Optimal Fiscal Policy in a Liquidity Trap

Am in between trips now, so have a bit of time to offer a few thoughts on this piece by Paul Krugman: Optimal Fiscal Policy in a Liquidity Trap. Hmm...where to start?

I think it was Ronald Reagan who once quipped that an economist is someone who sees something working in practice and then asks whether it might also work in theory. (A good one, I have to admit).

Many can relate to this sentiment. It is based on the idea that any given body of data largely "speaks for itself." We do not need abstract theories to interpret the world and help guide our decision making. Just look at the evidence, and use some common sense.

Well, one problem with this is that "common sense" frequently means different things to different people (e.g., my common sense; not yours, you dope). If it is indeed true that the data speaks for itself, how is it possible for people not to agree on what the data is saying? Evidently, data does not always "speak for itself;" it is subject to interpretation. And when data is limited, it is frequently difficult to discriminate between competing interpretations (theories). Scientists struggle to find the most plausible interpretations--a set of tentatively-held hypotheses, destined for modification (or even destruction) as the science progresses.

Why am I saying this? Well, in part because Krugman seems to toss a bone to this general idea in the opening paragraph of his article:

One thing that's been conspicuously missing from the back-and-forth among economists about fiscal stimulus is anything resembling a fully specified model. To some extent that's O.K. [...] But there are dangers in relying entirely on implicit theorizing: you can find yourself saying things you think must be true, but that turn out not to be true even in a simple model with maximizing agents.

What's this? It is a rather odd statement coming from a person who generally speaks as if he knows "the truth" on any given matter. But here (and recently elsewhere), he laments the absence of anything resembling a "fully specified" (read: "fully coherent") model. What's this all about?

Perhaps it is an implicit admission on his part that the historical evidence (as of Dec. 29, 2008) does not "speak for itself" --at least, not in a manner that would support his long-held and steadfast belief on this matter. And so, if the Conscience of a Liberal can finally admit to this, I should hope that others might now feel free to follow in his example.

Alright then, on to the main point of his article. His goal, quite clearly, is to demonstrate that what he strongly believes to be true actually possesses some theoretical legitimacy. He chooses as his framework of analysis a more-or-less standard New Keynesian (NK) model. The NK model traditionally downplays financial market frictions and highlights, instead, frictions in nominal wage/price adjustments. I say this to alert the non-specialist to the fact that Krugman wants us to understand the current liquidity trap as a phenomenon that arises in a world where financial market imperfections play no central role. (This may or may not be a legitimate abstraction for the purpose at hand--I admit to having my doubts).

On his blog he warns us that the paper is likely to be incomprehensible (because it was written in a hurry). Well, it is not so much incomprehensible as it is incomplete. It is, as he admits, simply a sketch of an argument.

And his argument is roughly this. Imagine that the economy is hit by a "shock" that renders households temporarily more patient; i.e., they now wish to delay their consumption purchases. This generates a large decline in consumer demand--on the flip side, a "savings glut." (Note: in the recent recession, consumption remained relatively stable--it was investment spending that tanked). The economy "wants" a lower interest rate and normally, this desire is accommodated by the Fed. But when the zero lower bound is reached, the lack of nominal price adjustment implies that current GDP (income) must decline to frustrate the glut in desired saving. The decline in GDP could be averted, or at least mitigated, by an appropriation of resources from households (in the form of a lump-sum tax), which the government is required to spend (consume).

Maybe there is something to this--I don't know. The result appears to hinge critically on the assumption of sticky prices, and one might legitimately wonder whether there is enough "stickiness" out there to render the effect quantitatively large and persistent. The interested reader may wish to consult: When is the Government Spending Multiplier Large? (Christiano, Eichenbaum and Rebelo, 2009). Their calibration appears to have an implausible degree of price ridigity built in, but please correct me if I am wrong.

I would like to say a few things about the way the K-man concludes his analysis:

The bottom line is that while we usually think of Keynesianism as the preserve of ad hoc models, in this case doing it "right"--using a macromodel with maximizing agents and a proper concern for intertemporal constraints--actually suggests a very strong case for big government spending in the face of a liquidity trap [...] So let's get those projects going.

Hmm...a case for big government spending? That's quite the conclusion from a qualitative model. Oh well, just a minor slip of the tongue, I'm sure.

