would perhaps be preferable if economists concerned with income distribution were to focus more on poverty than the outrageous incomes and wealth of the top 1%. It is unlikely that pure transfers from rich to poor through the tax system will solve - or efficiently solve - problems of poverty, in the United States or elsewhere. My best guess is that our time would be well spent on thinking about human capital accumulation and education, and how public policy could be reoriented to promoting both in ways that have the highest payoff.

Stephen Williamsonhttp://email@example.com:blogger.com,1999:blog-2499715909956774229.post-16336795089145904722014-11-13T08:21:00.000-08:002014-11-13T10:53:26.169-08:00Neo-Fisherians: Unite and Throw off MV=PY and Your Phillips Curves!

I've noticed a flurry of blog activity on "Neo-Fisherianism," and thought I would contribute my two cents' worth. Noah Smith drew my attention to the fact that Paul Krugman had something to say on the matter, so I looked at his post to see what that's about. The usual misrepresentations and unsubstantiated claims, apparently. Here is the last bit:
And at the highest level we have the neo-Fisherite claim that everything we thought we knew about monetary policy is backwards, that low interest rates actually lead to lower inflation, not higher. At least this stuff is being presented in an even-tempered way.

But it's still very strange. Nick Rowe has been working very hard to untangle the logic of these arguments, basically trying to figure out how the rabbit got stuffed into the hat; the meta-point here is that all of the papers making such claims involve some odd assumptions that are snuck by readers in a non-transparent way.

And the question is, why? What motivation would you have for inventing complicated models to reject conventional wisdom about monetary policy? The right answer would be, if there is a major empirical puzzle. But you know, there isn't. The neo-Fisherites are flailing about, trying to find some reason why the inflation they predicted hasn't come to pass — but the only reason they find this predictive failure so puzzling is because they refuse to accept the simple answer that the Keynesians had it right all along.
Well, at least Krugman gives Neo-Fisherites credit for being even-tempered.

Let's start with the theory. Krugman's claim is that "all of the papers making such claims involve odd assumptions that are snuck by readers in a non-transparent way." Those sneaky guys, throwing up a smoke screen with their odd assumptions and such. Actually, I think Cochrane's blog post on this was pretty clear and helpful, for the uninitiated. I've written about this as well, for example in this piece from last year, and other posts you can find in my archive. More importantly, I have a sequence of published and unpublished papers on this issue, in particular this published paper, this working paper, and this other working paper. That's not all directed at the specific issue at hand - "everything we thought we knew about monetary policy is backwards" - but covers a broader range of issues relating to the financial crisis, conventional monetary policy, and unconventional monetary policy. If this is "flailing about," I'm not sure what we are supposed to be doing. I've taken the trouble to formalize some ideas with mathematics, and have laid out models with explicit assumptions that people can work through at their leisure. These papers have been presented on repeated occasions in seminars and conferences, and are being subjected to the refereeing and editorial process at academic journals, just as is the case for any type of research that we hope will be taken seriously. The work is certainly not out of the blue - it's part of an established research program in monetary and financial economics, which many people have contributed to over the last 40 years or so. Nothing particular odd or sneaky going on, as far as I know. Indeed, some people who work in that program would be happy to be called Keynesians, who are the only Good Guys, in Krugman's book.

So, let me tell you about a new paper, with David Andolfatto, which I'm supposed to present at a Carnegie-Rocheser-NYU conference later this week (for the short version, see the slides) . This paper had two goals. First, we wanted to make some ideas more accessible to people, in a language they might better understand. Some of my work is exposited in terms Lagos-Wright type models. From my point of view, these are very convenient vehicles. The goal is to be explicit about monetary and financial arrangements, so we can make precise statements about how the economy works, and what monetary policy might be able to do to enhance economic performance. It turns out that Lagos-Wright is a nice laboratory for doing that - it retains some desirable features of the older money/search models, while permitting banking and credit arrangements in convenient ways, and allowing us to say a lot more about policy.

Lagos-Wright models are simple, and once you're accustomed to them, as straightforward to understand as any basic macro model. Remember what it was like when you first saw a neoclassical growth model, or Woodford's cashless model. Pretty strange, right? But people certainly became quickly accustomed to those structures. Same here. You may think it's weird, but for a core group of monetary theorists, it's like brushing your teeth. But important ideas are not model-bound. We should be able to do our thinking in alternative structures. So, one goal of this paper is to explore the ideas in a cash-in-advancey world. This buys us some things, and we lose some other things, but the basic ideas are robust.

The model is structured so that it can produce a safe asset shortage, which I think is important for explaining some features of our recent zero-lower-bound experience in the United States. To do that, we have to take a broad view of how assets are used in the financial system. Part of what makes new monetarism different from old monetarism is its attention to the whole spectrum of assets, rather than some subset of "monetary" assets vs. non-monetary assets. We're interested in the role of assets in financial exchange, and as collateral in credit arrangements, for example. For safe assets to be in short supply, we have to specify some role for those safe assets in the financial system, other than as pure stores of wealth. In the model, that's done in a very simple way. There are some transactions that require currency, and some other transactions that can be executed with government bonds and credit. We abstract from banking arrangements, but the basic idea is to think of the bonds/credit transactions as being intermediated by banks.

We think of this model economy as operating in two possible regimes - constrained or unconstrained. The constrained regime features a shortage of safe assets, as the entire stock of government bonds is used in exchange, and households are borrowing up to their credit limits. To be in such a regime requires that the fiscal authority behave suboptimally - basically it's not issuing enough debt. If that is the case, then the regime will be constrained for sufficiently low nominal interest rates. This is because sufficient open market sales of government debt by the central bank will relax financial constraints. In a constrained regime, there is a liquidity premium on government debt, so the real interest rate is low. In an unconstrained regime the model behaves like a Lucas-Stokey cash-in-advance economy.

What's interesting is how the model behaves in a constrained regime. Lowering the nominal interest rate will result in lower consumption, lower output, and lower welfare, at least close to the zero lower bound. Why? Because an open market purchase of government bonds involves a tradeoff. There are two kinds of liquidity in this economy - currency and interest-bearing government debt. An open market purchase increases currency, but lowers the quantity of government debt in circulation. Close to the zero lower bound, this will lower welfare, on net. This implies that a financial shock which tightens financial constraints and lowers the real interest rate does not imply that the central bank should go to the zero lower bound. That's very different from what happens in New Keynesian (NK) models, where a similar shock implies that a zero lower bound policy is optimal.

As we learned from developments in macroeconomics in the 1970s, to evaluate policy properly, we need to understand the operating characteristics of the economy under particular fiscal and monetary policy rules. We shouldn't think in terms of actions - e.g. what happens if the nominal interest rate were to go up today - as today's economic behavior depends on the whole path of future policy under all contingencies. Our analysis is focused on monetary policy, but that doesn't mean that fiscal policy is not important for the analysis. Indeed, what we assume about the fiscal policy rule will be critical to the results. People who understand this issue well, I think, are those who worked on the fiscal theory of the price level, including Chris Sims, Eric Leeper, John Cochrane, and Mike Woodford. What we assume - in part because this fits conveniently into our analysis, and the issues we want to address - is that the fiscal authority acts to target the real value of the consolidated government debt (i.e. the value of the liabilities of the central bank and fiscal authority). Otherwise, it reacts passively to actions by the monetary authority. Thus, the fiscal authority determines the real value of the consolidated government debt, and the central bank determines the composition of that debt.

Like Woodford, we want to think about monetary policy with the nominal interest rate as the instrument. We can think about exogenous nominal interest rates, random nominal interest rates, or nominal interest rates defined by feedback rules from the state of the economy. In the model, though, how a particular path for the nominal interest rate is achieved depends on the tools available to the central bank, and on how the fiscal authority responds to monetary policy. In our model, the tool is open market operations - swaps of money for short-term government debt. To see how this works in conjunction with fiscal policy, consider what happens in a constrained equilibrium at the zero lower bound. In such an equilibrium, c = V+K, where c is consumption, V is the real value of the consolidated government debt, and K is a credit limit. The equilibrium allocation is inefficient, and there would be a welfare gain if the fiscal authority increased V, but we assume it doesn't. Further, the inflation rate is i = B[u'(V+K)/A] - 1, where B is the discount factor, u'(V+K) is the marginal utility of consumption, and A is the constant marginal disutility of supplying labor. Then, u'(V+K)/A is an inefficiency wedge, which is equal to 1 when the equilibrium is unconstrained at the zero lower bound. The real interest rate is A/[Bu'(V+K)] - 1. Thus, note that there need not be deflation at the zero lower bound - the lower is the quantity of safe assets (effectively, the quantity V+K), the higher is the inflation rate, and the lower is the real interest rate. This feature of the model can explain why, in the Japanese experience and in recent U.S. history, an economy can be at the zero lower bound for a long time without necessarily experiencing outright deflation.

Further, in this zero lower bound liquidity trap, inflation is supported by fiscal policy actions. The zero nominal interest rate, targeted by the central bank, is achieved in equilibrium by the fiscal authority increasing the total stock of government debt at the rate i, with the central bank performing the appropriate open market operations to get to the zero lower bound. There is nothing odd about this, in terms of reality, or relative to any monetary model we are accustomed to thinking about. No central bank can actually "create money out of thin air" to create inflation. Governments issue debt denominated in nominal terms, and central banks purchase that debt with newly-issued money. In order to generate a sustained inflation, the central bank must have a cooperative government that issues nominal debt at a sufficiently high rate, so that the central bank can issue money at a high rate. In some standard monetary models we like to think about, money growth and inflation are produced through transfers to the private sector. That's plainly fiscal policy, driven by monetary policy.

In this model, we work out what optimal monetary policy is, but we were curious to see how this model economy performs under conventional Taylor rules. We know something about the "Perils of Taylor Rules," from a paper by Benhabib et al., and we wanted to have something to say about this in our context. Think of a central banker that follows a rule

R = ai + (1-a)i* + x,

where R is the nominal interest rate, i is the inflation rate, a > 0 is a parameter, i* is the central banker's inflation target, and x is an adjustment that appears in the rule to account for the real interest rate. In many models, the real interest rate is a constant in the long run, so if we set x equal to that constant, then the long-run Fisher relation, R = i + x, implies there is a long-run equilibrium in which i=i*. The Taylor rule peril that Benhabib et al. point out, is that, if a > 1 (the Taylor principle), then the zero lower bound is another long run equilibrium, and there are many dynamic equilibria that converge to it. Basically, the zero lower bound is a trap. It's not a "deflationary trap," in an Old Keynesian sense, but a policy trap. At the zero lower bound, the central banker wants to aggressively fight inflation by lowering the nominal interest rate, but of course can't do it. He or she is stuck. In our model, there's potentially another peril, which is that the long-run real interest rate is endogenous if there is a safe asset shortage. If x fails to account for this, the central banker will err.

In the unconstrained - i.e conventional - regime in the model, we get the flavor of the results of Benhabib et al. If a < 1 (a non-aggressive Taylor rule), then there can be multiple dynamic equilibria, but they all converge in the limit to the unique steady state with i = i*: the central banker achieves the inflation target in the long run. However, if a > 1, there are two steady states - the intended one, and the zero lower bound. Further, there can be multiple dynamic equilibria that converge to the zero lower bound (in which i < i* and there is deflation) in finite time. In a constrained regime, if the central banker fails to account for endogeneity in the real interest rate, the Taylor rule is particularly ill-behaved - the central banker will essentially never achieve his or her inflation target. But, if the central banker properly accounts for endogeneity in the real interest rate, the properties of the equilibria are similar to the unconstrained case, except that inflation is higher in the zero-lower-bound steady state. How can the central banker avoid getting stuck at the zero lower bound? He or she has to change his or her policy rule. For example, if the nominal interest rate is currently zero, there are no alternatives. If what is desired is a higher inflation rate, the central banker has to raise the nominal interest rate. But how does that raise inflation? Simple. This induces the fiscal authority to raise the rate of growth in total nominal consolidated government liabilities. But what if the fiscal authority refused to do that? Then higher inflation can't happen, and the higher nominal interest rate is not feasible. In the paper, we get a set of results for a model which does not have a short-term liquidity effect. Presumably that's the motivation behind a typical Taylor rule. A liquidity effect associates downward shocks to the nominal interest rate with increases in the inflation rate, so if the Taylor rule is about making short run corrections to achieve an inflation rate target, then maybe increasing the nominal interest rate when the inflation rate is above target will work. So, we modify the model to include a segmented-markets liquidity effect. Typical segmented markets models - for example this one by Alvarez and Atkeson are based on the redistributive effects of cash injections. In our model, we allow a fraction of the population - traders - to participate in financial markets, in that they can use credit and carry out exchange using government bonds (again, think of this exchange being intermediated by financial intermediaries). The rest of the population are non-traders, who live in a cash-only world.

In this model, if a central banker carries out random policy experiments - moving the nominal interest rate around in a random fashion - he or she will discover the liquidity effect. That is, when the nominal interest rate goes up, inflation goes down. But if this central banker wants to increase the inflation rate permanently, the way to accomplish that is by increasing the nominal interest rate permanently. Perhaps surprisingly, the response of inflation to a one time jump (perfectly anticipated) in the nominal interest rate, looks like the figure in John Cochrane's post that he labels "pure neo-Fisherian view." It's surprising because the model is not pure neo-Fisherian - it's got a liquidity effect. Indeed, the liquidity effect is what gives the slow adjustment of the inflation rate.

The segmented markets model we analyze has the same Taylor rule perils as our baseline model, for example the Taylor principle produces a zero-lower-bound steady state which is is the terminal point for a continuum of dynamic equilibria. An interesting feature of this model is that the downward adjustment of inflation along one of these dynamic paths continues after the nominal interest rate reaches zero (because of the liquidity effect). This gives us another force which can potentially give us positive inflation in a liquidity trap.

We think it is important that central bankers understand these forces. The important takeaways are: (i) The zero lower bound is a policy trap for a Taylor rule central banker. If the central banker thinks that fighting low inflation aggressively means staying at the zero lower bound that's incorrect. Staying at the zero lower bound dooms the central banker to permanently undershooting his or her inflation target. (ii) If the nominal interest rate is zero, and inflation is low, the only way to increase inflation permanently is to increase the nominal interest rate permanently.

Finally, let's go back to the quote from Krugman's post that I started with. I'll repeat the last paragraph from the quote so you don't have to scroll back:
And the question is, why? What motivation would you have for inventing complicated models to reject conventional wisdom about monetary policy? The right answer would be, if there is a major empirical puzzle. But you know, there isn't. The neo-Fisherites are flailing about, trying to find some reason why the inflation they predicted hasn't come to pass — but the only reason they find this predictive failure so puzzling is because they refuse to accept the simple answer that the Keynesians had it right all along.
Why? Well, why not? What's the puzzle? Well, central banks in the world with their "conventional wisdom" seem to have a hard to making inflation go up. Seems they might be doing something wrong. So, it might be useful to give them some advice about what that is instead of sitting in a corner telling them the conventional wisdom is right.

Stephen Williamsonhttp://email@example.com:blogger.com,1999:blog-2499715909956774229.post-77514278900772061782014-11-11T15:04:00.000-08:002014-11-12T06:22:01.100-08:00Monetary Policy NormalizationHere's a common view of how the Fed implemented monetary policy prior to the financial crisis.

The chart shows a typical framework, pre-financial crisis, that was used in hitting a particular fed funds rate target, depicted by R* in the figure. The downward-sloping curve is a demand curve for reserves, which essentially captures a short-run liquidity effect. The larger the quantity of reserves in the system overnight, the lower the fed funds rate. But, a key problem for policy implementation was that this demand curve was highly unstable, shifting due to unanticipated shocks to the financial system, and with anticipated shocks related to the day of the week, month of the year, etc. Operationally, the way the Fed approached the problem of hitting the target R* was, effectively, to estimate the demand curve each day, and then intervene so as to assure that Q* reserves were in the market, implying that the market would clear at R*, if the demand curve estimate were correct. Note in the figure that the fed funds rate was bounded above by the discount rate (no depository institution, or DI, would borrow from another institution at more than the Fed was offering) and by the interest rate on reserves, IOER (no DI would lend to another DI at less than what the Fed was offering). Prior to the financial crisis, the IOER was zero.

There were certainly other approaches the Fed could have taken to implementing policy during the pre-crisis period. For example, since the Fed was typically intervening by varying its quantity of lending in the overnight repo market, an alternative approach might have been to follow a fixed-rate, full-allotment procedure, i.e. fix the repo rate, and lend whatever quantity the market wanted to take at that rate. That would work very nicely if the overnight repo rate and the fed funds rate were identical, but they are not. Typically, overnight interest rates move together, but there can be a substantial amount of variability in the margin between the repo rate and the fed funds rate, for various reasons. For example, fed funds lending is unsecured while repos are secured; lending one day and settlement the next day happen at different times in the two markets, etc. So, given that the directive from the FOMC was in terms of a fed funds target, pegging the repo rate need not be the best way to carry out the directive. One could make an argument that targeting a secured overnight rate makes more sense than targeting the fed funds rate, but that would have required revamping the whole structure of FOMC decision making.

An important point to emphasize is that, contrary to central banking myth, the mechanics of the fed funds market pre-crisis had little to do with reserve requirements. The myth is that fed funds market activity was driven by the need of DIs to meet their reserve requirements - if reserves were too low, a DI would borrow on the fed funds market, and if reserves were too high it would lend. But the same would hold true if there were no reserve requirements, as reserve balances must be nonnegative overnight. Indeed in Canada, for example, where reserve requirements were eliminated long ago, the Bank of Canada operates within a channel system. The overnight target interest rate is bounded by the Bank of Canada's lending rate (on the high side), and the counterpart of the IOER in Canada (on the low side). Overnight reserves in Canada are typically zero, effectively, but we could characterize Bank of Canada intervention in roughly the same manner as in the figure above.

Before the Fed was permitted to pay interest on reserves, people speculated (see for example, see this paper by Marvin Goodfriend) that the IOER would establish a floor for the fed funds rate. Indeed, as Goodfriend pointed out, with sufficient reserves in the system, the IOER should determine the fed funds rate. Essentially this is what happened in Canada from spring 2009 until mid-2010, when the Bank of Canada operated with a floor system and an overnight rate (equal to the interest rate on reserves) of 0.25%. But, since the Fed began paying interest on reserves in late 2008, the effective fed funds rate has traded below the IOER, which as been at 0.25%.

The margin between the IOER on the fed funds rate has been substantial - sometimes as much as 20 basis points.

In a previous post I discussed some details of Fed proposals to modify its approach to financial market intervention. Since then, the FOMC has made its plans for "normalization" explicit in this press release from September 17. Normalization refers to the period after liftoff - the point in time at which the FOMC decides to increase its policy rate. Basically, the FOMC will continue to articulate policy in terms of the fed funds rate, and proposes to control the fed funds rate through two means: the IOER, and an overnight repurchase agreement (ON RRP) facility. As explained in my previous post, ON RRPs are overnight loans to the Fed from an expanded list of counterparties. ON RRPs do not "drain" reserves, as they are effectively reserves by another name. Reserve accounts are held by only some financial institutions in the United States, and not all financial institutions with reserve accounts (the GSEs - government-sponsored enterprises) can earn interest on reserves. Thus, ON RRPs expand the market for Fed liabilities, and allow more institutions to receive interest on overnight balances held with the Fed.

The Fed's plans for modifying policy implementation will actually matter little for the how monetary policy works. Whatever the means, the basic idea is to use monetary policy to influence short-term nominal interest rates by targeting an overnight interest rate, just as was the case before the financial crisis. The key issue in the implementation appears to be how the ON RRP facility should be managed. What should the ON RRP rate be? Should there be quantity caps on ON RRPs? If there are caps, how large should they be? A smaller difference between the IOER and the ON RRP rate potentially tightens the bounds on the fed funds rate. However, the majority of fed funds market activity currently consists of activity to (imperfectly) arbitrage the difference between the interest rate that GSEs can earn on reserve balances (zero) and the IOER. That arbitrage activity should disappear if the IOER/ON RRP rate margin decreases sufficiently, in which case the effective fed funds rate could actually increase above the IOER. As well, the smaller the IOER/ON RRP rate spread, the larger the quantity of ON RRPs relative to reserves on the liabilities side of the Fed's balance sheet. This distributes Fed liabilities differently in the financial system, in ways that we perhaps do not understand well, and with unclear implications.

How long after liftoff will the Fed's altered financial market intervention persist? This depends on how long it takes for the Fed's balance sheet to "normalize." In this case, normality means a balance sheet for which currency accounts for most of the Fed's liabilities, as was the case prior to the financial crisis. Currently, total Fed liabilities are about $4.5 trillion, of which $1.3 trillion is currency and $3.2 trillion consists of other liabilities, including reserves and ON RRPs. Currency as a fraction of total Fed liabilities can increase through two means: (i) assets disappear from the Fed's balance sheet; (ii) the demand for currency goes up. Assets can disappear from the Fed's balance sheet because they mature or are sold. The FOMC Policy Normalization Principles and Plans state no plans for selling assets - either Treasury securities or mortgage-backed securities. The plans specify that reinvestment in assets will continue until after liftoff, i.e. currently the size of the Fed's asset portfolio is being held constant in nominal terms. Therefore, there are currently no plans to reduce the quantity of assets on the Fed's balance sheet until after liftoff. Thus, for now, reductions in the quantity of non-currency liabilities will happen only as the stock of currency grows.

So, how long will it take until the Fed is in a position to conduct policy exactly as before the financial crisis? If the Fed continued its reinvestment program, and if currency grew at 5% per year, it would take more than 25 years for Fed liabilities to consist of currency alone. An end to reinvestment could mean that normalization could happen in 10 years or less, barring circumstances in which the Fed chooses to embark on new quantitative easing programs. Thus, in any case, and under current announced plans by the FOMC, the current regime - a type of floor-on-the-floor monetary regime - should be with us for some time.Stephen Williamsonhttp://email@example.com:blogger.com,1999:blog-2499715909956774229.post-19148943428808898172014-10-22T19:37:00.000-07:002014-10-22T19:37:19.202-07:00What's More Scary, Ebola or Deflation?David Wessel gives us five reasons to worry about deflation. Should we worried? Well, probably not for the reasons Wessel mentions, which are:

First:
Deflation is a generalized decline in prices and, sometimes, wages. Sure, if you're lucky enough to get a raise, your paycheck goes further–but those whose wages decline or who are laid off or work fewer hours are not going to enjoy a falling price index.
Here's what I think Wessel might be trying to say. Imagine a Woodford cashless world in which money serves only as a unit of account. As well, there are no sticky prices or sticky wages, but suppose there are labor market frictions, so that there is always some churn in the labor market and some unemployment. In this world, the inflation rate does not matter. Wages, prices, unemployment insurance benefits, etc., are all indexed to the aggregate price level. That's a useful starting point. You can see that Wessel is a little confused though, as in such a world, there's really nothing to "enjoy" about deflation. We really wouldn't care.

