MacroMania

Using Beveridge curve dynamics to identify cyclical and structural shocks

2012-01-24T08:45:00.000-08:00

I recently gave a short presentation to the Board of Directors of the Louisville branch of the St. Louis Fed. Following my presentation (which stimulated a lively discussion), I had the opportunity to listen to each member report on local economic conditions from different parts of Kentucky. Two themes stood out. The first was how "an air of uncertainty" along a variety of dimensions had "frozen" investment plans (with the apparent exception of younger entrepreneurs, who probably do not know any better-jk). The second was the unfilled demand for highly skilled, specialized workers (primarily in manufacturing).

I want to focus on the second theme here. In some sense, it is really amazing that firms are struggling to find qualified workers in an era of 8% unemployment. The Financial Times recently ran a piece on the subject: Skills Gap Hobbles US Employers, and I have to say that Mr. Greenblatt below would have fit right in at my BOD meeting:

Drew Greenblatt has been looking for more than a year for three sheet-metal set-up operators to work day, night or weekend shifts.

The president of Marlin Steel Wire Products, a company in Baltimore with 30 employees, Mr. Greenblatt says his inability to find qualified workers is hampering his business' growth. "If I could fill those positions, I could raise our annual revenues from $5m to $7m," he says.

He is offering a salary of more than $80,000 with overtime, including health and pension benefits. Yet in spite of extensive advertising, he has had no qualified applicants. He is trying to train some of his unskilled staff but says none has the ability or the drive to complete the training.

This quote identifies two problems. The first is what economists call "skills mismatch" caused by a "structural" shock. The second, that some workers are unwilling and/or unable to upgrade their skills is another matter that deserves attention, but is something that I will leave aside here.

Apart from anecdotal evidence, how does one go about measuring "skills mismatch caused by structural shock?" One idea, initially proposed by Abraham and Katz (JPE, 1986), is to use the comovement to in vacancy and unemployment rates to identify "cyclical" and "structural" shocks.

I put those terms in quotes because there are no set definitions for them. I like to think of a cyclical shock as an event that makes it more or less profitable to find the same kind of worker for the same kind of job. And I like to think of a structural shock as an event that makes it more or less profitable to find a different kind of worker for a different kind of job.

Anyway, the Abraham and Katz idea is that one would expect cyclical shocks to trace out a stable, negatively-sloped Beveridge curve. That is, one would expect the job-vacancy rate and the unemployment rate to move in opposite directions. A structural shock, by contrast, is expected to move vacancy and unemployment rates in the same direction. The idea here is that it is now more difficult to find the right kind of worker, so that even greater levels of recruiting intensity is likely to be associated with higher unemployment rates.

The FT article cited above uses this idea in the diagram to the right (together with the results of a Kaufman poll of entrepreneurs) to suggest that the high U.S. unemployment rate is primarily the consequence of "structural" factors.

Here is what the U.S. Beveridge curve looks like from May 2005 - November 2011 (The vacancy rate is computed from the Conference Board's help-wanted-online data, which is available from 2005 only).

As the HWOL measure of job vacancies is available at the city level, Constanza Liborio and I thought it might be interesting to see howjob availability varies across major U.S. metropolitan areas and how jobvacancy rates correlate with regional unemployment rates before and after the beginningof the most recent recession.

Specifically, the exercise we perform is as follows. Consider a major U.S. metropolitan area. Compute theaverage job vacancy rate and unemployment rate for this metropolitan area overthe prerecession period May 2005 – November 2007. Recalculate these averagessince the beginning of the last recession, December 2007 – November 2011. Next, compute the change in thevacancy rate and unemployment rate across these periods. Perform this exercisefor a set of the largest metropolitan areas in the U.S.

The results aredisplayed in the following figure.

Not surprisingly, we see that the unemployment rate in all these metropolitan areas went up since the recession began. However, the same is not true of job vacancy rates (that is, not all vacancy rates went down, as one might have expected). Specifically, while we observe the typical Beveridge curve dynamic in many jurisdictions (suggesting that cyclical factors are dominant), we also observe vacancy rates remaining relatively stable, or even rising, in several others (suggesting that structural factors are dominant).

So the tentative conclusion here is that the relative importance of cyclical vs. structural factors appears to vary across regions. To the extent that monetary policy is an effective stabilization tool, it cannot be expected to impact all regions of the country equally. In many regions, localized fiscal policies (education and training subsidies, etc.) may prove to be a more direct and effective tool.
Related story:
More Workers Moving for Out-of-State Jobs

Alien Employers or: How I Learned to Stop Worrying and let the World Run a Current Account Surplus

2012-01-10T11:48:00.000-08:00

Meet your new boss.

Back when the Greek crisis was just breaking, I remember having my morning coffee, still half asleep, TV turned on in the background, when I heard a news reporter ask an interesting question. I put my coffee down and turned to the TV. The Parthenon was in the background, communist banners were draped about, and small smokey fires burning here and there. And the reporter, standing excitedly in the middle of all this, rather earnestly asked what I thought was a very good question: Why should Germany even consider bailing out Greece?

Then, with hardly a pause, he breathlessly began to explain why. His answer went something like this...

"Why?! Let me tell you why, people..." [turns head to the left] "As I look over here, I see and Audi and a BMW..." [turns head to the right] "...and as I look over there, I see a Mercedes and a Volkswagen!" [turns to camera--big light bulb flashing over his head] "Greece is an extremely important export market for Germany!"

Well, as the following diagram shows, this certainly does appear to be the case (source):

So as far as I can gather, what the fellow is trying to tell us is this. The Germans should forgive Greeks their debts because, well, how else will the Greeks continue to afford importing German-made cars? After all, it is the Greek consumer that is selflessly keeping the German autoworker employed. Moreover, it has been a fine recipe for keeping German unemployment low, and growing German wealth. Yes, that's right...wealth in the form of...well, you know...grade A assets, like Greek government bonds.

Now where on earth might a fellow get an idea so bizarre as this? Well, how about here: Germans and Aliens (Paul Krugman):

But the Germans believe that their own experience shows that austerity works: they went through some tough times a decade ago, but they tightened their belts, and all was well in the end. Not that it will do any good, but it's worth emphasizing that Germany's experience can only be generalized if we find some space aliens to trade with, fast. Why? Because the key to German economic affairs this past decade has been a truly massive shift from current account deficit to surplus.

Now, other countries within Europe could emulate Germany's past if Germany herself were willing to let its current account surplus vanish. But it isn't, of course. So the German demand is that everyone run a current account surplus, just like they do -- something that would only be possible if we can find someone or something else to buy our exports. It remains remarkable to see with how little wisdom the world is governed.

Now, I'm not sure whether any German really has made an explicit demand for all countries to run current account surpluses. But if anyone did, it would clearly be silly. The current accounts of all countries must necessarily sum to zero; at least, in the absence intergalactic trade.

But then, that sort of gave me an idea. Why not a world current account surplus? What is an account, anyway? It's just a book-entry object. Let's give the account owner a proper name. And what's in a name? May as well call the account holder "Space Alien," with a "local" delivery address, say, the Pacific Ocean.

Next step. Contract some agency to print up Space Alien bonds, rate them AAA, then use them to acquire goods from all over the world, including ocean vessels. That should lower world unemployment. Then load the vessels with the newly purchased cargo, sail them out to their delivery point (the mid Pacific, say), and sink them all. (This last step is absolutely necessary, as sending the goods to any country on earth will mean job-killing imports for that country, jeopardizing their current account surplus). Alas, the Space Aliens will ultimately have to default on its debt but, you know, who really cares? Just means more work is needed to replenish our lost wealth.

Now, if you think this sounds a little loopy, let me direct you to this: Fake Alien Invasion Would End Economic Slump.

Of course, this is all just a variation of the old Keynesian prescription of employing people to dig up holes and fill them up again. And, contrary to what you may be thinking, the purpose of this post is not to argue against the ability of such a program to increase net employment. What I want to question instead is why running a current account surplus is necessary for all this hocus pocus to work?

Here's an idea. Instead of exporting vehicles to Greece, why don't German car manufacturers ship their cars to domestic German residents instead? The domestic purchasers could pay for the cars by issuing fake paper, just like their foreign counterparts. And when the time comes to default, well, at least all the BMWs, Audis, Mercedes, and Volkswagens will be residing on German soil.

The regional dispersion in U.S. vacancy and unemployment rates

2012-01-04T09:49:00.000-08:00

Since I happen to have handy some regional data on the help-wanted index (HWI) for the U.S., I thought it might be interesting to see whether U.S. vacancy and unemployment dynamics in a cross-section display any interesting patterns. (I would like to thank Kyle Herkenhoff for suggesting this exercise to me).

The regional HWI data is from the Conference Board. I explain here how the data was corrected for the recent substitution from print to electronic media in job advertising activities. That data was constructed for 36 U.S. cities. I construct a "vacancy rate" measure by dividing the HWI by the labor force and normalizing to 10 in 1990:1. Here is what the aggregate data looks like:

As one would expect, there is a strong negative correlation between vacancies and unemployment; this is the so-called Beveridge Curve.

Labor economists sometimes like to gauge labor market conditions by constructing a "labor market tightness" variable--the ratio of vacancies to unemployment, or the v/u ratio. The v/u ratio plays a prominent role equilibrium unemployment theory; see Diamond, Mortensen and Pissarides. As the following diagram shows, labor-market-tightness is highly procyclical.

Regional Patterns

The following diagram plots the unemployment rates for 36 metropolitan areas in the U.S. The solid black line is a population-weighted average (it corresponds to the national unemployment rate).

The figure shows that there is significant disparity in regional unemployment rates at all points in the business cycle. As the U.S. economy emerged from the recession in the early 1990s, regional variation in unemployment rates seems to have declined for the rest of that decade. Nothing much changed until the most recent recession, where we see a dramatic increase in both the average unemployment rate and its in its dispersion across regions.

Next, let's take a look at regional "vacancy rates" (the city-based HWI divided by regional labor force).

The dispersion in regional vacancy rates appears to be very, very large (measurement error?). Using my eyeball metric, it appears that the dispersion in vacancy rates is somewhat procyclical. In particular, look at how the dispersion appears to increase throughout the 1990s expansion--at the same time, the dispersion in unemployment rates is declining. This suggests that the dispersion in labor-market-tightness is procyclical; and indeed, the following diagram shows this to be the case.

It would be interesting to know what might be behind these regional differences in labor market tightness, and why this regional dispersion varies over the business cycle.

First, what accounts for the dispersion? In a basic Mortensen-Pissarides labor market search model, extended to incorporate regions, I think that the labor-market-tightness variable is likely to equate across regions (at least, allowing for factor mobility). Regional differences in tax rates, etc., might account for some of the disparity. But the measured disparity is huge.

Second, what accounts for the cyclical properties of the dispersion? Is it simply the case that some regions are populated by industries that are more cyclically sensitive to aggregate shocks? Or is it the case that the shocks themselves are concentrated in certain regions, with the effects propagating to other regions of the country?

If anyone would like to see this data plotted in a different way, or see some statistics reported, feel free to let me know. (Thanks to Constanza Liborio for preparing these graphs.)

On Paulo and Bobby, English and Math

2011-12-30T11:00:00.000-08:00

I was once told by an English professor that Joseph Conrad preferred to write in English (his third language) because sentence meanings in that language often had a wonderful ambiguity that added an artistic flair to his prose.

Well, I'm not sure if that story is true. But I do know that it is easy to misinterpret what people mean when they try to communicate their economic theories in "plain" English. That is why academic economists, when speaking among themselves, prefer to communicate in a much more precise language--math.

For those among you who do not understand this language, I'm sorry. I'll do my best to translate into English as I go along. What I want to do here is provide a formal (mathematical) framework to evaluate the discussion on Ricardian equivalence these past few days (see my previous two posts).

Before I get started, I want to make a few things clear. I was not trying to defend Lucas' claim that G fully crowds out private spending. I am not a Republican (I am a Canadian). I agree with some of things that Krugman says (just take a look at some recent posts). I am annoyed that Krugman repeatedly attacks Lucas for "not understanding his own theory." Not only was that was a low blow, but that sort of talk just promotes a division that I do not think exists in the profession. Moreover, and more to the point of what motivated my original post, in delivering his low blow, Krugman presented his own muddled view of the role that Ricardian equivalence played in Lucas' argument.

So let me try to clear things up. Note that I do not speak for Lucas here. What follows is one possible interpretation of what he had in mind. More precisely, it is what came to my mind when I was trying to interpret the content of his speech.

The model I have in mind is a simple overlapping generations (OLG) economy. People live for two periods; they are "young" and then "old." The population is constant. For simplicity, the young do not care for consumption. Instead, everybody wants to postpone consumption to old age (this is not a critical assumption).

The young are endowed with a unit of labor that produces output y (the young supply this labor inelastically, so we may treat y as an endowment). The young also possess an storage technology; k units of investment today yields F(k,g) units of output tomorrow, where g denotes government investment spending. I assume that output F(k,g) is increasing in both k (private investment) and g (public investment). For simplicity, assume that all capital depreciates fully after it is used in production.

Consider the following two specifications of F(k,g):

PF1: F(k,g) = f(k+g)
PF2: F(k,g) = A(g)f(k)

In PF1, private and public capital are perfect substitutes in production. What this implies is that an increase in g lowers the marginal product of (the return to) private capital spending. In PF2, private and public investment are complements. What this implies is that an increase in g increases the marginal product of (the return to) private capital spending.

I believe, though I am not sure, that Lucas had in mind specification PF1. At least, this is an assumption that is consistent with his conclusions. He would have come to a different conclusion if he believed PF2. Note: the choice of PF1 vs PF2 has nothing to do with Ricardian equivalence.

Let me continue to describe my model economy. There is a government security that earns a gross real rate of return R. In the present economic climate, with nominal interest rates close to zero, R<1 is the inverse of the gross rate of inflation. I treat R here as a policy parameter.

The budget constraints for a young agent in this economy are given by:

k + m = y - t
c = F(k,g) + Rm - T

So here, a young person must take his after tax income (y-t) and make a portfolio allocation choice: how much to invest in private capital k and how much in government money/bonds m. In old age, the agent gets to consume the proceeds of his investments, minus his future tax obligation T.

Next, we have to specify the government budget constraint. I consider two extreme cases.

GBC1: g = t + T/R
GBC2: g = (1-R)m

Under GBC1, I am assuming that the burden of financing g falls entirely on the young. This assumption (together with my use of lump-sum taxes) is going to generate a Ricardian equivalence result: the young are not going to care whether they are taxed now or later for g. (Note: Ricardian equivalence would not hold if I assume instead that the burden of finance falls on both the young and old--that is, if I assume that current g is financed by the current young and current old--in contrast, here I assume current g is financed by current young and future old).

Under GBC2, I assume that g is financed entirely through money creation (seigniorage revenue).

Finally, I consider two experiments:

E1: a permanent increase in g
E2: a temporary increase in g

OK, now let's investigate some of the properties of this simple model and see how it can be used to make sense of things.

Analysis

Case 1: PF1, GBC1, either E1 or E2

The key equation is the one that equates the marginal product of private capital investment to its opportunity cost:

[1] f'(k+g) = R

Result: An increase in g fully crowds out k (so future GDP remains unchanged). This is independent of whether the young are taxed now or later.

Does this conclusion rely on Ricardian equivalence? Well, yes and no (assuming distortionary tax finance would imply that an increase in g would decrease future GDP). Consider the next case.

Case 2: PF2, GBC1, either E1 or E2

The key equation now takes the form:

[2] A(g)f'(k) = R

Result: an increase in g stimulates k (so future GDP increases). This is independent of whether the young are taxed now or later.

This is the sense in which I believe Lucas' remarks have nothing to do with Ricardian equivalence (it has to do with his belief of PF1 over PF2). And indeed, what he literally says is "and taxing them later is not going to help." That is, it might even hurt--which can only be true if one departs from Ricardian equivalence (e.g., by assuming that the future tax hit will be distortionary). Again...words, words, words...we need an explicit model to decipher and evaluate what he really meant.

Aside: I often hear people say things like "Well, yes, if the increase in g is permanent, then it will fully crowd out. But this does not hold if the increase in g is temporary." My reply to this is: you are wrong. Take a look at the model above. It is possible for a permanent increase in g to increase GDP permanently. In particular, Cases 1 and 2 remain valid whether or not the increase in g is temporary or permanent (they hold for E1 and E2).

Case 3: PF1, GB2, E1

The key equation here is again given by [1]. A permanent increase in g is financed here by an inflation tax. Increasing g obviously requires increasing inflation (lowering R, the real return on government money). But if R is lowered, then condition [1] implies that k+g increases. That is, individuals substitute out of money and into capital (private or public). Consequently, if the government increases g permanently and finances it with money creation, output expands. (Note: this result need not be welfare improving. Do not confuse GDP with economic welfare).

Case 4: PF1, GB2, E2

OK, so here we have a one-time increase in g financed by a one-time increase in the money supply. I think that this is what Lucas likely had in mind when he claimed that a money-financed increase in g stimulates.

The analysis here becomes a little more complicated because we have to do "out of steady state" analysis. Let me instead give you the intuition.

It is known that for OLG models, that money is not generally neutral (despite the fact that prices are completely flexible--indeed, I think that price flexibility is critical for the non-neutrality result). In this model, a one-time increase in the money supply to finance a temporary increase in g will cause a surprise jump in the price level, which has the effect of reducing the purchasing power of the money brought into the period by the old. (If you are an Austrian, you will complain that the old have had their savings stolen by the surprise inflation policy). The effect is to divert purchasing power away from the old (who want to consume) toward the young (who would rather invest). This money-financed increase in g will stimulate; which is consistent with what Lucas said. Moreover, the result relies on a failure of Ricardian equivalence. (In a model with an infinitely-lived representative agent, the money-financed increase in g would have no effect at all, given PF1).

Conclusion

A reader of mine provided me with this quote (apparently, from Brad DeLong):

I learned this from Andy Abel and Olivier Blanchard before my eyes first opened: increases in government purchases are ineffective only if (a) "Ricardian Equivalence holds and (b) what the government buys (and distributes to households) is exactly what households would buy for themselves. RE by itself doesn't do it."

I think this is a nice way to summarize things. (Keep in mind that "ineffective" in the quote above means "no effect--whether good or bad.")

In conclusion, Lucas' remarks need not be interpreted as his theory relying on RE. Indeed, as I hope to have made clear above, his remarks, when taken together, require a departure from RE. The key assumption he makes, in my view (who really knows?) is the part (b) in DeLong's quote (my PF1). That part has nothing to do with RE.

Happy New Year, everyone!

Postscript Dec. 31, 2011
An economist that I admire once said this:

"...just talking plausibly about economics is not the same as having a real understanding; for that you need crisp, tightly argued models."

In case you missed it, Krugman takes a nice shot at me here: I Like Math. I like the cartoon! Moreover, I agree with what he says: "If you resort to math to justify what looks like a very foolish claim, and you can't find a way to express that justification in plain English, then something is wrong."

By "foolish," I presume he means "logically invalid" and not "empirically implausible." For those who speak the language of math and are familiar with OLG models, I have shown that there is a logic to the Lucas view as expressed in that speech. (I don't personally believe that the view is empirically plausible, but that is beside the point of my original post). I have shown that the logic implies a departure from RE; contrary to Krugman's claim. I have tried to express this logic in plain language here and here. And in keeping with the sentiment of the quote above (yes, by PK), I tried to re-express the logic in mathematical form to complement what I said earlier. If I have failed in any way, it is in my ability to communicate the idea in "plain" English. I am not as talented as Krugman in this regard. The logic of my argument, however, remains sound.

But I think it is now time to stop. Let me end by alerting you to an interesting take on the matter by Henrik Jensen: The Krugman Multiplier is Too Big. (He includes a link to a video of the speech by Lucas.)

Postscript Jan. 2, 2012

I should have linked up to this classic paper by Neil Wallace earlier than this, but better late than never: A Modigliani-Miller Theorem for Open Market Operations. As macroeconomists know, there is a strong connection between RE and MM (they are essentially the same proposition applied in different contexts). The Wallace paper asserts that open market operations "matter" only to the extent that some or all of the assumptions that underlie RE/MM are violated. Lucas believes that monetary policy matters. Ergo, his arguments (whatever they might be) cannot be based on RE alone.

Postscript Jan. 09, 2012

Well, I'm sure this one is going to fly under the radar, but I feel the need to record it here. It seems that Brad DeLong agrees with me (h/t Mark Thoma); see here. (Well, he doesn't mention me by name, but his elaboration squares with what I have been trying to say all along.)

Yes indeed, one may question whether the mix of publicly provided goods and services substitutes more or less well with privately supplied goods and services. It matters for whether how a change in G is likely to impact the economy. Ultimately, it is an empirical question. And it has nothing to do with RE. Krugman was wrong to question Lucas' understanding of his own theory. Instead, he could have legitimately questioned Lucas' parameter estimates governing the substitutability of private and public expenditure. But really now, I suppose that would have been a lot less fun.

Postscript Jan. 11, 2012

Krugman is like your neighbor's annoying little puppy that just won't stop gnawing at your feet. Scott Sumner weighs in here: Nobel Prizes for Alchemy?

Ricardian equivalence, for the last time

2011-12-28T14:01:00.000-08:00

Ah, controversy. What a great way to end the year!

I want to comment on Mark Thoma's post today about the Ricardian Equivalence Theorem (RET). Linking up to the interview with Barro was a good idea, Mark. Everyone agrees that the theorem has nothing to say about the effectiveness of G, and Barro explains all of this splendidly. Moreover, everyone agrees that since the conditions needed to render the proposition valid are violated in reality, the proposition cannot possibly be expected to make a perfectly accurate prediction of how altering the timing of taxes (holding G fixed) is likely to impact the economy. I guess that this is about where our mutual agreement ends.

What is there left to argue about? It's the holidays--I'm sure we'll find something. Let's start with Mark's opening paragraph:

I haven't said much about the recent flare up over Ricardian equivalence. Why? The answer's simple, the empirical evidence does not support it. Why argue about something when we already know it fails to adequately explain the data? Making the Ricardian equivalence assumption might be okay as a first approximation for some questions--though I'd argue that it mostly isn't--but in any case the theory does not adequately capture economic behavior.

I'm not exactly sure which flare up he is talking about, but I suspect that I may be involved in it somewhere, owing to this post here: Does Krugman Understand the Ricardian Equivalence Theorem?

I want to clear up a few things regarding that post. First, I was not trying to defend Lucas' views on fiscal stimulus. Lucas's view on the matter (insofar as one can gather it from what was clearly an informal and off-the-cuff speech) appears to be that a money-financed increase in G is stimulative, while a tax-financed increase in G is not. Now, there may be several ways to criticize the "rationale" of his argument. But whatever criticism you pick, it most certainly cannot be centered on Lucas' alleged appeal to the Ricardian equivalence theorem. For crying out loud--the man is claiming that the method of financing matters for a given G. This can only be true if the Ricardian proposition fails to hold in reality.

Now, what of Mark's claim that the empirical evidence does not support the RET? Well, as I said above, given that we live in a world of distortionary taxation, borrowing constraints, finite planning horizons, etc., etc., it would indeed be remarkable if the predictions of RET held up exactly in the data.

But surely that is setting the bar a little too high (not one of us has a theory that can perfectly predict such outcomes). Rather, the question is whether or not the assumptions constitute sufficiently good approximations for the purpose at hand (i.e., for a given policy experiment). Indeed, in the interview posted by Mark, Barro states his view on the matter quite plainly:

As a first-order proposition, it is right that it matters little whether you pay for government spending with taxes today or taxes tomorrow...

So, to Barro it seems that the empirical evidence broadly supports the proposition, at least, to a first-order approximation. If so, that is bad news for me, because I like to work with models where the proposition fails. It would, however, be good news for those promoting an increase in G in the face of large deficits (the size of the deficit should not factor into the debate, if the proposition holds true).

In any case, I'm not sure whether Mark's claim about the empirical evidence not supporting RET is entirely valid. I am reminded of a paper I once saw Emanuela Cardia present: Replicating Ricardian Equivalence Tests With Simulated Series. Here is the abstract:

This paper replicates standard consumption function tests of Ricardian equivalence using series generated from a model which nests Ricardian equivalence within a non-Ricardian alternative (due to finite horizons and/or distortionary taxation). I show that the estimates of the effects of taxation on consumption are not robust and that standard tests may have weaknesses which can lead to conflicting results, whether Ricardian equivalence holds or not. The simulations also show that no clear conclusions about Ricardian equivalence can be drawn from observing a low correlation between the current account and government budget deficits.