Second, I do not think of Keynesianism as the preserve of ad hoc models (even if Krugman may at times be). I think that JM Keynes was a very careful theorist, especially given the tools at his disposal. And I would like to stress that Keynes was not ashamed of theory:

But [this book's] main purpose is to deal with difficult questions of theory, and only in the second place with the applications of this theory to practice." - John Maynard Keynes, The General Theory of Employment, Interest, and Money, p. v.

Finally, Krugman leaves the impression that he has proven something very robust; a property that would hold in any NK model. A recent paper suggests that this is not the case: Fiscal Policy in an Expectations Driven Liquidity Trap (Mertens and Ravn, 2010). Here is the abstract:

We examine the impact of fiscal policy interventions in an environment where the short term nominal interest rate is at the zero bound. In the basic New Keynesian model in which the monetary authority operates a Taylor rule, globally multiple equilibria arise, some of which display all the features of a liquidity trap. A loss in confidence can set the economy on a deflationary path that eventually prevents the monetary authority from adjusting the interest rate and can lead to potentially very large output drops. Contrary to a line of recent papers, we find that demand stimulating policies become less effective in a liquidity trap than in normal
circumstances. The key reason is that demand stimulus leads agents to believe that things are even worse than they thought. In contrast, supply side policies, such as cuts in labor income taxes, lead to relative optimism and become more powerful.

Apparently, there is still much to learn...even if your initials are PK.

Greg Mankiw on Fiscal Policy

Just over one year ago, when "fiscal stimulus" was all the rage, I asked what I thought was a simple question: How do the proponents of fiscal stimulus know that it works? More precisely: what evidence can we bring to bear on the question of whether a large increase in government spending during a peacetime economic crisis stimulates GDP in a welfare-improving manner? (I allowed for the possibility that such a spending program may have desired redistributional aspects, but redistribution is patently not what people talk about when they speak of the benefits of fiscal stimulus--it is something that is supposed to make us all better off).

In case you're interested, you can refer to:

Does Fiscal Spending "Work?"
Believing in Fiscal Stimulus.
Believing in Fiscal Stimulus 2.

I appeared to have hit a nerve with some people on this topic. One chap named Bruce Wilder was particularly amusing (that is, if you find appalling ignorance and santimonious drivel amusing). This "debate" had the side benefit of leading me to think about a theory of religion. In any case, the record of this exchange can be found here:

Bruce Wilder on Andolfatto.
Religiousity in Macroeconomics and the Sad Case of Father Wilder.

As far as I was (am still) concerned, it all boiled down to personal beliefs (religion). There is simply not enough data (as far as I am aware of) that could lead any honest (agnostic) scientist to come down strongly on one side of the debate or the other. It led me to question to academic integrity of strong proponents of fiscal stimulus like Paul Krugman and Brad DeLong. (I do not feel quite the same way for strong opponents, as they are usually more honest about their beliefs: they simply do not want the government to interfere in the lives of its citizens, period. However, this may simply reflect a defect or bias on my part).

And then along comes Greg Mankiw, a self-described Keynesian. He recently published this in the Federal Reserve Bank of St. Louis Review: Questions About Fiscal Policy.

Mankiw is a gifted writer. I encourage you to read it. He begins the paper with a great analogy. But what I really loved was this line:

I am actually a believer in Keynesian theory; much of my research is in that field. But even as a believer in many aspects of Keynesian theory, I appreciate that you cannot approach this subject matter without showing some humility about what we, as economists, can truly be confident about.

My only quibble is why he only included economists in that worthy sentiment.

Other than that, all I have to say is:

Amen

John Cochrane on a Euro-Greek Tragedy

An excellent piece today by John Cochrane in the WSJ here. Here it is (in case you do not subscribe).

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Last week the Greek bailout ballooned into a gargantuan 750 billion euro (nearly $1 trillion) debt stabilization fund, including a $39 billion line of credit from the International Monetary Fund. This coincided with the European Central Bank (ECB) announcement that it would immediately begin purchasing junk-rated Greek debt.

It won't work. The problem isn't liquidity, psychology or speculators. Germany and France simply cannot borrow or tax enough to cover Europe's debts and looming deficits. So, barring a fiscal and growth miracle, we will either see sovereign defaults (larger and more chaotic for having been postponed) or the ECB will have to print euros to buy worthless debt, leading to widespread inflation. Since inflation lowers the value of promises to state workers and pensioners, and also is easy to blame on others, it will be an especially tempting escape.

Notice who is missing: Greek bondholders are not being asked to miss a single interest payment, reschedule a cent of debt, suffer any write-down, take a forced rollover or conversion of short to long-term debt, or any of the other messy ways insolvent sovereigns deal with empty coffers. Those who bought credit default swaps lose once again.