Second:
It can be hard (though, as we've seen, not impossible) for employers to cut nominal wages when conditions warrant; it's easier to give raises that are less than the inflation rate, which is what economists call a real wage cut. And if wages are, as economists say, marked by "downward nominal rigidity," then employers will hire fewer people.
So, suppose that there is a sustained deflation of, say, -2% per year. Also, suppose that there is a law stating that no firm can reduce an existing employee's nominal wage rate. Question: Will that constraint bind in enough circumstances to matter in an economically significant way? Answer: Probably not. Why? First, on average, real wages increase over time with productivity growth. Of course, if we are experiencing productivity growth of 1% per year, and an inflation rate of -2% per year, average nominal wages should be falling at about 1% per year. But, supposing all workers are identical, it can still be the case that each individual living in this world can have an increasing nominal wage profile over his or her lifetime, since individual productivity can be growing at a much higher rate than aggregate productivity, as the individual gains experience (and thus accumulates human capital) over his or her lifetime. But individuals are not identical. People experience random shocks to their health that affect their productivity, and particular skills become more or less valuable in the market as technology changes and demand shifts among goods and services. So, if everyone were paid their marginal products, this would in general require downward nominal wage adjustments for some workers in the face of generalized deflation. But there are ways to get around a constraint on reducing the nominal wage rate for a given worker in a given job. It may be possible to adjust the worker's assigned tasks - i.e. change the job instead of the wage. Also, benefits can be adjusted. There is always job turnover, so it is possible for a given firm to adjust wages for its workforce through attrition. Further, of course firms are not literally constrained to refrain from downward nominal wage adjustment. In the face of a persistent deflation, it's straightforward for managers to point that out to workers - presumably most workers know what the CPI is. As well, firms that find ways to reduce nominal compensation where appropriate in the midst of a deflation will do better than those who don't, and most workers faced with losing their jobs or taking a nominal wage cut would choose the latter. So, I can't see that this is a serious problem. If a nonnegativity constraint on nominal wage changes were serious business, I think labor economists would be paying more attention to it. The fact that they don't is important, I think.

Third:
As economic textbooks teach, the prospect that things will cost less tomorrow than they do today encourages people to put off buying. If enough people do that, then businesses are less likely to hire and invest, and that makes everything worse.
If people actually put this idea in textbooks, that is a bad thing. It's certainly not in mine. See my comment on #1. If deflation is just a sustained decrease in the unit of account, and nothing else, then it can't have any consequences for consumption/savings decisions. To say something about that we have to go more deeply into what is causing the deflation, its effects on rates of return on assets, etc. #3 makes no more sense than to say that there will be higher consumption and lower savings if the inflation rate is 5% rather than 3%. It's not clear why.

Fourth:
Deflation is terrible for debtors. Prices and wages fall, but the value of your debt does not. So you're forced to cut spending. This applies to consumers and to governments, and it is one of the biggest issues in Europe right now. As Yale University economist Irving Fisher wrote decades ago, debtors are likely to cut spending more than creditors increase it, and this can turn into a really bad downward spiral. (The experience of Japan, though, proves that an economy can have a prolonged period of moderate deflation without falling into that downward spiral.)
Unfortunately, Wessel does not make clear the difference between anticipated deflation and unanticipated deflation. #1 through #3 seem to be about anticipated deflation, while #4 is about unanticipated deflation. Most debt contracts are written in nominal terms, so if the inflation rate is lower than anticipated, this will redistribute wealth from debtors to creditors. The debtors are not actually "forced to cut spending." That might be one margin on which to make adjustments, but debtors might also work harder, or default on their debt. Does this redistribution of wealth just net out in the aggregate, as the creditors are better off, and will consume more, work less, and not be repaid if debtors default? Wessel invokes Irving Fisher to argue no, but I think the more important factor here - which Fisher never thought about, as far as I know - is the asymmetry due to bankruptcy costs. In contrast to inflation that is higher-than-anticipated, lower-than-anticipated inflation induces more bankruptcies, and the ensuing bankruptcy costs are a net loss to society. That could be important. But note that this is not particularly associated with inflation going into negative territory, but simply a feature of disinflation in general. But, note that the disinflation that occurred between 1980 and 1985 was in the neighborhood of 10 percentage points, depending on the inflation measure we look at. That experience was of course associated with a severe recession, but the U.S. economy bounced back quickly - no signs of a "bad downward spiral." So if central banks fall short of 2% inflation targets by one, two, or three percentage points, that doesn't seem like such a big deal. I'll discuss Japan below, but I don't think that's quite the unanticipated disinflation experience Wessel is looking for.

Fifth:
Cutting interest rates below zero is very hard. Yes, one way that central bank magic works is that the Federal Reserve and the European Central Bank cut inflation-adjusted interest rates below zero when times are bad, hoping to spur borrowing, spending and investment. But it's almost impossible for them to cut rates below zero. (Sure, there are some examples of negative interest rates, but they're not very negative.)

If there's 4% inflation, a zero interest rate works out to a -4% real (or inflation-adjusted) rate. At no inflation, a zero interest rate is, well, zero. And with deflation, a zero interest rate is a positive real rate. Deflation just makes all this harder to do.
I think what Wessel is getting at is that, with short term nominal interest rates at zero, a central bank is limited in its power to raise inflation, if we think that the way to lower inflation is to lower the nominal interest rate. Actually, as I'll explain below, short-term nominal interest rates at zero have a lot to do with why inflation is low in the world, as Irving Fisher (who Wessel seems to approve of) told us.

Theory
What causes deflation? Is deflation a good thing or a bad thing? It is now well understood that central banks can and should control inflation. So, if we observe low inflation, or outright deflation, this should have something to do with monetary policy. In standard monetary models, deflation can happen when the nominal interest rate stays at zero indefinitely. Indeed, a ubiquitous result is that a Friedman rule is optimal. Under a Friedman rule for monetary policy, the nominal interest rate is zero forever. Milton Friedman's argument was that a positive nominal interest rate represents a distortion. This distortion can be removed if the central bank acts to give money the same rate of return as other safe assets, which will typically imply deflation, at least on trend. So, theory tells us that deflation can be a good thing.

If that is correct, then why do so many central banks think that 2% inflation is a good idea? Perhaps there are good reasons to have a positive inflation tax. Currency systems are costly to operate. It requires real resources to replace worn-out currency and prevent counterfeiting. As well, currency is used for various nefarious things - tax avoidance and illegal drug purchases, for example. So, maybe it is optimal to have positive inflation as an implicit tax on currency holdings. As well, it may not make much difference for long-run economic welfare whether the inflation rate is 2%, 4%, 0%, or -2%. But having a stable inflation rate is welfare-improving, as this minimizes the unanticipated redistributions between creditors and debtors that occur with unexpected changes in the inflation rate, as discussed above. To achieve a stable inflation rate, the central bank has to announce an inflation target, and then set policy in a way that achieves this inflation target, thus establishing credibility. If the central bank's inflation target is 2%, and there is persistent deflation, then deflation is bad because it undermines the central bank's credibility.

Practice
Do we have any experience with economies that look more or less like Friedman rule economies? Japan, of course, is the standard - and only - example. From mid-1995 to the present, the overnight interest rate in Japan has been below 1%, and for much of that period close to zero.

Over this period there has certainly not been sustained deflation. If we confine attention to the pre-2014 period in the chart, the CPI inflation rate (year-over-year) has fluctuated between, roughly, -2.5% and 2.5%. The next chart shows the CPI level over the same period.

This last chart shows that, at the end of 2013, the price level was about the same as in mid-1995, so the average inflation rate over the period 1995-2013 was about zero. Thus, as far as experience in Japan tells us, if the central bank maintains the short-term nominal interest rate at close to zero for a long period of time, this produces volatile inflation, but not deflation (on average). Thus, the worry reflected in Wessel's piece concerning deflationary sprirals, or deflationary traps, seems not to be rooted in experience - or theory for that matter.

Wessel's concern of course was not specifically with Japan, but with recent low inflation as reflected in European consumer prices and world commodity prices. We could also add that recent inflation data has been on the low side in Sweden, Switzerland, the U.K., and in the U.S. What do all of these economies have in common with Japan during the period we examined above? Short-term nominal interest rates in all of these instances have been close to zero for extended periods. So what causes low inflation over long periods of time, and raises the possibility of deflation? Low short-term nominal interest rates over long periods of time.

Why can economies get stuck at the zero lower bound (essentially) on nominal interest rates for long periods of time - or forever? Theory tells us something about this. Work by Benhabib et al. summarized by Jim Bullard shows how a central banker who conforms to the Taylor rule can cause the economy to converge to a zero-lower-bound steady state. The Taylor-rule central banker sees low inflation, and persists in trying to raise inflation by keeping the nominal interest rate at zero. But this only serves to maintain inflation at a low rate - in fact, there is deflation, in the framework considered. Effectively, in the long run the real interest rate is determined by factors outside the control of monetary policy, under any circumstances. But then, if the nominal interest rate is zero for a long time, the inflation rate will then be determined by those non-monetary factors.

But what would be the harm in having a zero-lower-bound economy indefinitely? To answer this question, it's useful to look at the performance of the Japanese economy from 1995 until now. In the labor market, the unemployment rate was not indordinately high, ranging from about 3% to 5.5%.

As well, the employment rate for people 15-64 is currently 3 percentage points higher than in mid-1995.

What about real GDP and consumption?

There has certainly been trend growth in real GDP and consumption in Japan since 1995, but the growth rate has been low relative to the United States. In Japan, average growth in consumption over the entire period was 0.8%, and average growth in real GDP was 0.9%. It's important to note, though, that demographic trends are much different in Japan than in the U.S. Since 1995, total population in Japan has been essentially flat, and the fraction of retired people in the population has increased. So in terms of per capita real GDP growth, this tends to push U.S. and Japanese experience closer together.

To summarize some of the demographic effects in one measure, the next chart looks at average labor productivity (real GDP divided by employment) in the U.S. and Japan from 1995-present.

In the chart, I've normalized to make productivity equal in the two countries in mid-1995. You can see that the U.S. performed better over the whole period, but the better performance of the U.S. was over the period 1995-2000, and post-Great Recession (somewhat). Over the period from 2000-2008, productivity growth in the two countries was about the same.

So, overall, real economic performance in Japan during the zero-lower-bound period was not a disaster, nor was it particularly good. It's hard to say, though, from this cursory evidence, that low or negative inflation had much to do with any substandard performance of the economy. What is clear from the zero-lower-bound Japanese experience is that inflation was quite variable, as shown in the first chart. Clearly, if the Bank of Japan was trying to stabilize the inflation rate over this period, it was not doing a a good job. But perhaps there are unconventional monetary policies that the Bank could have pursued that would have permitted it to do better.

Indeed, in April 2013, the Bank of Japan embarked on a massive quantitative easing (QE) program. We can see the effects of that on the liabilities side of the Bank of Japan's balance sheet in the next chart, where we show the Japanese monetary base.

From the Bank of Japan's web site, here are the details of the Bank of Japan's QE program:
The Bank introduced "Quantitative and Qualitative Monetary Easing" (QQE) in April 2013 to achieve the price stability target of 2 percent in terms of the year-on-year rate of change in the CPI at the earliest possible time, with a time horizon of about two years. Under the QQE, the Bank continues to pursue a new phase of monetary easing both in terms of quantity and quality. It will double the monetary base and the amounts outstanding of Japanese government bonds (JGBs) as well as exchange-traded funds (ETFs) in two years, and more than double the average remaining maturity of JGB purchases.
So, given the two-year time frame, the Bank of Japan has about 6 months more to achieve its 2% inflation goal. How has it done? Here's the CPI path from April 2013:

So, this makes it appear that the Bank of Japan should come close to meeting its target. However, a large fraction of the increase in the CPI over this period is due to an increase from 5% to 8% in the consumption tax in Japan, which is effectively reflected one-for-one in the CPI. The tax increase occurred in April 2014, which you can readily see in the data. So, if we take out the effects of the tax increase, the CPI has been almost flat for the last year. So, there is no evidence that QE has had the effects on inflation that the Bank of Japan would like.

The Japanese experience therefore seems consistent with the following conclusions about the operating characteristics of an economy at the zero lower bound for a long time:

1. The central bank will fail to meet a 2% inflation target, on average.
2. The inflation rate will be highly variable.
3. If the central bank is counting on QE to help it hit a 2% inflation target while the short-term nominal interest rate is at the zero lower bound, good luck.
Stephen Williamsonhttp://email@example.com:blogger.com,1999:blog-2499715909956774229.post-78341660519850170462014-09-19T06:39:00.000-07:002014-09-19T06:39:58.572-07:00What Have We Learned Since 2009?In September 2009, Paul Krugman wrote "How Did Economists Get It So Wrong? The key points in that magazine article were:

1. Economists did not see the financial crisis coming, therefore there is something wrong with economics.
2. It's not hard to see what is wrong with economics - it got seriously sidetracked, roughly in 1970.
3. What to do? According to Krugman:
First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit — and this will be very hard for the people who giggled and whispered over Keynes — that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they'll have to do their best to incorporate the realities of finance into macroeconomics.
So, what's changed since 2009, at least in Krugman's mind? Not much, apparently. Krugman's Monday NYT column was titled "How to Get it Wrong." Now it's not just the economists who are stupid/misguided/nefarious - it's the policymakers as well. Maybe this is good news if you are an economist. If you are an economist and a policymaker, not so good, I'm afraid.

Not one to shy away from hyperbole and invective, Krugman tells us about an "enormous intellectual failure" in economics, and the "sins of economists, who far too often let partisanship or personal self-aggrandizement trump their professionalism." Economists are clearly a group of bad people, and if you follow the links in his piece, you can figure out who some of the bad guys are. Bob Lucas, for example, who played a starring role in Krugman's 2009 piece. Apparently Lucas was one of those people who imagined an "idealized vision of capitalism, in which individuals are always rational and markets always function perfectly."

So, let's start with that. Part of Krugman's game is to convince you of the moral inferiority of the people he disagrees with, which serves to excuse his name calling. That's what he says in this post:
And if you look at the uncivil remarks by people like, well, me, you'll find that they are similarly aimed at people arguing in bad faith ... what I'm doing is going after bad-faith economics — economics that keeps trotting out claims that have already been discredited.
The problem of course, is that "discredited" is in the eye of the beholder - Krugman's eye basically. If I follow those rules, I can "discredit" someone, then abuse them all I want.

So, what do the "discredited" economists do? Apparently, those bad people think that "individuals are always rational and markets always function perfectly." First, on rationality, I don't think Krugman has a published paper with irrational economic agents in it (someone please point one out to me, if this is incorrect). So, if we follow what Krugman does, rather than what he says, that might actually conform to my defense of rationality in economics:
In my view, irrationality is the great cop-out, and simply represents a failure of imagination. Rationality is so weak a requirement that the set of potential explanations for a particular phenomenon that incorporate rationality is boundless. If the phenomenon can be described, and we can find some regularity in it, then it can also be described as the outcome of rational behaviour. Behaviour looks random only when one does not have a theory to make sense of it, and explaining it as the result of rational behaviour is literally what we mean by 'making sense of what we are seeing'.
Second, modern macroeconomics (which Krugman detests) is replete with frictions - it's hardly about markets functioning perfectly. For example, Evil Ed Prescott did some work, with Finn Kydland, on models in which markets work really well. RBC models are basically special cases of Arrow-Debreu. The whole idea is to see how much you can explain without having to resort to frictions. But Kydland and Prescott received the Nobel Prize in 2004, in part for their work on time consistency. The basic idea is that the ability of a policymaker to commit is critical. Even a benevolent policymaker could choose bad policies if there is nothing to stop him or her from breaking promises. So, that's a world that doesn't work perfectly, and the time consistency idea has been highly influential in policy circles and in macroeconomic modeling. Indeed, it's very important in New Keynesian economics. That's an example of specific research by someone in Krugman's bad-person camp, that doesn't fit the profile. More generally, if you look through this year's SED program, you're going to find a lot of frictions - more frictions than you can shake a stick at. And this is from the society founded by the Minnesota macros, basically.

A new complaint of Krugman's is that the academic economic journals are ignoring good work:
...starting in the 1980s it became harder and harder to publish anything questioning these idealized models in major journals.
By "idealized models," I think he means Arrow-Debreu. That's quite a charge - apparently the economics profession is so ill that scientific progress is grinding to a halt. So, what's the evidence for the charge? Krugman quotes Ken Rogoff, who has a gripe:
There are more than a few of us in my generation of international economists who still bear the scars of not being able to publish sticky price papers during the years of new neoclassical repression.
Yes, and poor Rogoff was so repressed that he carried his scars from UW-Madison, to Berkeley, to Princeton, and now must reside, scarred, in that intellectual backwater, Harvard University. Complaints about academic journals are universal. There is no shortage of whining about the nasty Keynesians, the nasty theorists, the nasty new old non-neoclassical whoevers who reject one's papers. Being misunderstood comes with the territory in economics, I'm afraid. Best have a thick skin if you want to survive. If the best Krugman can come up with is a complaint from 13 years ago about what happened 30 years ago, this isn't worth much.

If there is an important change in Krugman's approach from 2009 to today, it's in what he expects from the profession. In 2009, he wanted people "to admit that Keynesian economics remains the best framework we have for making sense of recessions and depressions." Presumably "Keynesian economics" includes New Keynesian economics. Further, Krugman was willing to recognize, at that time, that there was interesting work going on outside of what we might call Keynesian thought:
One line of work, pioneered by none other than Ben Bernanke working with Mark Gertler of New York University, emphasized the way the lack of sufficient collateral can hinder the ability of businesses to raise funds and pursue investment opportunities. A related line of work, largely established by my Princeton colleague Nobuhiro Kiyotaki and John Moore of the London School of Economics, argued that prices of assets such as real estate can suffer self-reinforcing plunges that in turn depress the economy as a whole.
That seemed promising. At least Krugman was aware of some of the work, preceding the financial crisis, which dealt with financial frictions. A lot of that work continues, and there is much more of it now, propelled of course by the financial crisis experience. Some of that recent work was presented at a conference that I organized, with Mark Gertler (see above) at the St. Louis Fed late last year. The people at that conference were from both sides of the fence that Krugman imagines divides the macroeconomics profession. The papers were very interesting, and they went some way toward helping us understand the causes and consequences of the financial crisis. Progress!

The 2014 Krugman has lowered his sights considerably.
...the world would be in much better shape than it is if real-world policy had reflected the lessons of Econ 101.
This isn't a call for refurbishing macroeconomic thought with irrationality and frictions. What Krugman wants is a reversion to the technology of 1937. Why? From this blog post:
Why is output so low and jobs so scarce? The simple answer is inadequate demand — and every piece of evidence we have is consistent with that answer...there is a deep desire on the part of people who want to sound serious to believe that big problems must have deep roots, and require many hours of solemn deliberation by bipartisan panels.
So, now I'm confused. Krugman says macroeconomics went wrong after 1970, and one of the primary culprits was Lucas, who apparently told us that economies work perfectly, and don't need help from policymakers. Krugman also links to this 2003 paper by Lucas from which this quote is extracted:
Macroeconomics was born as a distinct field in the 1940's, as a part of the intellectual response to the Great Depression. The term then referred to the body of knowledge and expertise that we hoped would prevent the recurrence of that economic disaster. My thesis in this lecture is that macroeconomics in this original sense has succeeded: Its central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved for many decades.
This quote is intended as an example to show us how out to lunch mainstream economics was before the financial crisis. Obviously, Krugman is telling us, these guys didn't have a clue what was in store. But, in the conclusion to his paper, Lucas also tells us:
If business cycles were simply efficient responses of quantities and prices to unpredictable shifts in technology and preferences, there would be no need for distinct stabilization or demand management policies and certainly no point to such legislation as the Employment Act of 1946. If, on the other hand, rigidities of some kind prevent the economy from reacting efficiently to nominal or real shocks, or both, there is a need to design suitable policies and to assess their performance. In my opinion, this is the case: I think the stability of monetary aggregates and nominal spending in the postwar United States is a major reason for the stability of aggregate production and consumption during these years, relative to the experience of the interwar period and the contemporary experience of other economies. If so, this stability must be seen in part as an achievement of the economists, Keynesian and monetarist, who guided economic policy over these years.
This sounds nothing like the Lucas that Krugman is telling us about. In fact, he seems to have a lot in common with Krugman. Seems the 2003 Lucas thought that important inefficiencies exist in the absence of government intervention, and that "stabilization or demand management policies" can and did fix these problems. Lucas also tells us that the Depression problem has been fixed. We don't have to worry about it anymore - because stabilization and demand management are at the ready. Krugman says our current problems, as he sees them, can be fixed by standard "Econ 101" stabilization and demand management. Apparently Lucas was a dummy for thinking the depression problem had been solved by stabilization and demand managment. You idiot, our modern depression problem needs to be solved by stabilization and demand management.

Krugman is right, in a sense. The solutions to economic policy problems can indeed be simple - once you know the answer. It's determining the answer that is hard. If the solution to our policy problems was all in Econ 101, we wouldn't hire economists with PhDs to do economic policy. We wouldn't spend all the time we do hashing over policy problems, or arguing with Paul Krugman about why it's not as easy as he claims. Further, to say that the solution is in Econ 101 is actually an insult to Econ 101 students. Econ 101 students, if they are taught properly, know that the inefficiencies resulting from price and wage rigidity, if they exist, don't last forever, and if they lasted 6 years after a financial crisis occurred, we would be very surprised. Thus, a smart Econ 101 student might question why conventional demand management is going to solve whatever problem exists. Well-trained Econ 101 students also understand that, if we want to solve an economic problem, it will help a lot to understand the cause of the problem. If as Krugman tells us "textbook economics...didn't predict the crisis," or indeed tell us anything about what a crisis is, or what would cause it, what's it going to say about how to fix things up once the crisis hits, or six years after it went away?

Stephen Williamsonhttp://email@example.com:blogger.com,1999:blog-2499715909956774229.post-10469863691326160032014-09-08T17:51:00.000-07:002014-09-09T12:44:35.998-07:00Theories of Inflation and the European PredicamentHow do macroeconomists think about inflation? To get a grip on this, it's useful to dig into the history of economic thought. Long ago, in the mid-1970s, when I had no idea what formal economics was about (and, you might say, nothing much has changed), I had heard about "wage-price spirals." A web search will give you plenty of descriptions of what we might charitably call the "wage-price spiral theory" of inflation. Here's one that's as good as any:
When an economy is operating at near full employment and people have money to spend, demand for goods and services increases. To meet the demand, companies expand their businesses and hire more workers. However, at near full employment, most workers already have jobs. So companies have to lure workers with higher wages, which, of course, increases the companies' costs, explains the website Biz/ed. The workers then push for higher wages to meet the higher prices and expected price hikes, which increases company costs again. Theoretically, this continues in an inflationary spiral until a loaf of bread costs the proverbial wheelbarrow full of cash.
You'll notice that the behavior of governments and central banks doesn't enter into the story. Apparently a wage-price spiral is a self-fulfilling dynamic process which could start under any conditions and continue forever - unless something is done about it. In the 1970s, some policymakers thought the solution to a perceieved wage-price spiral problem was (naturally) wage-price controls. For example, Richard Nixon tried a 90-day wage-price freeze, and the government of Canada imposed wage-price controls for a much longer period of time. Such controls were advocated by economists like John Kenneth Galbraith, who perhaps wasn't taken so seriously by most academics, but even mainstream macroeconomists such as James Tobin could sometimes find "incomes policies" attractive.

