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

Thursday, March 5, 2015

Lifting Off...Sooner or Later

From Barron's yesterday we have this lovely headline: Two Fed Presidents Contradict Each Other on Same Day.
From the dovish corner, Charles Evans, president of the Chicago Fed, suggested that the Fed should be patient about raising rates and not act until 2016. He said: 
Given uncomfortably low inflation and an uncertain global environment, there are few benefits and significant risks to increasing interest rates prematurely. Let's be confident that we will achieve both dual mandate goals within a reasonable period of time before taking actions that could undermine the very progress we seek.
Weighing in for the Fed hawks, Kansas City Fed president Esther George said she thought the Fed should raise rates mid-year. Her take: 
This balanced approach framework supports taking steps to remove the extraordinary amount of monetary accommodation currently in place. The next phase in this process is to move the federal funds rate off its near-zero setting. While the FOMC has made no decisions about the timing of this action, I continue to support liftoff towards the middle of this year due to improvement in the labor market, expectations of firmer inflation, and the balance of risks over the medium and longer run.
I want to evaluate these two views in the context of a Taylor rule. The Taylor rule is simply a mathematical representation of how the Fed should (or will) set its policy rate in relation to the current state of the economy as measured by inflation gaps (inflation minus target inflation) and output gaps (output minus potential output). Every FOMC member presumably has a Taylor rule in mind if for no other reason than the existence of the Fed's dual mandate (the Congressional mandate that the Fed strive to stabilize inflation and employment around some long-run targets). 
A simple version of the Taylor can be written in this way:
i(t) = r* + p* + A[p(t) - p*] + B[y(t) - y*]
where i(t) is the nominal interest rate (IOER) at date t, p(t) is the inflation rate at date t, and y(t) is the (logged) real GDP at date t. The starred variables are long-run values associated with the real interest rate (r*), the inflation target (p*) and the level of "potential" GDP (y*). The parameters A and B govern how strongly the Fed reacts to deviations in the inflation target [p(t) - p*] and the output gap [y(t) - y*]. 
Let me start with the hawkish view (see also this presentation by Jim Bullard). According to this view, y(t) is below, but very close to y*. So, let's just say that the output gap is zero. PCE inflation is presently around p(t) = 1%. We all know that p* = 2%, so the inflation gap is -1%. Now, we have some leeway here with respect to the parameter A, but let's assume that the Fed responds aggressively to the inflation gap (consist with the Taylor principle) so that A=2. 
Now, if we think of the long-run real rate of interest as r* = 2%, then our Taylor rule delivers i(t) = 2%. Presently, the Fed's policy rate is i(t) = 0.25%. So, if you're OK with these calculations, the Fed should be "lifting off" (raising its policy rate) right now. Oh, and don't call it a "tightening." Instead, call it a "normalization." After all, even with i(t) = 2%, the Fed is still maintaining an accommodative stance on monetary policy because 2% is lower than the long-run target policy rate of r* + p* = 4%. 
What about the doves? Because doves like to emphasize the unemployment rate, the argument of a large negative output gap is now harder for them to make (see also here). But one could reasonably make the case that the output gap--as measured, say, by the employment rate of prime-age males--is still negative, let's say [y(t) - y*] = -1%. Let's be generous and also assume B=1. 
Now, if we continue to assume r*+p* = 4%, our dovish Taylor rule tells us that the policy rate should presently be set at  i(t) = 4% - 2% - 1% = 1%. So the recommended policy rate is lower than the hawkish case, but still significantly above 25 basis points. 
Thus, if we take the historical Taylor rule as a decent policy rule (in the sense that historically, it was associated with good outcomes), then one might say that the hawks have a stronger case than the doves. Both camps should be arguing for lift-off--the only question is how much and how fast. 
On the other hand, something does not seem quite right with the hawk view that things are presently close to normal and that the Fed should therefore normalize its policy rate. All we have to do is look around and observe all sorts of strange things happening. The real interest on U.S. treasuries is significantly negative, for example. Indeed, the nominal interest rate on some sovereigns is significantly negative. This does not look "normal" to a lot of people (including me). And so, maybe this is one way to rescue the dovish position. For example, one might claim that the real interest rate is now lower than it normally was, e.g., r* = 1%. (see this post by James Hamilton). If so, then this might be used to justify delaying liftoff.

