Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Saturday, January 17, 2015

On the Instability of Unilateral Fixed Exchange Rate Regimes

Was there an easy way to bet on a CHF/EUR appreciation? Because if there was, we must all be kicking ourselves for not exploiting that trade!

The difference between winning and losing in the FX market is usually just a matter of luck. To a first approximation, floating exchange rates seem to follow a random walk (see here). But the trade I'm describing here is one I think we should have expected to pay off for reasons beyond pure luck. That is, there is a pretty sensible theory of currency crises that might have guided our investment strategy in the present context. In particular, I'm thinking of Paul Krugman's (1979) model, which he describes here.

The basic idea is as follows. Suppose that a central bank wants to peg its currency relative to some other currency. Suppose that it does so unilaterally. The success of the peg will depend critically on its perceived credibility. This credibility may depend on, among other things, the amount of foreign reserves held by our intrepid central bank. To defend the peg, the central bank must stand ready to buy its own currency on the FX market, which it does so by selling off its stock of foreign reserves.

A unilateral peg of this sort is just ripe for speculation. The two most likely outcome in this case are (1) the peg holds or (2) the peg fails (the domestic currency depreciates). The trade in this case is to go short on the pegging bank's currency and long in the foreign currency. A speculator either breaks even if (1) or wins if (2). It's a can't lose proposition (but please don't try this at home kids). Rational speculators, recognizing the opportunity, start shorting the pegged currency. If they do so en masse, our little central bank will soon run out of reserves and be forced to abandon the peg--a self-fulfilling prophecy.

I didn't spot this in the case of the SNB because, well, Switzerland is not a banana republic--the Swiss Franc is considered a safe-haven security. And the SNB was pegging because it was worried about currency appreciation--not the usual concerns about excess volatility or depreciation. Of course, there was never any danger of the SNB running out of reserves--they can print all the Francs they want! So what was the danger?

Central bankers are by nature a highly conservative bunch. They become uncomfortable with things that are unfamiliar. Like balance sheets the size of the moon, for example. With an ECB QE policy on the horizon, there was the prospect of EUR for CHF conversions proceeding at an even more rapid rate--leading to a very, very large SNB balance sheet. My claim is this: we should have guessed that the SNB would have at some point in this process lost its nerve and abandoned the peg, allowing their currency to appreciate (And if it didn't lose its nerve, the peg would have been maintained, so we would not have lost on the other likely outcome of my proposed bet). Rational speculators anticipating this should have ... oh well, forget it. (Let's try it next time and see what happens?).

As for the SNB abandoning its peg, especially the way it did, well, it just seems crazy to me. It would have made sense if one thought that EUR inflation was likely to take off. But all the worry at present is directed toward the prospect of EUR deflation. Yes, that's right, the SNB is stocking up on a currency whose purchasing power is projected to increase. And as for being concerned about EUR inflation because of QE, it seems unlikely to me that the ECB wouldn't be willing and able to defend its low inflation target.

In short, I think the SNB could have let it's balance sheet grow much larger without any significant economic repercussions. Instead, by removing the peg as they did, they suffered a huge and needless capital loss on their EUR assets. Strange move. But how can we argue against the past success of Swiss bankers?

On the plus side, I suppose we can no longer claim the Swiss to be boring

Friday, January 9, 2015

On the Want of Bold, Persistent Experimentation

How should policymakers react to an economic crisis or ongoing economic malaise--an event that has taken them by surprise and/or left them searching for answers?

Brad DeLong's prescription is to follow the example set by FDR in the 1930s: How to Fix the Economy: "Try Everything".  He favorably quotes the former president, who once proclaimed:
The country needs and ... demands bold, persistent experimentation,” he said in 1932. “Take a method and try it. If it fails, admit it frankly, and try another. But above all, try something."
In some ways, this sounds admirable. But in other ways, it sounds...well, it sounds a bit crazy. Even DeLong acknowledges this when he writes:
To be sure, Roosevelt’s New Deal policies sometimes conflicted with one another, and quite a few of them were counterproductive. But, by trying everything, and then scaling up the most successful policies, Roosevelt was ultimately able to turn the economy around. 
Hmm. Ultimately turned the economy around? I guess so...even if it did take 8 years. One has to wonder how long it would have taken if FDR had done nothing at all?  I also wonder which of the many (some declared unconstitutional) experiments ultimately turned the economy around. The bold experiment of declaring war in 1941?