In current academic circles, there isn't much talk about wage-price spirals, though of course some ideas never die. Perhaps the primary achievement of the Old Monetarists - principally Milton Friedman - was to convince people that inflation control is the job of central banks, and that wage-price controls only produce inefficiencies (though experience with those policies was pretty convincing as well). So, if inflation control is the job of the central bank, and we think there is something wrong with the inflation rate, we know who to blame. Of course, Friedman seems to have failed to give central banks useful instructions for implementing inflation control. He argued that there is a direct link between money growth and long-run inflation, that monetary disturbances are a primary determinant of fluctuations in real GDP, and that "fine-tuning" is inappropriate. So, Friedman reasoned, the appropriate monetary policy is:
...that the monetary authority go all the way in avoiding such swings by adopting publicly the policy of achieving a steady rate of growth in a specified monetary total. The precise rate of growth, like the precise monetary total, is less important than the adoption of some stated and known rate. I myself have argued for a rate that would on the average achieve rough stability in the level of prices of final products, which I have estimated would call for something like a 3 to 5 per cent per year rate of growth in currency plus all commercial bank deposits or a slightly lower rate of growth in currency plus demand deposits only. But it would be better to have a fixed rate that would on the average produce moderate inflation or moderate deflation, provided it was steady, than to suffer the wide and erratic perturbations we have experienced.
Like wage and price controls, targeting of monetary aggregates was tried (in the 1970s and 1980s, primarily) and it failed. The relationships among monetary aggregates, inflation, and real economic activity proved to be highly unstable, causing Old Monetarist prescriptions to work poorly. That doesn't stop the proponents of Old Monetarism -a dwindling breed- from trying. We can still find work involving searches for the elusive ideal monetary aggregate or searches for the elusive stable money demand function.

So, if inflation control through money growth targeting works poorly, what to do then? Some central banks opted to target inflation directly or, more generally, there was some recognition that the central bank should take nonneutralities of money into account, and Taylor wrote down a simple rule of thumb that would allow for that. The Taylor rule was subsequently enshrined in New Keynesian models, along with an updated version of the Phillips curve.

The Phillips curve appears to be the modern version of the wage-price spiral. Typically, that's how the inflationary process is described for the lay person. For example, here's from a recent blog post in The Economist:
The American economy, we wrote in July, almost certainly has less room to grow than it used to. Estimates of the economy's potential output, or how much it can produce at a given time without serious inflationary pressure building, have been revised down substantially by the Congressional Budget Office and other economists studying the issue.
That was from a piece on potential output in the United States, but what I am interested in is the part about "serious inflationary pressure." Apparently there is more inflationary pressure the lower is the output gap - the difference between "potential" output and actual output. Clearly the writer(s) of this blog post subscribe to a Phillips curve theory of inflation. The Old Monetarists (Friedman) and modern structuralists (Lucas) may have thought they debunked Phillips curve thinking, but it's remarkably persistent. How come?

If you think a stable money demand function is hard to find, try to find a Phillips curve in the data. As with the money demand function though, nothing stops a committed Phillips curve adherent. Whether by finding the right combination of inflation measure and output gap measure, judicious use of Bayesian estimation, or whatever, by hook or by crook a Phillips curve can indeed be uncovered in the data. But, as I outline here, it's hard to make a case that the Phillips curve is helpful for thinking about inflation, its causes, and what to do about it. For example, Phillips curves are not useful in forecasting inflation (see this paper by Atkeson and Ohanian.).

Diehard Phillips curve folks, in extreme states of denial, will insist that the output gap is a latent variable, and thus the existence of low inflation implies that the output gap must be high. Indeed, from the blog post in The Economist, quoted above, if we take potential output to be defined by the behavior of the inflation rate (as seems to be implied by the quote), we should be able to back out a measure of of the output gap from the actual inflation rate. I'm pretty sure that, if you do that exercise, you will come up with nonsense.

But perhaps the Phillips curve - even as complete fiction - has been useful, if for nothing else than to permit agreeement among policymakers. In the recovery phase of a business cycle downturn, supposing the nominal interest rate and the inflation rate are low, an appeal to the Phillips curve can help in obtaining agreement to "tighten," i.e. to raise the policy rate. Even though inflation is low, it can be argued that "inflation pressure" exists, inflation threatens, and tightening should occur before it is too late. Old Monetarists, Old Keynesians, and New Keynesians alike, might find reasons to agree on that. Indeed, I think we can write down models where this would be self-fulfilling, and that type of reasoning - though it may actually be wrong - could yield the right policy decision. The policy decision would be right in the sense that it would avoid the bad equilibrium (bad in the sense of not achieving the central bank's inflation target) that converges to the zero lower bound and low inflation forever - see this paper by Jim Bullard.

So, what does this have to do with Europe? Here's what's happened to the average of inflation rates across countries in the Euro zone:

The inflation rate has fallen dramatically, and is now well below the ECB inflation target of 2%. As well, long bond yields (in this case of 10-year bonds) are down sharply:

Today's 10-year German bond yield is even lower than when I constructed this chart - it's 0.95%, relative to 2.375% for a 10-year U.S. Treasury bond.

The recent European experience might look familiar to someone who lived in Japan, say over the period 1990-1995. Here's CPI inflation in Japan:

And here's the 10-year bond yield for Japan:

There are some differences of course, for example it took longer for the inflation rate and bond yield to fall in Japan, but the experience is roughly similar.

What is the mandate of the ECB? From the ECB's web site:
The ECB's main task is to maintain the euro's purchasing power and thus price stability in the euro area.
In case it's not clear to you what that means, there is an explanation here. Apparently price stability means that inflation rates between 0% and 2% are more or less OK, negative inflation rates are not OK, and maybe 1.8% is more OK than 0.8%. Suffice to say, though, that the ECB is changing policy, or about to change policy, on several dimensions, so it appears to think that the inflation you see in the first chart is definitely not OK, or projected to be not OK. Draghi's press conference after the policy change makes it clear that he's worried about a decline in inflation expectations, which you can see in breakeven rates on European government bonds.

So, since it appears the ECB wants to increase the inflation rate in the Euro zone, how does it intend to to it? First, the ECB has reduced its policy rates. The interest rate on the ECB's main refinancing operations was reduced to 0.05%, and the interest rate on deposits at the ECB was reduced to -0.20%. The refinancing rate is important, as the ECB does not typically intervene directly in an overnight market as is the case, for example, in the United States, but by lending to financial institutions, and the key lending facility is "main refinancing." The ECB has also taken the unusual step of charging for the privilege of holding reserves at the ECB, i.e. the ECB currently has a -0.20% lower bound rather than a zero lower bound. People - Miles Kimball among them - who think that relaxing the zero lower bound on the nominal interest rate will solve the world's problems get very excited about this. Second, there is a central bank credit program about to get underway, i.e. TLTROs (targeted long-term refinancing operations), which is central bank lending to European financial institutions with attached incentives to encourage these institutions to lend to the private sector. Third, there are planned asset purchases by the ECB - quantitative easing (QE) - with some of the specifics to be worked out later. Again, Draghi answers some questions about this in his press conference. It seems the asset purchases will take two forms: asset-backed securities and covered bonds. A covered bond is basically a collateralized bond, secured by a specified set of assets on the issuer's balance sheet, rather than being subject to the usual seniority rules in bankruptcy proceedings.

What theory of inflation could we use to think about the ECB's change in policy? Though some deflation-scare stories sound something like old wage-price spriral stories in reverse, let's dismiss that. What about Old Monetarism? It's reported in the press conference that M1 in the Euro area was growing at 5.6% in July, and that wouldn't alarm a quantity theorist, I think. However, belief in the Phillips curve is certainly consistent with what the ECB is doing, or proposing to do. Real economic activity is deemed to be weak, so a Phillips curve adherent might think that has something to do with the low rate of inflation in the Euro zone. Then, if we follow Old or New Keynesian prescriptions, conventional monetary easing - lower nominal interest rates - should increase output and inflation. Unconventional easing (QE and relaxing the zero lower bound) could be added to the Keynesian mix, given the zero-lower-bound problem.

But what if we think more carefully about the key elements of the "easing" program?

Starting with the last policy change first - ECB asset purchases (QE) - we might ask why this might matter. The press conference I think makes clear what I have in mind. Draghi says:
So QE is an outright purchase of assets. To give an example: rather than accepting these assets as collateral for lending, the ECB would outright purchase these assets. That's QE. It would inject money into the system.
Then later:
Let me also add one thing, because the ABS may sound more, I would say novel, than they are in the ECB policy-making, and indeed, the modality is novel, because we would do outright purchases of ABS, but the ABS have been given as collateral for borrowing from the ECB for at least ten years, so the ECB knows very well how to price and how to treat the ABS that's accepted, especially since we have, - and this is in a sense another dimension that makes any precise quantification difficult at this point in time - we have narrowly defined our outright purchase programme to simple and transparent ABS.
So, you might ask why it would make a difference if the ECB purchases a given asset outright, vs. extending a loan to a financial institution with the asset posted as collateral. Why would there be a bigger effect - and on what - in the first case relative to the latter?

Next is the TLTRO. Details of this program can be found here and here. This is basically an incentive program for lending by ECB financial institutions, tied to main refinancing operations - a kind of subsidized lending program. There's no particular link to inflation, unless we think there is some mechanism by which more credit - or credit reallocation - matters for inflation.

Finally, let's look at the ECB's interest rate policy, which I want to spend some time on. There are two parts to this. The first is conventional easing, which in the case of the ECB is a drop in its main refinancing rate - the rate at which it lends to financial institutions. The second is unconventional - a drop in the interest rate on reserves to a lower negative rate. The key worry here is that the ECB becomes trapped in a state with low inflation and low nominal interest rates forever, and can't get out. Note that this is a policy trap, not the "deflationary trap" that some people worry about. This is what Jim Bullard discusses in this paper. It's well known that conventional Taylor rules can have poor properties, and can lead to policy traps of this type. If inflation is low, the central bank lowers the nominal interest rate, which leads to lower inflation in the long run due to the Fisher effect. Ultimately, the economy converges to a steady state at the zero lower bound with inflation lower than what the central bank wants, and it can't get out unless the policy rule changes. Further, note that relaxing the zero lower bound won't help. If the central bank charges negative interest on reserves, this only lowers the inflation rate at the low-inflation steady state.

Could a central bank actually get into a low-inflation policy trap and not figure it out? The Japanese case shows us that central bankers can be very stubborn. In the case of Europe, here's what's been happening to the overnight interest rate and the inflation rate over time:

And here's the same data as a scatter plot:

You can see that there is substantial variation in the real ex post interest rate, but the Fisher relation shows up in the scatter plot, just as it does for the United States. Given this, and the first four charts in this post, it might enter your mind that Europe might be going in the same direction that Japan did 20 or more years ago.

How could we think about monetary policy in this context? Our goal is to determine what it takes to increase the inflation rate in an economy, taking into account short run effects, and the Fisher effect, which will dominate in the long run. One model that captures some of what we might be interested in is a segmented markets model. I'm going to use it because it's simple, and the key implications may not be so different if we were to include other types of short-run monetary non-neutralities. A very simple segmented markets model is in this paper by Alvarez, Lucas, and Weber. The details of what I did are in these notes that I've posted.

In the model, there are many households which each live forever. Each has a fixed endowment of goods each period, and sells those goods in a competitive market for cash. Goods are purchased from other households subject to cash-in-advance. There are two types of households - traders and non-traders. A trader can trade in the bond market each period, and holds a portfolio of money and bonds. Non-traders do not trade in the bond market, and hold only cash. The central bank intervenes by way of open market operations, the result being that an open market purchase of government bonds initially affects only the traders. There is a nonneutrality of money, which comes about because of a distribution effect of monetary policy. An open market purchase will increase the consumption of traders in the short run, and it is the consumption of traders that determines bond prices. Thus, when the open market purchase of bonds occurs, this tends to increase consumption of traders and nominal and real interest rates go down. But standard asset pricing implies that there is a Fisher effect - higher anticipated inflation implies a higher nominal interest rate.

In my notes, I work out the local dynamics of this economy. I don't worry about liquidity traps as I'm interested in what happens when the central bank gets off the zero lower bound. If the central bank experiments with random open market operations, it will observe the nominal interest rate and the inflation rate moving in opposite directions. This is the liquidity effect at work - open market purchases tend to reduce the nominal interest rate and increase the inflation rate. So, the central banker gets the idea that, if he or she wants to control inflation, then to push inflation up (down), he or she should move the nominal interest rate down (up).

But, suppose the nominal interest rate is constant at a low level for a long time, and then increases to a higher level, and stays at that higher level for a long time. All of this is perfectly anticipated. Then, there are many equilibria, all of which converge in the long run to an allocation in which the real interest rate is independent of monetary policy, and the Fisher relation holds. A natural equilibrium to look at is one that starts out in the steady state that would be achieved if the central bank kept the nominal interest rate at the low value forever. Then, in my notes, I show that the equilibrium path of the real interest rate and the inflation rate look like this:

There is no impact effect of the monetary "tightening" on the inflation rate, but the inflation rate subsequently increases over time to the steady state value - in the long run the increase in the inflation rate is equal to the increase in the nominal rate. The real interest rate increases initially, then falls, and in the long run there is no effect on the real rate - the liquidity effect disappears in the long run. But note that the inflation rate never went down.

We could add things to this model - liquidity effects on the real rate from scarce safe assets, real effects of monetary policy on aggregate output, etc., and I don't think the basic story would change. The story is that a sustained increase in the inflation rate is not possible unless the nominal interest rate goes up. Further, note that the real interest rate goes up temporarily in the process, and with a more fully developed model, there may be pain associated with that. Of course, in economics free lunches are always hard to find. If we think that higher inflation in the long run is good for us, it's hard to imagine there wouldn't be some cost to getting there.Stephen Williamsonhttp://firstname.lastname@example.com:blogger.com,1999:blog-2499715909956774229.post-58359829987445864222014-08-19T08:21:00.000-07:002014-08-19T08:21:35.319-07:00Secular Stagnation: Useful Ideas or Hot Air?There is an ebook available on "Secular Stagnation: Facts, Causes, and Cures," which consists of a set of papers by a group of economists, brought together in an attempt to understand secular stagnation, and how we might address the problem, if it is one. Some of the papers are summaries of published or unpublished research, while others are more speculative.

What is secular stagnation? Apparently it's frequently on the lips of some people, but according to Barry Eichengreen,
...while the term 'secular stagnation' was widely repeated, it was not widely understood. Secular stagnation, we have learned, is an economist's Rorchach Test. It means different things to different people.
I think the problem here is that an idea cannot be understood if it's not an idea. The people who claim that the idea exists - principally Larry Summers and Paul Krugman - trace it to Alvin Hansen's "Economic Progress and Declining Population Growth," from 1939. Nicholas Crafts summarizes what Hansen had to say:
The first time around, 'secular stagnation' was a hypothesis famously articulated by Alvin Hansen ... Hansen argued that the US economy faced a crisis of underinvestment and deficient aggregate demand, since investment opportunities had significantly diminished in the face of the closing of the frontier for new waves of immigration and declining population growth. It was as if the US was faced with a lower natural rate of growth to which the rate of growth of the capital stock would adjust through a permanently lower rate of investment.

As we all know, these fears were completely without foundation – the delusions of a hypochondriac rather than the insightful diagnosis of a celebrated economist.
I think we could go even further than that. Not only were Hansen's writings the "delusions of a hypochondriac," but we would have a hard time making sense of his arguments in the context of the modern theory of economic growth, and what we know about the causes of growth and the reasons for differences in standards of living across countries. Suffice to say that a re-reading of Alvin Hansen won't enlighten us as to what we should expect from the world economy over the next twenty years or so.

But, what about the contents of this ebook? There are really two parallel notions of stagnation discussed in these contributed papers. For convenience, I'll call these growth stagnation and Keynesian stagnation. The growth stagnation idea appears to take conventional economic growth theory as a basis for how we should think about future economic growth, in the U.S. and in the world. From Hsieh and Klenow, empirical work on economic growth tells us that we can account for 10-30% in income differences across countries by differences in human capital, about 20% by differences in physical capital, and 50-70% by differences in TFP (total factor productivity). This should also apply to the time series. So if, for example, we are pessimistic about future TFP growth in the U.S., we then have a strong reason to be pessimistic about future real GDP growth in the U.S. On one side of the argument, Robert Gordon is a pessimist. Gordon points out that TFP growth was much lower after 1970 than in the period from 1920-1970, and he is confident that the average rate of TFP growth we experienced for 1970-2014 will persist for the next 25-40 years. Further, he is worried about four "headwinds," i.e. demographics, education, inequality, and government debt. Basically, a smaller fraction of the U.S. population will be working, educational attainment in the U.S. has plateaued and the quality of U.S. education may be in decline, inequality in incomes has increased and may continue to do so, and there are reasons to think that government debt could increase relative to GDP.

If reading Gordon's entry in this volume is inclined to make you depressed, Joel Mokyr's piece is a great pick-me-up. He says:
There is nothing like a recession to throw economists into a despondent mood. Much as happened in the late 1930s, many of my colleagues seem to believe that 'sad days are here again'. Economic growth as it was experienced by the world through much of the 20th century, they tell us, was a fleeting thing. Our children will be no richer than we are. Some of the best economists of our age, including Larry Summers, Paul Krugman, and my own colleague Robert J. Gordon, are joining the chorus of the doomsayers. It is said that we are faced by headwinds that inevitably will slow down growth and perhaps condemn us to secular stagnation. There is no denying that the population of the world is getting older, and that the fraction of people working (and supporting the aged) is falling everywhere except in Africa. The 'big pushes' driven by millions of married women taking jobs and the huge increase in college graduates that drove post 1945 growth were one-off boons, but they are no more. Growing inequality exacerbates demography. Slow growth is here to stay, say the secular stagnationists.

What is wrong with this story? The one word answer is 'technology'. The responsibility of economic historians is to remind the world what things were like before 1800. Growth was imperceptibly slow, and the vast bulk of the population was so poor that any disruption in food supply caused by a harvest failure could kill millions. Almost half the babies born died before reaching the age of five, and those who made it to adulthood were often stunted, ill, and illiterate. What changed this world was growth driven by technological progress. Starting in the late 18th century, innovations and advances in what was then called 'the useful arts' slowly began improving life, first in Britain, then in the rest of Europe, and eventually in much of the rest of the world. The story has been told many times over, but as Nobelist Robert Lucas once wrote, once you start thinking about it, it's hard to think of anything else.
So, we should stop moaning, and recognize that life is pretty good and likely to get much better.

Mokyr's point is that there is much important scientific advance happening right under our noses, and that this new science will be applied in many ways that we might find hard to imagine from our 2014 viewpoint, just as Alexander Graham Bell would have a hard time imagining an I-phone. Further, the effects of current and future innovations on economic welfare may not be measured well. For example, information has become much more accessible in myriad ways that make us better off, but not all of that is captured in GDP.

Technological change does create economic problems that we need to deal with, though. It is now well-understood that an important factor in the increase in the dispersion in income in the U.S. in the last 30 years or more has been technological change. This change can bring huge rewards to innovators while depreciating particular types of human capital. For example, David Autor has written about the hollowing out of the skill-distribution because information technology makes middle-level skills obsolete. This then becomes a challenge for U.S. education. Indeed, better access to public education at all levels is a possible remedy for the income-distribution problem that Gordon seems to be concerned with.

In terms of the growth stagnation story, there is nothing in this volume that sheds new light on the growth process, and would permit us to confidently project stagnation in the medium to long term, in the U.S., or in the world. We know a lot about how TFP, human capital accumulation, and physical capital accumulation, work to produce growth in per capita incomes, but we perhaps know little about the actual process of innovation, and how to predict it.

The idea that seems to have spurred the publication of this volume, however, is not growth stagnation, but Keynesian stagnation. But Keynesian stagnation does not appear - at least to me - to be in the Keynesian tradition. Keynesians have been quite comfortable with the idea that mainstream growth theory could guide our thinking about "long-run" issues, while sticky-price and sticky-wage economics could guide our thinking about "short-run" issues. For example, Robert Solow provided us with the foundation for modern growth theory, but also wrote (with Paul Samuelson) a classic paper on how to exploit the Phillips curve tradeoff. Similarly, Mike Woodford took a several-generations-later version of Solow's growth model (with credit to Cass, Koopmans, Brock, Mirman, Kydland, and Prescott, along the way), put in some sticky prices and monetary policy, and convinced central bankers that it would be a good idea to use such a model to think about short-run monetary policy. New Keynesian models have the property that monetary policy is non-neutral in the short run, but the mechanics of the basic growth model take over in the long run.

This is definitely not what Larry Summers and Paul Krugman have in mind. Here's the basic hypothesis, as stated by Summers:
Unfortunately, almost all work in both the New Classical and New Keynesian traditions has focused on the second moment (the variance) of output and employment. This thinking presumes that, with or without policy intervention, the workings of the market will eventually restore full employment and eliminate output gaps. The only questions are about the volatility of output and employment around their normal levels. What has happened in the last few years suggests that the second moment is second-order relative to the first moment – the average level of output and employment through time.
I'll take "New Classical and New Keynesian traditions" to be represented by the ideas of Mike Woodford - prices and/or wages are sticky in the short run, and in the long run the world works according to the Solow/Cass/Koopmans/Brock/Mirman/Kydland/Prescott growth model. But what Summers sees is a world that is not at "full employment" even in the long run. He doesn't say this, but presumably he thinks that price rigidity and/or wage rigidity can persist indefinitely.

So what's the problem? Summers points out that the real rate of interest has declined over time, and argues - in typical New Keynesian fashion - that this has created a zero-lower-bound problem. The actual real rate has fallen, but it should be lower than it is (the "natural rate" is lower than the actual real rate), but monetary policy cannot lower the real rate further, because the short-term nominal interest rate is at its lower bound of zero. Summers argues that this problem could persist long into the future. Stagnation is then essentially a nagging output gap, that monetary policy cannot correct in the "usual" fashion. Paul Krugman is basically on the same wavelength.

If you are a young macroeconomist, you might be thinking of Summers and Krugman as some creaky dinosaurs blowing hot air. Where is your model, Summers and Krugman, you might say. Well, Eggertsson and Mehrotra have fleshed out a theory that they think captures what Summers and Krugman are trying to get at. The Eggertsson and Mehrotra chapter in this volume is a summary of a formal academic paper that I discussed in this post. The gist of that blog post is that Eggertsson and Mehrotra - as with Eggertsson/Krugman, which is closely related - focus on the wrong problem. The key inefficiency in their model arises from a credit friction, but they are focusing their attention on the secondary zero-lower-bound inefficiency that the credit friction creates. Basically, the problem is insufficient government debt, and the solution is straightforward.