Regardless of positions, everyone seems to assume that liftoff will occur sooner or later. But as Jim Bullard observed here in 2010, the promise of low rates off into the indefinite future may mean low rates (and deflation) forever. Few people seem to take this argument seriously except for, gosh, the predictions seems to be playing out (see Noah Smith's post here). For those who hold this position, the question of liftoff becomes more like now or never, rather than sooner or later. 
To conclude, we see that the contradictory views expressed by Evans and George might spring from something as basic as a disagreement on what constitutes the "natural" rate of interest r*. Further disagreement might be based on the appropriate measure of "potential" y* and on the appropriate size of the parameters A and B. There are also other concerns (like "financial stability") that are not captured in the Taylor rule above that might lead Fed presidents to adopt different views on policy. 
In the immortal words of Buffalo Springfield: "There's something happening here, What it is ain't exactly clear." What this something is, its root cause, and what might be done about it seems rather elusive at the moment. And I mean elusive not in the sense that nobody knows. I mean in the sense that everyone seems to have an opinion, most of which are mutually inconsistent. It makes for interesting times, at least. 

Saturday, February 14, 2015

A Simple Model of Multiple Equilibrium Business Cycles

Noah Smith has a nice piece here on Roger Farmer's view of the business cycle.

The basic idea is that, absent intervention, economic slumps (as measured, say, by an elevated rate of unemployment) can persist for a very long time owing to a self-reinforcing feedback effect. The economy can get stuck in what game theorists would label a "bad equilibrium." This interpretation seems to me to be highly consistent with Keynes' (1936) own view on the matter as expressed in this passage:
[I]t is an outstanding characteristic of the economic system in which we live that, whilst it is subject to severe fluctuations in respect of output and employment, it is not violently unstable. Indeed it seems capable of remaining in a chronic condition of subnormal activity for a considerable period without any marked tendency either towards recovery or towards complete collapse.
Now, there is more than one way to explain how an economy can get stuck in a rut. A favorite argument on the right is that recessions are naturally self-correcting if the market is left to its own devices and that prolonged slumps are attributable primarily to the misguided, clumsy and uninformed attempts on the part of government policymakers to "fix" the problem (see here).

But there is another view. The view begins with an observation from game theory: most structures that govern social interaction permit many possible outcomes--outcomes that have nothing to do with the existence of any fundamental uncertainty. If we think of the macroeconomy as a collection of individuals interacting in a large "market game," then the same principle holds--we shouldn't be surprised to discover that many equilibrium outcomes are possible. This idea forms the basis of Roger's pioneering book: The Macroeconomics of Self-Fulfilling Prophecies.

According to Noah, "[Farmer's] approach is mathematically sophisticated, and uses the complex modern techniques that are ubiquitous in academic literature." While this is certainly true, I think there is an easy way to teach the basic idea using standard undergraduate teaching tools. In what follows, I assume that the reader has some knowledge of indifference curves, budget sets, and production possibilities frontiers.

The framework is the basic static "income-leisure" model. A representative household has a fixed unit of time that can be devoted to one of two uses: market work or home work. The household values the consumption of two goods: a market-produced good and a home-produced good. An individual household takes the return to market work as exogenous. If the (expected) return to market work fluctuates randomly over time owing to (say) productivity shocks, tax shocks, news shocks, etc., then the choices that households make can be depicted with the following diagram:

In the diagram above, the x-axis measures time devoted to home work (so that the distance n* is a measure of employment) and the y-axis measures output (real income). The straight lines correspond to the household's budget set (which corresponds to the production possibilities frontier for a linear technology). The curved lines represent indifference curves--how the household values the market and home goods. This is, in essence, the RBC theory of the business cycle: as the returns to economic activities vary over time, people rationally substitute into higher return activities and out of lower return activities. If these shocks are correlated across households, then in the aggregate we observe cyclical fluctuations in output and employment.

Is it possible to model Roger's world view using the same apparatus? Yes, it is. One way to do this is to imagine a fixed production possibilities frontier that exhibits increasing returns to scale. The basic idea is that the return to labor (more generally, any economic activity) is higher when everyone is working hard and vice-versa. The following diagram formalizes this idea.