In short, I think that the empirical evidence may be somewhat more mixed than what Mark suggests.

At the end of the day, I think that the key lesson of the RET is not (for example) that "deficit financed tax cuts do not matter." Rather, the lesson should be that "such a policy is likely to be much less stimulative than you would expect if you were to base your thinking on a model that did not incorporate Ricardian forces."

Now who wants to argue with that?

Does Krugman Understand Ricardian Equivalence? (Wonkish)

2011-12-27T11:14:00.000-08:00

Suppose that the government wants to acquire the resources necessary to implement a new expenditure program G = {g₁, g₂, g₃ ... }, where g_t denotes government purchases of goods and services at date t.

Let us take G as given. To begin their evaluation of G, macroeconomists ask the following two questions. First, what are the likely macroeconomic consequences of implementing program G? Second, does the answer to first question depend on how G is financed? (Financing is assumed to take the form of taxes, deficits, and money creation, or some combination thereof).

The Ricardian Equivalence Theorem (RET) is a proposition that helps us answer the second question above. In particular, the RET lays out a set of conditions that must hold for the following proposition to hold: It does not matter how the government finances G.

Whether the set of conditions holds in reality is a separate issue that need not concern us here. (You may be interested to read this article from the Economist on the subject page 1 and page 2). For now, let me emphasize what the RET does not say: The RET does not say that G does not matter (it says that the method of financing G does not matter).

The G is so unimportant in the RET, that it is useful to ignore it completely when teaching the theorem to students for the first time. That is, set G = {0, 0, 0 ...} and then ask whether it matters how G is financed. One way to finance such a program would be to cut taxes today and raise them tomorrow. Since G is fixed (at zero, in this case), this implies running a deficit today, which is matched by a surplus tomorrow. The RET states the conditions under which a deficit-financed tax cut like this does not matter. A deficit today simply represents a higher future tax bill; and people really don't care whether they are kicked in the a$$ today or tomorrow--it's still an a$$-kicking.

What I have just described is the stuff of elementary macro textbooks. We should all understand now that the RET has nothing to do with G. In particular, we should all know enough never to write a column with the title: A Note on the Ricardian Equivalence Argument Against Stimulus.

The title of Krugman's post shows that it is he who does not understand the Ricardian proposition. There is no "Ricardian Equivalence argument against stimulus." Indeed---the proposition can be used to defend bond-financed stimulus. (In particular, if deficits do not matter, then why not bond finance?)

Now, perhaps you might want to entertain the idea that Paulo knows all this and only chose the title to mock that horrible Bob Lucas fellow. Could be. Except for the fact that Lucas makes no reference to the RET in his informal speech.

In fact--good lord, can it be true--it appears to me that Lucas is making distinctly non-Ricardian arguments in his assessment of fiscal policy. Take a closer look at the passage quoted by Krugman. First, Lucas asserts that a money-financed increase in G will be stimulative; but that the stimulus part comes from the manner in which the spending is financed. (Because money can be thought of as zero-interest debt, this is virtually the same thing as saying that a deficit-financed increase in G will be stimulative.) Second, Lucas goes on to argue why he thinks a tax-financed increase in G will not be stimulative. In other words, his argument could be interpreted to be mean the method of finance matters. Needless to say, this is not a Ricardian Equivalence argument against stimulus.

One may agree or disagree with what Lucas has to say on any given issue (certainly, I do at times). But to come out and publicly declare the man to be ignorant of high-school economics--repeatedly--and on the basis of an informal speech--from a fellow Nobel-prize winner--who is himself is guilty of the charge leveled against his own colleague in the profession---well---holy cow, I don't know what else to say.

PS. A couple of related blog posts on this subject:
Responding to Krugman on Ricardian Equivalence (Andrew Lilico, The Telegraph)
Ricardian Equivalence Redux (Stephen Williamson)

Addendum (Dec 29, 2011)
And in my defense:
On what is and is not an argument about Ricardian equivalence (Andrew Lilico)
Ricardian equivalence heat (Steve Williamson)
In PK's defense:
The great Ricardian equivalence throwdown! (Noahopinion)

Note: I am surprised that no one picked up on the following. If some "conservatives" are claiming that increasing G is "a wash" by whatever mechanism they have in mind, then does it not follow that increasing G further is innocuous? And indeed, decreasing G must be a wash too, if this is indeed what they believe.

The China Factor

2011-12-19T09:25:00.000-08:00

The sovereign debt crisis in Europe has garnered most of our attention as of late. But should Europe really be our main concern? For several months now, many economists (including myself) have been casting a nervous eye over to China. Paul Krugman summarizes these concerns nicely in his NYT article today: Will China Break? Mark Gongloff earlier asked the million dollar question here: China's Shadow Banking System: The Next Subprime? Hmm...

P.S. And what's with these stories I keep hearing about China's missing bosses? (e.g., China's Vanishing Factory Bosses). Sounds ominous, if true. We truly do live in interesting times.

Beveridge Curves for 36 U.S. Cities (updated)

2011-12-12T14:06:00.000-08:00

On October 9, 2010, I posted some regional vacancy-unemployment data for the United States; see: Beveridge Curves for 36 U.S. Cities.

My measure of vacancies was the Conference Board's help-wanted index (HWI). A colleague of mine (Silvio Contessi) pointed me to a paper by Regis Barnichon (EL 2010) that identifies a major flaw in this data series. Barnichon summarizes the problem here:

The traditional measure of vacancy posting is the Conference Board Help-Wanted Index (HWI) that measures the number of help-wanted advertisements in 51 major newspapers. However, since the mid-1990s, this “print” measure of vacancy posting has become increasingly unrepresentative as advertising over the internet has become more prevalent. Instead, economists increasingly rely on the Job Openings and Labor Turnover Survey (JOLTS) measure of job openings. However, this measure is only available since December 2000 and cannot be used to contrast current labor market situations with past experiences.
In this paper, I build a vacancy posting index that captures the behavior of total—“print” and “online”—help-wanted advertising, by combining the print HWI with the online Help-Wanted Index published by the Conference Board since 2005.

Here is how Barnichon's correction looks for the aggregate data.

That is, the secular decline (blue line) in the original HWI series is estimated to be entirely the consequence of a substitution away from print to electronic forms of job advertising.

With this in mind, I asked my tireless research assistant (Constanza Liborio) to recalculate our regional Beveridge curves using Barnichon's correction (for those interested, I can email you a file describing the exact procedure employed).

The regional vacancy data was purchased from the Conference Board (their Help Wanted Online data series), so unfortunately, I cannot make it available to you without their permission. I have permission to display the data, however. Here is what we get.

Addendum: Dec. 13, 2011

As I have stressed in an earlier post, one should be careful in using these raw correlations to identify the source of disturbance; see: Interpreting the Beveridge Curve.

A reader points out that the Monster Employment Index (available since 2004) might be of some use for measuring regional employment opportunities.

On Bagehot's Penalty Rate

2011-12-01T10:19:00.001-08:00

What principles should govern the way a lender-of-last-resort (LLR) operates during a financial crisis? On this question, one is frequently referred to two key principles, attributed to Walter Bagehot in his book Lombard Street. The two principles are usually summarized as "lend freely and at a penalty rate." What does this mean?

In "normal times," firms regularly borrow cash on a short-term basis (say, to meet payroll). These loans are usually collateralized with a host of assets (e.g., accounts receivable, property, securities). The dictum "lend freely" in this context means to extend cash loans freely against the collateral that is normally put up to secure short-term lending arrangements.

The rationale commonly offered for the LLR is that during a crisis, "perfectly good" collateral assets are either no longer accepted as security for short term loans, or that if they are, they are heavily discounted (e.g., a creditor will only lend 75 cents for every dollar in collateral, instead of the usual 99 cents). Whatever the ultimate cause, this type of "liquidity crisis" creates havoc in the payments system. This havoc can be avoided, or at least mitigated, by a LLR that stands ready to replace the "missing" lending activity. (Or so the story goes.)

Let's say that the normal discount rate on high grade collateral is 0 < d < 1. So if a creditor offers to lend $99 for every $100 in collateral, d = 0.01 (one percent discount). Let's suppose that during a crisis, the discount rate rises to c > d. (If c = 0.5, then there is a 50% discount or "haircut" on collateral.) One issue that the LLR must address is the discount rate it should offer on an emergency loan. Let me call this discount rate p.

Now, if the LLR sets p = c, then what is the point of having an LLR? So clearly, if the LLR is to influence lending activity in any manner, it must set p < c. Opponents of LLR activity like to label p < c a "bailout." (This term is rarely defined precisely; it appears to be a label to attach to programs that one does not like.)

At the other extreme, the LLR could set p = d. In this case, the LLR is discounting collateral in the same way that the market does during "normal" times. If the LLR instead set p > d, it is charging a "penalty rate." (Note: I do not think that Bagehot ever used this term.) How should the LLR set this penalty rate and why? Here is Bagehot:

First. That these loans should only be made at a very high rate of interest. This will operate as a heavy fine on unreasonable timidity, and will prevent the greatest number of applications by persons who did not require it. The rate should be raised early in the panic, so that the fine may be paid early; that no one may borrow out of idle precaution without paying well for it; that the Banking reserve may be protected as far as possible. (emphasis, my own)

Well, O.K., so he does not appear to answer the question of what discount rate to apply; only that it should be "very high." But I am less interested here in the precise penalty rate as to the rationale for why a penalty rate is necessary. A colleague of mine (who appears to have done a great deal of reading in the area) suggests that the rationale was primarily to ensure that the Bank of England did not run out of reserves (an event that would have led to its failure, and the subsequent end of civilization in the minds of many at the time).

Of course, the Federal Reserve Bank of the United States does not face the prospect of running out of cash reserves, the way that the Bank of England did back then. This is because "cash" back then took the form of specie (gold and silver coin). "Cash" today takes the form of small denomination paper notes (and electronic digits in reserve accounts) that the Fed can issue "out of thin air." In light of our modern institutional structure, I wonder whether Bagehot, living in today's world, might not have dropped his "penalty rate" dictum?

Is there any good reason left for the penalty rate? Perhaps there is. But it is clearly of second-order importance during a financial crisis. First, lend freely. It is probably not the time to worry about this penalty rate or that penalty rate in the depths of a liquidity crisis. If an institution is deemed, after the fact, to have benefited "unfairly" at the expense of society during an emergency lending episode, then a "fee for service" (i.e., tax) could be applied after the crisis has passed.

P.S. Would be interested to hear from historians on this subject.

Postcript: January 30, 2012
I would like to thank Josh Hendrickson for sending me the link to this paper:

Turning Bagehot on his Head.
Abstract: Ever since Bagehot’s (1873) pioneering work, it is a widely accepted wisdom that in order to alleviate (ex ante) bank moral hazard, a lender of last resort should lend at penalty rates only. In a model in which banks are subject to shocks but can exert effort to affect the likelihood of these shocks, we show that the validity of this argument crucially relies on banks always remaining solvent. The reason is that when banks become insolvent, Bagehot’s prescription dictates to let them fail. Penalty rates charged when banks are illiquid (but solvent) then reduce banks’ incentives to avoid insolvency ex ante and thus increase bank moral hazard. We derive a condition which shows precisely when this effect on ex ante incentives outweighs the traditional one and show that it is fulfilled under plausible scenarios.

A bridge over the macroeconomic divide

2011-11-25T10:42:00.001-08:00

No one can deny that Paul Krugman is a gifted expositor of economic ideas. His column today, "Death by Hawkery," constitutes a fine example of this skill in action.

What I found most interesting in this column is something that would have almost surely escaped his average reader. In particular, I noticed that in telling his basic story, he appealed to a mathematically explicit model of credit cycles written by Nobu Kiyotaki and John Moore (JPE 1997).

Why do I find this interesting?

Well, first of all, I notice that at the time, Kiyotaki was affiliated with that great "freshwater macro" department at the University of Minnesota. You will also notice that the arch-devil Ed Prescott is thanked (among others) for his "thoughtful comments and help" on the paper.

I mention this because I think that Krugman has in the past overemphasized the disagreement that exists among the newer cohorts of macroeconomists (one could make the case that disagreement was much greater in the past); see, for example, here: Disagreement Among Economists. On this matter, I side with Steve Williamson, who I think has rightly taken Krugman to task on this issue; see here and here.

Secondly, I find it interesting that the mechanism highlighted by Kiyotaki and Moore in no way relies on nominal or real price rigidities. It is, in fact, a real business cycle model. Yes, you heard me correctly: Paul Krugman is appealing to an RBC model to help him account for recent events. (Granted, it is an RBC model that incorporates limited commitment, a friction that plays a prominent role in all modern macro theory; see my post here: Asset Shortages and Price Bubbles: A New Monetarist Perspective).

I think this constitutes evidence that the great macroeconomic divide is not as great as it is sometimes portrayed. Most of the disagreement I am aware of is of the gentlemanly "let us agree to disagree" type. But there is no fundamental disagreement in basic macroeconomic methodology among most academic macroeconomists. (There are, of course, healthy and welcome challenges from the fringes of the profession.)

Now for some comments on the economic ideas.

As you may have gathered from my previous post, I am generally sympathetic to the idea of expanding the supply of U.S. treasury debt at this time (with a commitment to unwind in the future, if and when economic conditions improve). Of course, a big question is what to do with the funds acquired in this manner. I'm with Krugman in that heck, we may as well use it to build physical capital (public infrastructure). Financing a corporate tax cut to stimulate domestic private capital spending might be a good idea too (not so politically popular though).

These provisional policy recommendations suggest themselves to me by way of a class of "new monetarist" models that I like to use to organize my thinking about things. But I should say, however, that I'm still not sure just how seriously to take these models (at least, their current incarnations). I'm still a little sketchy about how one might plausibly generate negative real rates of interest in these models; that is, models that take seriously the intertemporal production capabilities of actual economies (you will note that Krugman abstracts from physical capital in telling his little story).

I can't help but note that this same class of models might be used instead to support "conservative" policies. In particular, one force that can potentially drive the expected marginal product of capital (real interest rate) lower is the rational (or irrational) expectation of a future regulatory/tax burden paid for by capital accumulators of all types (including human capital).

If (and I emphasize the if) this is the (or a significant part of the) fundamental problem (and how do we really know that it is not?), then it is hard to see how treasury debt expansion and/or inflationary policy is going to solve it. Fixing the problem in this case means providing an environment that rewards private investment. Death by Dovery is also a possibility.

Not enough U.S. debt?

2011-11-23T07:40:00.001-08:00

One way to measure the ability to service debt is to compute a debt-to-income ratio. Suppose, for example, that your income is $50K per year, that your home is worth $200K, and that you have a $150K mortgage. Then your debt-to-income ratio is 150/50 = 3; or 300%.

Similarly, one way to measure the ability of a country to service its national debt is to compute debt-to-GDP (a measure of domestic income) ratio. The ratio of U.S. federal debt to GDP is currently close to 100%.

Of course, what has a lot of people worried is not the level, but the trajectory, of this ratio. Clearly, the debt-to-GDP ratio cannot rise forever.

No, but on the other hand, there is some evidence to suggest that it can feasibly go much higher. (Whether it should be permitted to do so is a different question, of course.)

Before I go on, I want to clear up a misguided analogy that I frequently hear repeated. The misguided analogy is the idea of the government behaving like a household running up a massive amount of credit card debt.

If this is the way you like to think about things, let me ask you this: Which of your credit cards charge you 0% interest? I ask because that is the interest rate creditors around the world are willing to lend to the U.S. federal government. And what sort of credit card company starts to reduce the interest it charges on your debt as you become progressively more indebted (see the figure above)?

In fact, the terms are even much better than 0%. The real cost of borrowing is measured by the real (inflation adjusted) interest rate. As the figure above shows, the real cost of borrowing has plummeted over the last decade for the U.S. government. As the following figure shows, the U.S. government can now borrow funds for 10 years at close to zero real interest. It can borrow funds for 5 years at a negative real interest.

Now, a negative real rate of interest is a pretty cool deal. Imagine importing 100 bottles of beer from China today, and having to return only 99 bottles next year. If the interest rate remains unchanged one year from now, you can rollover your debt and make a profit. For example, you could borrow another 100 bottles of beer from China, use 99 of these bottles to pay off your maturing obligation, and then drink the remaining beer for free. (Of course, domestic beer brewers would become upset at the lack of demand for their own product, but maybe they can be bribed with free Chinese beer?)

Before we get too carried away, however, I explain here why these very low real rates constitute bad news.

Why are real rates so low?

My own view is that this phenomenon, at its root, has little to do with Federal Reserve or Treasury policy. I believe that the decline in real rates on U.S. treasuries reflects a steady change in how agents and agencies around the world want to structure their wealth portfolios. There has been a massive substitution away from many asset classes into U.S. treasuries; and it is this fundamental market force that is driving real interest rates lower.

The phenomenon began in the early 1990s, with the collapse of the Japanese stock market. Then Mexico in 1994, the Asian crisis 1997-98, Russia in 1998, and Brazil in 1999; see Bernanke (2005). Investors became rationally pessimistic about the returns to investing in these countries, as well as similar countries that had not yet experienced crisis. The natural effect of this would be capital outflows from these countries into relative safe havens, like the United States.

The basic thesis here is very much related to what Ricardo Caballero calls a "global asset shortage." See his discussion here and here; and my own discussion here and here.

The global investment collapse associated with the recent recession has pushed already low real rates lower still. There has been a flight to U.S. treasuries not only by foreigners, but this time by Americans too. Evidently, the perceived return to domestic capital spending remains low. (Some basic theory available here.)

Policy

Given this pessimistic outlook, it seems unclear what monetary policy can do (the Fed is largely limited to swapping low interest currency for low interest treasuries).

I do, however, believe that there may be a role for the U.S. treasury (in principle, at least). In particular, given the huge worldwide appetite for U.S. treasury debt (as reflected by absurdly low yields), this is the time to start accommodating this demand. Failure to do so at this time will only drive real rates lower. For a world economy that is reasonably expected to grow, negative real interest rates imply a dynamic inefficiency. In short, this is the time to start raising real rates, not lowering them (real rates theoretically rise when new debt crowds out private capital, but note that new debt can also be used to finance corporate tax cuts to stimulate investment, if so desired).

Of course, what theory also tells us is that the government should also be prepared to reverse this recommended debt expansion (assuming that tax rates remain unchanged) once the domestic and world economy return to normal. One may legitimately question whether the government can be expected to make these cuts at the appropriate time. If the government lacks credibility along this dimension (or if future governments cannot be expected to abide by policies put in place by previous governments), then political forces may emerge to block an otherwise socially desirable debt expansion. Perhaps this is one way to interpret recent events.

Keystone Kops and Deficient Demand

2011-11-11T09:13:00.001-08:00

Don't worry Sir...we'll find a way to stop those Canadians!

Domestic capital spending has been very slow to recover in the U.S. following the official end of the previous recession. Why is this the case?

Deficient demand, that's why. People are pessimistic. Their pessimism leads them to cut back on spending. And because everyone cuts back on spending, there is little incentive to hire new workers or start new capital projects. This means lower incomes for workers, which leads them to cut back even more on spending. Fear has become a self-fulfilling prophecy.

That's right -- all you people in the private sector out there -- you're a bunch of scaredy cats. That's why the government needs to take your money and spend it for you. You'll be the richer for it.

The problem with this "scardey cat" hypothesis is that there seems to be plenty of evidence suggesting that the private sector would love to start spending, if only the government would let it.

James Hamilton lists a few examples here highlighting some of the impediments to capital spending in the U.S. energy sector: Making Jobs Priority One.

Here is Hamilton describing the Keystone Gulf Coast Expansion Project in greater detail. He summarizes nicely here (in Shovel Ready):

And TransCanada wants to spend $7 billion of its own currency (no federal dollars asked for at all) to build exactly what we need in the form of the Keystone Gulf Coast Expansion Project. The pipeline would add capacity to transport another 500,000 barrels each day from Canada, North Dakota, and other regions in the U.S. to refiners on the Gulf Coast. At a price differential of more than $20/barrel, that wold generate over ten million dollars in new wealth every day. Beneficiaries of that wealth creation include the estimated 20,000 Americans who would work on construction of the pipeline and the $5 billion in estimated new property tax revenue for state and local government over the pipeline's lifetime.

Evidently, this project has been "shovel ready" for at least three years now. The project is being held up because of environmental concerns; see here and here (although, see Mark Perry). In fact, just yesterday, the Obama administration once again postponed the critical permitting decision until 2013; see here. Among other things, the following is highlighted:

The delay pushes a decision on the contentious proposal well beyond the 2012 presidential election in November, allowing President Obama to avoid a politically fractious determination in the midst of his reelection bid.

The political calculus is obvious here. And sadly, it's probably a good political calculation. But I do not wish to criticize the politics behind this (and several other related) decision(s). Not here, at least.

What I should instead like to stress is this: Whatever the merits of the cases made against these large private capital expenditure plans, their effect is to depress private domestic capital spending. This depressive is not some psychologically induced "animal spirit" that so many commentators and policymakers appear fond of ascribing to private sector behavior. It constitutes a real "tax" on private economic activity. And while it may be hard to quantify precisely how much this "regulatory tax" is holding back the recovery in domestic capital spending, the evidence from the Keystone project alone suggests that it is not insignificant.

Fiscal multipliers: another caveat

2011-11-10T07:42:00.000-08:00

James Hamilton reminds us of what all Econ 101 students learn (or are supposed to learn) about the peculiarities of national income and product accounting and the caveats that need to be kept in mind when equating the measured GDP to true economic activity. The lesson is hammered home by Yoshiyasu Ono in this paper The Keynesian Multiplier Effect Reconsidered published earlier this year. Here is Hamilton's nice summary of the paper:

According totraditional Keynesian models, even for the case of a completely uselessgovernment project, if we were to raise private-sector taxes by just the amountneeded to pay the salaries of the hole-diggers, GDP would increase, with abalanced-budget multiplier of one. Yet, Professor Ono asks, how could payingthe crew a salary to dig a useless hole possibly lead to an improvement inwelfare relative to simply handing them a direct transfer and allowing them tospend more time safely and comfortably at home with the family? And, to makethings very simple, if the source of funds for paying the workers was in fact atax levied on those same individuals, how could we possibly conclude that theenterprise has increased total national income?

Theanswer is, we include government spending, even on useless projects, in thedefinition of GDP, and assume that the value of what is produced is the dollarsum that the government paid for it. The reason even useless governmentspending has a balanced-budget multiplier of one is that we now have afilled-in hole that we didn't have before. So we have more goods and services(in the form of a newly filled-in hole) than we used to, and impute the valueof this new extra stuff as added income for the nation as a whole.

To understand what underlies this phenomenon, we have to revisit the definition of GDP. The Gross Domestic Product is defined as the market-value of all final goods and services produced by domestic factors of production over some specified time period.

It is also useful to keep the following in mind. All production is, by definition, sold (inventory accumulation is treated as a capital expenditure). Therefore, total output equals total expenditure. Moreover, as any expenditure on one side of a transaction constitutes income on the other side, it follows that total expenditure equals total income. To summarize:

Output (GDP) is equivalent to Expenditure is equivalent to Income

Just to be clear, this is not a theory. It is an accounting identity (something that is true by definition). Now let me work through a series of examples.

First, suppose that a firm pays a worker $1 to produce an object that has a market value of $2. What is the contribution to GDP? The answer is $2. There are two ways to see this. First, the market-value of what has been produced/sold is $2. Second, total income has increased by $2. (Labor income has increased by $1 and profit income has increased by $1).

Now, suppose that a firm pays a worker $1 to produce an object that has a market value of $0. What is the contribution to GDP? The answer is zero. Again, there are two ways to see this. First, the market-value of what has been produced is zero. Second, while it is true that the income of the worker has increased by $1, this income gain is offset exactly by a $1 income loss for the firm. All that has happened in this example is a transfer of purchasing power from the firm to the worker. This is redistribution, not production.

Next, suppose that the government pays a worker $1 to produce an object that has a market value of $0. What is the contribution to GDP? The true contribution is zero. But that's not how the contribution will be measured in the NIPA. The NIPA assumes that the market value of the object produced by (or on behalf of) the government is $1. All that has happened in this example is a transfer of purchasing power from the taxpayer to the worker. This is redistribution, not production. But it will nevertheless be measured as production.