Now we are getting somewhere. The contribution in this volume from Cabellero and Farhi gives a nice synopsis of safe asset shortages and why such shortages produce the low real interest rates we have been observing. Before the financial crisis, high savings in the world combined with financial innovation created a high demand for safe assets - as stores of wealth, as collateral, and for exchange in asset markets. Governments can supply safe assets, but the private sector can also do it. So, if governments do not increase their outstanding debt in the face of an increased demand for safe assets, then the price of safe assets rises and real interest rates fall. This creates a profit opportunity for the creation of safe private assets. Indeed, asset-backed securities could perform such a role. But the financial crisis showed us that, in the face of poor regulation, the capacity of the private sector to produce safe assets can be limited. Further, when the private sector builds up a stock of "safe" assets which proves not be safe, the ensuing destruction and loss of trust can result in persistent inefficiencies.

The private sector is rebuilding its capacity to produce safe assets, but changes in private sector regulation are also serving to increase the demand for safe assets. For example, the liquidity coverage ratio included in Basel III banking regulation will create an additional demand for safe assets by commercial banks. Though there are things that central banks can do in the face of safe asset shortages (as I show here and here), a safe asset shortage is basically a fiscal problem. The safe asset shortage is reflected in binding financial constraints that imply the economy is non-Ricardian. Government debt matters, and an expansion in the stock of government debt can be welfare improving. Presumably this also implies a lower net cost of financing government projects, meaning that a safe asset shortage provides an opportunity for the government to finance education and infrastructure on the cheap. Note that we can come to that conclusion without ever invoking stickiness, multipliers, fallacy-of-this, or fallacy-of-that.

An interesting feature of this paper is that it captures some of Larry Summers's concerns about monetary policy and financial stability. In the model, when there is a shortage of safe assets, low real interest rates can create incentive problems in asset markets. Basically, creating safe private assets is profitable when the real interest rate is low, but misrepresenting unsafe assets as safe ones is potentially even more profitable. Conventional monetary easing acts to reduce the real interest rate, and therefore aggravates incentive problems. Indeed, if incentive problems are severe enough, a safe asset shortage induces a situation in which the central bank should not push the nominal interest rate to zero.

The editors of this volume, Coen Teulings and Richard Baldwin, seem convinced that the potential for secular stagnation, whatever it may be, requires some radical rethinking of policy approaches. I don't think so. While there is much we don't know about how economies work, and we continue to learn, normal economics is certainly not at a loss in dealing with the problems we face, or will face.

Stephen Williamsonhttp://firstname.lastname@example.com:blogger.com,1999:blog-2499715909956774229.post-70341858516964315082014-08-04T11:51:00.000-07:002014-08-04T11:51:28.200-07:00The ON RRP Facility and Post-Liftoff Fed Policy[See some related ideas in a post by John Cochrane.]

When the FOMC ultimately decides that short-term nominal interest rates in U.S. financial markets should rise, a lot will have changed since pre-financial crisis times. Principally, the Fed's balance sheet is about 5 times larger, total reserves have increased from about $10 billion on average in 2007 to about $2.8 trillion currently, and the Fed now pays interest on reserves.

Any central bank with a significant quantity of excess reserves outstanding overnight operates within a floor system, in which the interest rate on overnight liabilities of the central bank determines the overnight interest rate - in a financial system with no significant frictions. In the case of the U.S. Federal Reserve System, the frictions make all the difference, and create a thorny monetary policy problem for liftoff from essentially-zero overnight nominal interest rates.

The Fed's problem would be easy in a financial system like that in Canada, for example. In normal times, the Bank of Canada operates under a channel system. It targets an overnight interest rate, which is subject to an upper bound, which is the rate at which the Bank lends to financial institutions (the "Bank rate"), and a lower bound, which is the deposit rate for financial institutions at the Bank - the counterpart of the interest rate on reserves, or IOER in the U.S. Typically, the Bank rate is set at 0.25% above the target, and the deposit rate at 0.25% below the target. The idea is that no financial institution would borrow from another one at a rate above the Bank rate, nor would it lend to another financial institution at a rate below the Bank's deposit rate, so arbitrage will keep the target rate between the upper and lower bounds. Here's a chart showing the actual overnight rate in Canada:

Typically, the Bank pretty much nails its target. For example, in the chart, the target since mid-2010 has been 1%, and there has been little variability in the actual overnight rate around the target. An important point to note here is that lending and borrowing at the overnight rate is secured - this is a repo market.

Though normally the Bank of Canada operates a channel system, from April 21, 2009, to June 1, 2010, there was a floor system in Canada. Over this period, the Bank's deposit rate and the target rate were both set at 0.25%, with the Bank rate at 0.50%. Commensurate with that configuration of policy rates, the Bank also kept a positive quantity of reserves in the financial system overnight:

In Canada, there are no reserve requirements on banks. Overnight reserves would be zero, but for some slippage due principally to bad timing. For example, a financial institution could receive a large payment near the end of day, in which case it would be convenient to hold this as reserves overnight (no idea what was going on in early 2012). During the floor system period, you can see that the Bank of Canada targeted the quantity of overnight reserves at $3 billion - what the bank thought was sufficient reserves so that the floor of 0.25% would bind. With a floor system in place, there are sufficient reserves overnight such that arbitrage dictates that the overnight interest rate is equal to the interest rate on reserves.

But, you might say, that's not what has been happening in the United States since the financial crisis. There is a very large quantity of excess reserves in the U.S. financial system, and the IOER has been set at 0.25% since late 2008, but the fed funds rate - the overnight rate the FOMC currently focuses on - looks like this:

So, typically, fed funds have been trading below the IOER, and the interest rate differential has tended to increase over time. Over the last year, fed funds have typically been trading at 15 basis points or more lower than the IOER. Clearly, something is inhibiting arbitrage. What is it?

When Congress amended the Federal Reserve Act to permit payment of interest on reserves by the Fed, it specified that government-sponsored enterprises (GSEs) could not receive these payments. The key GSEs that matter in this respect are Fannie Mae, Freddie Mac, and the Federal Home Loan Banks (FHLBs). Most people know what Fannie Mae and Freddie Mac are up to, but most economists I have run into had no idea until recently what a FHLB is. The FHLB system was set up during the Great Depression as a housing finance vehicle. There are twelve FHLBs, each with a district (much like Fed districts, though FHLB districts are not identical to Federal Reserve districts) and member financial institutions. The members each hold nontradeable stock in the FHLB, and the primary activity of a FHLB is issuing tradeable securities to finance lending to member institutions. This lending is typically secured by mortgages, and the intention seems to be to direct financing toward low-income mortgage borrowers. FHLBs also hold a relatively small portfolio of mortgages, purchased outright. As is the case with Fannie Mae and Freddie Mac, FHLBs have reserve accounts with the Fed and, since GSEs receive zero interest on those reserve balances while commercial banks and other financial institutions currently receive interest at the current IOER rate of 0.25%, there would appear to be gains from trade.

GSEs which would otherwise hold reserve balances overnight could lend overnight on the fed funds market to commercial banks, for example. Those commercial banks could then hold the funds as reserves overnight, earning 0.25%, pay the GSEs x%, where 0 < x < 0.25, make a profit, and the GSEs and commercial banks would be better off as a result. Indeed, frictionless arbitrage would dictate that the GSEs would get all of the gains from trade, with x = 0.25. Why is this arbitrage activity, between GSEs and financial institutions with interest-bearing reserves important? Given that the U.S. financial system is awash in reserves, we might predict that there would be little reason for any financial institution to borrow on the fed funds market overnight, so that most fed funds activity should currently just be arbitrage. Indeed, Afonso et al. estimate that about 75% of lending on the fed funds market was accounted for by FHLBs, by the end of 2012.

But why is the arbitrage not perfect, or even close to it? Financial institutions that receive interest on reserves also face balance sheet costs associated with borrowing on the fed funds market. For example, deposit insurance premia depend on total assets, and there are capital requirements and other restrictions on commercial banks. As a result, the cost of fed funds borrowing is idiosyncratic - it will depend on a bank's size, and on the composition of its portfolio, for example. Of particular note is that branches of foreign banks in the U.S., because they do not have domestic retail deposits, do not pay deposit insurance premia, so they have a cost advantage over domestic banks in borrowing on the fed funds market. What would we predict then? Branches of foreign banks should be borrowing fed funds from FHLBs. Again, Afonso et al. estimate that, by the end of 2012, about 60% of borrowing on the fed funds market was being done by foreign-owned banks.

Liftoff?
Once liftoff occurs, presumably with a stock of reserves in the financial system that is on the order of what it is currently, what would happen if the Fed adhered to its existing operating strategy? One might expect that, as the IOER increased, the fed funds rate would follow. Perhaps the current margin of about 15 basis points between the IOER and the fed funds rate would be maintained. Perhaps that margin would increase. It's hard to say, given our imperfect understanding of what explains the margin in the first place. One might also ask: who cares about the margin anyway? Surely the overnight rate that is critical to most financial market participants is the IOER? Maybe in this idiosyncratic floor system we should be ignoring fed funds market activity, as that is just about arbitrage between GSEs and foreign-owned banks?

There are other alternatives, though. The New York Fed has been conducting experiments using an overnight reverse repurchase agreement (or ON RRP) facility. A reverse repo for the Fed consists of a loan, typically overnight, to the Fed, secured by collateral (typically Treasury securities) from the Fed's asset portfolio. But why would the Fed need to post collateral on a loan? Surely the Fed is good for it? But, if the Fed were to borrow unsecured, we would call that reserves. If the Fed borrows by way of reverse repos, then it is permitted to pay interest to anyone, including GSEs, and it can also borrow from financial institutions that do not hold reserve accounts. Indeed, to enlarge the set of financial institutions that can hold interest-bearing Fed liabilities, the New York Fed has approved an expanded list of counterparties which includes domestic commercial banks, foreign-owned banks, GSEs (including some FHLBs) and money market mutual funds (which do not have reserve accounts). ON RRP activity by the Fed is shown in the next chart:

We should then think of ON RRPs simply as reserves by another name. Relative to regular reserves, the only difference is that reserves are unsecured while ON RRPs are secured, but since the Fed is the borrower, that's irrelevant. The only relevant difference between reserves and ON RRPs is that, while some financial institutions (e.g. commercial banks) can hold both reserves and ON RRPs and earn interest on both, some financial institutions (GSEs) hold reserves at 0% interest and ON RRPs with positive interest, and some other financial institutions (e.g. money market mutual funds) cannot hold reserves at all, but can hold ON RRPs.

But, given that the ON RRP facility now exists, what to do with it? To figure this out, it helps to understand how policy would work in the liftoff phase in the absence of ON RRPs. Given the size of the Fed's portfolio, total liabilities of the Fed - in this case currency and reserves - is essentially fixed in nominal terms. For a particular IOER, asset prices, the prices of goods and services, and quantities, including the fraction of Fed liabilities held as reserves, adjust so that consumers and financial institutions are willing to hold the total stock of Fed liabilities. If the Fed sets a higher IOER, then everything adjusts, and presumably the fraction of Fed liabilities consisting of reserves will increase.

Now, throw ON RRPs into the mix. There are different ways in which the Fed could intervene in the repo market. For example, the Fed could decide on a quantity of borrowing on a particular day, and then conduct an auction among its counterparties. However, what the Fed seems to ultimately envision is a "fixed rate, full allotment" allocation mechanism, according to which a rate is set, and the fed accepts whatever is forthcoming at that rate. So far, full allotment appears not to have been attempted, as the ON RRP experiments conducted by the New York Fed, beginning in January of this year involved putting per-counterparty caps on takeup, with a fixed rate of .05%. Caps were increased over time, to $10 billion per counterparty in April 2014. As you can see in the last chart, outstanding ON RRPs in the last few months have come in mostly between $200 billion and $300 billion - on average somewhat less than 10% of total interest-bearing Fed liabilities.

Given a setting for IOER, there will in general be some critical value for the spread between the IOER and the ON RRP rate such that takeup is zero below that rate, and positive above it. From the New York Fed's experiments, it seems we are safe in assuming that this critical spread is at least 20 basis points. Further, suppose the spread is lower than the critical value, and the ON RRP rate increases with IOER held fixed. What happens? Fed liabilities will in general be more attractive, and ON RRPs will be more attractive relative to either reserves or currency. We would expect that short-term market interest rates would increase (not IOER of course), and more Fed liabilities would be held in the form of ON RRPs, with less held as reserves and currency. For example, perhaps some FHLBs which would formerly have been lenders on the fed funds market would now hold ON RRPs. This would reduce reserves and activity on the fed funds market.

Clearly, given the IOER, the ON RRP rate can be sufficiently high that reserves go to zero. That is, we know that if the ON RRP rate exceeds IOER, then no financial institution would wish to hold reserves. But, it's possible that reserves could go to zero with the ON RRP rate less than IOER, if there is sufficient demand for ON RRPs from the GSEs and money market funds. Further, with sufficient interest-bearing Fed liabilities in the system, it is possible that the ON RRP rate could be high enough that fed funds market activity could dwindle essentially to zero. We know that much of current fed funds market activity is just the result of arbitrage between GSEs and banks that earn interest on reserves, and this arbitrage activity would go away with a sufficiently high ON RRP rate.

Concerns
So, now that we have thought through how a system with three primary Fed liabilities - currency, reserves, ON RRPs - might work, what potential concerns might there be with such a framework?

1. There is potentially a lot going on here. How will the FOMC communicate monetary policy actions to the public in a simple and clear fashion? This was one of the subjects of discussion at June FOMC meeting (see the minutes):
Most participants agreed that adjustments in the rate of interest on excess reserves (IOER) should play a central role during the normalization process. It was generally agreed that an ON RRP facility with an interest rate set below the IOER rate could play a useful supporting role by helping to firm the floor under money market interest rates. One participant thought that the ON RRP rate would be the more effective policy tool during normalization in light of the wider variety of counterparties eligible to participate in ON RRP operations. The appropriate size of the spread between the IOER and ON RRP rates was discussed, with many participants judging that a relatively wide spread--perhaps near or above the current level of 20 basis points--would support trading in the federal funds market and provide adequate control over market interest rates. Several participants noted that the spread might be adjusted during the normalization process. A couple of participants suggested that adequate control of short-term rates might be accomplished with a very wide spread or even without an ON RRP facility. A few participants commented that the Committee should also be prepared to use its other policy tools, including term deposits and term reverse repurchase agreements, if necessary. Most participants thought that the federal funds rate should continue to play a role in the Committee's operating framework and communications during normalization, with many of them indicating a preference for continuing to announce a target range. However, a few participants thought that, given the degree of uncertainty about the effects of the Committee's tools on market rates, it might be preferable to focus on an administered rate in communicating the stance of policy during the normalization period. In addition, participants examined possibilities for changing the calculation of the effective federal funds rate in order to obtain a more robust measure of overnight bank funding rates and to apply lessons from international efforts to develop improved standards for benchmark interest rates.
To clarify what is going on here, if the Fed continues to announce policy in terms the fed funds market, this would require that the ON RRP rate be set sufficiently low relative to the IOER so that the fed funds market remains active. Use of the ON RRP facility has some advantages in this context. It works against segmentation in financial markets and thus gives interest-bearing Fed liabilities a broader reach, and it also puts a floor under the fed funds rate. The higher the ON RRP rate relative to the IOER, though, the less fed funds market activity there would be, and the greater the fraction of the interest-bearing Fed liabilities consisting of ON RRPs. Indeed, if the ON RRP rate were equal to the IOER, this might imply that most of the stock of Fed interest-bearing liabilities would be in the form of ON RRPs, as it is less costly for the GSEs and money market funds - which cannot earn interest on reserves - to intermediate ON RRPs than it is for commercial banks to intermediate reserves. Presumably the money market funds would expand and the commercial banks would contract.

2. A large ON RRP facility could eliminate fed funds market activity. Some people might ask why we should care. Borrowing on the fed funds market is unsecured, so each fed funds contract reflects idiosyncratic risk. In general, the "fed funds rate" is not a rate - it's a distribution. And in times of financial stress, the dispersion in that distribution can be substantial. You can see that in Figure 3 of this paper by Afonso et al. To get some idea of how risky the average fed funds market trade is, consider the margin between the fed funds rate and the 1-month T-bill rate in the next chart:

You can see that, even in normal times, there is a subsantial amount of risk in the fed funds market, and risk went up substantially during the financial crisis. We can certainly make a case that a central bank should be targeting an essentially risk-free overnight rate. Other central banks, including the Bank of Canada and Bank of England, see fit to target a repo rate.

In addition to the fact that the fed funds market is risky, a second problem is that the measured effective fed funds rate does not include all fed funds market trade, but only exchange through brokers. A large fraction of fed funds market activity is over-the-counter, and therefore goes unmeasured. There are indirect ways of measuring activity on the fed funds market, but these are problematic.

A third problem with the fed funds market is that central bank intervention in this market is unwieldy. In pre-financial crisis times, the New York Fed would attempt to hit a given fed funds rate target by predicting, on a given day, the demand for reserves, and then supplying the quantity of reserves that would satisfy demand at the target interest rate. This has lead to substantial fluctuations in the effective fed funds rate around the target, particularly during times of high financial market volatility. During the financial crisis, in addition to the problem that the fed funds rate was a questionable measure of the tightness of monetary policy (due to risk), the New York Fed seems to have had significant difficulty hitting the target.

All of these problems highlight the advantages of the ON RRP facility, and of the ON RRP rate as a permanent target for the FOMC. ON RRP activity is secured, so the ON RRP rate is essentially risk-free, and hitting a given ON RRP rate target is trivial using fixed-rate full-allotment. The Fed would simply fix a rate, and then accommodate forthcoming demand at that rate.

3. A dual system, with IOER above the ON RRP rate, would be more costly than it needs to be. Because holding interest-bearing Fed liabilities is more costly for domestic commercial banks than for foreign owned banks, GSEs, and money market funds, the Fed has to pay a premium to get banks to hold reserves. Thus, the Fed could achieve a given level of monetary accommodation, at lower cost, if the IOER is equal to the RRP rate, than if there were no ON RRP facility. This is roughly what Jeremy Stein is getting at:
You're saving the taxpayer a little bit of money. You might say one job you give to the Fed is to fund its balance sheet as cheaply as possible.

4. A large ON RRP facility could make the financial system less stable. Sheila Bair, for example, has argued that a fixed rate full allotment ON RRP facility would create a kind of escape route for the liability-holders of financial intermediaries to run to in the event of perceived financial distress.
Even a relatively minor market event could encourage a massive flow of funds to the Fed while contributing to a flow away from other short-term borrowers.
Students of money and banking history might find that argument curious. To quote from the original Federal Reserve Act, Congress wanted to
... provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.
The idea behind "furnishing an elastic currency" was to provide an escape route. The recurrent banking panics during the National Banking era (1863-1913) were essentially shortages of retail media of exchange. The ability of the banking system to supply media of exchange was impaired during panics, and this disrupted payments and aggregate economic activity. Unfortunately, the National banking system was not designed to take up the slack. With the Federal Reserve System in place, however, the Fed could act to make up for the financial disruption during a panic by supplying more currency, either through discount window lending or open market purchases. Disruption associated with repo runs is not so different. Repos are liquid assets - media of exchange - which are provided by private financial intermediaries. In times of financial stress, as during the recent financial crisis, the repo market can be disrupted. In such circumstances, it is the job of the central bank to take up the slack. One way to do this would be through a ON RRP facility. The private sector could be having a difficult time finding liquid assets, and the Fed could supply them through the ON RRP facility.

So, in conclusion, the ON RRP facility seems neither mysterious nor scary, and could play an important role in U.S. monetary policy in the future.Stephen Williamsonhttp://email@example.com:blogger.com,1999:blog-2499715909956774229.post-17214722729888216422014-07-15T09:09:00.000-07:002014-07-15T09:09:12.616-07:00Monetary Policy: Canada and the United StatesSince the financial crisis, monetary policy has been strikingly different in Canada and the U.S. The first chart shows overnight nominal interest rates - the overnight money market rate in Canada and fed funds rate in the U.S.

The fed funds rate has been below 0.25% since late 2008, but the Bank of Canada achieved liftoff in mid-2010, and the overnight rate in Canada has been at 1% since then. What about central bank balance sheets?

In Canada the size of the balance sheet increased modestly during the last recession, then declined somewhat. Currently total assets held by the Bank of Canada are slightly less than 5% of GDP. But, as is well-known, successive rounds of quantitative easing (QE) have increased the size of the Fed's balance sheet substantially, to close to 25% of GDP. As is also well-known, QE has lengthened the average maturity of the assets on the Fed's balance sheet. Currently, about 2/3 of the Fed's Treasury security holdings exceed 5 years to maturity, and the Fed holds a large quantity of long-maturity mortgage-backed securities. The next chart shows the composition of the Bank of Canada's portfolio of Canadian government debt.

In contrast to the Fed, which has reduced its holdings of Treasury bills to zero, the Bank of Canada still holds a large fraction of its assets as T-bills, though this fraction has come down since before the financial crisis. However, most of the shift in the Bank of Canada's portfolio was out of T-bills and into government bonds with maturity less than three years. Before the financial crisis, the Bank held about 2/3 of its portfolio of government debt in maturities less than three years, and that is roughly the case currently.

So, since the end of 2007, the Bank of Canada has increased the size of its balance sheet by a small amount, and lengthened the maturity of its government securities, also by a very small amount. There's really not much going on relative to the large QE intervention that occurred in the U.S., which included the purchase of a large quantity of asset-backed securities. Thus, the conventional view, given the currently higher overnight nominal interest rate in Canada, would be that Canadian monetary policy is substantially tighter than in the U.S. So, if I were a strong believer in the persistent real effects of monetary policy, if I thought that lower nominal interest rates meant higher inflation, and if I think that QE works as advertised, I might think that: (i) real economic activity should be depressed in Canada relative to the U.S., and (ii) inflation should be lower in Canada than in the the U.S. Is that what happened? First, real GDP:

The U.S. lost some ground to the U.S. during the recession, but growth in the recovery phase has been roughly similar. Next, the PCE deflator:

Again, there is a level effect in Canada vs. the U.S., relative to 2007Q4, but in the recovery phase the PCE inflation rate is roughly the same in the two countries, though somewhat higher in Canada in the last couple of years.

So, if you were to ask your average macroeconomist to back out monetary policy in Canada and the U.S. by looking at the last two charts, that person might tell you that it was about the same. But we know it wasn't.

I have seen a lot of stories recently about the effects of monetary policy on asset prices - bubbly talk, basically. If we take those stories seriously, we might expect to see more asset value appreciation in the U.S. than in Canada. In the stock market, that is certainly the case. The next chart shows the S&P 500 index, and a comparable measure for Canada.

