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

Sunday, August 30, 2009

Fiscal Multiplier Mockery

Just came across this IMF Staff Position Note by Olivier Blanchard (and coauthors) entitled Fiscal Policy for the Crisis.

The best part of this paper is contained in Appendix II: Fiscal Multipliers-A Review of the Literature, and Appendix III: Five Case Studies of Fiscal Policy During Financial Crisis.

The conclusion I arrive at in reading these appendices is that during a financial crisis: [1] fixing the financial sector is of primary importance; and [2] fiscal policies may be marginally beneficial at best, and seriously detrimental at worst.

In the body of the paper, the authors draw several lessons from history.

[1] Successful resolution of the financial crisis is a precondition for achieving sustained growth.

Here, they give the example of Japan during the 1990s. Evidently, "fiscal actions following the bursting asset bubble failed to achieve sustained recovery because financial problems were allowed to fester."

In short, fiscal stimulus failed in Japan. But we don't really want to believe that fiscal stimulus doesn't work. It didn't work here because things were not set up to allow it to work. I wonder how one might modify an IS-LM model to formalize this notion?

But there are more examples. "Delaying interventions, as was also done in the US during the Hoover administration and during the S&L crisis, typically leads to a worsening of macroeconomic conditions, resulting in higher fiscal costs later on."

So I guess that if we wait too long, the fiscal multiplier now is severely negative. Not sure what to make of this (like, where does this show up in the IS-LM model?). And in any case, they have their history wrong: Hoover did in fact react quickly to the crisis (although many of his measures were frequently blocked by the Democrats-Roosevelt, in particular-and then later adopted wholesale by the Democrats). And even though "interventions" were evidently delayed during the S&L crisis, I seem to recall a fairly protacted spell of growth in the 1980s. Unimportant details, I suppose.

Ah yes, but there was the "prompt and sizeable support to the financial sector by the Korean authorities that limited the duration of the macroeconomic consequences thus limiting the need for other fiscal action."

Huh? The Korean government fixed the financial sector, thereby eliminating the need for future fiscal stimulus? So fiscal stimulus is not needed, if the financial sector is repaired. This is supposed to be taken as evidence that fiscal stimulus is needed?

[2] The solution to the financial crisis always precedes the solution to the macroeconomic crisis.


[3] A fiscal stimulus is highly useful (almost necessary) when the financial crisis spills over to the corporate and household sectors.

Not sure where this came from; they cite no examples (and indeed, the examples above seem to suggest otherwise).

[4] The fiscal response can have a larger effect on aggregate demand if its composition takes into account the specific features of the crisis.

In this regard, they note that the tax/transfer policies implemented early in the Nordic crisis did little to stimulate output. Sure, the Ricardian equivalence theorem at work. As for "evidence" as to how a different composition of expenditure might work, they make the following compelling statement: "In theory, public spending on goods and services has larger multiplier effects..."

I see. That would be the same theory (IS-LM) that has absolutely nothing to say about financial crisis?

And so, on the basis of this, the authors' conclusions are:

The optimal fiscal package should be timely, large, lasting, diversified, contingent, collective, and sustainable: timely, because the need for action is immediate; large, because the current and expected decrease in private demand is exceptionally large; lasting because the downturn will last for some time; diversified because of the unusual degree of uncertainty associated with any single measure; contingent, because the need to reduce the perceived probability of another “Great Depression” requires a commitment to do more, if needed;collective, since each country that has fiscal space should contribute; and sustainable, so as not to lead to a debt
explosion and adverse reactions of financial markets.

And so there you have it. The fiscal multiplier is greater than one. Unless, that is, the stimulus in question is any one of: not-in-time, small, short, undiversified, non-contingent, non-collective, and unsustainable.

Thursday, August 27, 2009

Why the Growing Level of U.S. Debt May Not be Inflationary

History shows that high levels of government debt are frequently associated with inflation. The reason for this seems clear enough. At some point, maturing debt needs to paid back. At high enough levels of debt, rolling the debt over is no longer feasible. Cutting back government spending and raising taxes is politically difficult. The easy way out is simply to print new money. As the money supply expands, inflation resuts.

The rough logic described above would seem to fit the experience of many smaller economies that find themselves under fiscal pressure. But things may not work so simply for a select few dominant economies. Japan appears to be one example; and the U.S. another.