But why? The reasoning behind the Greek bailout is founded on several myths that need exploding:

• Saving the euro. We're told a Greek default would imperil the euro.

The opposite is true. Allowing Greece to default, or to renegotiate with bondholders, would be the best way to save the euro. A currency union is strongest without fiscal union. Then
countries are no different from companies. If they borrow and cannot pay back, investors lose money. The currency is unaffected.

The euro could become a monetary union with full fiscal union. I hate to think what EU budgets and taxes would look like if they were all run from Brussels, but at least that system might impose some discipline on national governments' incentive to borrow, spend, and demand bailouts.

But the euro will be a disaster as a monetary union with loose fiscal controls and constant speculation about will-they-or won't-they (or can-they-or-can't-they) trillion-euro bailouts and ECB financing. The Europeans have found the worst possible combination.

How did this happen? The euro's founders wrote rules against sovereign bailouts. They almost created a perfect currency: an international standard of value and medium of exchange, with a central bank mandated only to maintain a stable price level. The euro was not to be devalued to wipe out government debts or to gain temporary (and often illusory) trade or employment
advantages. In the next U.S. inflation crisis, the euro might have succeeded the dollar as the international reserve currency.

But the euro's founders also set debt and deficit limits. The problem is not that these limits were too loose. The problem is having them at all. The mere existence of the limits says, in effect, that politicians will have a hard time resisting bailout pressure. So the markets lent at low rates and gave high bond ratings. The EU rediscovered that it's much harder to grow a spine in the middle of a crisis.

The euro founders should have said instead, "Go ahead, use our currency if you like. Rack up any debts you want. We don't care, because we are not going to bail you out—we've set it up so we can't bail you out. Bond buyers beware."

The euro founders never decided whether they were creating the perfect currency without fiscal union, or if they were creating a fiscal union on the way to political union. They never decided if the euro was going to be the national currency for a future United States of Europe or a gold standard for the modern age. Now they have neither.

• Contagion.

We're told that a Greek default will lead to "contagion." The only thing an investor learns about Portuguese, Spanish, and Italian finances from a Greek default is whether the EU will or won't bail them out too. Any "contagion" here is entirely self-inflicted. If everyone knew there wouldn't be bailouts there would be no contagion.

• Systemic risk.

We're told that a Greek default will threaten the financial system. But how? Greece has no millions of complex swap contracts, no obscure derivatives, no intertwined counterparties. Greece is not a brokerage or a market-maker. There isn't even any collateral to dispute or assets to seize. This isn't new finance, it's plain-vanilla sovereign debt, a game that has
been going on since the Medici started lending money to Popes in the 1400s. People who lent money will lose some of it. Period.

• Saving the banks.

We're told that Greece must be bailed out, or large banks will fail. Savor the outrageous irony of this claim. Apparently, two years after the great mortgage meltdown, Europe's army of bank regulators missed the fact that large, "systemically important" banks had made firm-threatening bets on Greek debt. So much for the idea that more regulation will keep complex banks out of trouble.

If the claim is true (which I doubt), the right answer is to save the specific "systemically important" banks (or, better, their "systemically important" activities), not to bail out every Greek bondholder and the Greek government and to paper over the vast bank and regulatory failure that set up the problem.

Greece got in to trouble when it tried to sell new debt to repay its maturing short-term debt, just as Bear Stearns and Lehman Brothers did. If Greece had sold long-term debt, there would be no sudden crisis. In all the talk of restructuring euro finances, nobody is talking about forcing governments to borrow long-term, nor of managing the crisis by forcing short-term debtholders to accept new long-term debt rather than cash.

Letting someone lose money on sovereign debt is the acid test for the euro. If not now, when? It won't happen in good times, nor to a smaller country. The sooner the EU commits, and other countries and their lenders come to terms with the fact that they will not be bailed out, the better.

The current course—ever-larger and less-credible bailout promises, angry German voters who may vitiate those promises, vague additional fiscal supervision (i.e. more of what just failed miserably)—is not the answer.

The only way to solve the underlying euro-zone fiscal mess (and our own) is to slash government spending and to focus on growth. Countries only pay off debts by growing out of them. And no, growth does not come from spending, especially on generous pensions and padded government payrolls. Greece's spending over 50% of GDP did not result in robust growth and full coffers. At least the looming worldwide sovereign debt crisis is heaving "fiscal stimulus" on the ash heap of bad ideas.