Why does this happen? Is someone trying to pull the wool over our eyes? No. As it turns out, many of the government services produced by government workers are provided for "free" and are hard to value at market prices (national defense is a classic example). When this is the case, it does not seem unreasonable to impute the market-value of a non-priced service by the cost of production.

Having said this, the lesson here is that one should nevertheless use caution in interpreting the estimated multiplier effects of fiscal stimulus programs using historical data as indicators of the likely impact of contemporaneous spending measures on true (as opposed to measured) GDP. The estimates are surely biased upward, although by how much likely depends on the exact nature of the expenditure.

What I have just described is a caveat for those who are inclined to perform cost-benefit exercises using "Keynesian" multiplier analysis. This type of analysis emerged out of a static model (the Keynesian Cross), where the benefit of a $1 expenditure by the government had to exist contemporaneously (there is no explicit future in a static model), which explains why the existence of multipliers greater than unity are so important in this way of thinking about things.

There is a better way of evaluating the net benefit of a government stimulus program. This involves estimating the expected net present value of the program (easier said than done, of course). With the real return on U.S. Treasuries so low (see my previous post), with U.S. infrastructure reportedly in a sorry state, and with so many unemployed construction workers, I would be surprised to learn that there are few positive NPV infrastructure projects currently available.

Unfortunately, political shenanigans (from all sides) sometimes make a mockery out the attempt to estimate NPV in a systematic and unbiased manner. We appear to be living in such times.

Negative real interest rates

2011-11-03T09:39:00.000-07:00

The nominal interest rate is a relative price. It is the price of a dollar today measured in units of (the promise of) future dollars. For example, if the risk-free annual interest rate on a U.S. treasury is currently 5%, then one dollar today is valued at 1.05 future (one year from now) dollars.

Current dollars usually trade at a premium relative to future dollars; the degree of this "impatience" is reflected in the nominal interest rate. The higher the nominal interest rate, the more money is valued today vis-a-vis future money. A high nominal interest rate reflects the market's strong desire to have you part with your money today (in exchange for a promise of future money). Conversely, a low nominal interest rate reflects the market's ambivalence about where to allocate dollars across time. A zero nominal interest rate means that the market values current and future dollars equally. To the extent that it is costless to store cash over time, the nominal interest rate is bounded below by zero. This "fact" is sometimes referred to as the zero lower bound.

In macroeconomic theory, the nominal interest rate plays second-fiddle to the so-called real interest rate. The real rate of interest is also a relative price. It is the price of output today measured in units of future output (think of "output" as consisting of an expenditure-weighted basket of commonly purchased consumer goods and services.) So, if the risk-free annual interest rate on an inflation-indexed U.S. treasury is 2%, then one unit of output today is valued at 1.02 units of output in the future.

In the same way that the nominal interest rate measures the relative scarcity of money across time, one can think of the real interest rate as reflecting the relative scarcity of output across time. Economists typically focus on the real interest rate because people presumably care about output and not money (they care about money only to the extent that it may be used to purchase output).

Current output usually trades at a premium relative to future output; that is, the real interest rate is usually positive. The higher the real interest rate, the more output is valued today vis-a-vis future output. A high real interest rate reflects the market's strong desire to have you part with your output today (in exchange for a promise of future output). Unlike the nominal interest rate, however, there is nothing that naturally prevents the real interest rate from becoming negative; see Nick Rowe. And indeed, this appears to have happened recently in the U.S. The following diagram plots the real interest rate as measured by the n-year treasury inflation-indexed security (constant maturity) for n = 5, 10, 20; see FRED.

Prior to the Great Recession, real interest rates are hovering around 2% p.a. and the yield curve is upward sloping (long rates higher than short rates), at least until early 2006 (when it flattens). Following the violent spike up in real interest rates (associated with the Lehman event), real interest rates have for the most part declined steadily since then. The 20 year rate is below 1%, the 10 year rate is basically zero, and the 5 year rate is significantly negative. What does this mean?

The decline in real rates that has taken place, especially since the beginning of 2011, is a troubling sign. A negative 5-year rate implies that current output is now less valuable than future (5 year) output. In other words, (claims to) future output are now trading at a premium. This premium may be signalling an expected scarcity of future output. If so, then this is a bearish signal.

The decline in market real interest rates is consistent with a collapse (and anemic recovery) of investment spending (broadly defined to include investments in job recruiting). For whatever reason, the future does not look as bright as it normally does at the end of a recession. To some observers, this looks like a "deficient aggregate demand" phenomenon. To others, it is the outcome of a rational pessimism reflecting a flow of new regulatory burdens and a potentially punitive tax regime. Both hypotheses are consistent with the observed "flight to safety" phenomenon and the consequent decline in real treasury yields.

Unfortunately, the two hypotheses yield very different policy implications. The former calls for increased government purchases to "stimulate demand," while the latter calls for removing whatever barriers are inhibiting private investment expenditure. There seems to be room for compromise though. Surely there are public infrastructure projects that can be expected to yield a real return higher than zero? This is a great time for the U.S. treasury to borrow (assuming that borrowed funds are not squandered, of course).

In the event of an impasse, can the Fed save the day? It is hard to see how. The Fed's influence on real economic activity is usually thought to flow through the influence it has (or is supposed to have) on the real interest rate. One could make the case that real interest rates are presently low in part owing to the Fed's easing policies. But this would be ignoring the fact that the Fed's easing policies were/are largely driven by the collapse in investment spending. (I am suggesting that in a world without the Fed, these real interest rates would be behaving in more or less the same way.)

In any case, real interest rates are already unusually low. How much lower should they go? Is it really the case that our economic ills, even some of them, might be solved in any significant manner by driving these real rates any lower? My own view is probably not. If there is something the Fed can do, it is likely to operate through some other mechanism. The problem is not that real interest rates are too high. The problem is that they are not high enough (the robust economic prospects that push real rates higher appear to be absent).

Most Fed types probably hold the view that the main goal of monetary policy is to keep inflation low and stable so as to "anchor" inflation expectations; see James Hamilton on Ben Bernanke's 2007 inflation expectations speech. Bernanke defines well-anchored inflation expectations as being "relatively insensitive to incoming data."

We can compute a market-based measure of inflation expectations using a no-arbitrage-condition which states the the real rate of return on nominal and inflation-indexed treasuries should be roughly equal (the Fisher equation). The relevant nominal interest rates are plotted here:

Next, take the nominal interest rate above (at a given horizon) and subtract the corresponding real interest rate from the first diagram to get:

According to this data, the sharp spike up in real interest rates in the depths of the financial crisis stemmed entirely from a precipitous decline in longer-horizon inflation expectations. While inflation expectations appear to have rebounded to their more normal range of 2-3%, they continue to be more volatile than before the recession.

On the other hand, there is no evidence to suggest that inflation expectations are whirling out of control, one way or the other. I'm not sure to what extent this constitutes success. At the very least it is not utter failure.

Am off to Vancouver now for the 25th Annual CMSG!

What went wrong at MF Global

2011-11-02T07:47:00.000-07:00

Here is a nice quick summary of what went wrong: CNBC video (short, sweet, and to the point.)

It's the same old song. Big financial firm makes a big bet. Information flows relating to probable payoffs suddenly signal higher risk. Rating agencies move in to downgrade firm's liabilities. A "run" ensues (widespread redemptions) leading to...a liquidity event? or a solvency event? (only time will tell, I suppose.)

Why does MF Global matter? One reason is that the institution was added to the Fed's list of 22 primary dealer banks just 8 months ago. See WSJ article below.

Fed Takes Collateral Damage in MF Global Meltdown

WSJ
Tue, 1 Nov 2011
698 words

By Min Zeng
November 1, 2011, 10:16 AM ET

The Federal Reserve is among those feeling the pinch from the collapse of MF Global Holdings Ltd., which only eight months ago was added to the Fed’s list of 22 primary dealer banks.

MF Global’s spectacular downfall seems unlikely to pose a systemic financial risk to either the U.S. economy or the Fed, in sharp contrast to the fallout from Lehman Brothers in 2008. But it’s possible it will make the selection procedure tougher for primary dealers, an elite group of institutions with which the New York Fed conducts monetary policy and which are obligated to participate in U.S. Treasury debt auctions.

MF Global’s fortunes quickly went downhill over the past week amid concerns over its exposure to the euro zone’s sovereign debt. In this way, its travails underscore the potential contagion risks to the U.S. financial system via the primary dealer network. Besides MF Global, several primary dealers are owned by big European banks, including France’s BNP Paribas SA and Societe Generale SA, whose shares sold off in September due to concerns about their exposure to debts in Greece and other heavily indebted euro-zone sovereigns.

“At the very least these applications will undergo a much more stringent vetting procedure,” said Chris Rupkey, senior financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. “The lesson of history after these sudden financial bankruptcies is that regulators come down harder than ever. They don’t want to see another MF Global again on their watch.”

The Fed may need to increase the standards of its scenario analysis when determining the balance-sheet strength of the primary dealers, said Adrian K. Miller, senior fixed income strategist at Miller Tabak Roberts Securities LLC in New York.

A spokesman from the New York Fed declined to comment Monday afternoon.

The Fed had already tightened conditions for selecting dealers. The latest revision came in January 2010, which included an increase in capital requirements from $50 million to $150 million.

On that basis, some believe the Fed can’t be faulted for having one of its dealers go bankrupt.

“No one can hold the Fed responsible for the risk of the firm,” said Michael Franzese, head of Treasury trading at Wunderlich Securities in New York. “You try and put adequate procedures in place so it doesn’t happen but you have to trust people to do the right thing.”

Firms that have been seeking to join the primary dealer list include Toronto-Dominion Bank, the second-largest bank in Canada, and CRT Capital, a Connecticut-based broker dealer.

Membership has proven profitable at time when Treasury volumes have increased and demand for Treasury bonds has been fueled by the more conservative strategies of investors spooked by the euro-zone crisis and by the Fed’s support for the market.

After naming MF Global and Societe Generale to the list in February, earlier this month the Fed added BMO Capital Markets Corp. and Bank of Nova Scotia, both of Canada, boosting the dealer number to 22.

Now, with MF Global’s exit leaving a space open, other prospective dealers could campaign for entry, knowing that the central bank needs an enlarged pool to facilitate the giant bond transactions it undertakes to channel monetary stimulus into the economy, according to market analysts.

The Fed at the start of this month launched “Operation Twist” — a $400 billion operation to run until mid-2012 through which it will sell short-dated Treasurys and buy those with maturities of between six years and 30 years. Those transactions will be carried out via primary dealers.

Primary dealers will also be needed once the Fed starts to withdraw the cash it pumped into the banking system over the past few years, a strategy that has swollen the central bank’s balance sheet to beyond $2 trillion from less than $900 billion shortly before the 2008 financial crisis.

The Treasury Department has an interest in sustaining a large membership list for primary dealers, too. It needs these institutions to underwrite government bond sales as it continues to announce giant auctions to fund the fiscal deficit. If the auctions don’t go smoothly, the Treasury’s borrowing costs will rise.

The slogans stop here

2011-10-30T10:16:00.000-07:00

Tom Sargent finally speaks out; see here: The Slogans Stop Here.

In a telephone interview last week, Professor Sargent said he felt insulted by people who called him "non-Keynesian" or "right wing," terms that, he said, are based on a misunderstanding of his thinking. And he rejected attempts to categorize his views in simple slogans.
...
Fundamentally, he said, "What I really don't like is oversimplification." He tries to think things through, he said, and avoid having "one slogan fighting another."

I like this guy. He should start a blog. I've got the perfect name: Conscience of a Scientist.

What Happens If Europe Crushes the Swap Market?

2011-10-26T12:24:00.000-07:00

An interesting piece here by John Carney: What Happens if Europe Crushes the Swap Market?

An excerpt:

Many European politicians probably wouldn't mind killing the CDS market. From their point of view, the CDS market has been an unmitigated evil, allowing speculators to profit from the debt burdens of Europe's peoples. Even worse, because the bond market appears to react to widening credit spreads by pushing down the value of sovereign bonds, it appears to make government borrowing more expensive.

Some of Europe's leaders believe the CDS market is manipulated by hedge funds.

But the European leaders misunderstand the CDS market and its relationship to the bond market. The CDS market serves two important purposes: It's both a hedge for investors and an indicator of how risky the market thinks certain bonds are. Many investors are able to buy more of a country's bonds because they can reduce their risk by purchasing swaps that pay off in a default. And the price of the swaps is an indicator—albeit not always a reliable one—of the riskiness of the underlying bonds. In short, the CDS market provides liquidity and transparency to the bond market.

Take away that liquidity and transparency and governments will likely find that lenders are less likely to extend credit. With fewer opportunities to hedge, and prices based on less information, fewer investors will be willing to buy. That would mean selling bonds that have already been issued and staying out of new issues, which would ultimately push up the cost of government borrowing.

The rise and fall of Bitcoin

2011-10-24T09:02:00.000-07:00

Apparently, it's not so easy setting up a competing currency with a stable value. Bitcoin seems to be having a hard time as of late, losing more than 90% of its value since it's June peak; see here (h/t Fernando Martin). It will be interesting to see how the Bitcoin issuers respond to these challenges.

P.S. Steve Williamson provides a nice economic summary of bitcoin here.

The great sectoral shock of 2006

2011-10-19T12:26:00.000-07:00

There's a lot to disagree about when it comes to understanding the great recession and subsequent slow recovery. But at least one thing seems clear: the U.S. real estate sector has played, and continues to play, a significant role in the ongoing saga.

In this post I want to talk about an old theme: the idea that a shock in one sector of the economy can reverberate throughout the entire economy. This theme was highlighted by John Long and Charles Plosser in their classic paper Real Business Cycles (JPE 1983). But it was a view that really never gained much traction. The one-sector neoclassical growth model was, and continues to be, the preferred basic framework of modern macroeconomic analysis.

The fact that most economic sectors tend to expand and contract together has something to do with the willingness to approximate the economy as consisting of one sector. But in doing so, one is then led to search for explanations in terms of hypothetical "aggregate demand" and "aggregate supply" shocks. And so we hear today that the slow recovery is attributable to "deficient demand," and that this explanation is borne out by the survey responses of businessmen who report that their main problem is a lack of product demand. (I have spoken about the pitfalls of this interpretation here.)

In any case, what I want to talk about here is the work of my colleague Juan Sanchez (with Constanza Liborio) about the role of the construction sector in the great recession. Let's start off with a look at U.S. construction sector data over the period 2005-2010.

Construction sector GDP (value-added), gross output, and employment are all normalized to 100 in the year 2006. All variables decline by about 30% over the next four years. Note that the U.S. economy officially went into recession in December 2007. The decline in the construction sector occurred over a year before that.

The Direct Effect

Construction sector employment at it's peak in 2006:Q1 was 7,651,000 workers. By 2010:Q4, employment in this sector shrank to 5,505,000 workers; a decline of 28.1% (2,146,000 workers).

Total employment in 2006:Q1 was 135,401,000 workers. By 2010:Q4, total employment fell to 130,128,000 workers; a decline of 3.9% (5,273,000 workers).

Consequently, 40.7% of the decline in total employment over this period of time is directly attributable to the employment losses experienced in the construction sector.

This sounds like a big number--and it is. But there is reason to believe that it is, in fact, just a lower bound. That's because this direct effect is likely to have implications for product demand in other sectors that supply the construction industry.

Indirect Effects

The following data shows the share of a sector's output used in the construction sector (for the year 2006).

The way to read this graph is as follows. In 2006, roughly 3% of what was produced by the U.S. mining sector was used as an intermediate input in the U.S. construction sector; and so on. According to this data, Both manufacturing and retail depend heavily on product demand generated by construction.

Quiz: A business manager at the local Home Depot (retail sector) reports that her regular customers in the construction sector have scaled back their purchases. She would like to hire more workers but the problem, she explains, is a "lack of demand" for her store's product. It follows immediately and conclusively that the problem with the U.S. economy is "deficient demand" and that government stimulus is needed. Answer true/false/uncertain; and explain.

Input-Output Analysis

To get a rough sense of how the collapse of the construction sector may have spilled over into the rest of the economy via the intersectoral linkages described above, Juan uses the BEA input-output tables to construct a simple model.

To be conservative, he applies the actual decline of output in the construction sector from 2006-2007 (average of these two years) to 2009. Evidently, the effect will be larger if one considers the change from 2006 to 2010.

The result of this simple simulation exercise suggests that the collapse of the construction sector accounts for 46.4% of the decline in U.S. GDP and 51.9% of the decline in total employment (roughly 3.4 million jobs).

The following bar graph summarizes his results.

Juan uses the same model to ask how much of the expansion during 2002-2006 was attributable to construction. His analysis suggests that construction played a much smaller role in the expansion, accounting for only 7.4% of the increase in GDP over this period.

Conclusion

The rosy expectations that drove residential investment prior to the recession turned out to be overly optimistic. The "overbuild" in residential capital needs time to work off, through depreciation and population growth. The adjustments taking place in this sector will take time. To the extent that other sectors are tied to the fortunes of the construction sector, economic activity throughout the economy is likely to remain relatively depressed. What can or should be done about this remains an open question.

PS. If you would like to contact Juan to learn what he did in greater detail, send him a message here: sanchez@stls.frb.org

Wall street protesters (a bit of irony)

2011-10-08T15:29:00.000-07:00

This one is just too good not to share...

Oh, and heck, speaking of irony, here's another one...

Have a nice weekend!

P.S. I am also reminded of this classic scene from the Life of Brian: What Have the Romans Ever Done for Us?

The St. Louis Fed Financial Stress Index

2011-10-05T11:47:00.000-07:00

My colleague Kevin Kliesen (and his coauthor, Doug Smith) have recently introduced a new financial market stress index; see Measuring Financial Market Stress. Here's a link to the Appendix, which describes its construction and the data series used: appendix. A brief description:

The St. Louis Fed’s Financial Stress Index is constructed using principal components analysis. Briefly, principal components analysis is a statistical method of extracting factors responsible for the comovement of a group of variables. We assume that financial stress is the primary factor influencing this comovement, and by extracting this factor (the first principal component) we are able to create an index with a useful economic interpretation. We construct the STLFSI using 18 weekly data series beginning December 31, 1993. Prior to the principal components analysis, each of the data series are de-meaned and then divided by their respective sample standard deviations.

The index is available on FRED here. Let me reproduce some of this data here. Here is what the FSI looks like since December 2009.

Stress is on the rise, but looks like we're still a long way from 2008...

The big question, however, is whether the temperature will keep rising.

Inflation expectations: a downward march

2011-10-05T07:34:00.000-07:00

This graph is courtesy of my colleague, Kevin Kliesen.

If you squint your eyes near the end of the sample, you'll see that Operation Twist appeared, on impact, to move short and long inflation expectations in opposite directions. The effect did not last long, however. The march downward continues--for now, at least.

Update: October 7, 2011

At the request of one of my readers, I had my RA (Constanza Liborio) plot a measure of inflation forecast errors over the last five years.

The inflation rate data is based on headline CPI. We use quarterly inflation at annual rates, and then subtract off the rate of inflation expected in a quarter, 2 and 5 years prior. The results are plotted here:

It's not the uncertainty--it's the certainty

2011-10-04T12:53:00.000-07:00

I have moved over to the "it's not the uncertainty" camp. The president's statement below seems to make it absolutely certain what rewards are likely to lie ahead for those dare to dream of profit:

“This is exactly why we need this Consumer Finance Protection Bureau that we set up that is ready to go," Obama said. "This is exactly why we need somebody who's sole job it is to prevent this kind of stuff from happening. ... You can stop it because if you say to the banks, ‘You don't have some inherent right just to – you know, get a certain amount of profit. If your customers – are being mistreated. That you have to treat them fairly and transparently.”

The story is reported here: Obama Blasts Bank of America's Debit Fees.

Is this really the type of language that is expected to instill the confidence that is needed to stimulate investment? And do people really believe that they will not pay for services rendered if this this (more transparent) fee structure is prohbited?

A blogger's ten commandments

2011-09-28T07:36:00.000-07:00

I came by this the other day via a friend: A Liberal Decalogue, by the great philosopher Bertrand Russell. Thought you might enjoy it too.

1. Do not feel absolutely certain of anything.

2. Do not think it worth while to proceed by concealing evidence, for the evidence is sure to come to light.

3. Never try to discourage thinking for you are sure to succeed.

4. When you meet with opposition, even if it should be from your husband or your children, endeavour to overcome it by argument and not by authority, for a victory dependent upon authority is unreal and illusory.

5. Have no respect for the authority of others, for there are always contrary authorities to be found.

6. Do not use power to suppress opinions you think pernicious, for if you do the opinions will suppress you.

7. Do not fear to be eccentric in opinion, for every opinion now accepted was once eccentric.

8. Find more pleasure in intelligent dissent than in passive agreement, for, if you value intelligence as you should, the former implies a deeper agreement than the latter.

9. Be scrupulously truthful, even if the truth is inconvenient, for it is more inconvenient when you try to conceal it.

10. Do not feel envious of the happiness of those who live a fool's paradise, for only a fool will think that is happiness.

Source: A Liberal Decalogue, Bertrand Russell (1951)

European banks and US dollars

2011-09-27T08:20:00.000-07:00

I sometimes get asked why European banks are in apparent need of US dollars, and why the Fed is lending money to the European Central Bank (ECB).

Ah, the wacky world of international finance. I can't pretend to understand it fully--or even very well--but here are some thoughts nevertheless. (I'm learning a lot about this stuff from my colleague, Richard Anderson, but still lot's to learn!)

We have all heard about the apparent troubles European banks are having. They have (we believe) invested in the sovereign debt of fiscally strapped nations like Portugal and Greece; see here. Fine, you say. This might explain why they need short-term Euro financing, which the ECB can in principle supply. What the heck do they need USD for?

Well, evidently, European banks do not invest just in Europe. They also lend to companies operating in the US. Where do they get the USD to do this? A big source of funding apparently comes from U.S. money market mutual funds (MMMFs), which lend funds to branches of these foreign banks residing on US soil. (All of this somehow is governed by the US 1978 International Banking Act -- if you understand how, please write back!)

Now, when things start to look scary in the financial market, credit begins to tighten. And it looks like the American MMMF industry is running scared from Europe. Here is an interesting tidbit, published by the Investment Company Institute (ICI), an enterprise described to me as the "public face of the U.S. MMMF industry" The piece is called Deja vu--US Money Market Funds and the Eurozone Debt Crisis (by Chris Plantier and Sean Collins). Here is an excerpt:

Direct exposure to both public and private issuers in the European “periphery” countries is virtually zero. Since June, U.S. money market funds have almost eliminated holdings of Italian and Spanish government and private debt, including bank securities.

U.S. money market funds have reduced the maturity of their holdings in banks in Europe’s “core” (France, Germany, the United Kingdom, and other countries). According to JP Morgan Securities, 60 percent of U.S. prime money market funds’ holdings in French banks as of the end of August will mature in 30 days or less, compared to 28 percent of their holdings at the end of June. Shorter maturities provide flexibility and reduce the impact of any potential downgrades.

According to Crane Data, at the end of July, 69 percent of money market funds’ holdings in German banks and 67 percent of holdings in British banks were set to mature in 30 days or less.

So, MMMFs are shortening the maturity structure of their lending to European banks (and raising rates). This makes European banks more susceptible to a "rollover freeze"--an event where short-term financing collapses altogether. This is the "Lehman event" that policymakers worry about for Europe.

The policy response to date has been for the Fed to re-activate its swap line with the ECB. If you go to some websites and blogs, they might describe this operation as the Fed "creating money and pumping it into Europe." One could equally well describe it as the ECB "printing up Euros and pumping them into the US." That is, at its most basic level, the two central banks are simply exchanging "green money" for "blue money." This is the nature of a swap (for those who are prone to confusing the word "swap" with "gift").

I should like to point out a fact that is seldom emphasized. The dollars that the Fed lends to the ECB through the swap line are fully collateralized (and hedged against currency risk). The ECB gives the Fed Euros in exchange for USD; the operation is then reversed a short time later (and the Fed generally earns a small return for its service). The ECB then takes these dollars and lends them those European banks "in need" of short-term USD financing--including those European banks operating on US soil, making loans to US businesses. (Essentially, the ECB is subsidizing European banks--and it is the ECB that bears the risk, not the Fed.)

Is this policy response by the Fed and the ECB justified? That's a tough one. As usual, one can make arguments pro and con.