One of the problems associated with macroeconomic experimentation, apart from the fact that most experiments fail, is the aura of uncertainty it engenders. The appearance of senior leaders resorting to bold and persistent experiments is unbecoming and even a little scary. What will they think of next?! Should I invest now, or should I wait?!  It does not take a rocket scientist to appreciate the effect that policy uncertainty might have on prolonging an economic slump. I'm not sure how important this force is quantitatively (because it is hard to measure) but I don't think one can easily dismiss the role it can play in an economic crisis and recovery. Certainly, there is no shortage of narratives out there that blame FDR's "bold and persistent experiments" for transforming a recession into depression (many also blame President Hoover for the same reason).

Truth be told, I doubt that DeLong actually endorses "bold, persistent experimentation" in the sense of "anything goes." The set of "bold, persistent experiments" after all is very, very large. As he suggests, we already possess a set of tools--we (think) we know the nature of promising interventions--if only those squabbling politicians would employ them! In addition, he provides a short list of  potential interventions (some of which, like QE, were actually implemented).

It seems that DeLong was motivated to write this piece mainly to criticize Martin Feldstein's needlessly inflammatory language in promoting an otherwise sensible policy proposal. I do agree with DeLong on that sentiment. But if this was the intended purpose of his article, then why invoke Hoover-FDR fables?*  And why speak favorably of the FDR-style "kitchen sink" approach to macro policy?  After all, if we don't know what we're doing, then isn't the principle of primum non nocere at least as compelling?

*Note: FDR actually criticized Hoover in 1932 for his "reckless and extravagant" fiscal policy. Consider the following data:

Wednesday, December 31, 2014

Brad DeLong on the Employment-to-Population Rate

Brad DeLong offers his musing here on the U.S. employment-to-population rate. As a rough control for demographic factors, he focuses on prime-age workers--those aged between 25-54. And he decomposes prime-age workers by sex. I like this exercise. In fact I've looked at the same data in an earlier post here, making comparisons with Canada. 

DeLong normalizes the E-P rate for males and females to zero in the year 2000. For both sexes, the E-P rate is roughly 5% lower than in 2000. Here is his graph:

In reference to this data, DeLong asks a few questions. Heck, it's the end of the year and I'm in the mood to answer some of them.
(1) If the US economy were operating at its productive potential, the share of 25 to 54-year-olds who are employed ought to be what it was at the start of 2000. Back then there were few visible pressures leading to rising inflation in the economy.
Does anybody disagree with that?
I'm not sure, so I think I'll disagree. It's very hard, I think, to know precisely what constitutes "productive potential." And the use of the word "potential" leads us (possibly incorrectly) to interpret the deviations in the graph above as "cyclical" (mean-reverting) fluctuations. I think that some of the decline in the male E-P rate can be reasonably thought of as being "below potential." I base my assessment on this graph (which I plotted a year ago and uses the 16+ population as a base):

This longer time-series shows a modest secular decline in the E-P ratio in both the U.S. and Canada since 1976. Personally, I think it's unlikely that the local peak in 2000 represents some magical measure of "potential." My hunch is that there are "structural" factors at play here including, but not limited to, things like rising disability rates. Having said this, I also don't believe that the male E-P rate has fully recovered. As I've mentioned before, the current dynamic resembles very much what Canada went through in the 1990s, i.e.,

The idea that the female E-P ratio is far below "potential" is even more misleading, I think. There's something strange going on with U.S. female employment relative to other advanced countries (all which resemble Canada in the diagram below).