On Ron Paul and the Fed

What a way to start the day. Another interview on CNBC this morning with Ron Paul: Fed to Blame for Everything

Let me come clean: I basically share the man's distrust of heavy concentrations of power. And I think that secular stability in the general level of nominal prices is probably a good idea too. Thus, it appears that we share a number of beliefs. So why does the guy make my eyes roll whenever I hear him speak?

His problem, in a nutshell, is this: He ascribes too much power to the Fed. The power in the U.S. resides in Congress. It is Congress that spends, taxes, and issues treasury debt. Traditionally, the Fed simply determined the composition of government debt between its interest-bearing (debt) and non-interest-bearing (money) components. What sort of power is this? (Especially in relation to the power of Congress).

Ah yes, but the Fed has greater power than this. It can "lend to its friends" and "let its enemies fail." I presume he is talking about the Fed's emergency lending facilities, all of which have now wound down, with a healthy profit for the U.S. taxpayer.

But I am missing the point: The Fed has the ability to create money "out of thin air!" Whenever I hear this expression, I chuckle. We all have the power to create debt out of "thin air." When Microsoft creates shares to finance an acquisition, it creates the shares "out of thin air." If you bum a beer from a friend and promise to repay him next week, you create a debt obligation "out of thin air." Ooooo..."out of thin air!"

Evidently, Paul has been forecasting the current problems of the world since 1971 (the breakdown of the Bretton Woods system). Yep, there were certainly no problems prior to this. No inflation to speak of. Well, maybe a bit during the Korean war. And maybe a bit more during the Vietnam war. Oh, and let's not forget Lyndon Johnson's war on poverty. Fiscal strain, fiscal strain, fiscal strain...all the fault of the Fed, no doubt. This fiscal strain apparently had nothing to do with the breakdown of Bretton Woods...no, let's just blame the Fed for going off the gold standard. As if Arthur Burns had more power than Richard Nixon.

To be fair to Ron Paul, his position appears to be this. It is not ultimately the fault of the Fed. It is the fault of those in Congress who would like to use the Fed as their personal piggy bank to finance their pet "great society" spending initiatives. What Paul would like to see is an institution that prohibits Congress from making sneaky appropriations through the inflation tax.

If this is his view, then I have some sympathy for it. But I think that his energy here could be better spent elsewhere: there are bigger fish to fry in the realm of fiscal policy reforms.

The Euro Crisis

An interesting piece today in Spiegel: The Euro Crisis.
Take a look at this (a few pics reproduced below).

Duffie in Defense of Speculation

Darrell Duffie explains here why speculation is not a four-letter word (In case you do not subscribe to the WSJ, I reproduce the article below).

It's a nice and easy read. But I couldn't help notice that he does not exactly define the term for us (nor, for that matter, do those who wish to pass laws to prohibit the practice).

He seems to identify "speculators" as relatively risk-tolerant agents. These type of agents provide a social good by their willingness to absorb risk, giving the rest of peace of mind.

Of course, their willingness to absorb risk is not necessarily the same thing as their ability to absorb risk. If things turn out very poorly, the rest of us will be asked to absorb the risk. So maybe these "speculators" aren't quite as risk tolerant as they are made out to be (since they have no risk to bear when things turn out badly).

Hmmm...how to define these terms? Perhaps we need some sort of Devil's Dictionary (by Ambrose Bierce, in case you haven't read this--it is brilliant). OK, I propose to hold a contest. Please submit your preferred (cynical) definition of either "speculator" or "speculation." Here's mine:

Speculation (n): The risk-taking behavior of other people.