The RBC view is that there are two separate production functions shifting up and down (with the y-intercept moving between z_H and z_L. But suppose that the production function is in fact stable and that it takes the shape as traced by the solid kinked line connecting z_H to 1.0. The kink occurs at some critical level of employment labeled n_C. The individual's return to labor is expected to be high IF he expects aggregate employment to exceed n_C. Conversely, the individual's expected return to labor is low IF he expects aggregate employment to fall short of n_C.

Given this setup, whether the economy ends up at point A (the high-level equilibrium) or at point B (the low-level equilibrium) depends entirely on "animal spirits." That is, if the community as whole expects B then it is individually rational to choose B which, if done en masse, confirms the initial expectation. Likewise for point A. The allocations and prices associated with points A and B constitute self-fulfilling prophecies.

It is interesting to note that these two very different hypotheses can generate output and employment fluctuations that are observationally equivalent. How would the poor econometrician, uninformed of the true structure of the economy, distinguish between these two competing hypotheses? They both generate procyclical employment, productivity and wages. And if a slump lasts for an unusually long time well, RBC theory can claim that's just because people are rationally expecting a large future penalty (tax) on their employment activities (or, in the context of a search model, their recruiting investments). And if the economy oscillates randomly between A and B at high frequency, the Keynesian theory can claim that this behavior is a part of a "sunspot" equilibrium where fluctuations are driven by "animal spirits."

This observational equivalence problem is unfortunate because the two hypotheses have very different policy implications. The first interpretation more or less supports a laissez-faire approach, while the second interpretation suggests a fruitful role for a well-designed fiscal policy (in this model, even the credible threat of employing idle workers can keep the economy at point A without any actual intervention).

Isn't macroeconomics fun?


PS. I lifted these diagrams from my free online macro lecture notes, available here. (Warning: the notes are in desperate need of correction and updating. I'll get to it one day.)

Tuesday, February 3, 2015

Fedcoin: On the Desirability of a Government Cryptocurrency

It was J.P. Koning's blog post on Fedcoin that first got me thinking seriously of the potential societal benefits of government-sponsored cryptocurrency. When I was invited to speak at the International Workshop on P2P Financial Systems 2015, I thought that a talk on Fedcoin would be an interesting and provocative way to start the conference. You can view my presentation here, but what I'd like to do in this post is clarify some of the arguments I made there.

As I described in this earlier post, I view a payment system as a protocol (a set of rules) for debiting and crediting accounts, I view money as widely agreed-upon record-keeping device, and I view monetary policy as a protocol designed to manage the supply of money over time.

The cryptocurrency Bitcoin is a payment system with monetary objects called bitcoin and a monetary policy prescribed as deterministic path for the supply of bitcoin converging to a finite upper limit. I view Bitcoin as a potentially promising payment system, saddled with a less-than-ideal money and monetary policy. As the protocol currently stands, bitcoins are potentially a better long-run store of value than non-interest-bearing USD. But if long-run store of value is what you are looking for, we already have a set of income-generating assets that do a pretty good job at that (stocks, bonds, real estate, etc.). [For a comparison of the rates of return on stocks vs. gold, look here.]

Let's set aside Bitcoin's monetary policy for now and concentrate on the bitcoin monetary object. What is the main problem with bitcoin as a monetary instrument in an economy like the U.S.? It is the same problem we face using any foreign currency in domestic transactions--the exchange rate is volatile and unpredictable. (And our experience with floating exchange rates tells us that this volatility will never go away.) Bill Gates hits the nail on the head in his Reddit AMA:
Bitcoin is an exciting new technology. For our Foundation work we are doing digital currency to help the poor get banking services. We don't use bitcoin specifically for two reasons. One is that the poor shouldn't have a currency whose value goes up and down a lot compared to their local currency. 
For better or worse, like it or not, the USD is the U.S. economy's unit of account--the numeraire--the common benchmark relative to which the value of various goods and services are measured and contractual terms stipulated. With a floating exchange rate, managing cash flow becomes problematic when (say) revenue is in BTC and obligations are in USD. Intermediaries like Bitreserve can mitigate some this risk but, of course, at an added expense. Hedging foreign exchange risk is costly--a cost that is absent when the exchange rate is fixed.