Again, it's likely that a part of the post-2008 decline is cyclical. But its even more likely that most of the decline is structural (e.g., changing maternity leave benefits, etc.). My own feeling is that structural issues are better tackled through fiscal (or labor market) policies--not monetary policy.
(3) Even if you think–in spite of the absence of accelerating inflation–that employment in 2000 was above the economy’s long-term sustainable potential, there is no reason to believe that a U.S. economy firing on all cylinders would not have 25-54 employment to population rates–both male and female–back at their 2006 levels, a full 3%-age points–and 4%, 1/25–higher than today.
Does anybody disagree with that?
I'm not going to disagree with this.
(4) The U.S. economy’s convergence towards its potential is very slow: The 25-54 employment-to-population ratio has only risen by 1%-point over the past two years.
Does anybody disagree with that?
I'm not going to disagree with this either. However, my interpretation of this phenomenon is a "structural" one, which I explain here (see also here).
(5) Yet in spite of all these, the Federal Reserve believes that the U.S. economy is now close enough to its productive potential that unless some more things go wrong it is no longer appropriate for it to be buying assets and it will be appropriate for it in a year to start raising interest rates even though inflation is still below its 2%/year target.
Well, I'm not speaking for the Fed here (and remember, there are divergent views within the FOMC), but the consensus view seems to be that inflation is just "temporarily" below target. And the recent FOMC statement makes clear that any rate hike will be made contingent on the incoming data. Moreover, even if a rate hike is in the making, it is likely (in my view) to be described as progressing at a "measured pace," similar to the way it was in 2004.
The only way to square (1) through (4) with (5) is if the Greater Crash of 2008-2009 and the still-ongoing Lesser Depression really have pushed between 2 and 4%-age points of our 25 to 54-year-olds out of the labor force permanently, so that we can never get them back, or at least never get them back without an economy at such high pressure to produce inflation that the Federal Reserve regards as unacceptable.
Yes, I suppose this is just another way of saying that a major component of the decline in the E-P rates reported above are attributable to "structural" factors that are better dealt with (if at all) with fiscal policy.
This may be true.
But it does raise two questions: 
[1] What has made the Federal Reserve so confident that it is true that it is willing to make policy based on it–especially as current inflation is still below the 2%/year target?
Again, I am not speaking for the Fed here. But one argument I often hear is that additions to the Fed's balance sheet have not been very effective, especially in terms of improving the labor market. At the same time, people have expressed some degree of nervousness over "not knowing what they don't know" about operating with such a large balance sheet. The Fed is charting new territory here. The benefits seem small at best, and the risks are not fully known. There is some concern that a low-rate policy may induce a "reaching for yield phenomena," leading to financial instability.

Yes, inflation is still below the 2% target, but not that much below. Does a 1.5% inflation rate warrant a policy rate of 25 basis points? Historical Taylor rules evidently suggest that a higher (but still low) policy rate is desirable in the present circumstances. (Note, once again, this is not necessarily my own view.)
[2] If it is true that the missing 2 to 4%-age points of 25 to 54-year-olds now out of the labor force could not be pulled back in without allowing inflation to rise above it’s 2%/year target, isn’t that an argument for raising the 2%/year target rather than accepting the current 77% 25-54 employment to population ratio as the economy’s limit of potential?
No, I don't think raising the long-run inflation target (to say 3% or 4%) will have any measurable long-run impact on the labor market. A significantly higher inflation tax may even discourage employment (the long-run Philips curve may be positively sloped). If there are things that need "fixing" in the labor market six years into the recovery, they are probably better dealt with directly through labor market policies (like improved maternity leave benefits) or fiscal policies (tax cuts, wage/training subsidies, etc.)

Some background reading: Many Moving Parts: A Look Inside the U.S. Labor Market.

Thursday, December 18, 2014

Considerable Time and Patience a Decade Ago

According to USA Today:
Wall Street cheered as the Federal Reserve used a new word — "patient" — to basically let the market know that it isn't in a rush to hike short-term rates next year.
So, "patient" is the new buzzword. In other words, the Fed evidently ran out of patience with "considerable time." 

But just how new are these buzzwords? They're not new at all. Consider this from the December 09, 2003 FOMC statement, for example.
However, with inflation quite low and resource use slack, the Committee believes that policy accommodation can be maintained for a considerable period.
This "considerable period" language was also used in the August 12, September 16, and October 28 FOMC statements leading up to the December statement. The FF target rate at that time was 1%. Headline PCE inflation was running at about 2% (year-over-year), and the unemployment rate was about 5.5%.

Then, at the next FOMC meeting, the Fed switched from "considerable period" to "patient." From the January 28, 2004 FOMC statement
With inflation quite low and resource use slack, the Committee believes that it can be patient in removing its policy accommodation.
Note that "inflation quite low" in January 2004 was 2%. The FOMC continued to express "patience" in its March 16 statement. In its May 4 statement, "patience" was replaced with:
At this juncture, with inflation low and resource use slack, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured.
Note that the "with inflation still low" statement now corresponds to PCE inflation running around 2.5%. 

It wasn't until the June 30 statement that the FOMC finally raised the FF target rate by 1/4%. And for the next 17 meetings, the FOMC raised its policy rate by 25 basis points. 

Should the Fed at that time exhibited less patience, both in the the timing and pace of "lift off?" Certainly John Taylor seems to think so

And what about the situation today? While the unemployment rate today (5.8%) is not far from where it was eleven years ago, the policy rate is at 1/4% (instead of 1%) and the PCE inflation rate is at 1.5% (instead of 2%). At the risk of oversimplifying, there are basically two views on the matter.

The dovish argument is that with inflation and inflation expectations low (relative to target) and unemployment still elevated somewhat, keeping the policy rate at its floor seems like the right thing to do right now. What this has to do with "considerable time" or "patience," I'm not sure. It is a state-contingent policy. (Adding "considerable time" or "patience" to the statement simply reveals the FOMC's own assessment of the probabilities associated with future states of the world.)