On the pro side, one might note that US MMMFs have become somewhat skittish since the 2008 financial crisis. (You might remember an MMMF "breaking the buck" on Lehman's IOUs; see here.) They are now
very sensitive to adverse publicity about the firms they lend to (that is, invest in). And now, it is evidently the case that banks with foreign names, even if located on US soil, might "sound" risky.

From a purely economic standpoint, this credit contraction seems a little hard to understand (but then again, who are we to argue with how creditors want to bet their money?) It is my understanding, for example, that the short-term loans issued by U.S-based branches of European banks to American companies are fully collateralized (by American capital). If this is true, and if American industry is showing no signs imminent distress, then why should a potential haircut on PIIGS debt (borne by European banks) have the American MMMF industry sufficiently worried to pull their financing (of American industry) on such a dramatic scale? Are these fears overblown? And might such overblown fears increase the likelihood of a Lehman-style event for European banks?

On the con side, we have the usual arguments for why policymakers should just let the market get down to business and resolve any outstanding credit issues. Claims of imminent contagion are made largely to justify transfers of wealth (bailouts). Moreover, there is a possibility that policy interventions, like the Fed-ECB swap line, simply delay the inevitable debt restructuring that is presently necessary.

An interview with Bob Lucas

2011-09-26T07:51:00.000-07:00

An interesting interview with Robert E. Lucas, Jr. by Holman Jenkins (WSJ) here: Chicago Economics on Trial.

Let's face it, the "Chicago School" of economics—the one with all the Nobel Prizes, the one associated with Milton Friedman, the one known for its trust of markets and skepticism about government—has taken a drubbing in certain quarters since the subprime crisis.

Sure, the critique depends on misinterpreting what the word "efficient" means, as in the "efficient markets hypothesis." Never mind. The Chicago school ought to be roaring back today on another of its great contributions, "rational expectations," which does so much to illuminate why government policy is failing to stimulate the economy back to life.

Robert E. Lucas Jr., 74, didn't invent the idea or coin the term, but he did more than anyone to explore its ramifications for our model of the economy. Rational expectations is the idea that people look ahead and use their smarts to try to anticipate conditions in the future.

Duh, you say? When Mr. Lucas finally won the Nobel Prize in 1995, it was the economics profession that said duh. By then, nobody figured more prominently on the short list for the profession's ultimate honor. As Harvard economist Greg Mankiw later put it in the New York Times, "In academic circles, the most influential macroeconomist of the last quarter of the 20th century was Robert Lucas, of the University of Chicago."

Mr. Lucas is visiting NYU for a few days in early September to teach a mini-course, so I dash over to pick his brain. He obligingly tilts his computer screen toward me. Two things are on his mind and they're connected. One is the failure of the European and Japanese economies, after their brisk growth in the early postwar years, to catch up with the U.S. in per capita gross domestic product. The GDP gap, which once seemed destined to close, mysteriously stopped narrowing after about 1970.

The other issue on his mind is our own stumbling recovery from the 2008 recession.

For the best explanation of what happened in Europe and Japan, he points to research by fellow Nobelist Ed Prescott. In Europe, governments typically commandeer 50% of GDP. The burden to pay for all this largess falls on workers in the form of high marginal tax rates, and in particular on married women who might otherwise think of going to work as second earners in their households. "The welfare state is so expensive, it just breaks the link between work effort and what you get out of it, your living standard," says Mr. Lucas. "And it's really hurting them."

Enlarge Image

Terry Shoffner

Turning to the U.S., he says, "A healthy economy that falls into recession has higher than average growth for a while and gets back to the old trend line. We haven't done that. I have plenty of suspicions but little evidence. I think people are concerned about high tax rates, about trying to stick business corporations with the failure of ObamaCare, which is going to emerge, the fact that it's not going to add up. But none of this has happened yet. You can't look at evidence. The taxes haven't really been raised yet."

By now, the Krugmanites are having aneurysms. Our stunted recovery, they insist, is due to government's failure to borrow and spend enough to soak up idle capacity as households and businesses "deleverage." In a Keynesian world, when government gooses demand with a burst of deficit spending, the stick figures are supposed to get busy. Businesses are supposed to hire more and invest more. Consumers are supposed to consume more.

But what if the stick figures don't respond as the model prescribes? What if businesses react to what they see as a temporary and artificial burst in demand by working their existing workers and equipment harder—or by raising prices? What if businesses and consumers respond to a public-sector borrowing binge by becoming fearful about the financial stability of government itself? What if they run out and join the tea party—the tea party being a real-world manifestation of consumers and employers not behaving in the presence of stimulus the way the Keynesian model says they should?

Mr. Lucas and colleagues in the early 1960s were not trying to undermine the conventional prescriptions when they began to think about how the public might respond—possibly in inconvenient ways—to signals about government intentions. As he recalls it, they were just trying to make the models work. "You have somebody making a decision between the present and the future. You get a college degree and it's going to pay off in higher earnings later. You make an investment and it's going to pay off later. Ok, you can't do that without this guy taking a position on what kind of future he's going to be living in."

'If you're going to write down a mathematical model, you have to address that issue. Where are you supposed to get these expectations? If you just make them up, then you can get any result you want."

The solution, which seems obvious, is to assume that people use the information at hand to judge how tomorrow might be similar or different from today. But let's be precise, not falling into the gap between "word processor people" and "spreadsheet people," as Mr. Lucas puts it. Nothing is assumed: Data are interrogated to see how changes in tax rates and other variables actually influence decisions to work, save and invest.

Mr. Lucas is quick to credit the late John Muth, who would later become a colleague for a while at Carnegie Mellon, with inventing "rational expectations." He also cites Milton Friedman, with whom Mr. Lucas took a first-year graduate course.

"He was just an incredibly inspiring teacher. He really was a life-changing experience." Friedman, he recalls, was a skeptic of the Phillips curve—the Keynesian idea that when businesses see prices rising, they assume demand for their products is rising and hire more workers—even if the real reason for higher prices is inflation.

"Milton brought this [Phillips curve] up in class and said it's gotta be wrong. But he wasn't clear on why he thought it was wrong." In his paper for Friedman's class, Mr. Lucas remembers reaching for a very rudimentary notion of expectations to try to explain why the curve could not operate as predicted.

Growing up in the Seattle area, Mr. Lucas recalls a road trip he took as a youngster that terminated in Chicago, a city with two baseball teams! Chicago, in his mind, became "the big city," a gateway to a wider world. That, and a scholarship, is how he would end up spending most of his career at the University of Chicago.

We are sitting in an inauspicious guest office at NYU. A late summer sprinkle dampens the city. Mr. Lucas describes his parents as intelligent, reading people, neither of whom finished college—he suspects the Great Depression had something to do with it. "They got into left-wing politics in the '30s, not really to do anything about it, but to talk about. That was our background—me and my siblings—relative to our neighbors and relatives, who were all Republicans." In a community not noted for its diversity, his parents were especially committed to civil rights, his mother giving talks on the subject.

I ask about a report that he voted for Barack Obama in 2008, supposedly only the second time he had voted for a Democrat for president. "Yeah, I did. My parents are dead for a long time, but my sister says, 'You have to vote for Obama, for what it would have meant for Mom and Dad.' I felt that too. It's a huge thing. This [history of racism] has been the worst blot on this country. All of a sudden this charming, intelligent guy just blows it away. It was great."

Commodity money: It's back! (and it sucks)

2011-09-23T07:45:00.000-07:00

You may recall hearing that earlier this year, J.P. Morgan began to accept gold as collateral for some types of loans. The story can be found here. Here is an excerpt:

Gold hasn't reinvented itself as a currency yet. But it is getting closer.

J.P. Morgan Chase & Co. said it will allow clients to use the metal as collateral in some transactions. For example, a hedge fund wanting to borrow money for a short period can put up gold as collateral and use the borrowings to invest elsewhere, betting on making a better return. Typically, banks accept only Treasury bonds and stocks in such agreements.

By making the announcement, J.P. Morgan is effectively saying gold is as rock solid an investment as triple-A rated Treasuries, adding to a movement that places gold at the top tier of asset classes. It also is trying to capitalize on all the gold now owned by hedge funds and private investors that is sitting idle in warehouses.

O.K., so gold is not quite "money" (in the sense that it circulates widely as a medium of exchange). That is, if gold was money, one would not need to use it a collateral for a money loan, right? (You could use the gold to buy the stuff you wanted directly.)

But the use of gold as collateral in short-term lending arrangements nevertheless has the effect of increasing the liquidity of gold.

It is interesting too, to observe that the practice appears to be extending to other commodities, including copper and soybeans. Where is this happening? Apparently, in China; see China's copper collateral -- and covert credit and China and the magic financing (soy) beanstalk.

Evidently, the use of commodities as collateral constitutes an attempt by the private sector to get around China's highly regulated credit market. It is China's "shadow banking" system. Short term financing (at low rates) supported by "high-grade" collateral (like the private-label AAA MBS securities used as collateral in the U.S. repo market prior to 2008).

The problem, of course, is what happens to the shadow-banking sector when the value of the collateral plummets. (In case you haven't been paying attention, gold and copper prices have recently declined rather dramatically.) What happens is that creditors no longer want to roll over their short-term financing--they want their money back (and hey, you can keep the copper). Debtors, in a desperate attempt to acquire the cash to repay their loan, begin to dump copper on the market--the effect of which is to make matters worse.

And this is what is happening now; see: China Copper Prices Drop as More Bonded Copper Reaches Domestic Market.

I think that this experience gives us some hint as to why commodity money systems are not the panacea that some like to make them out to be. Sometimes, it even appears that the private sector prefers government money. Look, for example, at the way private-label MBS products were driven out of the U.S. repo market by U.S. treasuries in the recent financial crisis. It's a tricky business, trying to figure all this out. See also this discussion by Steve Williamson: Commodities and Money.

Interest rates and slumps: competing views

2011-09-22T11:34:00.000-07:00

As Paul Krugman notes here, the nominal interest rates on U.S. Treasuries are at historic lows. He seems to take this as vindication for his view that more government "stimulus" was/is needed. (I take "stimulus" here to mean deficit-financed government purchases of goods and services.) Well, let's think about it.

First of all, I think that Krugman (along with many others) deserve credit for recognizing that money-bond swaps (Fed policy) are largely irrelevant in very depressed environments. He (again many others too) also deserve credit for understanding the special "safe haven" role that U.S. Treasury debt plays in today's world economy. But does understanding all this necessarily lead to the conclusion that what the economy needs is more (it never seems to be enough) government "stimulus?"

Some of our economic theories suggest that the answer is yes, while some suggest no. What Krugman is suggesting is that the latter group of theories should be discarded because their predictions on nominal interest rates have been completely wrong. He is getting a little ahead of himself here.

Unfortunately for Krugman, there are theories out there that generate predictions broadly consistent with the data but which do not lead to the same policy conclusion. One such theory is the "new monetarist" model I published for the Bank of Japan (during my visit there in 2002): Monetary Implications of the Hayashi-Prescott Hypothesis for Japan. (See also here.)

The basic story is this. First, it is conceivable that "real" factors are contributing to a "growth slowdown." Here, one is free to pick your favorite bogeyman. Maybe it's becoming more difficult to expand the technological frontier (see, for example, Tyler Cowen). Maybe it's the fear that people (via their political representatives) will become more interested in appropriating wealth, rather than creating it (see, for example, The Grabbing Hand). Whatever the case may be, the upshot is that people--investors, in particular--are rationally pessimistic (over the future after-tax return to their investment activities today).

In the model I used in my BoJ paper (an overlapping generations model), rational pessimism generates a "flight to quality"--people begin to substitute government money/debt for private assets. The effect is deflationary (driven by the increase in real money demand). The economy looks like it is suffering from "deficient demand" (it is not). There is downward pressure on the real interest rate (as the demand for investment contracts). These are not crazy predictions.

In my model economy, the central bank has control over the real interest rate, and cuts in the interest rate stimulate investment and (future) GDP. When the nominal interest rate hits zero, the central bank can no longer influence the real interest rate via money-bond swaps (i.e., there is a "liquidity trap"). Real activity may be stimulated, however, by increasing the inflation target (the operation must be undertaken by the fiscal authority in my model; the monetary authority is powerless in a liquidity trap). It might also be possible for increases in G to expand GDP (as is the case in many neoclassical models). All of this is true. And yet, it does not follow that any of these "stimulus" programs are necessarily desirable (among other things, it depends on what social welfare function one adopts).

Now, I'm not absolutely sure about the empirical relevance of my little model. This is because I can think of another theory that generate predictions that are observationally equivalent to my model, and yet delivers very different policy prescriptions.

The model is the one evidently used by Krugman, DeLong, and others (Nick Rowe?). In a nutshell, recessions are caused by an increase in money (treasury) demand. That's just like in my model. But there is a big difference. In their view (as far as I can tell), the pessimism that drives up the demand for money is attributable to "irrational" fear. And if the private sector is afraid of spending, maybe the government sector should step in and take its place.

But perhaps this is not entirely fair. There is, in fact, a literature that explains how expectations can become self-fulfilling prophesies. I could, for example, modify my model to incorporate a form of increasing returns to scale in the economy's production technology. This could generate what economists call "multiple equilibria." Each equilibrium is determined by expectations. If people are optimistic, good things occur. If people are pessimistic, bad things occur. The pessimistic expectations are "rational" at the individual level, but not at the social level. There is potentially a role for policy here.

Krugman, DeLong and Rowe do not frame things in quite this way, so I'm not sure if this is what they are talking about. But Roger Farmer has been working in this area for a long time and I think his ideas are finally starting to gain some traction; see The Fear Factor.

Anyway, my basic point here is, as always, that we need to be more circumspect in our claims about what we know for sure. Beware of economists that make claims like this.

Fractional reserve banking

2011-09-19T09:38:00.000-07:00

Fractional reserve banking is sometimes portrayed as a sort of scam; a method by which rich bankers underhandedly sap the wealth of society. This short video here, How Fractional Reserve Banking Increases Inflation and Steals our Wealth, is fairly representative of a view I hear expressed quite often.

As you might have guessed, I think that this view is somewhat distorted and misleading. Let me explain why I feel this way.

The video starts off with an hypothetical depositor who starts off with $1000 and asks what happens when it is deposited. Right away we are off to a poor start.

Does he mean starting off with $1000 of cash? Or does he mean $1000 of money (say, in the form of a paycheck)? It makes a difference. When was the last time you made a cash deposit? If you are like me, you cannot remember when. Of course, money gets "deposited" all the time in your account. At work, for example, you might be paid by check or by direct deposit. But this is not what the guy means by "making a deposit"--these "deposits" are simply debit and credit operations in a linked system of accounts (your paycheck is credited to your account, and is debited from your company's account). What the guy means by a "deposit" is a cash deposit. The main source of cash deposits in all likelihood originates from the cash registers of retail businesses.

Alright then, evidently there is cash in circulation. These days, cash primarily takes the form of small denomination paper notes issued by a central bank, like the Fed (in the past, cash frequently took the form of specie--gold and silver coin). There is a demand for cash. Cash is useful for purchasing some types of goods and services when no other means of payment is available. (Cash is also used when transactors wish to keep their exchanges anonymous). And so people occasionally visit ATMs to make cash withdrawals. This cash ultimately finds its way in the cash registers of businesses (however, it is estimated that a lot circulates in the underground economy and, in the case of the U.S., outside of the country).

O.K., so where does banking fit in all this? Maybe your ideal view of a bank is simply as a place to keep your cash safe, kind of like your piggy bank. You deposit your cash with the bank, and the bank issues you a receipt, which constitutes a record of your cash deposit and represents a claim for cash (deliverable by the bank). Or the bank may simply record your deposit as a book entry item. Either way, your cash deposit constitutes a liability for the bank. These liabilities are sometimes called "bank-money" because, well, because they can be used as money. Receipts (especially if they are made payable to the bearer) can potentially circulate as money. Similarly, checks can be written ordering the transfer of cash sitting at the bank from one account to another. If the value of liabilities issued by the bank do not exceed the amount of cash it holds as assets, then we call this 100% reserve banking. (The liabilities issued by the bank are backed 100% by cash.)

Of course, banks do not just keep your cash safe and perform debit/credit transactions for you. They also make money loans. And here is where the confusion generally begins. It starts with the idea that the bank might have the temerity to lend YOUR cash out to someone else--at interest, to boot!

Well, that's not quite what happens. Let try me explain (well, to the best of my understanding, of course).

Suppose you want to start a restaurant business. You own the property and building, but nothing else (apart from your human capital). The building needs to be made into a restaurant. You need ovens, utensils, rooms to be made and finished, furniture, staff, advertising, accountants, lawyers, etc. How do you pay for all this stuff? You clearly have wealth (physical and human capital). You just don't have any cash.

But what do you need cash for anyway? Why not pay for all this stuff using your wealth? One way to do this, in principle at least, is to issue receipts representing shares in your wealth. These shares are liabilities against your wealth. Each share represents an IOU against the future income stream generated by your capital. (The IOUs could take a variety of forms. They could, for example, be made into coupons redeemable for food from your restaurant--something very similar to Canadian Tire Money).

Um, one problem. If you're like me, not very many people know who you are. A randomly selected member of society is unlikely to recognize us, or have any idea what we really own, or have any idea how well we might live up to the promises (IOUs) we issue. Basically, most of us are anonymous (except for within a relatively small network of friends and business relations--and even then, we keep a lot of information private). Anonymity renders our capital illiquid (it is not easily or widely accepted as a means of payment).

O.K., so scratch the idea of creating your own money. This is where a bank now comes in. Let's imagine that the bank reviews your business proposal and concludes that it is likely to be profitable. The bank also thinks that your capital is of high quality and that your ownership title is clear (btw, you are now no longer anonymous to the bank). Now, you might think that the bank is then going to lend you the cash you need to finance your operations. Well, you would be wrong (sort of). That is, you do not need cash--what you want is bank-money. And that's what you typically get from the bank: a money loan in the form of bank liabilities (not cash).

Now, the commentator in that video claims that this bank-money is created out of thin air. That is both correct and completely irrelevant; see my earlier post here. The bank-money (whether in the form of paper notes or book-entry objects) are backed by the assets you put up as collateral for your loan. As long as the loans officer makes good decisions about which business ventures to lend money to, the bank-money created by the bank is fully backed (and consequently, not inflationary; i.e., the new money issue is not dilutive). What the bank has in effect done here is transform your illiquid capital into a liquid liability. This is hardly an activity that one might reasonably label as being inherently "evil."

But this is not quite the end of the story. I have just made the claim that banks issue fully-backed liabilities that serve as money instruments. If this is true, then what do people mean by fractional reserve banking? Let me explain.

In practice, banks issue a very peculiar type of liability, called a demand-deposit liability. In the lingo of financial wonks, these are liabilities that have embedded within them a contractual stipulation known as an American put option. This option gives the debt holder (the depositor) the right to exercise a redemption option on demand at a fixed price. The redemption option in this case consists of the right to redeem bank-money for cash on demand (and usually at par, but frequently subject to a service charge). This is what happens every time you make a withdrawal of cash from your bank or an ATM.

Why do banks do this? Isn't is a recipe for potential trouble?

I don't know why banks do this. In many jurisdictions, it may constitute a legal restriction (as part of the bank charter). I'm not sure if the restriction is binding, however. That is, it is my understanding that banks used to do this even when they were not legally required to do so. Evidently, the redemption option is valued by those who make use of bank-money.

I am aware of only two (not necessarily mutually exclusive) explanations for this contractual stipulation. One is that consumers value insurance against "liquidity shocks" (events were only cash is accepted). The other is that the redemption option serves as sort of a discipline device for bank managers (see Calomaris and Kahn, AER 1991). That is, the put option makes the bank's liability a very short-term debt instrument, so that depositors can potentially pull out very quickly if they sense any hanky-panky. The threat of mass redemptions (and the bankruptcy it would entail) is presumably enough to dissuade self-interested bankers from absconding with depositor wealth.

Sounds wonderful except that, of course, only a very small fraction of a bank's assets are typically in the form of cash. Most of the bank's assets are tied up in "long-term illiquid" assets, like your house, or your human capital. Consequently, while the bank's liabilities may be fully backed, only a small part of this backing is in the form of cash. This is the true nature of fractional reserve banking.

The potential trouble, of course, comes to play when a bank (or worse, the banking system as a whole) is subject to a wave of mass redemptions. There is simply not enough cash in the banking system to honor all of its short-term debt obligations simultaneously. (This is not fraud or deceit; it is something that everyone is--or should be--plainly aware of.) In this event, banks are compelled to sell off their assets to raise the cash they need. This is not something that all banks can all accomplish simultaneously; at least, not without depressing asset values and creating a deflation (the fall in the price-level reflects an increase in the demand for, hence value of, cash relative to goods and services).

There are basically two (possibly more, as readers have suggested below) ways to eliminate retail-level banking panics (waves of mass redemptions). Neither are without cost. One way is to adopt some sort of national deposit insurance system. This is the system that presently exists in the United States (FDIC plus the Fed discount window). People criticize this system because it allegedly promotes moral hazard (banks are induced to take on excessively risky investments). On the other hand, the U.S. has not experienced a retail-level bank run since the Great Depression.

The other way to eliminate retail-level banking panics is to pass legislation requiring all banks to hold 100% cash reserves. This would, of course, kill the business that transforms your illiquid assets into a liquid payment instruments. But it would not necessarily kill the prospect of bank-run-like phenomena. This is because bank-run-like phenomena can emerge even without fractional reserve banking. The phenomenon is possible whenever short-term debt is used to financed long-term (illiquid) asset purchases, as is the case in the wholesale-level banking sector (the so-called "shadow banking" sector).

The use of short-term debt to finance long-term asset purchases (think of the overnight repo market) is, again, a very peculiar financing structure. Like the demand deposit liability, the structure is likely explained by the need to align incentives. While this structure may enhance efficiency along some dimension, it comes at a cost. The analog to a bank run here is a "roll over freeze." This is an event where creditors (depositors) refuse to rollover their short-term funding en masse. In this event, debtors must now scramble to raise funds or dispose of their assets (at "firesale" prices).

If this sounds familiar, it should: it is exactly what happened in our most recent financial crisis. It is also what policymakers currently fear might happen to European banks (who have borrowed USD short-term, to finance longer-term asset purchases; see here).

This just in from Father Paul's pulpit

2011-09-18T13:24:00.000-07:00

The slump in the United States and other advanced economies is the result of a failure of demand -- period, end of story. All attempts to claim that it is somehow structural, or maybe the result of reduced incentives to produce, have collapsed at first contact with the evidence. (link)

You've got to hand it to the man. He has the self-confidence of a Jesuit preacher who believes--really, truly believes in hell--and who fervently wants to share his revelation with us, the poor deprived masses. (Btw, doesn't a "failure of demand" also imply reduced incentives to produce?) I wonder what sort of reply he is expecting from this incredible statement?

Oh, I know, how about....Amen?

P.S. Forgive me Father Paul, for I have sinned. (I have committed the thought-crime of contemplating the possibility that this might not be the "end of the story"...am so ashamed; please prescribe penance.)

Update: This just in (thanks to the Arthurian). Guess he does have a sense of humor!

What Scott Sumner Knows for Certain

2011-09-16T10:33:00.000-07:00

Love TheMoneyIllusion. But does Scott go a little too far with this proclamation?

Here’s what we know for certain about the US business cycle:

1. If nominal wages are highly sticky, then NGDP slowdowns will raise unemployment.

2. Nominal wages are highly sticky for at least some workers.

3. The period after mid-2008 saw the largest NGDP growth collapse since the Great Depression.

4. The period after mid-2008 saw a huge rise in unemployment.

Points 3 and 4 are empirical statements (and they are true).

Point two sounds like an empirical statement too, but it is not really. The reason is that there are many different theoretical (and empirical) notions of what exactly constitutes a "sticky" nominal wage. Most people have in mind the idea that nominal wage rates do not appear to adjust quickly to changing economic circumstances. But ideally, the concept should be defined more precisely than this (preferably within the context of an explicit economic model). At the very least, we could then be absolutely certain that we were talking about the same thing!

(The other thing I should like to point out here is that people often ignore the huge monthly gross flows of workers into and out of employment. The wages of these workers likely display much more flexibility than those workers employed for some time at a given establishment. I discuss turnover issues here.)