And so, here is where the idea of Fedcoin comes in. Imagine that the Fed, as the core developer, makes available an open-source Bitcoin-like protocol (suitably modified) called Fedcoin. The key point is this: the Fed is in the unique position to credibly fix the exchange rate between Fedcoin and the USD (the exchange rate could be anything, but let's assume par).

What justifies my claim that the Fed has a comparative advantage over some private enterprise that issues (say) BTC backed by USD at a fixed exchange rate? The problem with such an enterprise is precisely the problem faced by countries that try to peg their currency unilaterally to some other currency. Unilateral fixed exchange rate systems are inherently unstable because the agency fixing the BTC/USD exchange rate cannot credibly commit not to run out of USD reserves to meet redemption waves of all possible sizes. In fact, the structure invites a speculative attack.

In contrast, the issue of running out of USD or Fedcoin to maintain a fixed exchange rate poses absolutely no problem for the Fed because it can issue as many of these two objects as is needed to defend the peg (this would obviously call for a modification in the Bitcoin protocol in terms of what parameters govern the issuance of Fedcoin). Ask yourself this: what determines the following fixed-exchange rate system:

Do you ever worry that your Lincoln might trade at a discount relative to (say) Washingtons? If someone ever offered you only 4 Washingtons for your 1 Lincoln, you have the option of approaching the Fed and asking for a 5:1 exchange rate--the exchange rate you are used to. Understanding this, people will generally not try to violate the prevailing fixed exchange rate system. The system is credible because the Fed issues each of these "currencies." Now, just think of Fedcoin as another denomination (with an exchange rate fixed at par).

Now, I'm not sure if Fedcoin should be a variant of Bitcoin or some other protocol (like Ripple). In particular, I have some serious reservations about the efficiency of proof-of-work mechanisms. But let's set these concerns aside for the moment and ask how this program might be implemented in general terms.

First, the Fedcoin protocol could be made open source, primarily for the purpose of transparency. The Fed should only honor the fixed exchange rate for the version of the software it prefers. People can download free wallet applications, just as they do now for Bitcoin. Banks or ATMs can serve as exchanges where people can load up their Fedcoin wallets in exchange for USD cash or bank deposits. There is a question of how much to reward miners and whether the Fed itself should contribute hashing power for the purpose of mining. These are details. The point is that it could be done.

Of course, just because Fedcoin is feasible does not mean it is desirable. First, from the perspective of the Fed, because Fedcoin can be viewed as just another denomination of currency, its existence in no way inhibits the conduct of monetary policy (which is concerned with managing the total supply of money and not its composition). In fact, Fedcoin gives the Fed an added tool: the ability to conveniently pay interest on currency. In addition, Koning argues that Fedcoin is likely to displace paper money and, to the extent it does, will lower the cost of maintaining a paper money supply as part of the payment system.

What about consumers and businesses? They will have all the benefits of Bitcoin--low cost, P2P transactions to anyone in the world with the appropriate wallet software and access to the internet. Moreover, domestics will be spared of exchange rate volatility. Because Fedcoin wallets, like cash wallets, are permissionless and free, even people without proper ID can utilize the product without subjecting themselves to an onerous application process. Finally, because Fedcoin, like cash, is a "push" (rather than "pull") payment system, it affords greater security against fraud (as when someone hacks into your account and pulls money out without your knowledge).

In short, Fedcoin is essentially just like digital cash. Except in one important respect. Physical cash is still a superior technology for those who demand anonymity (see A Theory of Transactions Privacy). Cash does not leave a paper trail, but Fedcoin (and Bitcoin) do leave digital trails. In fact, this is an excellent reason for why Fedcoin should be spared any KYC restrictions. First, the government seems able to live with not imposing KYC on physical cash transactions--why should it insist on KYC for digital cash transactions? And second, digital cash leaves an digital trail making it easier for law enforcement to track illicit trades. Understanding this, it is unlikely that Fedcoin will be the preferred vehicle to finance illegal activities.

Finally, the proposal for Fedcoin should in no way be construed as a backdoor attempt to legislate competing cryptocurrencies out of existence. The purpose of Fedcoin is to compete with other cryptocurrencies--to provide a property that no other cryptocurrency can offer (guaranteed exchange rate stability with the USD). Adopting Fedcoin means accepting the monetary policy that supports it. To the extent that people are uncomfortable with Fed monetary policy, they may want to trust their money (if not their wealth) with alternative protocols. People should be (and are) free to do so.