The hawkish argument is that the real economy is basically back to normal, that while inflation and inflation expectations are currently low, this is largely transitory. And in any case, the welfare cost/benefit of 1.5% inflation vs. 2% inflation is virtually nil. So, with inflation and unemployment at close to normal levels, why shouldn't the policy rate also start moving closer to normal levels? (There are also other concerns relating to low interest rates and financial instability--look at what happened the last time we had a "patient" Fed.) 

Stay tuned, folks.

Thursday, November 27, 2014

Bitcoiners: Surely we can do Buiter than this?

Willem Buiter has a very nice piece critiquing the Swiss Gold Initiative; see here.

Unfortunately, Buiter starts talking about Bitcoin, making false analogies between the cryptocurrency and gold. He should have just focused on gold.

As it turns out, both gold and Bitcoin do share some important characteristics. I've written about this here: Why Gold and Bitcoin Make Lousy Money.

The false analogy is in equating the mining of gold with the mining of bitcoin. Paul Krugman made the same mistake here: Adam Smith Hates Bitcoin. Here is the offending passage in Buiter's notes:
John Maynard Keynes once described the Gold Standard as a “barbarous relic”. From a social perspective, gold held by central banks as part of their foreign exchange reserves merits the same label, in our view. The same holds for gold held idle in private vaults as a store of value. The cost and waste involved in getting the gold out of the ground only to but it back under ground in secure vaults is considerable. Mining the ore is environmentally damaging, especially if it involves open pit mining. Refining the gold causes further environmental risks. Historically, gold was extracted from its ores by using mercury, a toxic heavy metal, much of which was released into the atmosphere. Today, cyanide is used instead. While cyanide, another toxic substance, is broken down in the environment, cyanide spills (which occur regularly) can wipe out life in the affected bodies of water. Runoff from the mine or tailing piles can occur long after mining has ceased. 
Even though, from a social efficiency perspective, the mining of new gold and the costly storage of existing gold for investment purposes are wasteful activities, they may be individually rational. The same applies to Bitcoin. Its mining is socially wasteful and environmentally damaging.
No, no, no and no. This analogy is all wrong.

Let me be clear about this. Bitcoin costs zero to produce. If one had control over the protocol, one could instantly and costlessly create as many bitcoins as one wanted. No environmental waste, no effort needed. The same is not true of gold.

But wait a minute, you might say. Doesn't mining for bitcoins require effort, consume resources, etc.? The answer is, yes, it does. But this fact does not make the analogy correct (though one can certainly understand why the analogy seems to be correct). Let me explain.

The purpose of gold miners is to prospect for gold. The purpose of Bitcoin miners is not to prospect for bitcoins. The purpose of Bitcoin miners is to process payment requests. A bank teller also processes payment requests. To say that miners are mining for bitcoin is like saying that tellers are mining for dollars. Understand? Let me try again.

Gold miners prospect for gold. But they do not necessarily get paid in gold. In fact, if they work for gold companies, they are likely to get paid in dollars. But they could get paid in gold, or anything else, for that matter. How they get paid does not take away their basic function, which is to discover new gold.

Bitcoin miners, like bank tellers, process payments. Miners, like tellers, want to get paid for the service they provide. It really does not matter how they are paid. As it turns out, miners are paid in the form of newly-issued bitcoins (as well as old bitcoins offered as service fees by transactors). But this does not mean that they are "mining for bitcoin" any more than a bank teller is "mining for dollars."

But isn't mining for bitcoin "wasteful?" In a sense, yes, but again, the "waste" here is not the same as the waste associated with commodity money. Again, let me explain.

We live in a "second-best" world, where people lie and cheat. In a first-best world, money would not even be necessary (see my post here: Evil is the Root of All Money). It is unfortunate that we need Bitcoin miners (and tellers) to process payments. But the resources consumed in this process are necessary, given the safeguards that have to enforced to ensure the integrity of the payment system.

The waste associated with mining gold is that in principle, gold money can be replaced by paper money (and please, do not give some weird "out of thin air" argument; see here.) Paper money, like Bitcoin, and unlike gold, is (near) costless to produce.

Note: Of course, the limit on the supply of bitcoin is determined by a community consensus on following the protocol that adopts the 21M limit. Bitcoin advocates argue that this "hardwired" protocol that governs the supply of bitcoin is more reliable and less prone to political manipulation relative to existing central banking systems. This all may be true, but does not take away from my argument above concerning the false analogy between gold and bitcoin.