But, not so for the housing market (these house price measures are not really comparable - Case/Shiller compared to a new house price index for Canada; but that's the best I could do):

So, maybe monetary policy - conventional or unconventional - isn't as big a deal as some people think it is.Stephen Williamsonhttp://email@example.com:blogger.com,1999:blog-2499715909956774229.post-36390490529269604322014-06-02T13:13:00.000-07:002014-06-02T13:13:16.365-07:00DepreciationFrom a post by Brad DeLong on Krusell and Smith's comment on Piketty's "Capital in the Twenty-First Century:"
As time passes, it seems to me that a larger and larger fraction of Piketty's critics are making arguments that really make no sense at all--that I really do not understand how people can believe them, or why anybody would think that anybody else would believe them. Today we have Per Krusell and Tony Smith assuming that the economy-wide capital depreciation rate δ is not 0.03 or 0.05 but 0.1--and it does make a huge difference...
From page 43 of Piketty's book:
This depreciation is substantial, today on the order of 10 percent of GDP in most countries...
Stephen Williamsonhttp://email@example.com:blogger.com,1999:blog-2499715909956774229.post-55012425120405838752014-06-01T10:44:00.000-07:002014-06-01T10:44:21.060-07:00Change of VenueI will shortly be taking up a full-time position in the Research Department of the Federal Reserve Bank of St. Louis. The Federal Reserve System has always been good to me, in spite of the grief I give the Fed from time to time. I'm looking forward to working with a first-class group of economic researchers, under superb leadership. We all intend to collectively move the institution forward to even bigger and better things.

Readers should not notice much difference in what I do here. I have to be a little more careful, I have to respect blackout periods around FOMC meetings, and sometimes I'll know things that I'm not permitted to tell you. You'll notice a disclaimer at the top of the page. That's essentially what appears (except for the "potshots") in the published work of Fed employees. The idea here is the same. What I write here need have nothing to do with the St. Louis Fed's position, the Federal Reserve System's position, the Board of Governors position, etc., on anything. But I don't intend to shy away from discussing policy issues.Stephen Williamsonhttp://email@example.com:blogger.com,1999:blog-2499715909956774229.post-46406553907759051542014-05-13T18:21:00.000-07:002014-05-13T18:23:03.226-07:00Secular Stagnation and Forgotten Monetary EconomicsSince Larry Summers's talk at the IMF in November, there has been some blog discussion of "secular stagnation." The secular stagnation idea seems to have originated with Alvin Hansen (AER, 1939), but I assure you that reading that will not enlighten you as to why we may or may not have entered a period of secular stagnation.

I have been as puzzled as anyone about secular stagnation and what it might mean, and I'm not sure that Paul Krugman's latest post on the topic helps much. There are three dimensions of aggregate economic data that Krugman wants us to think about, and he argues that these reflect aspects of secular stagnation. The first is the decline in the real rate of return on short-term government debt that has occurred since 1980. On this, I think it helps to broaden our perspective a bit, and look at a longer time series. The next chart shows the 3-month T-bill rate, minus the pce inflation rate (year over year) for the period 1948-2014.

If we take this as a measure of the real interest rate, we can see the decline in the real rate from 1980 to the present, which Krugman wants to draw our attention to. But, given the fact that the average real rate over the sample we're looking at is 1.13% (as shown in the chart) the 1980-2000 period is not the best benchmark we could choose, as the real rate was well above the sample average for most of that period. The real rate has certainly been low - on average - since 2000, but it was also low in the 1950s and the 1970s. So, in terms of this measure of the real rate, the low real rates we have been observing are not unprecedented, and there appears to be no particular reason for us to extrapolate low real rates into the future for a long period of time. Indeed, there are good reasons to think that the real rate should continue to increase. This is important, as it seems to be a key part of the Summers/Krugman narrative on secular stagnation. Summers and Krugman think that there is something that will keep the real rate low for an extended period of time and that - in Old Keynesian or New Keynesian fashion - this requires an extended period of time during which the central bank's nominal policy interest rate should be at the zero lower bound.

The other two aspects of the data that Krugman wants to focus on are the drop in household debt since the last recession, and the drop in the growth rate of the population aged 20-64. Through back-of-the-envelope calculations, Krugman translates what he sees in the data into a drop in the demand for consumption and investment of 7% of GDP, which I'm assuming he thinks will persist indefinitely. Of course, if we look at these observations through the lens of conventional long-run economics, the view for the future is anything but gloomy. Krugman is thinking that the increase in the savings rate as the result of low household debt, and the drop in the working-age population growth rate are bad news. But the Solow growth model - which forms the basis for modern growth theory, and which we teach to undergraduates (see Chapter 7 of this fine intermediate macro book) - tells us that an increase in the savings rate and a decline in the population growth rate will lead to a short run increase in the growth rate of per capita real income and a long run level increase in per capita real income. That seems like a good thing. So Krugman must have some kind of unconventional long-run economics in mind. But what is it?

I've been meaning to read "A Model of Secular Stagnation," by Gauti Eggertsson and Neil Mehrotra (E/M), which Gauti posted last month, but other things got in the way. E/M seems to have Krugman's blessing, and Simon Wren-Lewis provides some explanation, for those who might not be familiar with what E/M are doing. As far as I know E/M is the only attempt at making rigorous economic sense of what Summers and Krugman have been talking about.

So what is in the paper? E/M construct a 3-period-lived overlapping generations (OG) model to address the problem. Stripping their model down to essentials, suppose the population at each date consists of the young, the middle-aged, and the old, and that the total population grows at rate g. To start with, this is an endowment economy in which the young and old are endowed with nothing, and each middle-aged person has an endowment of y units of a perishable consumption good. Each person wants to consume in all periods of life, has time-separable utility, and discount factor B. Assuming that there are no assets in this economy - no money, no government bonds, no capital - the only exchange in this model is in a credit market in which the young are borrowers and the middle-aged are lenders. The young borrow, pay back their loans in middle-age, and use the returns on their loans to the young to consume in old age.

E/M add to this a borrowing constraint. There is an exogenous quantity d, which is the maximum amount that a borrower can commit to repay in the next period. Then they follow Woodford in treating this as a "cashless economy" in which zero money balances are held at all dates, and there are prices of goods in terms of money that support that equilibrium. Then, in a fashion familiar to everyone who has seen short-run New Keynesian models, wage/price rigidity is imposed - here in the form of permanent wage rididity - and then the model behaves much like in Eggertsson and Krugman's paper, except in a long run context. There are paradoxes of thrift, toil, and flexibility, more government spending is a good thing, etc.

For what I want to do, a 3-period OG model is not the best vehicle, as it has "startup" problems. Once we introduce other assets, it won't have nicely behaved equilibria. The following model will give us almost exactly the same thing as the E/M model does, but it's more tractable. Suppose an initial group of old people (who will come in handy later) who live only one period, with everyone else being two-period-lived. At each date there is a group of young and a group of old, and the total population grows at rate g. There is heterogeneity in each generation. A fraction a of economic agents are lenders who receive y units of the consumption good when young and 0 when old, and a fraction 1-a of borrowers who receive 0 when young and y when old. We'll assume log utility and discount factor B, as in E/M.

Unconstrained Cashless Economy
Without other assets in this economy, we just have a sequence of two-period Fisherian economies in which there is an intragenerational credit market with real interest rate r. With no borrowing constraints, the equilibrium interest rate is

(1) r = (1-a)/aB - 1

So, the real interest rate is determined by the discount factor and the ratio of borrowers to lenders. We can have a very low real rate if there are many lenders and few borrowers.

Constrained Cashless Economy
Now impose a binding borrowing constraint d on what a borrower can repay in old age. Then, the real interest rate is

(2) r = [(1-a)d(1+B)]/(Bya) - 1

So, in this case, the real interest rate is lower the lower is d, i.e. the tighter is the borrowing constraint. This is of course standard behavior in models with borrowing constraints - e.g. incomplete markets models.

E/M want to argue - in standard Woodford fashion - that for economic agents to be content with holding zero money balances in equilibrium, we must have

r >= -i/(1+i),

where i is the inflation rate. So if r is very low, then i must be very high so that the real rate of return on money does not exceed the real rate of interest.

So, now we have a problem. Woodford constructed his cashless economies so as to focus his attention on a sticky price friction. In doing so he was implicitly (or sometimes explicitly) stating that other types of monetary frictions do not matter much, or were safely ignored for the problems he was interested in. To show that a cashless economy made sense technically, Woodford constructed simple examples where this works, for example with money in the utility function (and separability) or by taking the "cashless limit" in an economy where money is used in transactions. It's not clear how this works in the context of this OG model, as of course these models were constructed and used, for example by Samuelson and Peter Diamond, as models in which outside assets (money and government debt) could matter.

Indeed, there are two potential inefficiencies that exist in this model (depending in part on how we define inefficiency). One is due to the borrowing constraint - a standard credit friction. The other is a standard dynamic inefficiency. And both of those frictions are things that we often use, in various contexts, to motivate a role for government and central bank liabilities.

Monetary Economy
Following up on that thought, suppose that we introduce a fixed stock of money, M, which is the collective endowment of the first period old. Then, we can construct equilibria in which this money is valued. But, the "cashless" equilibria we already worked out (equations 1 and 2) are also equilibria - what we call the "nonmonetary equilibria," for which money is not accepted in exchange because it is not accepted in exchange, and it thus has zero value. But what we are interested in are monetary equilibria, and we will restrict attention to stationary ones - equilibria where consumption allocations are constant across generations.

First, in the unconstrained case with no borrowing constraint, in the monetary equilibrium we are interested in,

(3) r = -i/(1+i) = g,

and this equilibrium exists if and only if

(4) B(1+g) > (1-a)/a

Then, either the monetary equilibrium exists, and it's Pareto optimal, or (4) does not hold, in which case the nonmonetary equilibrium is Pareto optimal. So, without the borrowing constraint, a fixed stock of money solves the dynamic inefficiency problem.

Next, suppose that there is a binding borrowing constraint. Then the real interest rate is the same as in equation (3), in the absence of other assets. But, suppose we introduce money, as before, as a fixed stock M of cash balances initially endowed to the old in the first period. As well, suppose the government can issue one-period government debt, and can tax lump-sum. But the government has some constraints on how it can tax, in that the young and old can be taxed differently, but all members of the same generation bear the same tax. So, suppose the government issues b units of government debt per young person each period, makes a lump-sum transfer b to each young person, and pays off the government debt (which is a perfect substitute for private loans) by taxing each old person lump-sum. Then, suppose that the government sets the level of government debt per young person at

b = y/[(1+g)(1+B)]

forever. If (4) holds, there exists a Pareto-efficient equilibrium with valued money, no matter how small d is, as that equilibrium has zero lending. It's the same equilibrium allocation we supported with no borrowing constraint and money as the only asset. If (4) does not hold, then we can obtain a Pareto efficient equilibrium in which money is not valued if the government sets the debt quantity according to:

b = (aBy)/[(1-a)(1+B)]

What's going on here? E/M write down a model with two inefficiencies: a dynamic inefficiency, and a credit friction. With sufficient flexibility in taxation, the government can solve both inefficiency problems with the appropriate provision of government liabilities. Why all the fuss with wage rigidity and zero-lower-bound "paradoxes" is not clear.

Another Model of Secular Stagnation
I can see what E/M and Summers/Krugman might be getting at though. The fact that real rates of return have been low since the financial crisis may be important, and could make a big difference for how monetary policy should proceed going forward. What elements would we want in such a model so that it can enlighten us about what is going on? It seems we would like to explain at a fundamental level why the real interest rate is low. This may reflect particular credit frictions, but we want to be explicit about what they are. Also, we would like to see a sufficient array of assets in this model. Perhaps some of these assets are used as collateral, which appears to have been important during and after the financial crisis. We also want to include the assets and liabilities that appear on both sides of the central bank's balance sheet. Otherwise, how can we analyze monetary policy in a sensible way? We also want the model to say something about liquidity traps in a low-real-interest-rate world.

I've got just the thing. The elements of the desired model I've sketched are right up the New Monetarist alley. We think of our research program originating, in part, with the work that Neil Wallace and his Minnesota students and coauthors did in the late 1970s and 1980s. Those people worked with various OG models - like the one that E/M study, and the one I was playing around with above. Of course we long ago moved on to other things. There's much current monetary research that uses versions of the Lagos-Wright model. I like this framework, not because it tells us much of anything new about monetary exchange, but because it admits a whole array of interesting financial and credit market behavior in a highly-tractable way. You can do much more with it than with an OG model.

So, here's an example. I didn't know until I read E/M that I had constructed a secular stagnation model, but according to them, that's exactly what my quantitative easing paper is. In that model there are banks, there's monetary policy, there's a collateral constraint (endogenous!), and you can have a negative real interest rate at the zero lower bound with positive inflation. There can be secular stagnation, in that the low real rate can persist forever, due to a shortage of collateral, and that collateral shortage is reflected in low output and inefficient exchange. The collateral shortage persists because of stupid fiscal policy, and the shortage can be mitigated with QE by the central bank. Cool, right? I think Krugman actually loves the thing, but can't bear to say it.

Stephen Williamsonhttp://firstname.lastname@example.com:blogger.com,1999:blog-2499715909956774229.post-10980633371285366362014-05-02T11:53:00.000-07:002014-05-02T11:53:18.337-07:00Equality, Monkeys, and BananasYou may have heard this story. I got it from John Kennan, who claims it originated with computer scientists. There are some monkeys in a cage. Someone puts a banana at the other end of the cage. When one monkey goes for the banana, the other monkeys are sprayed with a fire hose. This is repeated a few times. Then, whenever one monkey makes a move for the banana, the other monkeys beat him/her up. After a while, one monkey is replaced. Of course, that monkey goes for the banana and the others beat him/her up. This keeps happening, and eventually none of the monkeys in the cage have ever seen a fire hose. But whenever a new monkey arrives and makes an attempt to get the banana, he/she gets beaten up. Asked why, the monkeys say: "That's the way we've always done it."Stephen Williamsonhttp://email@example.com:blogger.com,1999:blog-2499715909956774229.post-85425348208085383442014-04-30T12:00:00.001-07:002014-04-30T12:02:55.288-07:00Crazy Like FoxesChris House's discussion of Tom Sargent's principles, and some of the related blog discussion, is closely related to what I said here. What I think House is getting at is the following. Self-described blogosphere "progressive" economists have a political agenda. They want particular changes in economic policy, and they try to use mainstream economics to support their policy conclusions. But House thinks this group is going overboard. His argument, as I see it, is that the case is being overstated, and that some people are being demonized in the process, who should not be. Overstating the case propagates ideas that will come back to bite us in the future - truth may hurt, but it can only help us in the long run. And the demonization of individuals who constructed key elements of what we do as economists cannot help the profession - this only leads to distrust of the economics profession by lay people.

I think that House, in his response to Paul Krugman, was overly gracious, to say the least. Here's what Krugman had to say. Krugman starts with this:
America, it goes without saying, has a powerful, crazy right wing. There's nothing equivalent on the left — yes, there are individual crazy leftists, but nothing like the organized, lavishly financed madness on the right.
Is the far right wing of U.S. society "crazy?" Of course not. Out of respect for the mentally ill, we shouldn't fling words like "crazy" around lightly. The far right is quite rational, and they have well-defined goals. They want easy access to all manner of dangerous weapons; they do not want extended government participation in health care; etc. Is the far right powerful? Yes and no. They have indeed been successful in promoting lax gun control. But the United States now has in place an extended health care program with government participation. Democrats control the executive branch and the Senate, though the House is of course in control of the far right wing of the Republican party, and the left seems to be losing on the Supreme Court.

Krugman goes on to say this:
Which brings me to this critical piece by Chris House. A while back House declared that both Ed Prescott and yours truly say crazy things; when asked for an example of me saying something remotely equivalent to something like Prescott's declaration that there is no evidence that Fed policy matters, he never did answer.

Now House takes me and Noah Smith to task for preaching to the left-wing echo chamber in what we wrote about the Tom Sargent speech that's making the rounds. And once again I have to wonder whether he actually read what I wrote, or simply assumed that it must be over the top.
Why this produced such a polite reply from House is beyond me. Krugman is (groundlessly) accusing House of making claims without evidence, and stating things about Krugman's post without reading it. I read all this stuff myself, and I thought House was quite fair and careful. Here's some of what Krugman actually said in his two posts (here and here) concerning Tom Sargent's 2007 Berkeley graduation speech:
So why the sudden attention to Sargent's 2007 speech? I think it's fairly obvious: it's essentially stealth anti-Keynesian propaganda, cloaked in the form of a widely respected and liked economist uttering what sound like eternal truths. But they aren't, and the real goal here is to undermine the case for fighting unemployment in the here and now. There are virtues to that 2007 talk, but right now is no time for 2007 Sargent.
That paragraph actually is crazy - it reflects paranoia. As I explain here, Sargent's speech is a very terse set of innocuous, mainstream, economic ideas, that are entirely consistent with Krugman's thinking, Mike Woodford's thinking, Ed Prescott's thinking - whatever. Anti-Keynesian propaganda, untruths, conspiracy? Nonsense.

Now, back to Krugman's last missive on the matter. This casts "progressives," and particularly Krugman's blogosphere friends - DeLong, Thoma, Konczal, and Wren-Lewis - as poor downtrodden "voices in the wilderness" fighting against a set of powerful bullies. I have no objection to an organized fight against the forces that make firearms proliferate, and the promotion of broad-based health care in the United States, for example. What I object to are bad economic ideas, and the misrepresentation of sound academic work in economics. And I think that is part of what gets propagated by at least some members of what is being characterized as a "progressive" group here. I think Mark Thoma and Simon Wren-Lewis are honest and have good intentions, but Krugman and DeLong? Not so much.

In the final paragraph of this last post, Krugman states:
I won't ever say anything I don't believe to be true...
I don't have hard evidence for this, but I think that's a lie. Given Krugman's body of academic work, I do not believe he can honestly state that there are easy solutions to our economic problems that are at the fingertips of typical undergraduate students in economics 101. How could he think such a thing? There may be a few problems for which the answers are easy, but most of this is very difficult. To state otherwise doesn't help anyone.Stephen Williamsonhttp://firstname.lastname@example.com:blogger.com,1999:blog-2499715909956774229.post-43544597070319928772014-04-28T08:30:00.000-07:002014-04-28T08:30:24.714-07:00Piketty and the MacroeconomistsI have not read a word of Thomas Piketty's Capital in the Twenty-First Century. As far as I can understand from secondhand and thirdhand accounts, it has something to do with outrage about the wealthy, measuring the rate of return on capital, and how we can tax those worthless wealthy bastards. The quotes and reviews on Amazon use words including "pioneering," "explosive," "seminal," "magisterial," etc. Some people want to petition the Pope to put Piketty in line for sainthood. This is pretty exciting. I think I should buy the book, and would be happy to contribute to Piketty's wealth. Hopefully he won't be successful in taxing himself back into poverty.

Tyler Cowen points out that there is a body of research studying wealth inequality, which apparently Piketty does not reference. This surprises me. After all, Paul Krugman (a very serious, straightforward, and trustworthy scholar, if there ever was one) points out that:
...if you think you've found an obvious hole, empirical or logical, in Piketty, you're very probably wrong. He's done his homework!
This bears investigating, I think.Stephen Williamsonhttp://firstname.lastname@example.com:blogger.com,1999:blog-2499715909956774229.post-83637294007881930262014-04-22T12:39:00.000-07:002014-04-22T14:52:13.651-07:00Tom Sargent: What's Between the LinesFor some obscure reason, Tom's Sargent's Berkeley graduation address from seven years ago is now getting attention in the blogosphere. It's innocuous stuff - basically core ideas in economics boiled down to life lessons for graduating seniors. Paul Krugman seems a little insecure about it though (here and here) and would like you to dismiss parts of it as some sort of right-wing "cockroach" ideas. I can see what Krugman is getting at - he might see these ideas as threatening, as they are at odds with his notion that economic policy is easy, or that large welfare gains from changes in policy are low-handing fruit. But I think you have to be a rather suspicious person to think that Sargent's synopsis of economic ideas represents a particular view on policy. Indeed, the ideas are entirely consistent with how Mike Woodford, or Ed Prescott, thinks about the world.

So, let's go through Sargent's address, so you can see what I mean:

I remember how happy I felt when I graduated from Berkeley many years ago. But I thought the graduation speeches were long. I will economize on words. Economics is organized common sense. Here is a short list of valuable lessons that our beautiful subject teaches.

[I had to think about whether I agree with the "organized common sense" view of economics. If common sense is supposed to be what the average layperson possesses, then economics is not common sense, as it's sometimes (if not often) counterintuitive. For example, Adam Smith told us that greed can be a good thing. That's certainly not part of collective wisdom, I think. But Sargent was trying to put the Berkeley graduates at ease. He's telling them that doing economics is just a matter of putting pieces of straightforward logic together to come up with a coherent set of ideas.]

1. Many things that are desirable are not feasible.
[This is typically one of the first things taught in Econ 101. As a society, and as individuals, we face constraints. But what are society's constraints? That's what economists argue about. Some people think, for example, that the U.S. economy is no more constrained in what it can achieve in 2014 than it was in 2007. Those people think that the decision-makers in the Fed and the U.S. Congress, are somehow not optimizing given their constraints - they think there are more desirable outcomes that are in fact feasible. Others don't agree.]

2. Individuals and communities face trade-offs.
[This is again a key part of any Econ 101 course - opportunity cost. This is about the nature of the constraints we face. Individuals face budget constraints. One can't have a new car without giving up something else - other goods and services in the present, or future consumption. Economic growth models tell us that, as a society, to attain higher productive capacity in the future, we have to give up consumption in the present. But, at the societal level, again, economists have key arguments about what the tradeoffs are. In the 1960s, Solow and Samuelson argued that a Phillips curve tradeoff existed - the central bank could achieve lower unemployment, but only at the expense of higher inflation; Milton Friedman said that this was only a short-run tradeoff, and in the long run no such tradeoff exists; the Phillips curve went out of fashion; the Phillips curve was resurrected in the 1990s by New Keynesians; many macroeconomists are still skeptical.]

3. Other people have more information about their abilities, their efforts, and their preferences than you do.
[I'm glad Sargent included this idea, which is not part of the typical Econ 101 curriculum. But this is at the heart of many contemporary economic issues. Why are there banks, and what do they do? What were the incentive problems that led up to the global financial crisis? What's a financial crisis about anyway? How do we explain unemployment and the process of labor market search? For all of these issues we have to think carefully about private information and how it matters for the functioning of markets and economic institutions. A whole array of economic machinery developed over the last 50 years allows us to come to grips with these things.]

4. Everyone responds to incentives, including people you want to help. That is why social safety nets don't always end up working as intended.
[This is closely related to #3. Take unemployment insurance (UI), for example. A key problem in designing a UI system is that there is moral hazard - it's hard for the government to observe how much effort the unemployed are putting into looking for a job, and the more generous is UI, the less effort is expended in searching. So, this represents another societal tradeoff. Providing better UI is good, as it provides insurance against a bad outcome - being unemployed. But the better insurance UI provides, the lower is the search effort of the unemployed, on average, and the higher will be the average unemployment rate. The latter is bad for society, as we lose output.]