The first point is clearly a theoretical proposition: if X, then Y. As a theoretical proposition, it is likely to remain valid only under a set of specific conditions. Unfortunately, Scott does not provide us with the model he has in mind. And to make matters worse, he seems to want to make us believe that, whatever this model is, it "for certain" applies to the U.S. economy. (Most of what I am complaining about is probably the by-product of loose blogger language, but I think it's important for some things to be more precise.)

Now, I can certainly think of a model that might deliver something resembling the proposition in question. Think of a neoclassical labor market model, where money is somehow necessary, and were nominal price adjustment (or formulating contingent contracts) is costly. Then think of an exogenous decline in the price level (who knows what might have been responsible for that). The implication is that the real wage rises and that this reduces the demand for labor (though why this translates into an increase in unemployment, and not an increase in non-participation, is not usually discussed).

As I have argued elsewhere (The Sticky Price Hypothesis: A Critique), Marshall's scissors (static supply and demand curves) are probably not the best tool we have available to interpret the labor market. The labor market is a a market in relationships, much like the marriage market. The spot wage is irrelevant in enduring relationships; what matters is the time-path of wages and the division of the joint surplus. There are many different wage paths that cost the firm the same in net present value terms. A "sticky" wage (whether real or nominal) need not have any allocative consequences.

I therefore confess that I, for one, do not know "for certain" that if nominal wages are sticky, then NGDP slowdowns will raise unemployment.

It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so. Mark Twain

What makes a central bank special?

2011-09-13T11:30:00.000-07:00

Nick Rowe over at WCI has an interesting post asking what makes a central bank special; see Currency, Interest, and Redeemability.

According to Nick, what makes a central bank special is not that it can borrow and lend, create money, and set interest rates. All of us can do these things in principle; and in practice, many large private financial institutions do do these things. The difference, as Nick explains, is what he calls "asymmetric redeemability." The Bank of Montreal, for example, issues money redeemable in BoC liabilities; but the reverse is not true.

I think that's right; but let me expand with a few related thoughts of my own.

If one looks at history, a recurring property of monetary economies is the emergence of a "base money" that serves as the redemption object for "broad money" objects. Frequently, the broad money is made redeemable, on demand, and at par, with the base money. (We might even call base money "central" money, as it serves as the focal point for all other monies.)

In modern economies, the demandable liabilities created by chartered banks (M1, say) constitute broad money made redeemable, on demand, and at par, with government cash (small denomination paper). In the antebellum US, private banknotes were made redeemable on demand at par for specie (gold and silver coin). And so on throughout much of recent monetary history.

Now, there are a lot of interesting questions that arise here that are not the main focus of my post here. For example, why do banks embed their liabilities with what amounts to be an American put option (liabilities made redeemable on demand at a fixed strike price)? Is it the byproduct of a legal restriction, or is it an equilibrium phenomenon?

Either way, it seems obvious that the agency in control of the supply of base money (the object of redemption) is going to be in a position to implement "monetary policy." Whether this is a good or bad thing is the subject of much debate of course (let's not get into that here). And so, I have to agree with Nick's conclusion:

There is something very seriously wrong with any approach to monetary theory which says we can assume central banks set interest rates and ignore currency. It is precisely those irredeemable monetary liabilities of the central bank (whether they take the physical form of paper, coin, electrons, does not matter) that give central banks their special power.

(He is, however, not quite right about private agencies not being able to issue irredeemable objects and get them to be used them as money; see Bitcoin).

Scott Sumner, who runs a very nice blog himself, has an interesting take on Nick's post; see: The Bank of Canada is Important Precisely Because it is not a Bank. Here is Scott:

Now let’s consider a different monetary system. Imagine a gold standard and a monopoly producer of gold. The gold mine company would reduce short term interest rates by increasing the supply of gold. Like currency, gold is irredeemable. But no one would call this gold mining company a “bank” because it possesses no bank-like qualities. Banks don’t create irredeemable assets, gold mines do.

Scott is trying to tell us that a central bank is not a bank; it is the monopoly supplier of base money. He also says that "banking has nothing to do with monetary policy."

I find it difficult to evaluate this view because he does not define "bank" or "monetary policy" here (although I'm sure he does elsewhere). Permit me once again to give my 2 cents worth.

A financial intermediary is an asset transformer. An insurance company, for example, takes "deposits" (premiums), purchases assets, and creates a set of state-contingent liabilities backed by these assets. A pension fund, as another example, takes "deposits" (contributions), purchases assets, and creates a set of time-contingent liabilities backed by these assets. A bank, finally, takes "deposits", purchases (or finances) assets, and creates a set of demandable liabilities backed by these assets.

So a bank is a special kind of intermediary. It is special because the demandable liabilities created by banks are used widely as payment instruments; i.e., money (and the demandable property of these liabilities probably goes a long way to enhancing their acceptability as money, but that's another story).

When a bank accepts your land as collateral for a money loan, it performs an asset swap. It is transforming your illiquid land into a liquid asset (the liability created by the bank). Banks are in the business of transforming illiquid assets into liquid assets. This leads us to ask what the Fed is doing when it purchases (say) MBS or UST assets? In my view it is transforming (relatively) illiquid assets into a very liquid asset (Fed cash). QE is banking; and it falls under the category of monetary policy, in my books at least.

So in some sense, all banks (private and public) are engaged in a form of "monetary policy." But it still remains true that a central bank with legislated monopoly control over the economy's base money object is "special" precisely for this reason. And any theoretical framework that is to have any hope of ever understanding the role of money and banking in society is going to have to model these objects explicitly; the way this guy does, for example.

Paul Samuelson on Social Security

2011-09-12T13:31:00.000-07:00

Great quote here, via Greg Mankiw's blog, by Paul Samuelson on social security:

Social Security is squarely based on what has been called the eighth wonder of the world--compound interest. A growing nation is the greatest Ponzi game ever contrived.

To the right is a cartoon, via Lones Smith, that is just too funny (and sad) for words.

Burtless: It's not regulatory and tax uncertainty

2011-09-05T09:41:00.000-07:00

Gary Burtless, an economist at the Brookings Institution, seems pretty sure that the relatively depressed levels of U.S. business investment and employment have nothing to do with the alleged uncertainty over future tax and regulatory regimes. Mark Thoma reports the story here.

The main thrust of the argument is contained in the following paragraph:

Then why was uncertainty about taxes and the future burden of the Affordable Care Act holding back business investment right now? If managers thought taxes or regulatory costs might go up in the future, wouldn't it make sense to take advantage of today's low taxes and lower burdens to invest and hire today? According to the "uncertainty" argument, businesses are fearful they might face high taxes and extra health cost in 2016 and 2018. Shouldn't they expand hiring right now and scale back employment when they actually face higher costs (if they ever do)?

Burtless raises some good questions here, but I don't think they are the nail-in-the-coffin he makes them out to be. Why not more investment now, if taxes might go up in 2016 or 2018?

First of all, I'm not sure that those are the only dates businesses have to consider (governments can raise taxes anytime). Second, many large capital projects take a lot more than just a few years to complete. Think about the act of committing a large amount of capital (belonging to you, your friends, your creditors, your shareholders) destined to payoff (if at all) sometime in the distant future. Once committed, this capital is almost completely irreversible and--significantly--it is easily appropriated, since capital cannot run away once it is built). Is it completely crazy to imagine that those contemplating such investments in the current economic climate might want to worry (among other things) the possibility of future changes in tax regime?

Well, maybe my argument does not work so well for employment. As Burtless suggests, why not hire people now and then lay them off if and when taxes rise? One response to this is: How does he know for sure that the future regulatory climate will allow firms to lay off people in this easy manner? If the U.S. is moving to a more European-style economic model (and I'm not saying here whether this is good or bad), then firms may at some point in the future face large penalties for letting workers go.

So what is the problem, according to Mr. Burtless. Predictably, it is this:

The odd thing is, when businesses are asked why they're not expanding, "high taxes" and "heavy regulatory burdens" and "tax uncertainty" don't feature as prominent answers. They mostly say they don't see good prospects for extra sales. But right-wing economists have their talking point, even if they make little sense, and they're sticking to them.

Ah yes, those evil right-wing economists (one can see the halo hovering over his head as he says this).

I've tackled the issue of how firms reply to these business surveys here: Deficient Demand: The Deflated Balloon Hypothesis. Basically the idea is as follows. Consider any shock that leads to a contraction in one sector of the economy. Imagine that sectors are characterized by an interlinking network of demands for intermediate goods and services. A collapse in residential construction can now be expected to reverberate throughout the economy. A decline in the demand for housing also leads to a decline in the demand for all the products that go into making houses. It would not be surprising for someone in the business of producing (say roof shingles) to report that his or her main problem appears to be a "lack of demand" for their product. But that by itself does not constitute evidence that the macroeconomic problem is a "lack of aggregate demand."

Burtless may very well end up being correct in his assessment. I'm just not sure how he knows for sure that what he says is true.

Updates: September 06, 2011

Regime Uncertainty: The Real (Option) Deal, Craig Pirrong
This is a direct rebuttal to Burtless (h/t Prof J)

Other related links:
Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed After the War, Robert Higgs
The Great Recession and Government Failure, Gary Becker (h/t Alex Karaivanov)

Krugman on Gross

2011-08-31T07:57:00.000-07:00

We have to give Bill Gross some credit for admitting his mistaken call on the U.S. Treasury market; see here.

Gross's call was based largely on the fact that the Fed's Treasury purchase program was about to expire. The idea is that with a large component of the demand for Treasury debt removed from the market, bond prices should fall once the program is terminated.

This is what you get when you apply the static Marshallian scissors toward understanding an economic phenomenon. It often works well. But not always. And in any case, we know that forecasting the path of security prices is a tricky business. This is what the efficient markets hypothesis tells us.

Gross's intuition was shared by a few of the macroeconomists I bumped into earlier this year at a macro conference in Konstanz. I remember one of my Fed colleagues and myself suggesting to a sceptical audience that one should not expect any dramatic bond price movement once the Fed's purchases ended, largely because the market had already discounted that event. I don't think we were very successful at persuading people. Well, we turned out to be right about that (maybe we got lucky). [Actually, I did give my view of Gross' predictions here in March 2011].

Subsequently, of course, the price of US Treasuries have risen substantially. We did not make that prediction (nor did we try). But evidently, Paul Krugman seems to think he did; see Who You Gonna Bet On?

Yep. All we need is the Econ 101 macro model to understand this crisis and predict bond prices. (Oh, and gold prices have shot up too...where do those appear in that model?)

Do we really need an IS-LM model to tell us that when two assets with similar risk properties and similar returns are swapped in the Fed's portfolio that nothing much is likely to happen? (And as I explain here, standard monetary models deliver "flight to quality" phenomena quite easily.)

Krugman's article gives the impression that simple IS-LM analysis could have predicted the recent fall in Treasury yields. Do people actually find this credible?

Fiat money in theory and in Somalia

2011-08-29T07:51:00.000-07:00

A classic question in the theory of money is how an intrinsically useless object like fiat money can possess exchange value. The modern theory of money has essentially settled on the answer first provided by Ostroy (1973). In a nutshell, circumstances may dictate that some objects are relative good for record-keeping purposes, quite apart from any other use they may have in consumption, production, or storage; see also, Kocherlakota (1998).

The basic idea is as follows. We know that monetary exchange is not necessary, even in economies where mutually beneficial bilateral barter exchanges do not exist (what economists clumsily call a lack of double coincidence of wants). This is not simply a theoretical statement; we know of (and indeed most of us belong to) small economies (networks of families and friends) that operate according to "gift giving" principles. We are willing to make individual sacrifices without monetary compensation, hoping that they will be noticed, remembered, and most importantly, reciprocated at some point in the future.

Gift-giving societies seem to work well enough in small groups. This is probably because it is relatively easy to keep track of (remember) individual contributions and rewards in small groups. This "societal memory" seems to break down in large groups. Evidently, there are limitations to how much information can be recorded securely in the collective minds of people who make up society. When this is the case, some substitute form of memory could be useful. This is where money comes in.

Imagine that there is an object that is durable, divisible, portable, hard to counterfeit, and in limited supply. A lot of commodities fit this description, including gold, silver, and salt (think of what "salary" means). Historically, privately-issued paper in the form of asset-backed securities (like the banknotes of antebellum America) have also fit this description. In larger economies, objects like these begin to circulate as a means of payment. They become money.

Let me explain the basic idea. In the past, I may have made a contribution to society for "free." Well, not exactly for free; but because I knew that my contribution would be noticed and reciprocated. But as my community grows, it becomes increasingly difficult for people to keep track of each other's contributions. Well, if that's the case, then it might make sense to record my gift in some other manner. Accepting a monetary object is one way to do this. The money in my possession constitutes information about my past contributions to society. In the language of Narayana Kocherlakota (currently president of the Minneapolis Fed), money is memory.

Because commodities (including the physical capital that may back paper money) have uses in consumption and production, an implication of this is that society must bear a cost if such goods are tied up in facilitating exchanges. Their value in exchange generally means that they are priced above their "fundamental" value; that is, they possess a "liquidity premium." (This is related to what Caballero calls an asset shortage.)

Now, here is where fiat money potentially plays a role. According to the theory described above, the role of money is to encode a particular type of information (relating to individual trading histories). But information like a credit history is intrinsically useless (one cannot eat someone's credit history, for example). So rather than tying up intrinsically useful commodities to record intrinsically useless information, why not delegate the job to an intrinsically useless asset instead? Like the U.S. paper dollar, for example. (Electronic book-entry objects can work as well.)

According to this view, the market value of fiat money consists exclusively of a liquidity premium. The asset has no intrinsic value, and yet it has a positive price. Fiat money is a "bubble" asset -- but this is a bubble that plays a useful social role (it economizes on commodities that have uses other than record-keeping).

Prior to Ostroy's work, the answer to the question of how fiat money can possess exchange value was that its value is somehow supported by government decree (the original meaning of the word "fiat"). In particular, the government could introduce paper and insist that taxes be paid in government paper.

A recent paper by William Luther and Lawrence White (Positively Valued Fiat Money after the Sovereign Disappears: The Case of Somalia) casts some doubt on the strength of the mechanism highlighted by this older view.

Evidently, it is the case that the Somali shilling continues to circulate in that country long after the government that issued that paper collapsed in 1991. Here is a quote from the paper:

One of the most astounding phenomena of the domestic market is the continued circulation of the old Somali bank notes. The Somali currency has had no central bank to back it up since the bank was destroyed and looted in 1991. Nonetheless,the currency has maintained value, and has floated against other foreign currencies that are traded freely in local markets.

One reason the shilling continues to maintain its value is no doubt related to the fact that it's supply can be trusted to remain relatively constant over time. In fact, it's supply may be contracting over time as notes wear out (I have heard stories of where old notes are laminated to make them more durable, but am unable to confirm this.) On the other hand, there is some evidence of counterfeiting; e.g.,

Perhaps the most convincing evidence that the Somali shilling held a positive value in the absence of sovereign support, however, is that individuals found it profitable to counterfeit these notes. Mohammed Farah Aideed ordered roughly 165 billion Somali shillings in 1996 from the British American Banknote Company based in Ottawa, Canada. Another 60 billion Somali shillings were imported by Mogadishu businessmen in 2001. In total, an estimated 481 billion in unofficial Somali shilling notes have been printed since 1991.

This counterfeiting phenomenon, however, does not appear to be excessive; and, indeed, it probably plays some positive role in keeping the supply of shillings relatively stable.

A Bad Rap for the Bond Raters?

2011-08-09T11:18:00.000-07:00

Who's going to listen to a company whose name translates to "average and below average"? Jon Stewart.

In my previous post (Wonderland), I asked what sort of evidence justifies making public sport out of the major bond rating agencies and their role in the recent financial crisis. The type of sentiment I question was repeated the other day by Paul Krugman here; I quote:

And S&P, along with its sister rating agencies, played a major role in causing that crisis, by giving AAA ratings to mortgage-backed assets that have since turned into toxic waste.

The first thing we have to ask, of course, is what does a AAA rating actually mean? The only thing most people know is that AAA is the highest rating that agencies attach to bonds. But that's an ordinal statement; it does not necessarily imply "absolutely free of risk." Apart from death and taxes, there are no perfect guarantees in life.

The second thing we have to ask is what sort of risk are the ratings trying to measure. In a nutshell, they measure the risk that the terms of a contract are not fulfilled. They do not measure the liquidity risk associated possession of the asset (the major problem during the financial crisis). Note: by liquidity risk, I mean the ease with with one can dispose of an asset (or use it as collateral in a loan) over a short period of time, without the asset being ridiculously discounted in the market.

Now, there seems to be no question that in the depths of the crisis, a lot of MBS was treated as if it were toxic (it was heavily discounted). But as I said above, bond ratings do not (I do not think) measure liquidity risk. They measure things like, well, did the MBS actually deliver on the interest and principal that was expected?

It surprising how difficult it is to find out just how much of the outstanding MBS actually did end up as toxic waste. Paul Krugman seems to think it was a lot. So do a lot of other people. But where is the data?

I decided to ask Gary Gorton, who knows more than most about these matters. Here is how he replied to me:

Of the notional principal amount of AAA/Aaa subprime bonds issued in the years 2006, 2007 and 2008 (which is almost $2 trillion), the realized principal loss as of Feb 2011 is 17 basis points – almost nothing, but much higher than AAA/Aaa other stuff. Yes, I think the agencies are being treated unfairly by uninformed people. There are many other facts that are similar that are also inconsistent with the popular narrative of the crisis.

If this is true, it is indeed remarkable. The actual losses on these "toxic" products has been tiny. That is the type of risk that was being evaluated. (I might add that the losses on bank deposits during the great financial panics of the U.S. National Banking Era (1863-1913) were reportedly in the order of 50 basis points.)

Evidently, Gary has a PhD student working on this. I look forward to reading her findings (and reporting them here). Of course, if anyone out there has evidence relating to this question, I'd greatly appreciate hearing from you.

Update: August 10, 2011

Thanks to Jesse for this link to Bond Girl, who makes a lot of the same points (and more).

I also received this note from Don Brown (thanks, Don--I will investigate):

I cannot verify current loss=17bp figure, but it doesn't sound surprising to me. HOWEVER, that misses the point. There are significant losses to be taken on 05-07 vintage subprime, due to massive delinquencies. It will be on the order of 12-15% of the original amount of AAA subprime securities that FNMA/FHLMC bought. I encourage you to do your own original research to verify this, but as a quick back-of-the-envelope:

I know that agency portfolios were buying wide-window AAAs off subprime, mostly 06-07 vintage. They bought a lot ($250B if I remember correctly). Note: portfolios were the hedge funds that FN/FH were running, outside of their traditional business as mortgage guarantor.

Average original subordination was 26-30%. So actual losses on subprime would have to be around this level to start showing losses. Currently, actual losses aren't at this level, but it's easy to see that they will increase (barring a miracle).

To date, most subprime deals have taken losses in the 15-20% range (percentage of original balance). They have serious delinquencies 40-60% of current balance (serious dlq defined as 90+ days dlq, FCL, or REO).

15% current losses leave you with 11-15% subordination (on average). Currently, subprime loss severity is around 80% (upon liquidation of the house). For a 50% dlq deal => 50%x80% = 40% additional losses from here (distributed over time). That would imply actual losses of 25-29% on the current face of the class. Average factor for these classes are 0.55. Very roughly, this translates to 12-16% loss on the original investment.

For examples, take a look at OOMLT 07-5 1A1(cusip 68403HAA0) and CWL 06-26 1A (cusip 12668HAA8). One of the agencies owns these classes (almost all subprime deals have a Group1 / Group2 structure. Group1 was conforming balance subprime loans that went to the agencies). You can find the remittance reports at BoNY web site or CTS. They are publically available.

Update: August 14, 2011

Rebel Economist (see comments below) directs me to this interesting link: Is Blaming AAA Investors Wallstreet Serving PR?

Wonderland

2011-08-08T16:45:00.000-07:00

Yep, things just seem to keep getting curiouser and curiouser...

For starters, I seem to find myself agreeing with Paul Krugman here: Credibility, Chutzpah and Debt. Well, except that it may not be as easy as he imagines to implement a sustainable fiscal policy, and I disagree with his laying the entire blame on an "extremist right." But what he says about the major ratings agencies may largely be true. Not that I can tell for sure...I am no expert in rating bonds. I'm not even sure about this claim (that I've heard repeated elsewhere):

And S&P, along with its sister rating agencies, played a major role in causing that crisis, by giving AAA ratings to mortgage-backed assets that have since turned into toxic waste.

I would very much like to know how many AAA rated MBS actually did turn toxic. Does anybody know? (Please send data, or links to estimates.)

I ask this because to some extent, I think that the bond rating agencies sometimes get a raw deal from public perception. It is my understanding (and I reiterate that I'm no expert) that what is being rated is the prospect of default on a set of debt covenants. While it may be true that MBS was treated as "toxic" by market participants (repo) during the crisis, this was more a "liquidity" event (perhaps based on the fear that some MBS were toxic, but not knowing the identity of which). As far as I can tell, bond ratings are not meant to capture liquidity risk. And perhaps most of that MBS continued to generate income. I'm just not sure how much of it did.

In any case, this takes me to the issue of the recent S&P downgrade of "long term" U.S. debt. The S&P statement can be found here.

Gosh, on the surface, the downgrade seems to be crazy. That is, the prospect of a nominal default seems remote; a real default (via surprise inflation) seems much more likely (though, this is not what is being rated). On the other hand, this is what a friend of mine had to say on the matter:

These ratings are educated opinions about how likely it is that holders of US debt will get their money back (including the yield). A AAA rating means it is basically a sure thing. AA- means there are conceivable, albeit not terribly likely, circumstances under which the funds will not materialize. This is not a direct comment on politics or the various reasons this event might happen. There are various reasons, including continued high spending, insufficient tax revenue, too little growth for the economy to pay the required taxes,... These are all lumped together in determining the rating. Of course, political types wish to point to their favorite reason, whether it is Democratic spending or Tea Party opposition to taxes. But don't let this confuse you. The point is simply that there is so much debt -- and it's growing -- that there is now real uncertainty about whether it can/will ever be paid.

What I find most interesting is the market reaction to recent events. First, I guess it's not too surprising to see how the price of gold has behaved recently; it has surged upward.

The "curiouser" part, however, is with respect to how the price of long-term U.S. debt has behaved. Here is a plot the price of Barcley's 20+ year U.S. bond fund.

Whoa! How do we make sense of the joint upward movement in the price of gold and (future) U.S. money; especially as the latter has just been downgraded?

The behavior of U.S. debt over the last few years has really intrigued me. Yes, the U.S. has a huge amount of outstanding debt out there. But you know what? The rest of the world seems to want it. Despite some bluster out there about replacing the USD (and US Treasuries) as the world reserve currency, I just don't see this happening any time soon. I know that a lot of people would like to see this happen. Might want to be careful what we wish for out there!

Ron Paul on Bernanke's Press Conference

2011-04-29T13:28:00.000-07:00

CNBC interview with Congressman Ron Paul yesterday (April 28, 2011); click here.

The interviewer begins by quoting a statement Paul made after Bernanke's news conference:

Bernanke continues to ignore his culpability for the inflation all Americans suffer due to the Fed's relentless monetary expansion.

Let's take a look at U.S. inflation since 2008. Here it is.

The average annualized rate of inflation over this time period is a dizzying 1.6%. Note the significant deflation experienced during the economic crisis. Ah, good times. The rate of return on your money was really high back then! I can recall clearly how savers were rejoicing...praising the Fed for the deflation.

PCE inflation measures the nominal price of a basket of consumer goods. You know, the stuff people buy to maintain their material living standards. This price index was actually falling in 2010. For better or worse, the Fed interprets "price stability" as 2% inflation. This explains QE2.

PCE inflation has recently jumped up to near 5%. This jump is attributable primarily to food and energy prices. Despite what some people like to believe, the Fed does not control food and energy prices (at least, not separately from other prices). Most economists attribute these relative price changes to geopolitical events and other temporary global shocks affecting the world supply and demand for food and energy.

It seems that what Congressman Paul means by inflation (judging by this interview) is "commodity price inflation." I think he must have in mind the price of commodities like gold. Why is the price of gold rising? Because people are dumping the USD and flocking to a "currency" they can trust.

Well, alright. There is probably something to this notion of currency substitution. If the Fed grows the money supply, its value must fall. The price of gold must rise. In the interview above, the Congressman claims that even grade schoolers can understand this (suggesting that Bernanke cannot).