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By DARRELL DUFFIE
George Soros, Washington Democratic Sen. Maria Cantwell and others are proposing to curb speculative trading and even outlaw it in credit default swap (CDS) markets. Their proposals appear to be based on a misconception of speculation and could harm financial markets.
Speculators earn a profit by absorbing risk that others don't want. Without speculators, investors would find it difficult to quickly hedge or sell their positions.
Speculators also provide us with information about the fundamental values of investments. When the fundamentals appear favorable, they buy. Otherwise, they sell. If their forecasts are correct, they profit. This causes prices to more accurately forecast an investment's value, spreading useful information. For example, the clearest evidence that Greece has a serious debt problem was the run-up of the price for buying CDS protection against the country's default.
Is this sort of speculation wrong? I have not heard why.
Those who call for stamping out speculation may be confused between speculation and market manipulation. Manipulation occurs when investors "attack'' a financial market in order to profit by changing the value of an investment. Profitable speculation occurs when investors accurately forecast an investment's fundamental strength or weakness.
An example of manipulation is an attack on a currency with a fixed exchange rate in an attempt to cause a devaluation of that currency. Mr. Soros allegedly attacked the British pound in 1992 and the Malaysian ringgit in 1997. An attack on the equity or CDS of a bank could create fears of insolvency, leading to a bank run and allowing the manipulator to profit from his attack.
In the week of Lehman Brothers' bankruptcy in September 2008, John Mack, then CEO of Morgan Stanley, suggested that the difficulties facing his firm stemmed from such an attack. But firms complaining of unfounded short-selling often had real problems beforehand.
A market manipulator can also attempt to profit by "cornering" a market. This is done by holding such a large fraction of the supply of an asset that anyone who wants to buy that asset is at the mercy of the corner holder when negotiating a price.
The market for silver was temporarily cornered in 1979-80, when Nelson Bunker Hunt and his brother William Herbert Hunt held silver derivatives representing approximately half of annual global silver production. In the end, the Hunt brothers were unable to maintain a corner. As they sold, silver prices fell, causing them calamitous losses.
Market manipulation for profit is not easily done. If the fundamentals of supply and demand suggest that the value of something is $100, then a manipulator must buy at prices above $100 in order to drive the price up or to accumulate a monopolistic position. He then owns an asset that on paper could be worth more than what he paid for it. However, he must sell his asset in order to cash in on his profit. This spurs the price of that asset to fall, as the Hunt brothers learned.
Simply driving up the price, as speculators are alleged to have done in the oil market in 2008, is not enough. To make a profit, a manipulator needs to obtain monopolistic control of the supply. Given the size of the oil market, that seems implausible, absent a major and sustained conspiracy.
In the United States, trade with an intent to manipulate financial markets is generally illegal. Regulators should keep anti-manipulation laws up to date and aggressively monitor potential violators.
Speculation is not necessarily harmless. If a large speculator does not have enough capital to cover potential losses, he could destabilize financial markets if his position collapses. The Over-the-Counter Derivatives Markets Act, which could come up for a vote in the Senate soon, will hopefully reduce such risks.
It would be better for our economy to enforce anti-manipulation laws, and require that speculators have enough capital to cover their risks, than to attempt to squash speculation.
Mr. Duffie is a professor of finance at Stanford University's Graduate School of Business.

Outing the Fed

It is said that we get the government we deserve. Well, if this is true, then judging by the vitriol spilling out of the mouths of some of our elected representatives, we are all morons.

Here's the latest, from the Nation: Outing the Fed. Some selected tidbits with commentary follow.

Rep. Alan Grayson, the first-term Florida Democrat who partnered with Paul to pass the House version, has a distinctive way of explaining things with brutal clarity. "Fed Chairman Ben Bernanke doesn’t want an audit because Ben Bernanke doesn’t want to be audited," Grayson said. "Treasury Secretary Tim Geithner, the former head of the New York Fed, doesn’t want an audit because Tim eithner doesn’t want to be audited."

This sanctimonious twit should be tarred and feathered for his hypocrisy. (Wouldn't we all love to see the skeletons in his closet). In any case, he continues to propagate the myth that the Fed is never audited. I have addressed this issue here.

Forget all the official blabber about "Fed independence." The central bank has never been independent from the most powerful bankers it is supposed to regulate. The everyday relationship is incestuous. What the Fed and its main constituency of Wall Street power houses really fear is that people will get a better look at their corrupt private dealings. During the financial crisis, the central bank handed out something like $2 trillion in emergency loans and other goodies. All efforts by Grayson and others to find out who exactly got this money were rebuffed by the Fed governors. Bloomberg sued for disclosure and won in Federal court. The Fed is appealing the ruling.

Please explain this "everyday incentuous relationship" that the Fed evidently has with the big banks it is "supposed to regulate." As I explained here, the Fed has primary regulatory authority over only 15% of the nation's banks (whether measured by number of banks, or by assets). What on earth are they talking about here?

Yes, during the crisis the Fed did "hand out" something like 2 trillion in emergency loans (and other "goodies"? like what?). What is conveniently ignored here is that most of this emergency lending has been repaid with penalty interest rates. Perhaps they have failed to notice that the Fed remitted an extra $25 billion or so in 2009 to the Treasury; see here. Yes, yes...I demand to know who the Fed lent all this money to that was ultimately repaid with a very high return! Who were the recipients of this bailout!? (Blah, blah, blah...in the meantime, with Congress handing out bona fide bailout money to its favored special interests...)