5. There are tradeoffs between equality and efficiency.
[Closely related to #5. For example, redistribution of income through the income tax system (progressive taxation by which we tax the rich at a higher rate than the poor) can be seen as a form of social insurance. Being born poor is no fault of an individual, and may disadvantage him or her for life. Just like UI, progressive taxation acts to insure people against bad outcomes. But redistribution changes incentives. If I am born poor, the insurance provided by the government discourages me from investing in my own human capital - acquiring education and skills that allow me to do better. Similarly, those born rich are also discouraged. Why acquire high-level human capital if the return on that human capital is low because it is taxed at a high rate? Again, society faces a tradeoff - we can redistribute the pie, but that tends to make the pie smaller.]

6. In an equilibrium of a game or an economy, people are satisfied with their choices. That is why it is difficult for well meaning outsiders to change things for better or worse.
[Note here that Sargent doesn't say it's impossible to make things better - it's just difficult. Here's an example. A typical Econ 101 example of this principle at work is the minimum wage law. Workers and firms engage in private contracts. Firms offer jobs at particular wages - the people who are employed in those jobs have accepted those terms of employment. The firms and workers did the best they could under the circumstances. So why should we intervene in these private contracts, for example by imposing a floor on the wage a firm can offer a worker? Well, we might see this as social insurance, in which case we are back to #5. What's the tradeoff? Further, an issue that comes up here is that the tradeoff might be better if we use one mechanism to redistribute income rather than another. In this case, Econ 101 tells us that we're better off as a society if we redistribute using the tax system, or lump sum payments to the poor rather than by using the minimum wage. One problem with the minimum wage is that we're taxing the firms we're asking to provide employment for the poor.]

7. In the future, you too will respond to incentives. That is why there are some promises that you'd like to make but can't. No one will believe those promises because they know that later it will not be in your interest to deliver. The lesson here is this: before you make a promise, think about whether you will want to keep it if and when your circumstances change. This is how you earn a reputation.
[Anyone who has had to deal with 2-year-olds - or has been the chair of an economics department - understands this perfectly. The people whose behavior you are trying to shape with your current promises have excellent memories and will punish you forever if you break those promises. This is the basis for limited commitment models in economics. Limited commitment - e.g. the "time consistency" problem - has been highly influential in policy debates, from Kydland and Prescott's watershed work on. Limited commitment is also key to credit relationships, and the use of collateral - again crucial for figuring out the financial crisis, and the role of policy in the crisis.]

8. Governments and voters respond to incentives too. That is why governments sometimes default on loans and other promises that they have made.
[Again, this is critical for thinking about current policy issues - sovereign debt problems for example. Commitment and incentives were at the heart of the Fed's rationale for its recent forward guidance experiments. In New Keynesian macro models, which formed the theoretical backdrop for the policy, promises about the future are important for attaining good results in the present, in contexts where conventional policy doesn't work. But when the future arrives, the policymaker will want to go back on the promise, so commitment to the policy is required. Of course, this is a bad example of commitment at work, as the Fed botched it.]

9. It is feasible for one generation to shift costs to subsequent ones. That is what national government debts and the U.S. social security system do (but not the social security system of Singapore).
[Most of what you need to know about this is in Peter Diamond's 1965 paper. This is one of the neatest tricks in economics. The world consists of overlapping generations of individuals. If we can get each young generation to give a gift to each old generation, then (under some conditions) we can make everyone better off - forever. So there are some circumstances where - indeed - we can get something for nothing. In practice, the gifts from young to old can be accomplished through a social security system, through government debt (as Diamond showed), or through monetary exchange (as Samuelson showed). Very cool.]

10. When a government spends, its citizens eventually pay, either today or tomorrow, either through explicit taxes or implicit ones like inflation.
[This is closely related to #1 and #2. Running a government requires real resources - workers, buildings, fuel, etc. Those resources don't come for free - there are tradeoffs. Some people - Krugman for example - would argue that there are circumstances in which more government spending is effectively free. The argument is that, if there are unemployed workers willing to work, then employing them makes them better off, and gives the rest of us more stuff to boot. In the story, there can even be a multiplier - a free lunch - by which one unit of government spending produces more than one unit of additional GDP. The odd thing about this is the disconnect between modern Keynesians and Old Keynesians on the issue. Multipliers somehow seem convincing - they satisfy the "common sense" test of the person on the street. But the standard multiplier mechanism is nowhere to be seen in a mainstream New Keynesian model. Further, in episodes like World War II with massive increases in government spending, it's clear what the resource costs are - a small drop in current private consumption, and a very large drop in private investment spending (future consumption).]

11. Most people want other people to pay for public goods and government transfers (especially transfers to themselves).
[You can see this in current debates over health care. Some senior citizens receiving medicare benefits see those benefits as some kind of birth right, but object to government programs that attempt to extend health insurance to the previously uninsured. There are some goods and services for which public provision is appropriate - national defense being the leading example. But it's impossible to provide an appropriate amount of public goods if we are going to finance their provision through voluntary contributions (as we do in NPR pledge drives). We have to collectively agree to government confiscation (tax collection) to make this work.]

12. Because market prices aggregate traders' information, it is difficult to forecast stock prices and interest rates and exchange rates.
[This is just simple financial arbitrage - there are no free lunches available to your average financial market participant. Fama called this the "efficient markets hypothesis." But that's a misnomer, as by now we understand that perfect arbitrage in financial markets can occur in economies which are highly inefficient in the standard economic sense.]

So, Sargent has been pretty terse - that's the way he is. But these 12 ideas are very much mainstream. The ideas are consistent with economic inefficiency, a role for government, and provide a basis for analyzing how governments and central banks can make our lives better. I'm not sure what Paul Krugman is afraid of.Stephen Williamsonhttp://email@example.com:blogger.com,1999:blog-2499715909956774229.post-33994762898929821912014-04-20T13:05:00.000-07:002014-04-23T15:49:41.578-07:00Deflation in Sweden: Svensson's Advice is the Problem, Not the SolutionAs Lars Svensson notes, Sweden now has inflation that ranks among the lowest in the world. From the Riksbank's website, CPI inflation in Sweden looks like this:

The Riksbank has a 2% inflation target, so clearly they are missing on the low side. Of course, given the typical wishful thinking of central bankers, you can see from the chart that they are forecasting that they will hit the target a year from now, and exceed it later in 2015 and 2016.

So, why is inflation so low in Sweden? Svensson claims:
The deflation has been caused by the Riksbank's tight monetary policy since the summer of 2010.
In Sweden, the Riksbank's policy rate is the repo rate, which is set by the Executive Committee of the central bank, and has followed this path since 2008 (again, from the Riksbank's web site):

So, does the repo rate path in the last chart represent a policy that was too tight, i.e. was the policy rate too high? How could we answer that question? Svensson might think about policy in terms of a Taylor rule, so it might help to look at the performance of the real side of the economy in Sweden. Here are real GDP growth rates (from the Riksbank's web site again):

For good measure, we should look at the real GDP levels too:

So, in the last two charts, you can see that the downturn in Sweden during the recession was larger, but the recovery was stronger than in the US, with Swedish real GDP returning to its pre-recession level earlier than in the U.S. But there has been lower growth in Sweden in 2012-13 so, relative to 2007Q4, the US and Sweden are in essentially the same place.

The Riksbank kept the policy rate at 0.25% well into 2010 and then, as the recovery proceeded at a normal pace and inflation increased, the policy rate went up, in typical Taylor-rule fashion. The policy rate reached a peak of 2% (not very high, right?) in late 2011, and then, as the Riksbank started to see real GDP growth below 3% and inflation below the 2% target, it quite promptly began cutting the policy rate. The policy rate is currently at 0.75%, and plans for its future path, conditional on the forecast, can be seen in the second chart. But what happens if the inflation rate stays low? From the Riksbank's last policy statement:
Monetary policy needs to remain highly expansionary to contribute to inflation rising towards the target. Although inflation has been somewhat lower than expected, only a minor revision has been made to the inflation forecast. The Executive Board of the Riksbank has therefore decided to hold the repo rate unchanged at 0.75 per cent. It is judged appropriate to begin gradually raising the repo rate in one year's time, when inflation has picked up.

As economic activity strengthens, inflationary pressures are expected to rise. However, it is uncertain how quickly inflation will rise, particularly as it has been weaker than expected for some time now. The repo-rate path has therefore been adjusted down somewhat and reflects a greater probability of a repo-rate cut in the near term compared with the assessment made in February.
That's from a section titled "Low Interest Rate Until Inflation Picks Up." Clearly, if inflation remains low, the policy rate will remain low.

So, it seems to me that the Riksbank has been, and is, playing pretty much by the Old-Keynesian/New Keynesian book. Why Svensson doesn't like what the Riksbank was and is doing is not apparent from the data. We need to dig deeper to find out why he's so critical. Svensson was a Deputy Governor of the Riksbank from May/2007 to May/2013. At a critical juncture in June 2010, the Executive Board of the Riksbank voted to increase the policy rate 1/4 point to 0.5%. Svensson dissented:
Deputy Governor Lars E.O. Svensson entered a reservation against the repo-rate path and advocated a repo-rate path with a repo rate of 0.25 per cent through the fourth quarter of 2010, and thereafter a gradual return to the repo-rate path of the main scenario. Lars E.O.Svensson maintained that such a repo-rate path results in a better outcome for both resource utilisation and inflation, with both lower unemployment and CPIF inflation closer to the target.
After leaving the Riksbank, in September 2013 Svensson wrote this post, in which he claims that, if the Riksbank had not only done what he had recommended in June 2010, but kept the policy rate at 0.25% until the current time, the inflation rate would be at the 2% target, and unemployment would be lower. In Svensson's September 2013 post, it is not clear to me what model he used to come up with his counterfactual, but suffice to say that, whatever the model is, it tells us that a short-term real interest rate of -1.75% can be sustained for 3 1/2 years, which seems goofy. One thing I would be interested in seeing is the output this model produces under the actual path for the policy rate. My guess is that it predicts inflation well above what actually occurred. Off the top of my head, I would say that, under Svensson's policy scenario, the inflation rate would currently be lower, and the unemployment rate would be about the same as what we're actually seeing in Sweden now.

Of course, this is just quibbling over history. What does Svensson think the Riksbank should do now if it wants to hit its 2% inflation target?
The most important thing is that the Riksbank takes the inflation target seriously and stops neglecting it. In order to get inflation back to target soon, the policy rate has to be lowered quickly to 0.25 percent or even zero. If this does not help, the Riksbank – as other central banks at the zero lower bound with too low inflation and too high unemployment – will have to use unconventional (but by now frequently tested) policy measures. These include a negative policy rate, large-scale asset purchase to lower long interest rates (quantitative easing), a low policy-rate path for a longer period with different variants of "forward guidance", foreign-exchange interventions to depreciate the currency or at least (as in Switzerland) prevent it from becoming too strong, and to aim to overshoot the inflation target for a few years.
By now, it should be well known that Taylor rules have some very undesirable properties. In particular, a central bank which follows a Taylor rule blindly can get stuck in a policy trap, in which the policy rate is at the zero lower bound, and inflation is low or negative. The central bank wants higher inflation, and thinks it will achieve this by lowering the policy rate, which is not feasible, so the policy rate stays at the lower bound and - given that the Fisher relation holds in the long run - inflation stays low or negative. This is the policy trap that Svensson's advice would lead the Riksbank into.

Once the Riksbank is stuck at the zero lower bound, what would Svensson have it do? Unconventional policy is the prescription. As Svensson notes, unconventional policy has been "frequently tested." So how did that work out? In the U.S., as you know, the Fed has been deeply into unconventional policy for the last five years - quantitative easing (QE) and forward guidance in particular. But apparently those experiments have not been so successful, as the inflation rate has been falling for the last two years or more:

Another notable experiment is the Bank of Japan's "Quantitative and Qualitative Monetary Easing Program," which began in April 2013. Here's how that's going:

While there was a bit of a burst in inflation toward the end of 2013, the year-over-year inflation rate in Japan is now less than 1/2%.***

In Sweden, the Riksbank cannot consistently meet its inflation target of 2% if the policy rate stays low or goes to zero. The Fisher relation guarantees that. In order to meet its inflation target, the Riksbank has to increase the policy rate - there's no other way to do it.

In addition to the standard Taylor-rule policy-trap problem, there are two elements of Svensson's unconventional policy recommendations that further exacerbate the problem, in terms of how Svensson looks at it. First, if QE works in the long run the way I've modeled it, then it will ultimately produce less inflation, not more, if the policy rate stays low or at the zero lower bound. Second, consider Svensson's "negative policy rate" recommendation. This appears to be a variant of the idea that, if our problem is a binding constraint on the nominal interest rate at zero, then we should relax the constraint by somehow taxing the liabilities of the central bank. Miles Kimball loves this idea. Basically, the central bank could tax reserve accounts, and there are schemes that might allow taxation of currency or its electronic replacement.

What would be the effect of taxing central bank liabilities? For simplicity, think about a world with perfect certainty. In the long run, standard asset pricing gives us the Fisher relation, which is

R = r + i,

where R is the short-term nominal interest rate, r is the real interest rate, and i is the inflation rate. If central bank liabilities are not taxed, then arbitrage gives us the zero lower bound, i.e. R cannot fall below zero. But if we tax central bank liabilities at the rate t per period, then the lower bound on R is -t. Therefore, in the long run, if R is targeted at its lower bound by the central bank,

i = - r - t

So, if we think that r is invariant to monetary policy in the long run, then if the central bank pegs the nominal interest rate at its lower bound, and central bank liabilities are taxed, this will make long-run inflation lower.

Basically, people who advocate for taxes on central bank liabilities as a means for increasing inflation are making the same error as are people who are concerned that the currently large stock of reserve balances in the United States might ultimately produce more inflation (a group of people that may or may not have once included yours truly). For example, you might think that, if you tax central bank liabilities, then people have less inducement to hold those liabilities, and inflation results due to some kind of hot-potato effect. Similarly, you might think that, as assets other than money become more attractive (as the economy recovers and real returns rise), that inflation might rise, for a similar reason. Well, that logic is wrong. To induce people to hold central bank liabilities when the nominal interest rate has been at its lower bound for a long period of time, the inflation rate must be sufficiently low, so that the real return on money is sufficiently high. If we tax central bank liabilities, or the real returns on alternative assets are higher, the inflation rate must be all the lower in the long term, in order to make central bank liabilities sufficiently attractive that people will hold them.

***Addendum: I made an error in the chart by including a March observation which was a preliminary estimate for something that was not in fact the national CPI. Here's the chart that (correctly) drops the last observation:

So that doesn't give the dramatic story I thought it did, i.e. year-over-year inflation is still up around 1.5%, though short of the Bank of Japan's 2% inflation target. Note as well, that if we look at the levels, in January the CPI fell, and there was no change in February.

Further, if we take a longer view:

So, in spite of the recent blip in inflation, the average rate of inflation in Japan over the last twenty years is about zero, and in that 20-year period we have seen other short bursts of inflation. Thus, the Bank of Japan seems to have had some difficulty in producing inflation - but this time may be different. Given that the Bank seems intent on holding the short-term nominal interest rate at zero (essentially), I don't see it, but I'm curious to see how the data unfolds.
Stephen Williamsonhttp://email@example.com:blogger.com,1999:blog-2499715909956774229.post-70508696030999062082014-04-09T12:44:00.002-07:002014-04-20T10:32:06.392-07:00The FRB/US Model and InflationThe Board of Governors has posted details on the structure of the FRB/US model, the data used in estimating the model, published work using the model, etc. If you have access to EViews, it appears you can also run simulations. There is even a long disclaimer, presumably to cover cases where someone takes the model too seriously, uses it for retirement planning or some such, and then wants to sue the Fed. On this, I have a proposal, which is a blanket disclaimer to cover everything - public speaking by Fed employees, casual chit-chat in the coffee shop, whatever:
Please don't ever pay close attention to what we say, or take any action based on such utterances. We're only joking most of the time anyway. If you really think we're saying something important, you're not as smart as you look.
That should do it, I think. The Fed can state this once, and then never say it again.

The FRB/US model, used by the Board for forecasting and policy analysis, is the culmination of perhaps 45 years of work. Various generations of management at the Board have directed some smart people to work on this thing, and you can feel the weight of the large quantity of quality-adjusted hours of work that went into putting it together. But is it any good? Could the Board do just as well or better at forecasting with a much simpler tool? Could a well-educated and well-informed economist do a respectable job of central banking without ever looking at the output of the FRB/US model?

Long ago in a galaxy far far away, large-scale macroeconometric models were taken very seriously. This 1959 paper by Adelman and Adelman was published in Econometrica. They simulated the Klein Goldberger model on an IBM 650, which was the first mass-produced computer. Here's what that looked like (from Wikipedia):

The Klein-Goldberger model was small relative to the FRB/US model - 15 equations. It was first estimated in 1955 using electro-mechanical desk calculators. In those days running a regression was a big job - you will understand the magnitude of the task if you have ever had to invert a matrix by hand. By the late 1960s, the Klein-Goldberger model had evolved into the large-scale FRB/MIT/Penn model, which is a distant ancestor of the FRB/US model.

But shortly after large-scale models had been warmly embraced by policymakers in central banks and governments, they were trashed by the upstarts of the macroeconomics profession. I think the modern notion of the Lucas critique is that it calls into question "reduced-form" economics, "implicit theorizing," and such. But Lucas's paper actually had a more narrow focus. Lucas was criticizing large scale macroeconometric models. This is the key quote from his paper:
The thesis of this essay is that it is the econometric tradition, or more precisely, the "theory of economic policy" based on this tradition, which is in need of major revision. More particularly, I shall argue that the features which lead to success in short-term forecasting are unrelated to quantitative policy evaluation, that the major econometric models are (well) designed to perform the former task only, and that simulations using these models can, in principle, provide no useful information as to the actual consequences of alternative economic policies. These contentions will be based not on deviations between estimated and "true" structure prior to a policy change but on the deviations between the prior "true" structure and the "true" structure prevailing afterwards.
Clearly, this was not taken to heart at the Board, as the FRB/US model - in spite of some claims to the contrary - does not look so different from early macroeconometric models. Indeed, if Klein and Goldberger were alive, I don't they would find the FRB/US model an unfamiliar object, though the documentation is dressed up in the language of modern macroeconomics as practiced in most central banks. So, was Lucas wrong, or what?

There's a lot going on the the FRB/US model, but suppose we focus on something the Fed cares about, and is instructed to care about: the inflation rate. Inflation determination appears to be in a New Keynesian spirit. So, one thing that has changed from 1970s-era large scale macroeconometric models is that the money demand function has disappeared, and monetary quantities appear to be nonexistent. Inflation is determined - roughly - by an output gap and trend inflation, which is a survey measure of the ten-year-ahead inflation rate. For example, if a shock occurs in the model which causes a positive output gap, then inflation rises, and over time inflation will revert to the long run trend, which is exogenous.

So, this is purely Phillips-curve inflation determination, which certainly does not square with how I think about the inflation process. Neither does it square with the data, which is notoriously at odds with the view that output gaps are important in explaining or forecasting inflation, or the view that Phillips curves are stable. The Phillips curve does particularly badly over the past couple of years or so. Here is the output gap measure used in the FRB/US model:

So, given that, the FRB/US model tells us that inflation should have been rising recently. But headline pce inflation and core pce inflation have been falling:

If you look at Flint Brayton's memo on "A New FRB/US Price-Wage Sector," in the FRB/US documentation, you can get some idea of how the Board staff think about this. Staff members of course monitor how the model is predicting out of sample, but the model had not been doing well:
Inflation in the recent recession and its aftermath did not decline nearly as much as the 1985-2007 estimates would have predicted, a result that is common to many models of inflation.
So, apparently they found that the Phillips curve they had estimated was not stable - during the recession it was making inflation forecasting errors on the low side. The solution was to re-estimate:
ML estimation over a longer sample period that ends in 2012 reduces the sector's unemployment slope coefficient by more than half.
ML is maximum likelihood. So, if the sample is extended to 2012, the Phillips curve starts to go away - the slope coefficient gets much smaller. But the Board staff doesn't seem to like this:
An alternative and more cautious re-assessment of the unemployment slope is obtained with Bayesian methods. Using the 1985-2007 ML parameter estimates and their standard errors as a prior, Bayesian estimation over the longer sample reduces the slope coefficient by one-third.
So, apparently being "cautious" is when you ignore the data and go with your intuition.

This is important, as it tells us something about how the Governors and the FOMC chair think about monetary policy decisions. The FRB/US model seems to be producing the Board's forecast and some policy scenarios that are used as input at FOMC meetings. And we know that Janet Yellen takes FRB/US quite seriously. The FOMC is predicting that the inflation rate will rise over time to 2%, and Janet Yellen has told us that she thinks that, under that scenario, the Fed's policy interest rate should start rising in spring 2015. Some people want to interpret that as a hawkish statement, but I don't think so, because I think the forecast - and FRB/US - is wrong. The FOMC has also stated that the policy rate will stay low if inflation continues to be low or falls, and I think that is the likely outcome, for reasons I have discussed before. So, given what the FOMC has told us about its policy rule, my prediction is that the policy rate will be where it is for considerably longer than Janet Yellen thinks it will.Stephen Williamsonhttp://email@example.com:blogger.com,1999:blog-2499715909956774229.post-26564371658196852852014-03-31T13:42:00.001-07:002014-03-31T13:42:10.423-07:00Taylor RulesJohn Taylor has a blog post which reviews the origin of the Taylor rule and why we should think it's good guidance for central bankers. In making his points, Taylor quotes from a reply I made to a comment on one of my posts, so I'll supply that reply in full:
When Taylor first wrote down his rule, he didn't make any claims that there was any theory which would justify it as some welfare-maximizing policy rule. It seemed to capture the idea that the Fed should care about inflation, and that there exist some non-neutralities of money which the Fed could exploit in influencing real economic activity. He then claimed that it worked pretty well (in terms of an ad hoc welfare criterion) in some quantitative models. Woodford used the Taylor rule to obtain determinacy in NK models, and even argued that it was optimal under some special circumstances. But NK models are very special. Typically they ignore financial factors that I think we can agree are important, and certainly don't address issues to do with what you're calling "financial stability."

So what's optimal? I don't think we have a good grip on this. I don't think we understand fully the nature of the central bank's influence on real economic activity, and we don't fully understand the costs of inflation. 2% inflation is optimal? Why?