Let us consider the U.S. Unlike most other economies, there appears to be a huge worldwide demand for U.S. Treasuries and U.S. dollars (which can be thought of as zero-interest Treasuries). A large scale increase in the supply of these government debt instruments need not lead to a depreciate in their value if there is a correspondingly large scale increase in the worldwide demand for these objects. What is the evidence that this may be happening?

Foreigners Snap Up Treasuries Even as US Debt Keeps Rising

But why should this be so? What accounts for what appears to be an insatiable demand for US debt, especially in the wake of the recent financial crisis?

Ricardo Caballero of MIT offers some hints in a very interesting piece entitled: On the Macroeconomics of Asset Shortages. After reading this paper, I started thinking in the following way. Tell me what you think.

There is a high and growing demand for low-risk assets, both as a store of value, and as collateral objects in payment systems (e.g., repo and credit derivatives markets). This growth has exploded over the last 20 years or so; and stems from the demand from emerging economies and innovations in the financial sector. There is a worldwide "shortage" of good quality (low-risk) assets, like U.S. Treasuries (which explains their relatively low yield). Indeed, many of the innovations in the financial sector can be interpreted as the private sector's response to this shortage: the creation of "low-risk" tranches of MBSs allowing these objects to substitute for U.S. Treasuries as collateral in the rapidly expanding repo market.

The recent financial crisis was centered in the repo market. Very suddenly, agents in the repo market were no longer willing to accept MBS as collateral (or if they did, at very large "haircuts"). The demand for U.S. Treasuries exploded (I seem to recall a day when their yields actually went negative). At the same time, there was a worldwide "flight to quality;" which again, manifested itself as large increase in the demand for (relatively safe) U.S. Treasuries.

If this is more or less true, then the implication is this: The massive increase in the supply U.S. Treasury debt may very be "socially optimal" in the sense that the U.S. government is simply supplying the world with an asset that is in very high demand (which, in turn, means that the demanders obvious find some value in the existence of such an asset). To the extent that this "new demand regime" remains stable, the added supply of U.S. Treasuries will impose no financial burden on the U.S. (indeed, they make off like bandits, as the Treasuries are ultimately purchased by exporting goods and services to the U.S.).

The million dollar question, of course, is whether the high world demand for U.S. debt will persist long into the future (and whether the U.S. government will "overissue" debt beyond what is called for by this new high-demand regime). Who knows what will happen. But it appears to me that IF the U.S. government plays its cards right, it may very well enjoy its higher debt levels without the prospect of inflation. U.S. citizens will benefit (from the sales of Treasuries for goods) and the world will be grateful to hold a stable asset.

Well, maybe. But that was a big IF. What could possibly go wrong?

Wednesday, August 26, 2009

William Poole on Ben Bernanke

For those of you who may not know, I have recently joined the Federal Reserve Bank of St. Louis as a VP in the research division. Will keep you posted on things that I learn (and am allowed to reveal).

We were recently asked to comment on an article written by Bill Poole, former president and CEO of the Fed here in St. Louis. He asks the question: Should President Obama reappoint Fed Chairman Bernanke? See here. His conclusion is "no." (too late, it appears).

So what's his beef? Essentially, that some of the new policies initiated by Bernanke have violated stipulations in the Federal Reserve Act (FRA) and that, in doing so, he has comprised the Fed's political independence. The relevant stipulations are section 13(3) and section 14(b).

Poole grants Bernanke some leeway in terms of the emergency measures adopted in March 2008 (Bear Stearns) and September 2008 (AIG). But he believes that the Fed's Commercial Paper Funding Facility (CPFF) violates section 13(3). He may have a point here; but there is not much a leg for him to stand on as the term "exigent" is not precisely defined.

Poole also believes that the Fed's buying program for Mortgage Backed Securities (MBS) is not authorized under Section 14(b). I beg to differ. As far as I can tell, the act does allow for purchases of assets that are guaranteed by the U.S. government. The MBS purchased by the Fed are fully insured by the Treasury (and indeed, they are generating a very nice return).

Poole makes some very good points about distancing the Fed from politics as much as possible. But I do not believe that he makes a compelling case against reappointment. Among other things, he does not propose alternative candidates (many of the apparent frontrunners would likely view Bernanke's interventions as too conservative). Bill should be careful what he wishes for.

In any case, it looks like Bernanke will be reappointed (after a good grilling in front of the Senate). Considering the alternatives, I think this was the right choice.