Postscript, February 06, 2015.

A number of people have asked me why we would need a distributed/decentralised consensus architecture to support a FedCoin. In the talk I gave in Frankfurt, I actually made two proposals. The first proposal was called "Fedwire for All." This is basically digital cash maintained on a closed centralized ledger, like Fedwire. It would be extremely cheap and efficient, far more efficient that Bitcoin. But of course, it does not quite replicate the properties of physical cash in two respects. First, as with TreasuryDirect, the Fedwire accounts would not be permissionless. People would have to present IDs, go through an application procedure, etc. Second, the Fed is unlikely to look the other way (as it does with cash) in terms of KYC restrictions. So, to the extent that these two latter properties are desirable, I thought (at the time I wrote this piece) that we needed to move beyond Fedwire-for-All to Fedcoin. There may, of course, be other ways to implement these properties. I'm all ears!

Sunday, February 1, 2015

Money and Payments, or How we Move Marbles.

I'm writing this to serve as background for my next post on Fedcoin. If you haven't thought much about the money and payments system, I hope you'll find this a useful primer explaining some basic principles.

I view the payments system as a protocol (a set of rules) for debiting and crediting accounts. I view money as an object that is used to debit/credit accounts in a payments system. I view monetary policy as a protocol to manage the supply of money over time. Collectively, these objects form a money and payments system.

One way to visualize the money and payments system is as a compartmentalized box of marbles, displayed to the right. The marbles represent agreed-upon monetary tokens--record-keeping devices (see also the discussion here). The compartments represent individual accounts. Paying for a good or service corresponds to moving marbles from one account to another.

What makes a good marble? What is the best way to manage the supply of marbles over time? And what is the best way to move marbles around from account to account? There are books devoted to addressing these questions.

A good marble should have easily recognizable and understandable properties. This is one reason why complicated securities make poor money. Fiat money and senior claims to fiat money make good money along this dimension because everyone knows that fiat money is a claim to nothing (so there is no asymmetric information, a property emphasized by  Gorton and Pennaccchi, 1990). Gold, even if it is coined, is not especially good along this dimension because it is heterogeneous in quality (and it's not costless to have it assayed, see here). Plus, precious-metal coins can be shaved (although, there is no motivation to shave token coins).

A good marble should also be durable, divisible, and difficult to counterfeit. Paper money issued in different denominations can have these properties. And while virtual money can easily be made durable and divisible, it is extremely easy to counterfeit. For this reason, trusted intermediaries are needed to create and manage a virtual money supply (at least, up to the invention of Bitcoin). Gold (and other precious metals) have these desired properties. But to the extent that these metals have competing uses, it is inefficient to have them serve as accounting marbles. Unless you don't trust the intermediaries that manage the fiat-marble supply, that is. (Unfortunately, there have been enough failed experiments along this dimension to warrant some skepticism.)

How should the supply of marbles be managed over time? Advocates of the gold standard want the supply to be determined by the market sector (through mining). This protocol means that the supply of money is essentially fixed over short periods of time, and grows relatively slowly over long periods of time (although, big new discoveries have often led to inflationary episodes). If the demand for money increases suddenly and dramatically (as it is prone to do during a financial crisis), then the consequence of a fixed short-run supply of money is a sudden and unanticipated deflation. Because nominal debt obligations are not typically indexed to the price-level, the effect of this protocol is to make a recession larger than it otherwise might be. The idea behind a central bank as lender-of-last resort is to have an agency that can temporarily increase the supply of money (in exchange for "excessively" discounted private paper) to meet the elevated demand for money so as to stabilize the price-level. In effect, such a policy, if executed correctly, can replace the missing state-contingency in nominal debt contracts. Whether a central bank can be trusted to manage such a policy in responsible and competent manner is, of course, another question. Let's just say that there are costs and benefits to either approach and that reasonable people can reasonably disagree.

Apart from cyclical adjustments the money supply, there is the question of whether money-printing should ever be used to finance operating expenditure (seigniorage). Generally, the answer is "yes"--at least, once again, if it is done responsibly. It is of some interest to note that the Bitcoin protocol uses seigniorage to finance payment processors (miners). The idea here, I suppose, is that the protocol, which is a computer program and not a politician--can be trusted to manage the inflation-tax optimally. That is, at least for a limited amount of time--the long-run supply of bitcoin is presently capped at 21M units.