You might hope that we could muddle along with a simple Taylor rule driving central bank behavior. It's simple, and maybe close enough to optimal, given what we know. But it's well-known that it can have bad long run properties. For example, the Fed can think that 2% inflation is optimal, but converge to a long-run equilibrium in which inflation is too low. Or the Fed can have incorrect beliefs about the long-run real interest rate, or the output gap, which will imply that the policy is wrong.
Taylor seems to agree with some of that, but he clearly has some differences. Let's focus on his last paragraph:
Later research (which Steve mentions) was very important. The proof of exact optimality of the rule in certain simple models as shown by Mike Woodford (and also Larry Ball) helped improve people's understanding of why the rule worked well. Finding robustness to a surprisingly wide variety of models was quite useful, as was the historical finding that when monetary policy was close to such a rule, performance was good and when it departed, performance was not so good. But this all depended strongly on the economic theory and policy optimization results in the original research.
What Taylor does not mention is the evidence, for example from Benhabib et al., that Taylor rules can yield unintended consequences - convergence to steady states with inflation below the central bank's target. People might have thought of those results as theoretical curiosities, but some central banks in the world appear to be in danger of exactly that unintended consequence. For example, in the United States, the recent path for the year-over-year pce inflation rate looks like this:

The FOMC took great pains to explain its Taylor rule in the last FOMC statement. But, in spite of the fact that the FOMC's target inflation rate is 2%, and Keynesian output gaps are falling, inflation has been falling for two years, and is well below 2%. Seems not to be working according to plan, don't you think? It's surprising though, that this should surprise anyone.

John Cochrane has more on this in a post from last week. Basically, he sketches a theory to make sense of the notion that, in order to raise the inflation rate to achieve its target, the Fed will have to raise it's nominal policy rate. As he points out, it's important to be specific about the relationship between monetary and fiscal policy. What's left out of his story is the determination of the real interest rate, which is important, but of course John is just giving us a sketch.Stephen Williamsonhttp://firstname.lastname@example.com:blogger.com,1999:blog-2499715909956774229.post-22998236153387256392014-03-27T09:46:00.001-07:002014-03-27T11:58:29.007-07:00Money Creation: Propagating ConfusionI'm a little late on this, but I saw some commentary on this Bank of England article by McLeay, Radia, and Thomas, "Money Creation in the Modern Economy." The article appears intended for lay people, as a basic introduction to how banking, money, and monetary policy work. If this accurately represents how Mark Carney thinks about these things, we're in trouble.

The article's authors claim that there are some popular misconceptions about how money creation works, and the central bank's control over that process. They seem to want to clear things up for us. Some people have had strong reactions to the article, and Simon Wren-Lewis links to some of that. It's a confused article, so it's really not surprising that it's lead to confused reactions.

As the authors cite Tobin's Commercial Banks as Creators of "Money," and refer to it extensively, it's useful to start there. Tobin's paper, written in 1963, is one of my favorite papers in monetary economics. You can guess where Tobin is going from the scare quotes in the title. Here are Tobin's conclusions:

The key insight - as important today as in 1963 - is that we sometimes take the word "money" far too seriously. In reality, assets exist on a spectrum in terms of what we think of as liquidity, and there is not much point in drawing some arbitrary line between what is money and what is not. Further, we should not draw a line between financial intermediaries that issue highly-liquid liabilities, and those that do not. Particularly given the financial crisis, I think it is now more widely understood that the financial system works as a whole - it can't be compartmentalized into institutions that the central bank should be concerned with, and those it should not.

For the arguments in the article, Tobin's point 4 is particularly important. Tobin thought it best that we think of commercial banks as financial intermediaries and, as such, to analyze their role in terms of normal economics. Indeed, people lose their grip on reality when they start thinking of central banking, and "money" creation, as some kind of hocus-pocus.

So, McLeay, Radia, and Thomas (MRT) begin their article by clearing up two "misconceptions." The first one is:
...that banks act simply as intermediaries, lending out the deposits that savers place with them.
Well, that's a really bad start, as that's not a misconception, but a very useful way to begin thinking about what a bank does. A bank is indeed a financial intermediary - it borrows from one set of people and lends to another set of people. The second "misconception":
...is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money — the so-called 'money multiplier' approach.
I'm on board with that. The money multiplier is probably the most misleading story that persists in undergraduate money and banking and macroeconomics texts. Take someone schooled in the money multiplier mechanism, and confront them with a monetary system - such as what exists in Canada, the UK, or New Zealand - where there are no reserve requirements, and they won't be able to figure out what is going on. Confront them with a system with a large quantity of excess reserves (the U.S. currently), and they will really be stumped.

But, though MRT recognize that the money multiplier story may not be illuminating, that traditional story is actually part of their anti-misconception for "misconception" #1. The authors state:
...rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.
Well, in the money multiplier stories I heard, that actually seemed to be important. In the traditional textbook account, the central bank conducts an open market operation by purchasing government debt with reserves. Banks have more reserves, which they cannot collectively rid themselves of, but they start lending more, as they have reserves in excess of their reserve requirements. When a bank makes a loan, it simply gives the borrower a deposit at the bank. The borrower will presumably spend the funds in the deposit account, but the deposit balance stays in the banking system, and the multiplier process continues until the reserve requirement binds.

That's essentially the story that MRT are telling, but without the initial reserve injection. I think Tobin would object just as strongly to what MRT are saying as to the money multiplier story that he wrote about in 1963. Here's why. Lending by a bank does not somehow create the deposit liabilities that support that lending. For example, suppose bank 1 makes a loan for $20,000, and credits $20,000 to the borrower's deposit account. Then, the borrower purchases a car for $20,000, and when the transaction clears the borrower's deposit account at bank 1 is debited $20,000, and the deposit account of the car dealer at bank 2 is credited $20,000. Bank 1 also receives a debit of $20,000 to its reserve account, and Bank 2 receives a credit of $20,000 to its reserve account. Now, suppose that the car dealer withdraws the $20,000 from its deposit account in cash. Now, bank 2 is in the same position as before - there is no net change in its deposit liabilities or its reserve account balance. At bank 1, liabilities are no different than initially, but the composition of assets has changed. Reserves are now $20,000 lower, and loans are $20,000 higher. But, suppose that the car dealer who sold the borrower the car had taken out a loan from bank 1 in order to finance the car as inventory. Further, suppose the car dealer pays off the loan - with $20,000 in cash. So loans fall by $20,000 and reserves rise by $20,000 at bank 1. So now the banking system looks exactly the same as initially.

I just made up a series of transactions, but that story makes as much sense as what MRT describe as a "money creation" process. The story simply is not helpful. It would be much more useful to tell a story for lay people that focuses on the bank as a financial intermediary, with deposits and loans determined jointly by the behavior of depositors, borrowers, and banks. Basically, it's a general equilibrium problem, and we have to get this across in a way that people will understand. Making up stories about transactions and balance sheets doesn't help.

Then, once people understand something about financial intermediation and asset transformation, it's more straightforward to tackle central banking and what that is about. Basically, the central bank is just another financial intermediary, that competes with private sector intermediaries. To the extent its actions matter, that's because the central bank has some special advantages or powers in providing intermediation services.

MRT go further astray when they discuss how monetary policy works. Again, it seems their intention is to clear up a misconception:
Central banks do not typically choose a quantity of reserves to bring about the desired short-term interest rate. Rather, they focus on prices — setting interest rates.
And again, they don't get it right. My understanding of the Bank of England's operating strategy is that the Bank sets the Bank Rate, which is the counterpart of the U.S. discount rate, and also the interest rate on reserves. Correct me if I'm wrong, but this is a channel system with no channel - effectively the overnight rate, the central bank lending rate, and the interest rate on reserves, are identical. So, in pre-financial crisis times, the overnight rate target was the Bank Rate, and the Bank of England would hit its target through intervention in the repo market. So, pre-financial crisis, the Bank did not literally "set" the overnight rate. It achieved a particular market outcome through a standard type of intervention, which would literally adjust the quantity of outside money to hit the target. So, the Bank of England seemed to have been doing what its economists said it was not doing.

Post financial crisis, you can see the state of the Bank of England's balance sheet here. As in the U.S., the central bank's balance sheet has grown, as has the stock of reserves. It therefore appears that (and this may not be quite correct, as I had trouble finding detailed Bank of England balance sheet information - please help me out if you know where to find it), as in the U.S., the interest rate on reserves determines the overnight rate, and repo market intervention (at the margin) is irrelevant. So, the current environment comes somewhat closer to what MRT are describing, though their view of bank behavior leaves a lot to be desired.

My last complaint is about MRT's analysis of the effects of QE (quantitative easing). The example they give again involves balance sheet entries. You can find this in the section beginning on page 8 of the article. It turns out they want us to think of QE as a central bank action that "creates broad money directly." What a funny idea. In the example, illustrated on Figure 3 on page 11, the Bank of England purchases government debt from a pension fund, which has no reserve account. The effect of the central bank action is to reduce the pension fund's holdings of government debt, and increase the pensions fund's bank deposits. In turn, the pension fund's bank sees an increase in its deposit liabilities and an increase in its reserve balances. Then the claim is that the pension fund proceeds to readjust its portfolio, which it is now apparently unhappy with, so QE has some effect.

Well, hold on. By this logic, if the Bank of England purchased T-bills from the pension fund, this would have the same effect. But MRT's argument is based on being in a liquidity trap. So, they have to show why it makes a difference that the asset purchases are of long-maturity government debt rather than short maturity government debt. Further, suppose that the pension fund has a reserve account, so that the asset purchase is a swap of reserves for government debt. Surely that can't make a difference to the ultimate effect of the purchase, but clearly MRT think it's critical that inside money increase as a result of the purchase in order for it to have an effect.

If you find that weird, then you'll also find "Quantitative Easing Explained,"  from the Bank of England's website, just as weird:
This policy of asset purchases is often known as 'Quantitative Easing'. It does not involve printing more banknotes. Furthermore, the asset purchase programme is not about giving money to banks. Rather, the policy is designed to circumvent the banking system. The Bank of England electronically creates new money and uses it to purchase gilts from private investors such as pension funds and insurance companies. These investors typically do not want to hold on to this money, because it yields a low return. So they tend to use it to purchase other assets, such as corporate bonds and shares. That lowers longer-term borrowing costs and encourages the issuance of new equities and bonds to stimulate spending and keep inflation on track to meet the government's target.
Central bankers in the U.S. typically use market-segmentation stories as arguments for why QE works. But in those stories, there is segmentation in the market for government debt - by maturity. The Bank of England is telling us that there are two key segments to the financial market - banks and non-banks. The banking sector is not integrated with the non-banking sector perhaps, as MRT seem to want to argue, because banks have reserve accounts and non-banks do not. That's wrongheaded. Either you knew this before the financial crisis (for example by reading Tobin's 1963 paper), or you learned it during the financial crisis: It's foolish to draw a line between financial intermediaries that are "banks" and those that are not; indeed it can get us into big trouble.Stephen Williamsonhttp://firstname.lastname@example.com:blogger.com,1999:blog-2499715909956774229.post-66354747335052136562014-03-19T12:16:00.000-07:002014-03-19T12:16:10.196-07:00The March 19 FOMC StatementAs anticipated, the FOMC statement contains new forward guidance language. The language is vague, and rather loquacious. If I'm not mistaken, this is the longest post-FOMC-meeting press release on record.

The important novelties in the statement  are in paragraphs 5 and 6. Paragraph 5 reads:
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.
Any numerical targets - except a reaffirmation of the 2% inflation goal - are now left out, which I think is a good thing. The FOMC is telling us that it will look at everything, and that the policy rate will likely stay where it is well into next year. We're basically back to "extended period" language, but it seems to have taken many more words to get that idea across.

Paragraph 6 is:
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 Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.
Paragraph 5 told us something vague about when "liftoff" will occur - the date at which the policy rate starts to increase. Paragraph 6 concerns post-liftoff Fed behavior. The "balanced approach" is outlined in this 2012 speech by Janet Yellen. "Balanced" means following a Taylor rule derived from a loss function with equal weights on squared deviations of the unemployment rate and inflation, respectively, from their targets. In Yellen's speech, she used 5.5% as an unemployment rate target and 2% as an inflation rate target. But the second sentence in the paragraph also tells you that, for a period of time after liftoff occurs, the policy rate will be less that what the balanced approach implies. Presumably that's to fulfill the commitment implied by the old forward guidance language (see my last post).

Two comments:

1. It's clear what the model is here. It's a 3-equation reduced form New Keynesian model ("IS" curve, Phillips curve, Taylor rule). It's the Phillips curve which is driving the Fed's inflation forecast. Essentially all of the regional Feds and the Board have inflation increasing very gradually to 2% in the long run. Thus, the Fed expects that, given the policy rule laid out in paragraphs 5 and 6, that it will be getting close to its targets of 2% inflation and (presumably) 5.5% unemployment in a couple of years. One problem is that the Phillips curve hasn't been doing so well lately as an inflation predictor (as if it ever did well), what with inflation and unemployment both falling. A second problems is that, if inflation continues to be low, that will extend the tapering period, and extend the period until liftoff. This, as we know, just leads to self-fulfilling low inflation. There is no recognition of that possibility in the statement.

2. Why use so many words to say so little?

Note that Kocherlakota dissented:
Voting against the action was Narayana Kocherlakota, who supported the sixth paragraph, but believed the fifth paragraph weakens the credibility of the Committee's commitment to return inflation to the 2 percent target from below and fosters policy uncertainty that hinders economic activity.
I don't quite understand his objection. If he thinks the statement implies an overshooting of the 2% inflation target (which I assume he doesn't like), that's in the second sentence of paragraph 6, not in 5. Maybe he just wanted to include an explicit 5.5% unemployment rate threshold in paragraph 5. Better left out, I think.
Stephen Williamsonhttp://email@example.com:blogger.com,1999:blog-2499715909956774229.post-79250287639945728792014-03-18T11:43:00.000-07:002014-03-18T11:43:33.994-07:00The Labor Market and the FOMC MeetingThe FOMC will meet today and tomorrow. Given that there has been little news that would change the economic forecast, the Fed is likely to continue "tapering" - the monthly reductions in the size of asset purchases that began in December. This meeting may be important though. First, this will be the first FOMC meeting chaired by Janet Yellen. Second, with the unemployment rate at 6.7% and falling on trend, the Fed's 6.5% threshold will soon be passed, so the FOMC will have to come up with a new framework for forward guidance.

In this Q&A with John Williams, President of the San Francisco Fed, he was asked about potential changes in forward guidance:
Q. You have advocated replacing the Fed's current guidance on interest rates, which is linked to a specific unemployment rate, with a less specific description of objectives. Isn't that necessarily a less effective kind of guidance?

A. Back in 2011 the qualitative guidance wasn't strong enough and so we went to the data-based concrete guidance and I thought that whole period was very successful. We had a disconnect between our views of where the policy was going and what the market thought. We used some pretty strong language saying what our intentions were and that seemed to work pretty well. I think that was really helpful and in many ways successful. As we've gotten away from truly extraordinary times and we're in a transition toward somewhat more normal times, then the argument for trying to put out this really strong signal about, 'We're not going to raise interest rates until we see this one thing happen or this other thing happen,' I don't think is the right approach because it puts way too much attention on one aspect of the data. My preference would be to see us moving to describing our policies in our statements much more consistently and clearly. Here are our objectives, here's where we are relative to them, and given this progress that we've made, here's the policy stance we're taking and here's how we're going to adjust this going forward. If that's more the approach we're going to take it would be vaguer or more general than a number. But I think it would be more accurate.
So, Williams says that we went through some "extraordinary times" that required unusual forward guidance. According to him, that unusual forward guidance worked. But now times are not so extraordinary any more, so we need more ordinary forward guidance. This forward guidance will be "vaguer" but will somehow reveal how the Fed thinks about the world, so that private sector decision makers can confidently predict how the Fed will behave in particular situations.

This speech by Charles Plosser, President of the Philadelphia Fed, comes to much the same conclusion, though by a different route. Plosser says:
Economists have learned that expectations play an important role in determining economic outcomes. When businesses and households have a better understanding of how monetary policy is likely to evolve, they can make more informed spending and financial decisions. If policymakers can reduce uncertainty about the course of monetary policy, the economy is likely to perform more efficiently.
So, that seems like the kind of forward guidance that Williams wants now. But Plosser also says:
A somewhat different rationale or view of forward guidance is that it is a way of increasing accommodation when the policy rate is at or near the zero lower bound. Some models suggest that when you are at the zero lower bound, it can be desirable, or optimal, to indicate that future policy rates will be kept "lower for longer" than might otherwise be the case. Thus, policymakers may want to deliberately commit to deviating from what they would otherwise choose to do under normal conditions, such as following a Taylor-like rule. In these models, such a commitment would tend to raise inflation expectations and lower long-term nominal rates, thereby inducing households and businesses to spend more today.
That's the forward guidance for extraordinary times that Williams discussed. Plosser does not seem to think that was such a good idea:
The FOMC has not been clear about the purpose of its forward guidance. Is it purely a transparency device, or is it a way to commit to a more accommodative future policy stance to add more accommodation today? This lack of clarity makes it difficult to communicate the stance of policy and the conditionality of policy on the state of the economy.
So, Williams thinks that extraordinary forward guidance was a success, but apparently Plosser doesn't agree. He thinks that, in the private sector, people were confused - they couldn't figure out whether the Fed was speaking ordinary forward guidance or extraordinary forward guidance. Here's what I think is going on. Post-financial crisis, the Fed was under a lot of pressure to do something about the state of the labor market. At the zero lower bound, "doing something" meant doing something extraordinary, and one of the extraordinary policies the Fed adopted was a form of forward guidance. That policy received support from the academic work of Mike Woodford and coauthors. In New Keynesian (NK) models, forward guidance is a commitment to future policy actions that are not time-consistent - once the future arrives the central bank would choose a different policy action if it could. To provide stimulus at the zero lower bound, according to NK models, the central bank would need to commit to a future path for the nominal policy rate that would remain lower than it would otherwise be (given previous Fed behavior) for a longer period of time.

It could be that the Fed's motivation was wrong. Maybe NK models are a poor guide for monetary policy. But, suppose that we think NK models are the cat's meow. Then, for forward guidance to work, the FOMC would have had to clearly communicate: (i) what they were committed to; and (ii) that they were committed. The FOMC first announced that the policy rate would be low for an extended period; then, the policy rate was to be low at least until some calendar date; then that calendar date changed; then a threshold was announced in terms of the unemployment rate; then the FOMC started saying things about how the threshold didn't matter, and Fed officials began discussing other labor market indicators - the participation rate, the employment/population ratio - that might matter for its decisions. So, private sector individuals who care about these things would have a right to be confused about whether any commitment existed, and what the commitment was about. Thus, I'm very puzzled as to why Williams is calling the FOMC's extraordinary forward guidance experiment a success.

But, extraordinary forward guidance is now history, and hopefully we'll never revisit that experience. The FOMC is currently concerned with the nature of current and future ordinary forward guidance. If we want to make a prediction about the nature of what will show up in the FOMC statement on Wednesday, a good guess is that this will the "vague" guidance that Williams envisions. Plosser, who is on the other end of the spectrum from Williams, seems on board with that. In my opinion, vague language is exactly what is required. The FOMC should avoid making any commitments to numerical targets or thresholds for things it cannot control over the long run, and over which it may sometimes have little influence in the short run.

Here's something interesting in Williams's Q&A with the New York Times:
Some economists see evidence that inflation is tied to short-term unemployment. Right now we have a lot of long-term unemployment and a lot of people who have stopped looking for work. That suggests you could start to see wage and price pressures before the economy has returned to full employment.
So, let's explore that idea. This is what the recent time series of unemployment and vacancy rates looks like:

So, as the FOMC statement says, the unemployment rate remains elevated, relative to the sample in the chart, but the vacancy rate is back up to 2004 levels. If we look at this in the form of a Beveridge curve relation, with the points representing pre-recession observations, and the line connecting observations after that, the data looks like this:

In the chart, you can see the shift to the right in the Beveridge curve, but the recent data is not as far off the pre-financial crisis relationship as it was.

But Williams is arguing that there are differences if we look at short vs. long-term unemployed. If we examine unemployment rates by duration of unemployment (number of unemployed divided by total labor force), the data looks like this:

For those unemployed less than five weeks (currently about one quarter of all unemployment) the unemployment rate is the lowest it has been since late 2000. For those unemployed 5-14 weeks, the unemployment rate is lower than in 2002-04, and for 15-26 weeks, the unemployment rate is almost down to 2002-04 levels. Thus, the elevated unemployment rate is coming almost exclusively from the very long term unemployed - 27 weeks or more.

If we plot Beveridge curves by duration of unemployment, we see another version of the same story. For those unemployed less than 5 weeks, the most recent observation is well to the left of the pre-financial crisis cloud:

For 5-14 weeks, the Beveridge relationship looks stable:

For 15-26 months you can observe the rightward shift in the relationship:

And this is even more pronounced for 27+ weeks unemployed:

What about Phillips curves? At the aggregate level, using the same sample as for the Beveridge curves, except quarterly rather than monthly data, with inflation measured as the annualized quarterly percentage change in the PCE deflator:

So, you may see a Phillips curve relation in that chart, but I don't - particularly in the recent data, where we have seen falling unemployment and a falling inflation rate.

But what if we disaggregate? Here's a Phillips curve for those unemployed less than five weeks:

Maybe there's something going on there, but I wouldn't want to base a policy decision on what I see in that chart. Seems like the observed Phillips curve predicts about 3% inflation given the current unemployment rate, but we're seeing about 1%. So much for that. Here are the other Phillips curve relations - not much going on there either:

When Williams says that "some economists see evidence that inflation is tied to short-term unemployment," he may mean Robert Gordon. But I think Williams and Gordon should read this JEL paper by Mavroeidis, Plagborg-Møller, and Stock. The upshot of that work is that Phillips curve coefficient estimates are extremely sensitive to specification and changes in the data set. The conclusion that one should draw, I think, is that econometricians estimating Phillips curves are not estimating anything useful - the estimates cannot be taken seriously in a policy exercise.

As should be clear from Williams's Q&A, recent FOMC statements, and public statements by Fed officials, the Phillips curve is alive and well in policy circles. But the weight of the empirical evidence (also see my charts in this post) makes one wonder what some people on the FOMC could be thinking. The idea that some measure of slack in the economy can help explain inflation, or predict it, appears rather foolish.

In the past, however, the Phillips curve has been a convenient fiction, which allowed the FOMC cover to increase the overnight nominal interest rate target. A persistently low nominal interest rate target ultimately produces low inflation. That's a prediction common to a wide class of mainstream monetary models, and the Fisher relation is a strong empirical regularity. If the FOMC argues that a "tight" labor market predicts higher future inflation, and that the nominal interest rate should go up when the labor market is tight, that ultimately becomes self-fulfilling. But in our current circumstances, even if we're seeing "tightness" in terms of short-term unemployment, we're not going to see significantly higher inflation as long as the policy rate remains low.

Thus, it's possible that sentiments like Williams's could lead the Fed to do the right thing for the wrong reason. If the Fed wants higher inflation, the policy rate needs to rise, and this may happen if the idea catches hold with the FOMC that the labor market is tight. My guess, however, is that the idea won't actually take hold. But listen to what Janet Yellen says tomorrow. That should tell us a lot about where the committee is headed.Stephen Williamsonhttp://firstname.lastname@example.com:blogger.com,1999:blog-2499715909956774229.post-72020407643929108602014-03-11T14:34:00.000-07:002014-03-11T18:16:11.460-07:00Why are Canadians Working So Much More Than Americans?If we track real GDP in the United States and Canada since the beginning of the last recession, the history looks similar.