Recent money supply and gold price dynamics seem to support Congressman Paul's hypothesis, which he states as some sort of obvious universal truth. But if this is so, then what explains the following data?

The graph above plots the price of gold and the (base) money supply over the 20 year period September 1980 to March 2001. As you can see, the Fed created a lot of money "out of thin air" over this 20 year period. The base money supply increased by over 300%.

Imagine that you are 50 years old in September 1980. Imagine that a trusted friend of yours--oh, let's say your doctor--convinces you to put all your savings into gold. The reason he offers is that the Fed is pursuing a policy of "relentless money expansion." He warns you that the money supply is set to grow by 300% over the next 20 years. So you listen to him.

You buy gold at $673 per ounce. And then you wait. You wait until you turn 70. And then you go to withdraw your savings. You discover that the gold price in March 2001 is $263 per ounce. That's a whopping rate of return of...wait for it... -60% over 20 years. That's a minus sixty percent.

All you kids understand now? Viva la gold standard! Class dismissed.

Krugman and Carney on the Fed

2011-04-29T10:00:00.000-07:00

Here are a couple of interesting interpretations of what's going on in the mind's of Fed officials. The first is by Paul Krugman (via Mark Thoma); see: The Intimidated Fed. The second is by John Carney; see: Why Won't the Fed Do More to Fight Unemployment?

I'm not sure about Krugman's claim about Bernanke being "bullied" by the "inflationistas." I think that John Carney has it just about right here.

Meet the FOMC

2011-04-26T08:29:00.000-07:00

From CNBC News, a nice little snapshot of the people who currently make up the Federal Open Market Committee.

When people think of "the Fed," they might picture a monolithic building in Washington, D.C., or the serenely smiling, bearded face of its chairman, Ben Bernanke.

But the reality is, the group making decisions about raising or cutting rates or pumping money into the economy through so-called quantitative easing is made up of several highly educated, opinionated individuals with sometimes-conflicting ideologies, personalities and policy specialties.

Meet the Federal Open Market Committee.

Time to replace the Core Inflation measure?

2011-04-14T07:54:00.000-07:00

As almost everyone knows, inflation appears to be ticking upward. PCE inflation has recently approached an annual rate of around 5%. However, core inflation--the inflation rate that strips out the food and energy components of the consumption basket--remains relatively subdued (almost 2%, though it too has been rising as of late).

The Fed is widely understood to have an implicit inflation target of 2%. And the Fed has been known in the past for preferring the core PCE inflation measure over actual (headline) inflation numbers. With food and energy prices rising rapidly as of late, the reference to core inflation makes the Fed look out of touch with the prices consumers actually pay for their daily basket (food and energy make up about 25% of the average consumption basket).

What, if anything, justifies looking at price indices that strip out components of the index? A cynical view is that the Fed may prefer core to headline because it evidently makes the Fed's performance look better (in terms of keeping inflation low). This cynical view conveniently ignores the fact that headline inflation is frequently below core.

If you want to educate yourself about the issues surrounding the use of core, I recommend that you read this piece by Jim Bullard: Headline vs. Core Inflation: A Look at Some Issues. He starts as follows...

Monetary policymakers are responsible for maintaining overall price stability, which is usually interpreted as low and stable inflation. In order to decide on appropriate policy actions given their objective, policymakers need to know the current rate of inflation and where it is headed. What makes for a reliable predictor of future inflation has been debated throughout the years and continues to be the subject of economic analyses today.

and concludes with...

In the end, the policymakers' goal is to use the inflation measure that helps them achieve low and stable headline inflation in the long run.

In short, the Fed is not wedded to any particular policy-relevant measure of inflation. Many different measures should likely be used as input into any policy decisions.

In terms of the use of core inflation, my own personal view leans toward dispensing with any inflation measure that strips out components of the consumption basket. If the main object of doing so is to get at some measure of "trend" inflation, then why not just compute a trend directly? For example, here is what one would get by using a simple exponential trend:

My crude measure of trend is not that much different from core. I doubt that there would have been any substantive difference in the way policy was actually conducted if reference had been made to this (or some other) measure of trend over the core measure. And an explicit reference to trend rather than core may have deflected the silly charge made by some that the Fed does not care about food and energy prices.

Ron Paul's Money Illusion (Sequel)

2011-03-23T08:11:00.000-07:00

As I promised to do here, I am posting a sequel to my original column: Ron Paul's Money Illusion. I want to thank everyone who took the time to comment and criticize the views expressed there because it has led to me to sharpen my thinking on the matter. I doubt that what I have to say here will sway opinion one way or the other, but I at least hope that the nature of my criticism will be more clearly understood.

The purpose of my original post was to critique a statement I've heard Fed critics repeat ad nauseam. The statement can be found in Paul's book End the Fed (p. 25):

One only needs to reflect on the dramatic decline in the value of the dollar that has taken place since the Fed was established in 1913. The goods and services you could buy for $1.00 in 1913 now cost nearly $21.00. Another way to look at this is from the perspective of the purchasing power of the dollar itself. It has fallen to less than $0.05 of its 1913 value. We might say that the government and its banking cartel have together stolen $0.95 of every dollar as they have pursued a relentlessly inflationary policy.

I think that the first part of this statement is true, so I do not wish to dispute this fact. On the other hand, I think that one might reasonably ask whether this fact alone should be a source of great consternation (especially in the presence of other, more pressing, policy concerns). As for the final sentence in the quote above, well, I think it is just plain false. Now let me explain why I think all this.
Let me begin with the picture most popular with end-the-fed types--a graph depicting the declining purchasing power of the USD. I use postwar data without loss of generality, since most of US inflation has happened since then.

This picture plots the inverse of the price-level (as measured by the consumer price index). I have normalized the price-level to $1.00 in 1948. It falls to roughly $0.11 in 2010. This corresponds to roughly a nine-fold increase in the price-level or about a 4.6% annual rate of inflation. (Note that the rate of inflation has slowed considerably since 1980).

The picture above is used by some end-the-fed types to great effect in generating anger and fear among some members of the population. Anger via the claim that the Fed has stolen 90% of (the purchasing power) of your money; and fear through the prospect of this purchasing power approaching zero in the not-too-distant future.

Graphs like the one above have their uses. But one should not get too carried away with a single picture. Let me draw you another picture. This one plots the inverse of the U.S. nominal wage rate (total nominal wage income divided by aggregate hours worked).

This graph plots the purchasing power of the USD, where purchasing power is now measured in terms of labor, rather than goods. This graph shows that you need a lot more money today than you did in 1948 to purchase 1 hour of labor. Another way of saying this is that the average nominal wage rate in the U.S. has increased by a factor of 25 since 1948. Is this a cause for alarm?

No. In fact, there is very little one can conclude from these pictures, which are plots of nominal variables. We need more information than this to make any substantive statements about the impact of nominal wage and price dynamics. In the absence of money illusion, people care about real variables--not nominal variables. To put things another way, people eat bread, not money. The nominal price of bread, in of itself, is an uninformative measure. What would be informative is its nominal price in relation to one's nominal income (or wealth). The first graph above has nothing to say about how nominal incomes have evolved.

Let me now combine the two graphs above into one picture, with both series inverted, and with both the price-level and nominal wage rate normalized to $1.00 in 1948 (the actual nominal wage rate was $1.43).

According to this (publicly available) data, the price-level (CPI) has increased by about a factor of 10 since 1948. But the average nominal wage rate has increased by a factor of 25. (There is, of course, considerable disparity in wage rates across members of the population. But I am aware of no study that attributes significant wage or income heterogeneity to monetary policy. Of course, if readers know of any such studies, I would be grateful to have them sent to me.)

The figure above implies that the real wage (the nominal wage divided by the price-level) has increased by a factor of 2.5 since 1948. This is undoubtedly a good thing because it implies that labor (the factor we are all endowed with) can produce/purchase more goods and services. More output means an increase in our material living standards (Though again, I emphasize that this additional output is not shared equally. But surely a laissez-faire world advocated by some is not one that would generate income equality either.)

Now, an interesting question to ask is how the picture above might have been altered if the price-level had instead remained more or less constant. Judging by the emails I receive, many people evidently believe that the nominal wage path depicted above would have largely remained the same (that is, they apparently seen no connection between nominal wages and the price-level).

If this was indeed true, then the average real wage in America would have increased by a factor of 25, instead of 2.5 under a regime of price-level stability. And if you believe this, or something close to it, then the conclusion would indeed be startling: the inflation generated by the Fed has apparently served only to reduce the purchasing power of labor (diverting resources to powerful capitalists). This claim--or some variation of it--is implicit in the quoted passage above.

I suggested, in my original post, that there is reason to believe that under an hypothetical regime of price-level stability, the nominal wage rate in the graph above would instead have ended up increasing only by a factor of 2.5 (more or less)--the factor by which real wages actually rose. This is what I meant by my claim of long-run neutrality of the price-level increase; and it is also what I meant by Ron Paul's Money Illusion (which is subtly different than claiming the superneutrality of money expansion; more on this later).

Some evidence in favor of my "long-run neutrality view" is to be found in the time-path of labor's share of income (GDP):

I see no evidence in the data here that our higher price level today has whittled the share of income accruing to labor. Moreover, I see no evidence suggesting that episodes of high or low inflation are related in any systematic way to the resources accruing to labor. (In fact, I see some evidence of a rising labor share during the high inflation decade of the 1970s.) But perhaps other data tells a different story. If so, I'd like to see the data (i.e., instead of a short email claiming that I am wrong).

And what about the effect of inflation on the return to saving? I received many emails like this one:

Please, Mr. Andolfatto explain to me how this works out for someone who has been a careful saver of his money and now sees the purchasing power of that money destroyed? Please explain to me how this works out for a retired person on a fixed income who sees the declining purchasing power of that income?

These are good questions. The way they are asked suggests that I am in favor of inflation. I am not. It's just that I do not want to overstate the economic significance of inflation. Especially a low and stable inflation rate regime, like the one we have been living in for the past 30 years. And especially in light of what I view as potentially much more significant economic problems.

The concern expressed above would certainly be valid if the following was true: [1] if many people are forced to save in the form of zero-interest cash; and [2] if inflation is high and volatile. There are many episodes in history where savers have been hurt by an unexpected increase in inflation. I do not wish to defend the actions of any agency responsible for episodes of high and volatile inflation. And certainly, there are many economists within the Fed that are critical of past (and even current) Fed policies.

But this is not the regime we currently live in. As I said, inflation has been (relatively) low and stable for over 30 years now. And the Fed is committed to keeping inflation to keeping inflation "low and stable" (implicit inflation target is 2%). The argument that a "careful saver" over the last 30 years "just now" sees the purchasing power of that money destroyed seems implausible to me. Most people do not hold the bulk of their savings in the form of cash. (And if people were holding their savings in the form of Treasury bonds, they would have experienced significant capital gains over the last couple of years with the decline in nominal interest rates.) I think its fair to say that most people, or the people who manage their money, expect inflation. Market-based measures of inflation expectations show that inflation expectations are currently around 2%; see here.

I might add, as an aside, that in the emails I received promoting this line of argument, the writer typically professed concern for the "poor and unsophisticated saver." It was interesting to note that in each and every case, the writer him/herself was always very eager to point out their own sophisticated saving behavior--having, for example, invested in gold and silver (as I show here, you would have done better investing in stocks).
Well, and what about those on fixed incomes? The writer above mentions retired persons on fixed incomes. I presume he means nominally fixed pension benefits? (These benefits are generally indexed to inflation, though perhaps imperfectly.)

I think that a lot of the concern here is with respect to the fact that the prices of some goods (like food and energy) have recently risen very sharply and that, for most people, there is no correspondingly sharp increase in nominal incomes. People are right to be concerned. Here is an interesting picture from the WSJ:

The data show that some prices are rising rapidly. Some prices are not moving much at all. And some prices are even falling. In short, there are economic forces at work that are changing the system of relative prices. These relative price changes reflect fundamental changes in the structure of supplies and demand in the world economy. These changes would occur whether the Fed was in existence or not. Indeed, we expect relative price changes to be a normal part of a laissez-faire economy.

Finally, someone posed the following question to me:

Please explain to me how this (inflation) works out for the rest of the country when Wall Street bankers are the first to get their hands on newly printed Fed money, so that they can bid up all kinds of prices, including rents on apartments, which makes it difficult for anyone but a Wall Streeter to afford to live in Manhattan?

There is no persuading the people who organize their worldview around a web of conspiracy theories, but let me try anyway. First, this makes it sound like the Fed simply hands out cash to people. It does not. The Fed is not permitted to hand out cash in exchange for nothing in return. When the Fed creates new money, it uses the new money to purchase assets from another party. The Fed engages in asset swaps; there are no "helicopter drops." (It is the government that injects money into the economy via purchases of goods and services.)

Indeed, the business of banking is mainly a business of creating liquidity through asset swaps (e.g., when you take out a mortgage, a private bank creates and lends you book-entry money in exchange for your house as collateral). Even in a private banking system, someone must be the first to get their hands on newly created money. Even under a gold standard, someone will be the first to get their hands on newly discovered gold. And as for the price of real estate in Manhattan...I'm not sure what to say. It is one reason why I live in St. Louis!
I want to return to the last sentence in the End the Fed quote above:

We might say that the government and its banking cartel have together stolen $0.95 of every dollar as they have pursued a relentlessly inflationary policy.

This claim is simply false. Let me explain why.

Monetary economists make a clear distinction between base money, broad money, and wealth. The layperson typically makes no distinction between "money" and "wealth." Wealth is denominated in dollars. But this does not mean that all wealth is in the form of dollars (most of it is in the form of physical capital). Most people will interpret "dollars" in the quoted passage above to mean "wealth." Thus, the statement de facto claims that the Fed bears responsibility for stealing 95% of our wealth. This is a preposterous claim.

It is true, however, that something has lost 95% of its value since 1913. But just what is this something?

Answer: It is the outstanding stock of base money in the year 1913. (One dollar created yesterday, for example, has not lost 95% of its value as of today.) This 1913 money stock constitutes a tiny fraction of our total wealth. Moreover, since it has been in circulation for almost 100 years (much of it held by banks themselves in the form of reserves), the loss in its purchasing power has been spread over countless individuals, agencies, and generations.

Having said this, it remains true that inflation constitutes a tax. Seigniorage revenue refers to the purchasing power the government creates through the act of creating new money. Seigniorage revenue is also sometimes called an inflation tax. As far as taxation goes, seigniorage in the U.S. is small potatoes; see here. It constitutes a tiny fraction of government revenue (the bulk of which comes in the form of direct taxation).

Some people wonder how this is the case today, given the massive expansion in the Fed's balance sheet. The short answer is that seigniorage comes from permanent increases in the supply of new money (where the new money is ultimately used to purchase goods, rather than assets). The Fed, in its commitment to keep inflation "low," has implicitly promised to unwind its balance sheet at some point in the future should circumstances dictate. (Unwind in the sense of selling off its accumulated holdings of income-generating assets in exchange for base money).

If the Fed maintains its credibility (and this will be the hard part going forward), then there is little reason to expect even a huge temporary increase in the supply of base money to have an explosive impact on inflation (Japan's own quantitative easing experience provides an excellent example of this). This is, of course, something that the Fed monitors very closely.

To conclude, I think that the "currency debasement hurting the poor unsophisticated saver and man-on-street wage earner" argument is largely overstated. The assertion that "the Fed has stolen 95 cents of every dollar" I view as absurd. There are legitimate criticisms one could level at the monetary institutions of this country, but these are not some of them.

There are fundamental market forces at work in today's world that are causing the return to labor, saving, and entitlements to vary over time. I think that there is good reason to believe that these fundamental or "real" factors are much more consequential than the monetary or "nominal" factors emphasized by some people. But this topic is best left for a future column.

Romanian translation of this article available here.

Out of thin air?

2011-03-08T13:12:00.000-08:00

Have you ever said something like "Let me buy you a beer next week"?

I'm sure you have. We all issue promises of this sort. And we frequently use such promises as a form of currency. For example, we might say something like "Hey, why don't you give me a beer now...and let me buy you a beer next week?"

I have just described a simple credit exchange. Societies rely heavily on promising-making and promise-keeping. It is the foundation of all financial markets.

I'd like to point out something about the promises you make. They are made "out of thin air." The promises that other people make are also made "out of thin air" (including politicians like you-know-who). Oh, some may write the promises down in the form of IOUs or other legal documents. But really, as Chamberlain discovered on his return from Germany, we know the intrinsic value of paper (promises).

The fact that promises are made "out of thin air" does not mean they are worthless. The value of a promise is determined by the perceived (and ultimately, actual) credibility of the promise-maker to make good on his/her promises. The relevant concern of those who rely on financial agencies is the credibility of they claims they make. The fact that financial agencies issue promises "out of thin air" is a red herring. And if the charge is made with exclamation, well...forgive me for suspecting that the motive is to arouse impassioned anger, rather than rational discourse.

The Fed creates fiat money (yes, out of thin air). But fiat money in itself does not constitute a promise against anything in particular (on the other hand, there are those who argue that it is a promise to discharge a tax obligation). In a gold standard regime, a Fed note would constitute a claim against gold. But we do not presently live in a gold standard regime. So what sort of promise underlies fiat money?

Apart from any intrinsic value determined by its ability to discharge a tax obligation, the value of fiat money ultimately hinges on its scarcity. More precisely, it depends on how its supply is managed over time. Or even more accurately: it depends on the expectation of how its supply is to evolve over the indefinite future. This expectation hinges critically on the credibility of the money supply manager.

In our current regime, the Fed is (implicitly) promising to keep inflation centered around 2% per year. The actual inflation rate dipped considerably below this number during the past recession and it is now considerably higher (owing largely to the boom in commodity prices). But if one draws a trend line through these ups and downs, we're basically sitting close to 2%.

Now, we can argue at length about whether 2% is the right number. The Fed calls 2% "price stability," but clearly it is not price stability in a literal sense. The real rate of return on non-interest-bearing money is -2%. This is currency debasement; albeit, at a rather slow rate relative to the 1970s or Zimbabwe's recent experience. Price-level stability requires an inflation rate of 0%. The Friedman rule suggests that a moderate deflation is desirable.

Anyway, back to my main point. Which is that condemnations of the Fed based on charges of creating money "out of thin air" are off the mark. The discussion should instead center on whether the Fed, as currently construed, is an institution that can be trusted to make good on its promises. This is the same question one would ask of any agency, public or private.

And if the Fed is abolished, and then what? What replaces it? A gold standard? Here is what one person wrote to me on the subject:

And yes, a gold standard would be fine by me. Is there an argument against the gold standard that I don't know about? Also, as an example of hyperinflation, how about when Roosevelt rounded up everybody's gold in 1933, and then debased our currency by 50% ?

I think this highlights a point that I have been trying to make for some time now. The "gold standard" is nothing more than a promise made "out of thin air" by the government. Look at how easily Roosevelt abrogated that promise in 1933. What makes people believe that the same thing cannot happen again? (Related arguments apply to so-called "free banking" regimes.)

Sure, we might say that such acts are or should be prohibited under the Constitution. But the Constitution is also a document that has been fabricated "out of thin air." I have been told by some that the existence of the Fed is itself a violation of the Constitution. So you see how easy it is to violate that venerable document.

Imagine that it is somehow possible to make the gold standard credible and absolute. If this is possible, then it must also be possible to make a fiat money standard credible and absolute. Just replace the gold with fiat tokens. As a bonus we would have an efficiency gain (commodity monies are better utilized as commodities, rather than exchange media).

So, please, enough of this "out of thin air!" stuff. It's tiresome for those who know better, and distracting for those who do not. Let's divert attention to more substantive issues.

For example, the Fed has a legislated monopoly over the supply of small-denomination paper. Is this a good idea? What if we keep the Fed as is and allow free-entry into the business of money creation? If an unfettered private money system works well enough, it might drive Fed notes out of circulation. On the other hand, perhaps the demand for Fed paper will remain. Government paper (in the form of US Treasuries) drove out private money (AAA tranches of MBS) in the repo market in the past financial crisis. Now, isn't that interesting?

The free-banking vs. central-banking debate

2011-03-06T14:59:00.000-08:00

Ah, what a lovely way to start the day. A glorious morning, cool and fresh. A meeting of aged soccer players on a lush and muddy turf. No broken bones. No pulled hamstrings. I even scored a goal. Oh, the joy.

And now back home to read over my fan mail. You know...I had no idea that Americans were so passionate. I think that
American-style passion frightens us little Canadians. I suspect that this is what makes Canada so dull. And it's probably the reason I left too. Welcome to the jungle, Mr. Andolfatto.

As many of you can imagine, I've been the recipient of hundreds of rather nasty emails lately. I don't know any other way to describe it except as "awesome." Oh, I don't especially like being called names and being insulted, but it's no big deal (academics need pretty thick skins to survive). The awesome part is how people are so eager to express their views. It is, I think, a part of what makes America great.

Now for a little story--some background, I guess. Long ago, a remarkable debate took place about the optimal way to organize an economy's money and banking system. The proponents of free-banking eventually lost out to those who favored some form of central bank regime. The nature of these debates are nicely summarized by Vera Smith in her book, The Rationale of Central Banking.

Then for a long time, it seemed that very few people were interested in this debate anymore. Oh, a few academics would talk about it here and there. But if one was interested in practical monetary policy issues, well, one simply had to take the existence of a central bank as given.

That attitude always struck me as wrong-headed. As a young academic, I was interested in the theoretical foundations for monetary exchange. And I became fascinated in the experiments with money and banking regimes that were tried in the past. I made a point of teaching this to my students. And, in particular, I emphasized the free-banking alternative.

And now I find myself employed at a central bank (I still retain affiliation with my university). Well, I'm at a regional branch of a central bank (there are 12 regional Feds). And because of my present employment, many people evidently believe that I am a hard-nosed central bank type whose sole purpose is to defend the institution and its policies. As if an academic could or would want to ignore 20 years of scholarly research on the subject just like that. No, that's not how it works--and it's not the reason I was hired by the St. Louis Fed (if it was, I would not have come).

I love the research division here in St. Louis. My colleagues are great and the intellectual atmosphere is vibrant. The debates we have among ourselves often get lively. And yes, we sometimes talk about the merits of gold standards, free-banking, etc. I have even invited George Selgin, an ardent and articulate proponent of free-banking, to visit us in St. Louis and give us a lecture on the topic (which he has agreed to do some time in the future).

As an academic who has devoted a considerable amount of time on the subject, I cannot say that I presently fall strongly on either side of the debate. I can see merits (and defects) in both points of view. And I think it is great that Ron Paul has brought the subject back into the spotlight. As an academic interested in the subject, it is no less than thrilling. I think I can speak for most of us economists working at the St. Louis Fed in saying that we welcome a healthy debate. (And do not make the mistake of thinking that all Fed economists necessarily fall on one side of the issue).

To make a solid case one way or the other, it is important to keep the facts straight. (Yes, I realize that I am setting myself up for more abuse but please, spare yourself the trouble.) Moreover, it is also important, I think, not to present data in a misleading light. Now, I do not think everything Ron Paul says is wrong. In fact, as I said in my original post, I appreciate the libertarian philosophy. But if one wants to promote libertarianism based on sound intellectual foundations, it does the cause no good to make and promote misguided statements about money, prices, and the role of central banks. History is replete with examples of bad government policies in place well before the existence of central banks. In my view, it is wrong to convey the impression that something close to economic nirvana will dawn in the absence of a central bank.

In my original post, I wanted to attack one particular idea promoted by Ron Paul. (I did not mean to attack the man personally, and I regret the adjective I used to describe what I thought of his idea). I want to be clear that the post was not meant to critique all or even most of the Congressman's ideas--nor was the post meant to serve as a defense for the Fed.

It is my belief that Ron Paul promotes a misleading argument concerning the fact that our price-level today is much higher today than it was 100 years ago. His argument implicitly suggests that nominal wages today would be roughly where they are at even in the absence of currency debasement. This is, in my view, just plain wrong.

But for people who believe it (and evidently there are many out there that do), it provokes rage against the Fed. It is as if the Fed has stolen virtually all of their wages and that real material living standards today would be much higher if only the price-level had remained at its 1913 level. This proposition is grossly at odds with the evidence, which shows roughly 2% annual real growth in per capita income and roughly stable income and expenditure shares. There is, of course, considerable discussion about growing income inequality. But almost every paper I read about this phenomenon seems to point either to skill-biased technological change or competition from emerging economies. I'm not sure what Fed policy has to do to with those forces.