Tuesday, November 18, 2014

Japan: Some Perspective

So Japan is in recession.  And it's all so unexpected. Ring the alarm bells!

Well, hold on for a moment. Take a look at the following diagram, which tracks the Japanese real GDP per capita since 1995 (normalized to equal 100 in that year). I also decompose the GDP into its expenditure components: private consumption, government consumption, private investment, and government investment (I ignore net exports). The GDP numbers go up to the 3rd quarter, the other series go up to only the 2nd quarter.

In terms of what we should have expected, I think it's fair to say that most economists would have predicted the qualitative nature of the observed dynamic in response to an anticipated tax hike. That is, we'd expect people to substitute economic activity intertemporally--front loading activity ahead of the tax hike, then curtailing it just after. And qualitatively, that's exactly what we see in the graph above. But does the drop off in real per capita GDP really deserve all the attention it's getting? I don't think so. The fact that the economy was a little weaker in the 3rd quarter than expected (the two consecutive quarters of GDP contraction is what justified labeling the event a "recession") is not really something to justify wringing one's hand over. Not yet, at least.

By the way, if you're interested in reading more about the Koizumi boom era, see my earlier post here: Another look at the Koizumi boom.

Saturday, November 15, 2014

Roger Farmer on labor market clearing.

While I'm a huge fan of Roger Farmer's work, I think he gets this one a little wrong:  Repeat After Me: The Quantity of Labor Demanded is Not Always Equal to the Quantity Supplied. I am, however, sympathetic to the substantive part of his message. Let me explain.

The idea of "supply" and "demand" is rooted in Marshall's scissors (a partial equilibrium concept). The supply and demand framework is an extremely useful and powerful way of organizing our thinking on a great many matters. And it is easy to understand. (I have a pet theory that if you really want to have an idea take hold, you have to be able to represent it in the form of a cross. The Marshallian cross. The Keynesian cross. Maybe even the Christian cross.)

The Marshallian perspective is one in which commodities are traded on impersonal markets--anonymous agents trading corn and human labor alike in sequences of spot trades. Everything that you would ever need to buy or sell is available (absence intervention) at a market-clearing price. The idea that you may want to seek out and form long-lasting relationships with potential trading partners (and that such relationships are difficult to form) plays no role in the exchange process--an abstraction that is evidently useful in some cases, but not in others.

I think what Roger means to say is that (repeat after me) the abstraction of anonymity, when describing the exchange for labor services, is a bad one. And on this, I would wholeheartedly agree (I've discussed some of these issues in an earlier post here).

Once one takes seriously the notion of relationship formation, as is done in the labor market search literature, then the whole concept of "supply and demand" analysis goes out the window. That's because these well-defined supply and demand schedules do not exist in decentralized search environments. Wage rates are determined through bargaining protocols, not S = D. To say, as Roger does, that demand does not always equal supply, presupposes the existence of Marshall's scissors in the first place (or,  more generally, of a complete set of Arrow-Debreu markets).

And in any case, how can we know whether labor markets do not "clear?" The existence of unemployment? I don't think so. The neoclassical model is one in which all trade occurs in centralized locations. In the context of the labor market, workers are assumed to know the location of their best job opportunity. In particular, there is no need to search (the defining characteristic of unemployment according to standard labor force surveys). The model is very good at explaining the employment and non-employment decision, or how many hours to work and leisure over a given time frame. The model is not designed to explain search. Hence it is not designed to explain unemployment. (There is even a sense in which the neoclassical model can explain "involuntary" employment and non-employment. What is "involuntary" are the parameters that describe an individuals' skill, aptitude, etc. Given a set of unfortunate attributes, a person may (reluctantly) choose to work or not. Think of the working poor, or those who are compelled to exit the labor market because of an illness.)

Having said this, there is nothing inherent in the neoclassical model which says that labor market outcomes are always ideal. A defining characteristic of Rogers' work has been the existence of multiple equilibria. It is quite possible for competitive labor markets to settle on sub-optimal outcomes where all markets clear. See Roger's paper here, for example.

The notion that supply might not equal demand may not have anything to do with understanding macroeconomic phenomena like unemployment. I think this important to understand because if we phrase things the way Roger does, people accustomed to thinking of the world through the lens of Marshall's scissors are automatically going to look for ways in which the price mechanism fails (sticky wages, for example). And then, once the only plausible inefficiency is so (wrongly) identified, the policy implication follows immediately: the government needs to tax/subsidize/control wage rates. In fact, the correct policy action may take a very different form (e.g., skills retraining programs, transportation subsidies, job finding centers, etc.)