I have normalized real GDP to 100 for each country in 2007Q4. You can see that the recession proceeded in similar ways, with Canada coming out a bit better. Real GDP was 1.4% higher in Canada in 2013Q4 relative to the U.S, as compared to 2007Q4. However in per capita terms, the U.S. did a bit better than Canada, as population growth 2007-2014 was more then two percentage points higher in Canada than in the U.S. (due to higher immigration).

But labor market conditions in Canada and the U.S. look very different, as David Andolfatto has pointed out. I'm going to use those differences to help sort out some of the issues raised by John Cochrane regarding the behavior of the employment/population ratio in the United States.

Though I want to focus on employment, it's useful to look first at unemployment rates in Canada and the U.S., to see some of the important differences.

As you can see, from the early 1980s until 2007, the unemployment rate was substantially higher in Canada than in the U.S. - at times by as much as four percentage points. But during the recession, Canada and the U.S. reversed roles. From trough to peak, the unemployment rate increased about six points in the U.S., and by about three points in Canada. During the recession, the unemployment rate was higher in the U.S., and unemployment rates are currently about the same in the two countries.

Next, let's look at aggregate employment/population ratios.

Here, you can see that employment/population ratios were similar in Canada and the U.S. before the recession, but the ratio dropped about two percentage points in Canada, and about four in the U.S. Currently, adjusting for the size of the working age population, the number of workers is close to 5% higher in Canada than in the U.S. That's a big number.

If we look at the whole time series in the last chart, there are some interesting things going on. In particular, before 1990, the behavior of employment/population ratios in the two countries was similar, with employment a little higher in the U.S. Then, in the early 1990s, Canada experienced a drop in the employment/population ratio of a similar magnitude to what occurred in the U.S. in the last recession. Indeed, we can just reverse the labels for post-1990 and post-2007, and the behavior looks much the same. In the early episode there is a small decline in the U.S. and a big one in Canada, and the opposite occurs in the later episode. A key point here is that large and persistent declines in employment are nothing new for rich countries, and need not have anything to do with financial crises.

Next, I'll show you the differences in behavior by gender.

So, just as in Olympic hockey, the Canadian men and women are both outdoing their U.S. counterparts. Interestingly, the current gap is much larger for women than for men. And, if we look at the whole time series, we can see similar patterns in the early 1990s episode and the recent recession. In the early 1990s, there is a large decline in employment in Canada, but the drop is larger for men than for women. And in the recent recession, the employment decline for men is larger than for women in the U.S. Note that this is also true for Canada. During the last recession, the employment/population ratio declined for men, but was roughly flat for women.

Finally, we'll look at the cross-country differences by age, with 15-24 first.

(Note here that I'm using annual data instead of monthly as in the previous charts. This is just what I could easily get access to). For the young, the difference between Canada and the U.S. is currently huge. Before 1980, both countries look about the same, then employment falls for the 15-24 group in Canada, but remains stable in the U.S. However, after 2000 there is a precipitous decline in youth employment in the U.S. There is a decrease in employment in Canada in this group during the last recession, but the decline is much larger in the U.S.

Next are the prime-age workers, aged 25-54.

Here again, the current difference between employment in Canada and the U.S. is huge, though not as great as the difference for 15-24. Something that shows up quite clearly in this chart is the secular decline in the U.S. employment/population ratio that begins about 2000. This secular decline is interrupted by a period of growth that corresponds roughly to the U.S. housing boom.

Finally, the old geezers (including yours truly), aged 55-64.

(Here we're back to monthly data, but with shorter time series, starting in 1995 instead of 1976). In this age group, you see only a small decline in employment in the U.S., and the recession is not even discernible in the Canadian data. But, what was a large employment gap between the U.S. and Canada in 1995 has declined to essentially zero.

It's important to understand what is driving the trend increase in the employment rate of older workers in Canada. That's due primarily to the changing behavior of older women over time. The labor force participation rates of younger women have increased on trend since Word War II in Canada. Thus as these women move through the age cohorts, average labor force participation has increased over time. In the sample depicted in the last chart, baby boom women, who have higher labor force participation than older cohorts, are accounting for an increasing larger fraction of the 55-64 group.

People are trying to get a grip on what caused the dramatic decrease in the employment-population ratio in the U.S. during the last recession, and why that ratio has shown little increase since the recession ended. So, in light of what we have learned from the above charts, let's run through some possible explanations.

1. Aggregate demand is persistently low. In hardcore Keynesian thinking, real GDP is demand-determined. Thus, the path of real GDP is determined by aggregate demand. But, look at the first chart. In the hardcore Keynesian mind, aggregate demand has been roughly the same (adjusting for population growth) in Canada and the U.S. since the beginning of the last recession. The North American economy is highly-integrated. Yet, what we see in the third chart is a difference of about 5% in employment between Canada and the U.S. So, I'm going to dismiss this explanation as a non-starter.

2. Taxation. As Noah Smith points out, it seems this should go the other way. Apparently marginal income tax rates are higher in Canada than in the U.S., so according to Ed Prescott, maybe Americans should be working harder than Canadians. But, perhaps we should expand our notion of what "taxation" is. In Canada, there is socialized medicine, financed through the tax system. In the U.S. - at least until Obamacare came into effect - most Americans were getting health care through private insurance provided as a benefit of employment. But from my point of view, the way I pay for health care looks just like a tax. When I lived in Canada, my federal and provincial income taxes would be withheld from my paycheck. In the U.S., my health insurance premium is a before-tax deduction from my paycheck.

So, suppose I think of the resource cost of health care in the U.S. as being like a tax. From the World Bank, in 2011 Canadian taxes were supporting health care expenditures of 11.2% of GDP, while U.S. "taxes" were supporting expenditures of 17.9% of GDP. So, I think if we did the calculation, we would find a substantially higher "tax" burden in the U.S. than in Canada. In the U.S., health care is a substantial inefficiency burden on the U.S. economy. The World Health Organization tells us that Canada is #12 in the world on the life expectancy scale (80.4 for men; 84.6 for women), while the U.S. is #35 (77.4 for men; 82.2 for women). For the U.S., this is much like having a larger government that delivers a lower quality of service.

But how does inefficient health care delivery affect labor supply decisions in the U.S.? First, consider pre-Obamacare arrangements. Paying a health insurance premium through my employer is like paying a tax, but I only get the benefit if I'm working. Thus, on net, the way health care was financed in the U.S. may have served to increase employment relative to Canada. As well, the tax was lump-sum, conditional on working, so it didn't affect my choice of hours of work - the intensive margin. Indeed, the negative wealth effect would tend to make me work harder. Post-Obamacare, it's a different story. Now, I get the healthcare benefit whether I work or not, which looks more like Canada. So, this should reduce labor supply by discouraging labor force participation - the extensive margin.

The direct effects of health care inefficiencies seem not to help us in explaining employment differences in Canada and the U.S., unless perhaps those inefficiencies are reflected in relative wages, which in turn affect labor supply. For example, protection for the health care sector (monopoly power; patent protection for drug manufacturers, for example), tends to inefficiently allocate capital in the economy toward the health care sector. This makes wages lower than they would otherwise be outside of the health care sector, which reduces non-health care labor supply, and health care labor supply is constrained by the medical profession. I am not aware of any work that measures this kind of effect.

3. Demography. This paper by Kapon and Tracy at the New York Fed suggests that the decline in the employment/population ratio in the U.S. could be explained by demographics. As the population ages, on average, labor supply declines. The problem with that idea is that the age structure of the population in Canada and the U.S. is very similar. Since World War II, fertility rates in Canada and the U.S. have been roughly the same. There are differences in immigration, certainly - Canada admits more immigrants, and its immigration policy is very different - but that's not going to explain the differences in behavior post-2000 in the two countries.

4. The Financial Crisis. Canada experienced only a mild decline in housing prices and residential construction during the recent recession. Thus, though we see a similar decline in real GDP in the two countries, the differences in sectoral composition of output could be important for the labor market. There also may have been greater dispersion in the decline in aggregate activity within the U.S. as opposed to within Canada during the recession. You may not think residential construction is a large enough sector to account for the differences in employment, but if we consider all the ancillary sectors - consumer durables and services, for example - related to housing, the effects could be large in the labor market.

4. Pre-Crisis Sectoral Issues. First, it would be useful to know what caused the large drop in the employment/population ratio in Canada post-1990 (see the third chart). That might give us some clues. Second, one possible story about the U.S., post-2000, is that there was an important secular sectoral shift that commences around 2000, but was masked by the post-2000 housing boom, which was essentially construction under false pretenses. If the sectoral shift is what was driving what we see in the time series, it had to affect men more than women, the old not at all, prime age workers somewhat, and young workers a lot. This also must have been a sectoral shift that affected the U.S., but not Canada.

I'm not sure where this leaves us. As John Cochrane says, you can't work all of this out in blog posts.
Stephen Williamsonhttp://email@example.com:blogger.com,1999:blog-2499715909956774229.post-53342411729271826082014-03-09T18:18:00.000-07:002014-03-09T18:18:28.615-07:00Monetary Policy and the Financial CrisisThe FOMC transcripts for 2008 are indeed interesting reading. If you want to dip into these, I would recommend skipping some of the talk at the regular scheduled meetings, some of which is just formal statements by the participants, and pay close attention to the inter-meeting conference calls.

It's clear from the transcripts that the FOMC was dealing with situations for which it was unprepared. Even for people with a knowledge of historical financial panics - the National Banking era panics (1863-1913) and the Great Depression - what happened in 2008 was unprecedented. The fact that the dysfunction was centered in very large financial institutions, and in the financial markets in which they were active, rather than in retail commercial banking, made all the difference. I'm going to focus on two main (and related) points: (i) Decisions by the FOMC about the fed funds rate target during most of 2008 ultimately mattered little for the effects of monetary policy, or for the unfolding crisis, during 2008; (ii) Effective power in the Federal Reserve System during the crisis was concentrated at the New York Fed and the Board of Governors. The Presidents of the regional Feds had little influence on the big decisions that drove the response to the crisis.

Monetary Policy and the Fed Funds Market

During the September 16 FOMC meeting, which occurred the day after the Lehman failure, Bernanke said the following:
We have been debating around the table for quite a while what the right indicator of monetary policy is. Is it the federal funds rate? Is it some measure of financial stress? Or what is it? I think the only answer is that the right measure is contingent on a model. As President Lacker and President Plosser pointed out, you have to have a model and a forecasting mechanism to think about where the interest rate is that best achieves your objectives. It was a very useful exercise to find out, at least to some extent, how the decline in the funds rate that we have put into place is motivated. In particular, the financial conditions do appear to be important both directly and indirectly—directly via the spreads and other observables that were put into the model and indirectly in terms of negative residuals in spending equations and the like. The recession dynamics were also a big part of the story. I hope that what this memo does for us—again, I think it's extraordinarily helpful—is to focus our debate better. As President Plosser pointed out, we really shouldn't argue about the level of the funds rate or the level of the spreads. We should think about the forecast and whether our policy path is consistent with achieving our objectives over the forecast period. I am sympathetic to the general view taken by the staff, which argues that those recession dynamics and financial restraints are important, that we are looking at slow growth going forward, and that inflation is likely to moderate. Based on those assumptions, I think that our policy is looking actually pretty good. To my mind, our quick move early this year, which was obviously very controversial and uncertain, was appropriate.
The "quick move" Bernanke was referring to here was the 3/4% drop in the fed funds rate target (to 2.25%) on March 18, following the assisted merger of Bear Stearns with JP Morgan Chase on March 16. At the September 16 FOMC meeting, in spite of the Lehman collapse, Bernanke seemed confident that a 2% fed funds rate target could be maintained through the crisis, as he stated later in the FOMC conference call on October 7:
On the economic growth side, what is particularly worrisome to me is that, before this latest upsurge in financial stress, we had already seen deceleration in growth, including the declines, for example, in consumer spending. Everyone I know who has looked at it—outside forecasters and the Greenbook producers here at the Board—believes that the financial stress we are seeing now is going to have a significant additional effect on growth. Larry gave some estimates of unemployment above 7 percent for a couple of years. So even putting aside the extraordinary conditions in financial markets, I think the macro outlook has shifted decisively toward output risks and away from inflation risks, and on that basis, I think that a policy move is justified. I should say that this comes as a surprise to me. I very much expected that we could stay at 2 percent for a long time, and then when the economy began to recover, we could begin to normalize interest rates. But clearly things have gone off in a direction that is quite worrisome.
Of course we know that things were about to go off in an even more worrisome direction, and a forecast in October 2008 of unemployment slightly above 7% for a couple of years was way off the mark.

So, was the decision to hold the fed funds rate target at 2% at the September 16 meeting a big mistake? On September 16, the most recent information the FOMC had was the July year-over-year PCE inflation rate, which was 4.2%, and the August unemployment rate number, which was 6.1%. Suppose the FOMC had been following Janet Yellen's "balanced" approach, i.e. a Taylor rule with equal weights on squared unemployment deviations and squared inflation rate deviations from their respective targets. Also assume, following Yellen, a target unemployment rate of 5.5% and a target inflation rate of 2%. Then, if the FOMC were thinking in terms of a long-run real interest rate of 2%, Yellen's rule would have dictated a fed funds rate target in excess of 4% in mid-September. Adjust downward for financial market stress (as Yellen would be inclined to do), and a 2% fed funds target does not look unreasonable. On September 16, the FOMC participants seemed to be thinking that financial market disruption would be on the order of what occurred in March 2008 when Bear Stearns was taken over. It's hard to argue why they should have thought otherwise, given what they knew at the time.

Thus, in order to make the case that the FOMC goofed on September 16, we would have to argue that Janet Yellen's view of the world is/was wrong. I don't think the people castigating the Fed for too-tight monetary policy in the face of the crisis want to make that argument.

But I think we can argue that the FOMC did not quite have a grip on how to read developments in the overnight financial markets, and the meaning of the fed funds rate at the time. To see this, first consider the time series for the effective fed funds rate and the 1-month T-bill rate (the shortest-maturity interest rate on U.S. government debt).

You can see that, before late 2007, the 1-month T-bill rate tracks the fed funds rate reasonably closely (with fluctuations in the difference that I don't quite understand). But, note that the margin between the two rates becomes more volatile from late 2007 through 2008. If we look at the difference between the two rates, we can see that more clearly:

Clearly there is a large margin, on average, and a lot of volatility, from late 2007 to mid-2008, and again around the Lehman failure. If we look only at 2007-08, the two interest rates look like this:

The fed funds market is unusual, relative to overnight markets that exist in other countries, and it has features that make it an awkward forum for central bank intervention, particularly in times of crisis. Trading in the fed funds market is over-the-counter, and some of it occurs through brokers, with the brokered transactions being the only ones that are accounted for in the calculation of the effective fed funds rate. Fed funds trades are unsecured. That's important, as in times of crisis, the interest rate on an individual fed funds market transaction will reflect counterparty risk associated with the borrower.

What do we know about the quantity of trading on the fed funds market? Perhaps not so much. This paper by Afonso, Kovner, and Schoar, at the New York Fed, measures fed funds quantities and prices using the "Furfine algorithm," which looks for patterns in payments through Fedwire that look like fed funds market transactions. The measurement is far from perfect, but the authors give us two important findings: (i) There was a substantial increase in the dispersion in interest rates across federal funds transactions following the Lehman collapse; (ii) there was only a small reduction in the quantity of fed funds market trading, post-Lehman. Thus, activity in the fed funds market reflected a substantial increase in counterparty risk after mid-September 2008, but the fed funds market did not "freeze."

The key measure of the effect of conventional monetary policy is the riskless overnight interest rate. That was certainly not the fed funds rate, especially during the financial crisis. Afonso, Kovner, and Schoar find a high degree of dispersion in fed funds transactions prices in fall 2008, reflecting substantial counterparty risk. But there seems to be something else going on, stretching back into 2007, which shows up in the charts in the time series for the 1-month T-bill rate and the fed funds rate. Unless there is something peculiar about 1-month T-bills, I think we can infer that the risk free overnight rate had fallen substantially below the fed funds rate as far back as mid-2007. Here's what the two interest rates look like from August-December 2008:

So, note that the 1-month T-bill rate is in low territory post-Lehman. It's at most 1%, and is typically under 50 basis points. Further, we can see in the next chart that payment of interest on reserves (initially different rates on required and excess reserves) beginning in October 2008 failed to put any kind of floor on the 1-month T-bill:

Therefore, given the actions of the Fed, including lending through the discount window, lending through the TAF (term auction facility), lending to AIG (beginning September 17, 2008), etc., the effective policy rate appears essentially to have gone to zero when Lehman failed - and stayed there. Some people on the FOMC appear to have been thinking the same thing, as is evident in the October 7 conference call:
MR. LACKER. ...I think it would be worthwhile, as we go on with financial markets in such turmoil, to reflect on whether ... our lending is the equivalent of pushing on a string, to use another metaphor from the Great Depression.
CHAIRMAN BERNANKE. Quoting Keynes, I see, Jeff.

Once the riskless overnight rate goes to zero, there's a liquidity trap. Broad-based lending programs or overnight repo transactions by the Fed will have no effect, though if trading has indeed ceased in segments of the financial market, or financial insitutions are indeed facing liquidity crises, then targeted lending or targeted asset purchases by the Fed can matter. You'll note in the quote above that central bankers can have a little fun while dealing with financial crises, apparently. Lacker is known for being on the laissez faire end of the central-bank-intervention spectrum, and Bernanke is kidding him for sounding like a Keynesian (though there is actually nothing particularly Keynesian about a liquidity trap).

So, what to make of this? There are hints that, when the Fed achieves "liftoff" (an increase in the Fed's policy rate above 0.25%), the New York Fed's standard day-to-day intervention mechanism will change. In particular, it seems the Fed plans on having a substantial quantity of reverse repos on its balance sheet on a regular basis, and may target an overnight repo rate rather than the fed funds rate. This will require that the Fed have timely information on overnight repo transactions on some homogeneous set of repos - e.g. those collateralized with a standard class of Treasury securities. I'm not sure if such information is readily available, but it needs to be for this to work. This will eliminate the effects of counterparty risk on the targeted overnight rate, and other features that were creating the margin between the fed funds rate and Treasury securities in 2007-8. This can only make monetary policy more effective when the next financial crisis happens. As well, repo market intervention by the Fed would tighten up arbitrage in the overnight market of interest for the Fed, for reasons discussed here.

Financial Crisis Intervention and the Distribution of Power in the Fed System
As I've mentioned before, the key policy decisions made by the Fed during the financial crisis related to lending programs (discount window and TAF), institution-specific interventions (e.g. related to the Bear-Stearns merger and lending to AIG), and unusual asset purchases (e.g. of commercial paper). Some of the regional Fed Presidents played some role in these decisions. For example, the Richmond Fed President would have played some role in the takeover of Wachovia (headquartered in Charlotte, NC) Wells Fargo, and the Boston Fed President would have been consulted in relation to intervention with respect to money market mutual funds (headquartered in Boston). But, much of the intervention involved only decisions by the Board of Governors and the New York Fed, or day-to-day judgement calls by the New York Fed. For example, the lending program to AIG, announced September 16, resulted from a decision by the Board, in consultation with the Treasury.

Some FOMC participants were worried about the ad hoc nature of the interventions, particularly with regard to large financial institutions. This statement by Bernanke is particularly revealing:
I have been grappling with the question I raised for President Lacker, and I would be very interested in hearing other views either now or some other time. The ideal way to deal with moral hazard is to have in place before the crisis begins a well-developed structure that gives clear indications in what circumstances and on what terms the government will intervene with respect to a systemically important institution. We have found ourselves, though, in this episode in a situation in which events are happening quickly, and we don't have those things in place.
We don't have a set of criteria, we don't have fiscal backstops, and we don't have clear congressional intent. So in each event, in each instance, even though there is this sort of unavoidable ad hoc character to it, we are trying to make a judgment about the costs—from a fiscal perspective, from a moral hazard perspective, and so on—of taking action versus the real possibility in some cases that you might have very severe consequences for the financial system and, therefore, for the economy of not taking action. Frankly, I am decidedly confused and very muddled about this. I think it is very difficult to make strong, bright lines given that we don't have a structure that has been well communicated and well established for how to deal with these conditions. I do think there is some chance—it is not yet large, but still some chance—that we will in fact see a much bigger intervention at the fiscal level. One is tempted to argue that by doing more earlier you can avoid even more later, but of course that is all contingent and uncertain. So we will collectively do our best to deal with these very stressful financial conditions, which I don't think will be calm for some time.
The idea that a consistent policy framework for crisis intervention did not exist at the Fed, and that the absence of such a framework may have contributed to the severity of the crisis, is an idea that has been explored, post crisis, by Jeff Lacker.

Here's something I think is interesting. The next chart shows repurchase agreements and reverse repurchase agreements on the Fed's balance sheet.

For the Fed, a repo is an asset - a secured loan to a private sector financial institution. Similarly, a reverse repo is a liability for the Fed - a loan by a private sector financial institution to the Fed. Repos can be overnight assets, or of longer maturity. As is evident in the chart, before the financial crisis the Fed was typically on both sides of the repo market on a given day, but there was much more variability in repos than in reverse repos. Thus, day-to-day intervention by the New York Fed consisted primarily of variation in the quantity of overnight repos to hit the fed funds target rate. Beginning in late 2007, and in a more pronounced way in 2008, the Fed began taking a large net position in the repo market, to the point where it was lending about $80 billion on net in the repo market in mid-2008. Presumably this was intervention intended to inject liquidity into the "shadow banking" system.

Next, look in more detail at only 2008:

Here, note that the New York Fed engineered a large increase in reverse repos after the Lehman collapse, to the point where it essentially became a large repo financial intermediary, borrowing from one set of repo market participants and lending to another set. Further, from early October 2008 until the end of the year, Fed repos were constant, and all the variation in Fed repo market activity was in reverse repos. In the second-to-last chart, you can see that repo holdings went to nil early in 2009, and reverse repos have increased, most recently to an average of about $200 billion, as the Fed experiments with what is likely to form the basis for a new operating strategy.

The New York Fed has a substantial amount of latitude in how it manages the System Open Market Account (SOMA). For example, the decisions about the repo market interventions that we can see in the last two charts appear to have emanated from the New York Fed. Over time, power in the Fed has become increasingly concentrated in Washington and New York. During the financial crisis, there was even more relative power wielded by the New York Fed in particular, given its proximity to Wall Street, and the nature of the policy interventions. Further, I think the crisis produced a permanent increase in the power of the Board of Governors and the New York Fed relative to the rest of the Fed system. I haven't looked at these numbers, but my guess is that we would see a substantial shift in resources - wages and other costs - in terms of what is spent in Washington and New York, vis-a-vis the regional Feds. That should certainly cause some concern in the regional Feds, and I think it's also a public concern. Part of the strength of U.S. central banking is (was?) decentralization.

Stephen Williamsonhttp://email@example.com