I am no defender of inflation. But the US inflation rate has been low and stable for decades now. Seigniorage revenue is small potatoes relative to the appropriations made by Congress via direct taxation. Ending the Fed will do little, in my view, to diminish the level of those appropriations. Tackling that issue will take serious tax reform--a reform that would have to take place whether or not a Fed was in existence.

Now, there may be other reasons for abolishing the institution, but if so, then why not emphasize those? As I said in my original post, there are many legitimate arguments one could level at the Fed as an institution or in the way it conducts its policy. But it does no service to the libertarian cause to attack the Fed with misleading arguments (that are mixed in with other more legitimate ones). It does no good because opponents to the libertarian cause can latch on to the lame arguments and use them to discredit the more worthy ones.

The Fed was established by an act of Congress in 1913. The Fed is operating under the rules established by Congress. If you have a problem with these rules, then I encourage you to lobby your Congressional representatives to change them. Blaming the Fed for following the law as established by Congress (and other guidelines, such as the dual mandate) seems like a rather strange way to go. But hey--power to the people.

The Ron Paul Thing

2011-03-04T15:42:00.000-08:00

I've taken down my post entitled "Ron Paul's Money Illusion" because it seems to have provoked mindless rage rather than thoughtful debate.

A part of this is my fault for saying that, while I respected many of the Congressman's libertarian ideals, I thought that he could be more circumspect at times. Well, I didn't exactly use this language, if you know what I mean. And for that, I want to apologize to the Congressman and all of his ardent supporters.

Having said this, I stand by the substantive point that I was trying to make. That column, however, was written too hastily. So I think I'll rewrite it, this time a little more carefully, and with a little less colorful language (and maybe a little more data).

A good weekend to all.
DA

Jobs Go Unfilled Despite High Unemployment

2011-03-03T10:23:00.000-08:00

Came across this interesting article today: Jobs Go Unfilled Despite High Unemployment. Here is the opening snippet:

For the 15 million Americans who can’t find jobs the labor market is like an awful game of musical chairs. There are many more players than there are available seats.

Yet at Extend Health, a Medicare health insurance exchange firm in Salt Lake City, the problem is just the opposite—a growing number of chairs to fill and not enough people with the skills to fit the jobs. “It seems like an oxymoron in this environment that you can somehow be challenged to find great workers,” CEO Bryce Williams admits, almost sheepishly.

Extend Health’s call center workers help retirees navigate the process of signing up for commercial Medicare Advantage and drug coverage plans. For this fall’s Medicare Enrollment season, the firm will need close a thousand workers. The ideal candidate is over 40, with a background of financial services in order to qualify for insurance licensing.

“They need to be able to pass the state of Utah exam, which is not easy, “he explains. “They need to have a background in comparing the financial metrics of trying to help someone compare and analyze and give great advice.”

Williams has hire a recruiter, plans to roll out billboards along Interstate-15 in Utah, and is now looking at establishing a new call center out of state where the firm can find more people to train and hire.

“We like being in Utah but at a certain point you max out on the total pool of people that you can tap," Williams says. “So, we're going to have to look at other states.” Part of Williams’ problem is that his business is in a sector that’s facing a skills gap.

A Tight Labor Market For Skilled Jobs

Overall labor demand softened in February, but online ads for computer science jobs were up more than 15 percent from January, according to The Conference Board Help Wanted Online Data Series (HWOL).

While there are more than twenty-five job seekers for every open position in fields like construction, in technology, health and science-related jobs the exact inverse is true.

For computer science jobs and skilled health care practitioners, there were just over three ads for every job seeker in February. For life sciences jobs like medical science researchers and chemists, the ratio was 2 to 1.

"It’s the equivalent of a seller’s market in real estate,” says Jeanne Shu, HWOL Project Coordinator. While those occupations are seeing a lot of growth, employers are scrambling to find available qualified workers.

“If they can't find the right person with the right skill set they'll hold out longer for them."

I figure that there's something more than "deficient demand" going on here. But maybe that's just me...

Update: March 13, 2011

Some more interesting anecdotal evidence here: Factories having trouble finding workers.
(I thank Mike Ward for the link.)

U.S. Inflation and Inflation Expectations

2011-03-02T08:32:00.000-08:00

Here are a couple of slides, courtesy of my colleague Kevin Kleisen. The first depicts recent U.S. inflation, both core and headline.

So, following a rather sharp decline in the headline CPI rate, we see an even sharper increase more recently. The core measure, however, remains relatively low and stable.

This next graph depicts a variety of market-based measures of inflation expectations. You may recall that the Fed was recently concerned that inflation expectations were drifting too low (relative to the implicitly desired target or around 2%). Inflation expectations now appear to have converged to pre-crisis levels. One could make a legitimate case that to the extent this was a part of the goal for QE2, the policy was a success.

Of course, the fear that many people have is that inflation may somehow get out of control. It is a legitimate concern and one that ranks high on the list of FOMC members.

And then there are a host of other concerns, like the ones outlined here by Pimco Managing Director Bill Gross: Economy May Reverse Course When Fed Buying Ends. I especially like this quote:

"Who will buy Treasuries when the Fed doesn't?" he asked. "I don't know."

I'm sure Mr. Gross is a smart guy. But statements like that just make him sound a tad foolish.

Think about it. A USD is the equivalent of a zero-interest-bearing small denomination Treasury bill. So when the Fed is purchasing longer dated Treasuries, what is it doing? It is selling zero-interest bills for (slightly) positive-interest bills. Would a deceleration in this asset-swap activity really have the dramatic effect Gross suggests? (He is suggesting a sharp spike in Treasury yields). I doubt it. In fact, the implied tightening is likely to keep a lid on inflation expectations and hence keep nominal interest rates low (via the Fisher effect).

But we shall see...

Ed Leamer on Deflation Dread Disorder

2011-03-01T10:41:00.000-08:00

The always entertaining Ed Leamer here on Deflation Dread Disorder (The CPI is Falling!).

(let me know if the link does not work for you).

On job openings and job availability

2011-02-17T08:31:00.000-08:00

Paul Krugman is a tireless writer. That's the good part. The bad part (you knew this was coming) is that...well, he can also be a tiresome writer.

Consider this: A Rising Natural Rate. Here, he is commenting on some analysis by the SF Fed trying to estimate some measure of the "natural" rate of unemployment. Fine, nothing wrong with this. But then he slips this in:

Right now, there are very few job openings relative to the number of unemployed:

So there’s no question that right now, the demand side is what is constraining unemployment.

Ya got that? Paulo says that thar's no question bout it. Thar's deficient demand out in them thar hills. An y'all see that l'il ol' dyergram up thar? Well...that thar jus' goes ta prove it. Lessen' yer blind, that is. Lessen' yer sum evil laysay fare type.

Well, I hate to break it to those who demand and consume this brand of religion, but there might just be some question about it. Shhhh...what I am about to say is super secret...economists aren't really sure what's going on. I mean, think about it. If we knew what was going on, there would be no need for economic research. You know...research...that activity that brings so much joy to you know who (The Joy of Research).

But I don't want to be too hard on Paulo. Evidently, he has an agenda to push and he pushes it from a particular philosophical perspective. I can respect that. What I don't like is the constant allusion to certainty--the lack of humility in what we know--the notion that the data "speaks for itself." These are the tactics used by politicians, not academics. This is what I find so tiresome in his otherwise fine writing.

But maybe I should cut him some slack. Evidently, it must be some sort of Nash best-reply to fluff up one's feathers this way and show no sign of weakness. There is always some right-wing nut job out there waiting to pounce, to tear apart, and to misrepresent anything that might be construed as capitulation on his part. He knows this. I know this. Now we all know this. So let's set it aside and take a closer look at that data.

The chart above appears to be drawn from the Job Openings and Labor Turnover Survey (JOLTS). This is a great data set, but it has its limitations.

The question I'd like to ask is whether it really is the case that there are more unemployed workers than available jobs. According to JOLTS, the answer is yes. But this does not mean it is so in the economy.

It could be the case that many, perhaps even most, job openings are not advertised (hence not picked up by JOLTS). There are, evidently, a lot of farm jobs available that Americans refuse to work at (see: Despite Economy, Americans Don't Want Farm Work). Many unadvertised jobs are poor-paying jobs. Everybody knows they're out there. If you need a quick (and legitimate) buck, you send your application to McDonald's. There are arguably millions of these low-skill low-pay jobs around. Jobs are not scarce. (What is scarce are good jobs that are well-matched with the characteristics of all those available to work.)

The JOLTS data itself provides some evidence that many job openings are not measured. In particular, take a look at this:

So there's no question that right now, the supply side is what is constraining unemployment.

Cyclical asymmetry in the unemployment rate

2011-02-15T09:14:00.000-08:00

Economists have known for a long time that there is a cyclical asymmetry in the unemployment rate. In a recession, the unemployment rate tends to spike up quickly and sharply. During an economic expansion, the unemployment rate tends to decline only gradually. Consider the following data, for example:

The shaded regions roughly depict the periods over which the unemployment fell from peak to trough. As you can see, what the U.S. is experiencing right now looks a lot like what Canada experienced in the early 1990s. Evidently, it takes time to rebuild the employment stock after a shock. And the bigger the shock, the longer it seems to take. Is this a puzzle? Not if you believe we've experienced a Humpty Dumpty moment; but it is if you believe in Deflated Balloons; see here.

Yah...see that protracted decline in the Canadian unemployment rate from 1992 to 2008? That was because of deficient demand. Demand was clearly deficient for almost 20 years. Shoulda increased G more, I guess.

Is gold a good store of value?

2011-02-10T18:57:00.000-08:00

I know I'm asking for trouble here. Goodness, simply mention the yellow stuff and people go crazy. In an earlier post, I asked Is Gold Money? I answered "no." To all those who were deeply wounded by this answer, I am truly sorry. But the answer is still "no."

Of course, the answer depends in part on how "money" is defined. There are legal definitions, like "lawful tender" and "legal tender" (they are distinct). There are operational definitions, like M1 and M2. But the definition I used was an economic one. Money is an object that "circulates widely as a means of payment." In the U.S. today, cash fits this description. So do the electronic digits sitting in your chequing account (so M1 fits).

But gold, in whatever form it takes, does not fit this description. Unlike government cash and bank digits verifiable by debit card, there is no standardized easily recognizable gold unit circulating widely as a payment instrument in the U.S. today. If you were to try to pay your groceries with gold coins, they might accept them, but at a huge discount. This discount reflects the illiquidity of gold. Gold is not money.

This is not to say that one should therefore not own gold. Even if gold is not money now, it may be one day in the future. And even if it is never money, it may still constitute a good store of value. Certainly, gold appears to be a better store of value than, say, the USD. The price of gold, measured in units of USD, has been rising over time. The purchasing power of the USD has been falling over time (inflation). So gold is a better store of value than the USD.

But so what? Who in their right mind stores value by tucking USD under their pillow? Cash is easily transformed into an interest-bearing asset, like a government or corporate bond. Or one could purchase a wide basket of equities, like the S&P500. The question I want to ask here is whether gold is a better store of value than one of these competing storage devices.

In what follows, I choose the S&P500 total return index (assumes that dividends are re-invested). The experiment is as follows. I am going to take four years: 1970, 1980, 1990, and 2000. For each of these years, I am going to imagine investing $1 in gold and $1 in the stock market. Then I'm going to track how well these two investments store value from the starting date to the present.

Returns since 2000

If you had invested $1 in gold in 2000, you would now be up almost 500%. In contrast, your investment in the S&P500 would have returned virtually zero. Gold appears to have an excellent store of value over the last decade.

Gold is frequently touted as a superior inflation hedge. Yet, the US inflation rate over the last decade was not very high. Nevertheless, gold kicked a$$, so to speak. Good for gold. Good for gold bugs.

Returns since 1990

Whoa, this looks a little different, don't it? If you had invested $1 in gold 20 years ago, you would have gone 15 years with negative to zero returns. A late sample rally makes your return look a little better, but over this longer sample period, the S&P500 kicks gold's a$$. But maybe we just have to look at a longer time horizon...

Returns since 1980

Oh, gosh. That didn't work, did it? In fact, over 30 years, the relative return on gold looks absolutely horrible. Well, at least the return looks more stable, if that's any consolation.

Return since 1970

Alright, we knew things had to get better for gold--and they did. The 1970s, a high-inflation episode, was a terrible decade for stocks and a very good one for gold. And it is the memory of this decade that remains burned in a gold bug's brain.

And it's a good lesson to have burned into one's brain. It probably justifies holding some gold in a diversified portfolio of wealth. Can't help but note, however, that even allowing for the disaster that was the 70s, the stock market still outperformed gold in the long-run. Something to keep in mind.

The health care debate

2011-02-06T18:17:00.000-08:00

As some of you probably know, I am a Canadian citizen and have lived most of my life in Canada. I moved to the United States about a year and half ago. I now live in St. Louis and am privileged to be working at the Federal Reserve Bank of St. Louis. The Fed, incidentally, offers what I think is an excellent health benefits package. And so far, I have been mightily impressed with the health care services provided at Barnes Jewish Hospital. I am fortunate.

When I first moved here, I did not know too much about how health coverage worked in the U.S. Heck, I am still not entirely sure what to believe. I have some vague recollection of hearing stories about poor Americans being denied access to critical care, just because they could not afford it. I wonder whether this can possibly be true.

Here is an excerpt from Paul Krugman's piece "A Tale of Two Moralities:"

There’s no middle ground between these [conservative and liberal] views. One side saw health reform, with its subsidized extension of coverage to the uninsured, as fulfilling a moral imperative: wealthy nations, it believed, have an obligation to provide all their citizens with essential care. The other side saw the same reform as a moral outrage, an assault on the right of Americans to spend their money as they choose.

Wealthy nations, liberals believe, have an obligation to provide all their citizens with essential care. The implication, of course, is that the United States does not do so; at least, not prior to Obamacare. But is what Paul Krugman asserts true? (He is also asserting that conservatives, as a matter of their moral philosophy, do not believe that all citizens should be provided with essential care--an outright lie, of course--but a different matter that I do not wish to pursue here).

And here is Kevin Horrigan, a columnist in St. Louis with his article today: "A Commodity or a Right?"

Health care, regardless of its considerable effect on the economy and the national debt, is not just another consumer item. Like food and water, health care is a fundamental right. We don't let people starve or freeze to death in this country (usually), so why do we routinely let them suffer and die for lack of access to health care?

Again, I ask whether this last claim is factually correct? Do people in America routinely suffer and die for lack of access to health care?

Personally, I cannot say for sure one way or the other. My inclination is to doubt these claims (which is not to deny the existence of many other problems associated with healthcare). But the evidence supporting my view is mainly anecdotal.

When I first got to the bank, I became friends with one of the janitorial staff at the gym. We got to talking and I learned that she had at one time needed a lung operation. Evidently, she was poor and uninsured at the time. She is now healthly as a horse. I'll let you fill in the blanks.

Shortly after that, I attended a lecture by Steve Lipstein, CEO and president of Barnes Jewish Hospital (and Chairman of the Board of the St. Louis Fed). The talk, as far as I can remember, was largely devoted to espousing the virtues of the Obamacare legislation. In his talk, he made a remark that made my jaw drop to the table. He told the audience that Barnes-Jewish does not turn anyone way; they do not ask whether people have insurance...they do not even ask if they are American citizens. I would like to believe that this is true at all U.S. hospitals, but perhaps it is not.

So it seems to me, though I stand corrected if wrong, that the U.S. already has universal health care coverage. Of course, when the uninsured go for treatment, someone has to pay for it. That someone, it appears, is the rest of us who regularly make insurance premiums (this is another point made by Lipstein in his talk). In other words, the U.S. already has a system whereby the "rich" subsidize the insurance and health costs of the "poor."

Of course, recognizing this (if it is even true) is not the same thing as claiming that the current system is any good or in no need of reform. I found this article by Randall Hoven quite interesting: "A Conservative Case for Universal Health Coverage."

The impression I am forming is that the healthcare debate has more to do with insurance than it does with healthcare availability. It appears to be a quirk of the American system that health insurance is tied to your employer. So, if you lose your job, and suddenly become sick (afflicted by a pre-existing condition), you may suddenly find yourself uninsurable. You will still have access to healthcare, of course--that is not the issue (even if liberals like Krugman and Horrigan would like us to believe this to be the case). But if you have any assets, you will have to use these assets to pay for your healthcare. This can be a terrible hardship and, evidently, is a major cause of personal bankruptcies in the U.S. Of course, if you are poor, you have no assets and so this does not apply.

So I am wondering: Have I got this just about right? If I have missed the boat on this one, please set me straight.

Update: February 10, 2011

One of my readers sent me something that I thought was too good not to bring to the forefront here. The author goes by the name of "o.jeff," in case that means anything to you.

A Simple Health Care Financing System (by o.jeff)

* Each person is required to put 15% of his or her income into a health savings account.

* All health care spending comes from this account.

* If a charge to your health care account is larger than your balance, then your account balance goes negative. This is effectively a federal health care loan.

* When your account balance is negative, 20% of your income is deducted from your income until your account balance is positive again.

* The money in this account is your money. When you die, any positive balance is passed on in your estate. If you have a negative balance, your assets must first pay off any negative balance in your health care account.

* If you have insufficient assets to pay off your negative balance at death, then the balance is "written off."
Additional points:

* This program replaces all government health care programs, including Medicare and Medicaid. The taxes for these programs would be eliminated.

* Most employers would probably stop offering health insurance as a job benefit. This would free every private employer of this burden and the cost it levies on them. This makes U.S. businesses more competitive.

* The payment for health care services would be immediate and swift--like using a credit card at Wal-Mart. However, providers would be required to retain records about the transaction for a period of time to allow audits for fraud.

* All of the people who are presently employed in medical offices and hospitals to fight insurance companies could be repurposed into actually providing health care services. An enormous gain in productivity.

* People would largely be spending their own money, and thus, they will be more careful about how it is spent. (With today's third party payment of medical expenses, there is little reason for a person to try to spend less.)

* Doctors might get tired of answering the question "How much does this cost?" but the question will be coming from their patient, right in front of them, rather than some nameless guy at an insurance company.

* Cost shifting already happens when non-insured/indigent go to a hospital for treatment. This plan simply makes it very transparent. These people will carry a negative balance funded by all of us. The hospitals would not have to cost shift, and so their prices should become more reasonable immediately.

* The health savings account would be for legitimate health care spending only. Fraud would be very strictly punished--both on the side of the provider and consumer.

* Health care products and services typically covered by an employer-sponsored plan would be eligible.

* Dependents would be paid for out of their guardian's accounts.

* 15% would be a minimum. You could deduct more if you want.

* There would be a maximum account balance per dependent. For example, the maximum account balance might be $75,000 plus $25,000 per dependent. (When this limit is reached, no salary deduction would be required.)

* Funds would be deposited in FDIC/NCUA insured bank accounts. You would get to pick the institution. I would likely pick a local credit union.
Other points:

* I think we should probably include in this plan a sales tax on medical care and services to pay for indigent care (those who die with negative balance). This tax should cover whatever our generation is predicted to cost in indigent care. It might be 3-5%.

* Private health insurance would be largely eliminated. However, insurance companies might provide "negative balance" insurance. That is, when you die with a negative balance, the insurance would payoff your balance. This would avoid an asset sale when a spouse dies first, for example.

O.jeff concludes with this:

Singapore has a system similar to this. My novel contribution is the notion of a "negative balance" in the health saving account, which is effectively a government-provided loan for health care (displacing the insurance model we have today).

p.s. Those who have zero lifetime earnings would simply die with a negative balance (and no assets), which would be paid for via the sales tax levied on all medical care.

Time to short treasuries?

2011-02-04T10:56:00.000-08:00

U.S. Treasuries over the last two years have served as sort of a safe-haven for investors (something that still has gold bugs scratching their heads). But with the worst of the financial crisis over, and growing evidence of U.S. and world economic expansion, there is good reason to believe that long-term real interest rates are likely on the way up (reflecting the increasing world demand for investment).

Ceteris paribus, higher real rates also imply higher nominal rates. That's bad news for treasuries. And though the Fed has promised to keep inflation in check (around 2% per annum), the market might have different ideas concerning the Fed's willingness and/or ability to deliver on its promise. Market expectations of inflation appear to have risen lately. Via the Fisher relation, one would expect this to put further upward pressure on nominal interest rates. Again, this is bad news for treasuries.

Note that I am not personally making any forecast about where interest rates are likely to go in the future. All I want to say is that IF you believe nominal interest rates are likely to continue their way upward, you may want to play this by shorting U.S. treasuries. And an easy way to do this is to go long on the Proshares Ultrashort 20+ Treasury ETF; see recent performance below (on Canadian exchanges, try ticker symbol HTD).

What could go wrong with this trade? Well, the fact remains that U.S. treasuries are likely to retain their role as a safe-haven instrument, at least for the near future. So, surprise events in sovereign debt markets, for example, may very well make TBT tumble again. And then there's the Middle East...what could possibly go wrong there?

Is gold money?

2011-02-02T20:23:00.000-08:00

You've seen the advertisements on TV. They come in two forms:

[1] We will buy your gold!!!
[2] We will sell you gold !!!

Ad type [1] argues that with gold prices at an all time high, now is a good time to cash out of your inventory of gold (jewelry, coins, etc.). All you have to do is put your gold in an envelope and mail it to them; they will mail you back cash. They promise to reverse the transaction if you are not happy.

Ad type [2] argues that with gold prices going higher, now is a good time to turn your cash into gold. This type of ad typically stresses the virtue of gold as money, something that will retain its value even as the world comes to an end.

Maybe the rational-agent hypothesis is indeed taking things a step too far.

Let us settle on a (loose) definition of money. Let me say that money is an object that circulates widely as a means of payment. This is to say, money is liquid; it is not discounted (severely, at least) in quid-pro-quo trades. Something like that.

In today's world, gold (whatever form it may take) is not liquid. Try paying for your morning coffee with bullion and be prepare to be astounded at the discount you are offered (on your gold, not the coffee!).

In ad type [1], people are trying to buy your gold...that is, buy it with cash (money). This ad appeals to people who want cash now. They want to buy things, now. So, if gold is money, why don't they just use the gold to buy the things they want now? Answer: gold is not money.

In ad type [2], people are trying to buy your money...that is, buy it with gold. If gold is in fact money, why would they want to sell it for paper? This ad appeals to people who want to make provisions for the end of the world. When society collapses, no one will want to hold fiat money; but everyone will hunger for gold.

These people are delusional. Think of Mad Max. People will hunger for food, water, and fuel -- not gold. Which is to say, not only is gold not money in a disaster scenario -- it is not even wealth!

I wonder whether the people who fall for ad type [2] ever ask themselves why these prognosticators of future financial turmoil appear so willing to buy their paper money for gold? Yep, they must be mighty fine folks to be willing to dispose of their gold supplies in exchange for your fiat paper.

So there you have my little rant of the day. But I am snowed in. And maybe watching too much TV (CNBC -- First in Business Worldwide).

PS. Subsequently came across this related link: Is Gold Money?

Don't do it for us. Do it for Canada.

2011-02-01T10:55:00.000-08:00

The backdrop here is Bill C-32, an Act to amend the Canadian Copyright Act. The bill would criminalise the act of circumventing, or making available to the public the ability to circumvent, digital rights management software locks. In short, the bill is basically designed to strengthen property rights over intellectual property.

Contrary to what many may think, the economic argument for these laws is not as strong as one might imagine. For those interested in understanding why, please refer to this fine blog by Michele Boldrin and David Levine: Against Monopoly. In Canada, we have Michael Geist offering good arguments against certain aspects of C-32.

But the purpose of this post is not to debate C-32. What I want to show you is this: a letter recently published in a major Canadian newspaper, written on behalf of a group of "concerned Canadian authors." Despite C-32's attempt to strengthen copyright law, these authors evidently do not think it goes far enough. The reason for this is because C-32 may allow for some degree of fair use. (For related commentary, see Meera Nair's interesting blog: Fair Duty).

Fair use. Oh, the horror. Oh, the hypocrisy. (They evidently have zero concept of how their own creative works have been built on the shoulders of free social capital.)

Anyway, take a look at the letter. Who did they employ to write it? I mean, it's one thing to state one's objections to a pending legislation; I have no problem with this. But the tone...the language...my goodness...it reads as if it were written by a petulant child (and this is perhaps giving them too much credit, as I think the maturity level in most children exceeds that which is displayed in this letter).