Alright, so how about the payments system. What are the different ways of rearranging marbles in a ledger?

The most basic method of payment is the combination of a physical cash exchanged in a P2P meeting. When I buy my Starbucks latte, I debit my wallet of cash and Starbucks credits its cash register by the same amount. The ledger that describes the distribution of physical cash holdings (and the histories of how each unit of cash has moved across accounts over time) is hidden from all of us. This is why cash transactions are associated with a degree of anonymity.

Another popular way to make a payment is via a debit card. In this case, Starbucks and I have accounts in a ledger that is managed by the banking system. These accounts are stocked with virtual book-entry objects. When I pay for my latte with a debit card, I  send a message to the banking system asking it to debit my account and credit the merchant's account. In this protocol, the banking system verifies that I have sufficient account balances and executes the funds transfer. The protocol obviously relies on the use trusted intermediaries to manage the ledger and keep it secure. Also, because bank accounts are associated with individual identities and because centralized ledger transactions can be recorded, there is no anonymity associated with the use of this payments protocol.

The Bitcoin protocol is an amazing invention--I'm on record as describing it as a stroke of genius. The amazing part of it is not it's monetary policy (which I think is flawed). Its main contribution is to permit P2P payments in digital cash without the use of a centralized ledger managed by a trusted intermediary. (In fact, the economic implications of this invention extend far beyond payments; see Ethereum, for example).

What makes digital cash without an intermediary so difficult? Think of digital cash as a computer file that reads "one dollar, SN 24030283." Suppose I want to email this digital file to you in payment for services rendered. When I take a dollar bill out of my pocket and send it to the merchant, there is no question of that dollar bill leaving my pocket. For the same thing to be true of my digital dollar, I would be required to destroy my computer file "one dollar, SN 24030383" after sending it to the merchant. The problem is that  people are likely to make endless copies of their digital money files. In other words, digital money can be costlessly counterfeited. And this is why we make use of intermediaries to handle payments in a virtual ledger. (We don't expect the intermediaries to counterfeit our balances...our main complaint with them is that they charge too much for their accounting services!)

There is no need to get too far into the details of how the Bitcoin protocol manages this feat. If you are interested, you can consult this book by the inspirational Andreas Antonopoulos. The main idea behind the protocol is a distributed public ledger (called the block chain) that is updated and made secure through the collective efforts of decentralized payment processors (called miners). I find it interesting how the Bitcoin consensus mechanism resembles, in spirit at least, the communal record-keeping practices of ancient gift-giving societies. In a gift-giving society, who contributes what to the collective good is recorded on a distributed network of brains. This is easy to do in small societies because there's not much to keep track of and verbal communication is sufficient to keep all nodes updated.

I want to end with a a couple of notes. First, isn't it interesting to note the coexistence of so many different monies and payments systems? Even today, a great deal of economic activity among small social networks (family, close friends, etc.) continues to be supported by gift-giving principles (including the threat of ostracism for bad behavior). This coexistence is likely to remain going forward and I think that open competition is probably the best way for society to determine the optimal mix.

It is also interesting to note that almost every money and payments system requires some degree of trust. This is also true of Bitcoin. In particular, the vast majority of Bitcoin users cannot read C++ and even for those that can, most are not about to go and check all 30MB (or so) of the Bitcoin source code. Nor will most people know what to do with a 30GB (and growing) block chain. Core developers? Mining coalitions? Who are these agents and why should they be trusted? The protocol cannot be changed...really? It won't be changed...really? It's just software, my friend. There's no guarantee that a consensus will not form in the future to alter the program in a materially significant way that some users will not desire. The same holds true for any consensus protocol, including the Federal Reserve Act of 1913 and the U.S. Constitution.

In my view, people will come to trust Bitcoin (or not) depending on its historical performance as a money and payments system. This is perfectly natural. It is not necessary, for example, that a person learns precisely how an internal combustion engine works before operating a motor vehicle. Most people drive cars because our experiences and observations tell  us we can trust them to work. And so it is with money and payments systems.

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.