But what really got me was the concluding statement.

Pathetic. Truly pathetic.

Binky Chadha: Non-investors are overweight stocks

2011-01-26T16:42:00.000-08:00

With the Dow closing near 12,000 today, I thought I'd peruse the CNBC (First in Business Worldwide) webpage to see what analysts were talking about. I'm not sure why I do this...I am almost always left scratching my head afteward. A deficiency on my part, no doubt. Maybe some of you out there can lend me a hand.

Take this, for example. Here is a CNBC segment entitled "Pick a Pro's Brain," a short interview with Deutsche Bank's Binky Chadha labeled "Investors Are 'Very Underweight' Stocks." The entire interview sounds like gibberish to me. The man is speaking in a language that I trouble understanding.

What does it mean, in particular, for investors to be underweight stocks?

I think we can all agree that the outstanding stock of equity shares is owned...by someone, at least. It is therefore impossible for the population as a whole to be under or overweight in stocks. It is only possible for different groups holding different positions to be considered under or overweight.

Now take the set of potential owners. It appears that this set can be divided into two subsets: investors and non-investors. I'm am not entirely sure what governs this division.

In any case, the claim is that investors are underweight stocks. Fine. But simple arithmetic then implies that non-investors must be overweight stocks.

So I am wondering: Is this, in fact, what Binky is saying? And if it is indeed what he is saying, then why is knowing this interesting, and how is knowing this important?

Holier than thou

2011-01-19T11:37:00.000-08:00

Took a bit of a break from blogging lately. (I do have a day job, after all.) Unfortunately, I peeked into the blogosphere. Couldn't help it. Big mistake!

Exhausted by economic analysis, Paul Krugman has decided to stump from another pulpit these days. See here: A Tale of Two Moralities (via interfluidity).

Ah, the moral high ground...how intoxicating! The conscience of a liberal...I am reminded of Gordon Liddy's gem:

A liberal is someone who feels a great debt to his fellow man, a debt which he proposes to pay off with your money.

According to Krugman, there is a "great divide" in America today. What defines this boundary?

One side of American politics considers the modern welfare state — a private-enterprise economy, but one in which society’s winners are taxed to pay for a social safety net — morally superior to the capitalism red in tooth and claw we had before the New Deal. It’s only right, this side believes, for the affluent to help the less fortunate.

The other side believes that people have a right to keep what they earn, and that taxing them to support others, no matter how needy, amounts to theft. That’s what lies behind the modern right’s fondness for violent rhetoric: many activists on the right really do see taxes and regulation as tyrannical impositions on their liberty.

There’s no middle ground between these views.

Is this really an accurate characterization? To me, the divide seems to be defined more over the issue of who (or what body of institutions) should be trusted with the job of redistributing wealth. On the left, we have those who believe that a central authority is best suited for this job. On the right, we have those who believe that local governments, or private philanthropic institutions, are better suited for this job.

I do not believe that those with a libertarian streak (like myself) appreciate being demonized for, say, opposing a tax hike by the central government. I might oppose such a tax and at the same time favor a tax hike at the state or local level (if I thought the funds are to be put to good use). I might be against a tax hike altogether, and be in favor of redistributing existing government expenditures away from the military and to the disadvantaged. Or, I might just want to keep more of my money so that I have greater control over how to disburse it among competing charities. The "liberal" attempt to construe any of these positions as "immoral" along some dimension is, well, simply shameful, I think.

AIG Repays the Fed

2011-01-14T13:57:00.000-08:00

New York Fed Ends AIG Assistance with Full Repayment
For release at 12:25 p.m. EST on January 14, 2011

NEW YORK – The Federal Reserve Bank of New York (“New York Fed”) today announced the termination of its assistance to American International Group, Inc. (“AIG”) and the full repayment of its loans to AIG as a result of the closing of the recapitalization that was announced on September 30, 2010. As of today, AIG will no longer have any outstanding obligations to the New York Fed.

Today’s closing represents a substantial step toward achieving the Federal Reserve’s dual goals of stabilizing AIG and ensuring its repayment of government assistance. It reflects the significant progress AIG has made in reducing the scope, risk and complexity of its operations and stabilizing its operating results. The accelerated repayment of the New York Fed frees up collateral that will enable the company to access private debt markets, an essential step toward facilitating the U.S. Department of the Treasury’s future sale of the common stock it owns.

"This concludes an important effort by the Federal Reserve to stabilize the financial system in order to protect the U.S. economy" said William C. Dudley, President of the New York Fed.

With today’s closing of the recapitalization, the New York Fed’s revolving credit facility has been fully repaid, including interest and fees, and its commitment to lend any further funds has been terminated ahead of the credit facility’s scheduled expiration in September 2013.

In addition, the New York Fed has been paid in full for its preferred interests in the AIA and ALICO special purpose vehicles. A portion of those interests has been redeemed with proceeds from AIG’s sale of ALICO to MetLife, Inc. The remaining interests have been purchased by AIG through a draw on the Treasury Department’s Series F preferred stock commitment and transferred to the Treasury Department.

The closing of AIG’s recapitalization also marks the termination of the AIG Credit Facility Trust, which was established to hold an approximately 79 percent controlling equity interest in AIG for the sole benefit of the U.S. Treasury, the general fund of the U.S. government. The Trust’s equity interest in AIG is being exchanged for common stock of AIG and transferred to the Treasury.

“We are grateful to Jill M. Considine, Chester B. Feldberg, Peter A. Langerman, and Douglas L. Foshee for their invaluable contributions and commitment to the execution of their responsibilities as Trustees,” Mr. Dudley added.

About the Federal Reserve’s actions related to AIG

In September 2008, the Board of Governors of the Federal Reserve System authorized the New York Fed to provide AIG with an emergency loan of up to $85 billion to prevent its disorderly collapse, which could have had catastrophic consequences to the U.S. economy during the most damaging financial crisis in 70 years. The assistance provided by the Federal Reserve was restructured over time, and was supplemented in November 2008 and April 2009 by additional financial assistance from the Treasury Department under the Troubled Asset Relief Program.

As part of the November 2008 restructuring of the government’s assistance to AIG, two special purpose vehicles, Maiden Lane II LLC and Maiden Lane III LLC, were created with loans from the New York Fed to purchase various mortgage-related securities in order to address AIG’s capital and liquidity strains. The loans extended by the New York Fed to the Maiden Lane II and III facilities remain outstanding and are being repaid from the assets in those facilities. The fair values of the portfolios well exceed the balances of those loans.

Irrational exuberance over the balanced budget multiplier

2010-12-27T13:27:00.000-08:00

Christmas time is the most magical time of the year. A time to believe in elves, talking reindeer, snowmen running amok, and...for some economists, the Keynesian cross.

The Keynesian cross. We (the economics profession) like to etch it deeply into the minds of fresh undergraduates, one cohort after another, year after year. Is it any surprise that for most educated laypeople, this is the only macroeconomic language they understand?

And here is a Christmas gift--from Professor Robert J. Shiller--to those of us who have been primed since youth to be receptive to this sort of message: Stimulus, Without More Debt. The argument for why a tax-financed increase in government spending will work is summarized as follows:

The reasoning is very simple: On average, people’s pretax incomes rise because of the business directly generated by the new government expenditures. If the income increase is equal to the tax increase, people have the same disposable income before and after. So there is no reason for people, taken as a group, to change their economic behavior. But the national income has increased by the amount of government expenditure, and job opportunities have increased in proportion.

In other words, the Keynesian cross (formal exposition available here). Econ 101 in action, kids!

So what, pray tell, is your beef with this, Mr. Grinch?

First, it's not that I have anything against the Keynesian cross, per se. I can appreciate the basic idea it is trying to convey. And it's just a simple model, after all--it seems silly to hold a personal grudge against an inanimate object. What I am against is in placing it (or any other economic theory, for that matter) on an exalted alter. Models should not, in my view, be worshipped in this manner. And while I'm on the subject of religion, I'm also against beginning an argument with a preordained conclusion (in this case, that more stimulus will certainly be needed, because unemployment is high).

Having said this, I think that the Keynesian cross is a delightfully perverted object. It can be (and has been) used to support almost any type of government appropriation. In fact, I feel like writing a letter myself to this end.

Dear Congressman:
The economy is in dire need of help. It needs to be stimulated. I am willing to stimulate it, with your help.
To this end, I ask that you appropriate a sum of $X from my fellow citizens and divert this money to me.
As this money does not belong to me, I promise to spend it...to return it to my fellow citizens, so to speak. Of course, I will make them work for it...given the clear want of work in our present economic climate. The income so earned in exchange for their idleness will undoubtedly be spent--adding income to the pockets of everyone. No one will even notice the initial appropriation, as all of the money borrowed will be returned in the manner just described.
Signed (your name); noble servant of society.

Now, try to imagine everyone writing this letter and that Congress acts accordingly. I hope you can see as well as I how nothing but good can come of this. Whatever the ailment, the cure, evidently, is to increase spending. Indeed, to force people to spend if they refuse on their own. When the Keynesian cross is your hammer, every macroeconomic problem nail looks like deficient demand.

Second, it's not that I don't believe that an increase in G will lead to an increase in Y. There is evidence that it can. Heck, even standard neoclassical theory says it can. Whether it does or not in a given set of circumstances is a different matter. And even if it does, it is not entirely clear that increasing Y in this manner is socially desirable. It may be. Or not. It depends on a lot of things. I do not view the proposition as self-evident and beyond critical examination. In contrast, according to Shiller:

But the balanced-budget multiplier is simpler to judge: If the government spends the money directly on goods and services, that activity goes directly into national income. And with a balanced budget, there is no clear reason to expect further repercussions. People have jobs again: end of story.

(Don't you love it when you are granted license to stop thinking? End of story, indeed.)

Third, its not that I'm against increasing (components of) G. Public works projects of the sort mentioned by Shiller (building highways and improving our schools) were advocated by sensible economists long before Keynes (as evidence of this, note that public works were implemented in the Depression well before publication of the General Theory). What I have a problem with is in using some silly theory to support the notion, for example, that taxes should be raised to finance a large public capital expenditure. Shiller has been rightly celebrated for his work in the theory of finance, and on asset price bubbles in particular. But is this not a rather odd stand to take for a professor of finance?

Now, I'm no expert in finance myself, so maybe I should be careful in what I'm about to say. But it seems to me that a large capital expenditure should be financed with debt. The debt service could be supported by toll revenue (on bridges and roads) and user fees in general, backed by the Treasury, if needed. The use of tax finance advocated by Shiller in his balanced-budget exercise implicitly assumes (among other things) lump-sum taxes. For some thought experiments, the assumption of lump-sum taxes is innocuous enough. But this is not one of those cases. Taxes are distortionary and to the extent that they are needed to support public spending, they should be spread out over time. This is a standard principle of public finance (I think).

Maybe Shiller believes in this standard principle, but views it as politically infeasible (given the current appetite for debt reduction). Possibly. But if so, I would rather have expected a rousing defense of these standard principles. Americans are not necessarily against debt; they are against wasteful spending. Given that America has an infrastructure (crumbling as it may be be) should be taken as evidence, I think, that people are generally willing to support worthy public enterprises--where worthiness is judged by a project-by-project cost-benefit analysis.

And speaking of standard principles, what ever happened to the quaint idea of evaluating the merit of public capital expenditure on a net present value basis, instead of some magic-multiplier concept? There is probably a good NPV case to be made for implementing such projects in a recession, even in the absence of positive externalities. Indeed, if what we read about America's "crumbling infrastructure" is true, these projects should have been started several years ago. Perhaps they were not because the economy was at that time judged to be "overheating." After all, the same Keynesian cross logic suggests decreasing G during a boom (crumbling infrastructure be damned). D'oh!...dang Keynesian cross.

The Great Canadian Slump: Can it Happen in the U.S.?

2010-12-22T14:06:00.000-08:00

The large decline in U.S. employment has had me reminiscing about Canada's similar experience in the early 1990s. I remember Pierre Fortin's presidential address to the Canadian Economic Association in 1996, entitled The Great Canadian Slump. Fortin seems to place much of the blame for this episode on the Bank of Canada; a claim hotly contested by Chuck Freedman and Tiff Maclem of the BoC here. I see that Stephen Gordon of WCI was reflecting on this episode in Canadian economic history as well; see here.

Let's begin by looking at employment-population (E/P) ratios. Population for Canada is 15+; for the U.S., it is 16+ civilian, noninstitutional (sample period 1976:1 - 2010:3).

The two series are similar up until about 1990. Then the recession hit. And it hit much harder and longer for Canada.

In 1990, E/P dropped by less than 2 percentage points in the U.S.; and dropped by about 4 percentage points in Canada. Now take a look at 2008; it is exactly the opposite. Canadians, apparently, don't need a world financial crisis to generate crisis-like employment slumps. In fact, the financial crisis appears to have had relatively little impact on Canada (that is, relative to the U.S., and relative to Canada in 1990).

One thing that might be of interest (or concern) for Americans is the length of Canada's employment slump. The E/P ratio essentially flat lined for about 5 or 6 years; and did not attain its pre-recession peak of 62% until well into the next decade.

Let me normalize real per capita GDP and the E/P ratio each to 100 in 1990:1. Here is what Canada's output and employment history looks like for the 1990s:

Now, that's what I call a jobless recovery!

It's interesting to look at other measures of labor market activity too. The next graph shows the participation rates (labor force divided by adult population):

Part rates are similar until 1990, and then exhibit almost a mirror image. Note that the U.S. participation rate shows some evidence of secular decline since reaching its peak. The next graph plots unemployment rates (unemployment divided by labor force):

The large gap in cross-country unemployment rates that emerged in the early 1980s and persisted for two decades elicited a fair amount of hand-wringing and a collective gnashing-of-teeth in Canada. To see what people were talking about, have a look here.

The main point I want to convey here for Americans is that the prospect of a prolonged jobless recovery, with persistently high unemployment rates, is not outside the realm of possibility. Such an episode has occurred in the recent past and, moreover, it occurred in an economy that is more similar to the U.S. than perhaps any other (in particular, Canada is not Japan).

This does not, of course, mean that a jobless recovery is inevitable. But I do think it might be worth exploring what parallels (if any) exist between these two episodes, and to see what might be learned from it. Will keep you posted, but in the meantime, feel free to share your thoughts.

Interpreting the Beveridge Curve

2010-12-18T13:32:00.000-08:00

The Beveridge curve (BC) refers to the relationship between job vacancies and unemployment. There are really two types of BCs: one empirical, and one theoretical. The empirical BC is simply a scatterplot of vacancy and unemployment data. Think of data as the entrails of a gutted animal. The theoretical BC is an interpretation of those entrails, as divined by an economic haruspex.

The empirical BC is usually negatively sloped. Except for when it isn't. (You know how it is.)

The theoretical BC is a very intuitive creature. If some measure of general business conditions improve, especially in terms of economic outlook, businesses will generally want to expand their investments. And this includes investment in the form of replenishments to their labor force. If the labor market is subject to search frictions, the hiring process will take time. But an increase in job openings will generally make it easier for unemployed workers to find a job, so we would expect unemployment to decline as job vacancies rise.

Sometimes, however, the BC appears to "shift" its position (e.g., if the BC looks like a shotgun blast). These apparent shifts are sometimes interpreted to be the consequence of shocks that somehow lead to increased search frictions (let me label these "structural" shocks). In his fine Nobel prize lecture, Christopher Pissarides gave the example of Brittain 1975-84:

Usually though, the BC has a sharper negative slope. This was certainly the case in the United States; at least, until recently. Here is a plot of the U.S. BC using JOLTS data. Both job openings and unemployment are divided by a measure of population (16+ civilian). The dots represent the empirical BC and the solid line represents a theoretical BC.

A fairly conventional interpretation of the pattern above is that the U.S. experienced a cyclically-induced increase in unemployment; at least, approximately up until the recession was formally declared ended. These are the blue dots (lying close to that BC line I am forcing into your brain). Since then, something screwy appears to have happened in the labor market. There is evidence of increased recruiting activity, but no evidence of declining unemployment (the red dots).

Is this evidence of some greater difficulty in matching unemployed workers to available jobs? Did the recent recession leave us with some "structural" problems? If so, can we identify precisely what these "structural" problems are, and what--if anything--might be done about it? These are just some of the questions people are asking theses days.

Unfortunately, I'm not presently able to answer these questions. What I offer, instead, is some speculation on another question that has been floating in my mind lately. In particular, is the pattern of the U.S. BC plotted necessarily inconsistent with the notion that "structural" shocks have afflicted the labor market throughout the recent recession?

It was Steve Williamson's blog post here that got me thinking about this. Underlying much of the modern theory of search in the labor market is the Phelps/Pissarides aggregate matching technology:

[1] h_t = x_tM(v_t,u_t)

where h denotes hires, v denotes job openings (vacancies), and u denotes unemployment. For quantitative applications, M(.) is usually specified to be Cobb-Douglas; e.g., M(v,u) = v^0.5u^0.5. The x parameter corresponds to the TFP parameter in a standard aggregate production function. Following Steve, I use the JOLTS data to compute the matching function "Solow residual:"

[2] log(x_t) = log(h_t) - 0.5log(v_t) - 0.5log(u_t)

And here is what I get:

The red dots depict TFP from December 2007 (the official start of the recession) onward to October 2010.

According to the plot above, events beginning with the recession have reduced matching function efficiency by about 20%. That's a big drop. But what does it mean? It's important not to get too carried away with this result. In particular, we have all the usual measurement problems to contend with when constructing TFP measures. For example, much or perhaps even most of the decline in measured TFP may be the consequence of (unmeasured) reductions in search intensity.

On the other hand, there does not appear to be any good reason to simply dismiss the result as evidence of increased search frictions. We just lived through an episode that tore apart many ongoing relationships. Picking up the pieces and putting them back together again (possibly in new and more productive ways--re: Schumpeter's creative destruction) may be a bit more difficult this time around. Ultimately, I think we will need to examine the microdata to assess the "disruptiveness" of the recession. Perhaps a study along the lines of Rogerson and Loungani (JME 1989)--who look at PSID data--might shed some light on the matter.

But until then, if we take the measured TFP data seriously (and, again, I emphasize the caveats), might this warrant reinterpreting the U.S. BC in the following way?

The red dots represent the empirical BC since the beginning of the recession (Dec 2007); the time when the estimated matching function TFP appears to weaken.

It is interesting, I think, to examine this interpretation in the light of a simple labor market search model. In an earlier post, I argued that a negatively sloped BC is not inconsistent with a sequence of shocks that deteriorate matching efficiency; see here. Let me show you what I mean, via a simple example (that restricts attention to steady-states).

There is a cyclical variable, labeled y. This denotes the output produced by a job-worker pair. I assume a "fair share" bargaining rule that divides this output into wage and profit components. A firm's flow profit is given by the share ξy. The present value of this profit flow is denoted J(y). This value is procyclical; i.e., it will increase when the cyclical variable y increases.

If a firm wants to open a job vacancy, it must bear a cost κ. It is successful in finding an unemployed worker with probability xq(θ); where θ = v/u is the "labor market tightness" variable, and where q(.)=M(.)/v. If the new hire starts work next period, the expected present value of posting a vacancy is xq(θ)βJ(y). The following zero-profit condition determines the equilibrium labor market tightness:

[3] xq(θ)βJ(y) = κ

Condition [3] determines θ(y,x). It is easy to show that θ is increasing in the "cyclical" variable y and the "structural" variable x.

Finally, there is a stock-flow equation that determines the equilibrium unemployment rate: u = σ / (σ + xp(θ)); where σ is an exogenous match separation parameter (job destruction rate).

I parameterize this simple model and compute the equilibrium vacancy-unemployment combinations under two scenarios (GAUSS code available on request). First, I vary the "cyclical" variable y 15% above and below its mean value, holding x fixed. Then, I hold y fixed at its mean value and vary the "structural" variable x 15% above and below its mean. And here is what I get:

What is interesting here is that a permanent decrease in the match efficiency parameter x leads to a permanent decline in job creation and permanent increase in unemployment (of course, I am not suggesting that these "structural" shocks are in any way permanent in reality). I think it was Abraham and Katz (JPE 1986) who led many (including myself) to believe that structural changes should lead to a positively-sloped BC. Of course, they did not have an explicit model. According to this simple model, they appear to be wrong. We may at least conclude that they are not necessarily correct.

In short, one reason why job openings may have declined is because it is generally more difficult for firms to find the right worker. Indeed, given how circumstances may have changed since the recession, firms may not--as of yet--even know what type of skill set constitutes the best hiring investment. Until this uncertainty in the match-making process sorts itself out, it may make sense to recruit less intensively.

Okun's Law Rules the FOMC

2010-12-15T09:24:00.000-08:00

Zzzzz...oh...what's that? The FOMC say's what?

Information received since the Federal Open Market Committee met in November confirms that the economic recovery is continuing, though at a rate that has been insufficient to bring down unemployment.

(Full statement available here.)

Stop the presses! New headline: Central bank warns recovery too slow to curb unemployment (Financial Times, Dec. 14, 2010).

Oh no! Well, we'd better get that growth going then. What's everyone waiting for? Increase G! Increase M! Increase...increase.....Zzzzzz.

Sorry, but I stayed out way past my regular bedtime last night. And for some strange reason, I find myself mulling over this curious phrase: "...though at a rate that has been insufficient to bring down unemployment." Why did the FOMC include it in their statement? What does it mean? And where does it come from?

Let me start with the last question first. It comes from the late Arthur Okun, who discovered something called Okun's law back in the 1960s. Evidently, Okun's law was widely taught back in the day. These would have been the days when most of the now senior members of the FOMC were impressionable youngsters; see -------->

Alright, so now we know where it comes from. But what does it mean? Obviously, it refers to some sort of ironclad law of economic nature, right?

Uh, well...no, not exactly. When the law breaks down, proponents like to refer to it as a "rule of thumb," instead. To be honest, it's really just a statistical correlation. When economic growth goes up, the unemployment rate goes down. At least, on average this is what happens at business cycle frequencies.

Of course, it's also true that when the unemployment rate goes up, economic growth slows down. To put things another way, output tends to go up when more people are working. I know it's quite the shocker, but many economists believe this to be true. This is why they pay us the big bucks.

But why am I confusing you in this manner? Let's see what that great purveyor of purloined propositions (PPP) has to say about the subject: Growth and Unemployment.

What you see is that unemployment tends to fall when growth is high, rise when it’s low or negative. You also see that growth has to be fairly fast — more than 2 percent — just to keep the unemployment rate from rising. Why? Well, productivity is rising, so that you can produce any given level of output with fewer workers; so output has to rise to keep employment from falling.

(That darned productivity growth--scourge of the labor market.)

Alright, so what is PPP trying to say here, especially in that last sentence? As far as arithmetic goes, it's obviously correct (the language is sloppy, but let's cut him some slack). But arithmetic is not theory. He is trying to explain the empirical correlation of Okun's law. And explanation requires theory. Where is the theory?

To see what I mean here, let me alter the last sentence in the quote like this:

Well, productivity is rising, so that you can produce any given level of output with fewer workers; so employment has to rise if output is to rise at a more rapid pace.

As far as arithmetic goes, this statement is also correct. But the sentence appears to convey a different message, doesn't it?

Evidently, there's more to Okun's law--the way it is commonly expressed--than a simple correlation. It seems to be sort of a "theory" too (I use the term loosely here). The theory is to be found in the assumption that the direction of causality runs one way only, and that it runs from output to employment, rather than the other way around. Output growth causes--nay, output growth is needed--to bring unemployment down. I guess the idea that more employment might cause more output--reversing the causality--seems less obvious.

The way Okun's law is commonly expressed naturally leads to more sympathy for "demand side" policies, like increasing G or M, to stimulate employment. I am not saying that this shouldn't be done. What I'm saying is that the arithmetic supplied by PPP is not what supports such a policy. My use of the arithmetic, for example, might instead be used to support "supply side" policies, like a cut in the payroll tax. It would be equally wrong to abuse arithmetic in this manner.

Anyway, I think it is time to bring my morning rant to a close. But I still haven't answered the question of why that silly phrase was included in the FOMC statement. Would anything of any substance have been lost if the statement had not included it? It's not as if QE2 can only be justified if one believes in Okun's law (PPP version). I guess it's difficult to rid oneself of some youthful impressions.