Plunging Yields

The nominal yields on "high-grade" government debt instruments continue to plunge; see here. Real interest rates on U.S. government debt are negative (I talk about real yields here).  It is a pretty bearish sign when the only thing investors appear to trust is the ability of (some) governments to service their debts.

The "flight to safety" phenomenon is a natural response by investors when uncertainty (along several dimensions) increases. Much of this uncertainty appears to be political in nature; even Mark Thoma appears to agree (of course, Mark blames the Republicans for this; as if only one side of a boxing match can be held responsible for inflicting harmful blows and counter punches.)

Although political uncertainty is almost surely playing a role in current events, one should not discount the role that political certainty can play. Greek youth, for example, appear certain that the governance of their country will remain hopelessly inept for the foreseeable future; and so many are flocking to other parts of Europe, including Germany. (Are the young reneging on their "obligation" to finance entitlements for the old?)
 
Not all that ails us has its roots in politics though. Personally, I think that the recent recession was associated with a significant "structural" shock that will take a long time to work out (see here). The U.S. unemployment remains elevated at 8.1%. People are eager to work (at well-paying jobs). At a Hyundai plant in Montgomery, Alabama, more than 20,000 have applied for one of the 877 job openings; see here. At the same time, employers appear to be having a hard time finding qualified workers in several occupations, including truck drivers, software developers, laborers, nurses, machinists, accountants, scientific researchers, administrative assistants, leisure and hospitality workers, and repair technicians; see here. 

Tax policy shocks and the business cycle

I have to admit that I never ascribed much importance to the idea of "tax policy shocks" as an important driver of the U.S. postwar business cycle. I thought of such shocks as perhaps playing a supporting role, along the lines of Tax Disturbances and Real Economic Activity in the Postwar United States (Tony Braun, 1994).

But I just came across a paper that has led me to re-evaluate my views on this matter: Empirical Evidence on the Aggregate Effects of Anticipated and Unanticipated U.S. Tax Policy Shocks (Karel Mertons and Morten Ravn, 2011). Here is the abstract:

We provide empirical evidence on the dynamics effects of tax liability changes in the United States. We distinguish between surprise and anticipated tax changes using a timing-convention. We document that pre-announced but not yet implemented tax cuts give rise to contractions in output, investment and hours worked while real wages increase. In contrast, there are no significant anticipation effects on aggregate consumption. Implemented tax cuts, regardless of their timing, have expansionary and persistent effects on output, consumption, investment, hours worked and real wages. Results are shown to be very robust. We argue that tax shocks are empirically important impulses to the U.S. business cycle and that anticipation effects have been important during several business cycle episodes.

There's a lot of interesting material in this paper, and I encourage anyone interested in understanding the effects of fiscal policy to read it.

One result I found interesting is the apparent temporary depressing effect of an anticipated tax cut, consistent with the predictions of a standard dynamic general equilibrium model...

Our results appear consistent with strong supply side effects of tax changes. The strong decline in investment and the drop in hours worked in response to a pre-announced tax cut is consistent with the idea that future lower taxes motivate firms to delay purchases of capital goods and gives rise to intertemporal substitution of labor supply. Indeed, Mertens and Ravn (2011) show that a DSGE model can account quite precisely for the dynamics of output, investment, and hours worked that follow after unanticipated and anticipated changes in taxes...

The boom associated with an announced tax cut seems to begin only when the actual cut is implemented. Together, these two pieces of evidence make for an interesting interpretation of what caused (or at least contributed to) the early 1980s recession.

Anticipated tax liability changes were particularly relevant impulses to the business cycle during the early 1980’s recession, the expansion that followed thereafter, and during the early 2000’s. 

Particularly interesting is the 1980’s episode where we find that ERTA (Economic Recovery Tax Act) 1981 and the Social Security Amendments of 1977 together had a large impact on the U.S. economy. The Social Security Amendments of 1977 (signed by Carter in December 1977) included a 0.56 percent tax increase implemented in 1981. This tax liability change had an expansionary effect on the economy prior to its implementation but provided a negative stimulus once implemented in 1981.

ERTA 1981, signed by Reagan in August 1981, was associated with major tax cuts implemented gradually from 1982 to 1984. These anticipated tax cuts had a negative impact on the U.S. economy from late 1981 up till the end of 1983, the same time as the negative effects of the Social Security Amendments of 1977 were setting in. When the Reagan tax cuts were eventually implemented through 1982 to 1984, it provided a major stimulus to the economy during the mid 1980’s. Together, these anticipated tax cuts therefore stimulated the economy prior to 1981, gave rise to a contractionary effects from 1981 to late 1983, and helped the economy recover thereafter.

Of course, these tax shocks are not estimated to be the whole story. Evidently, they account for around 20-25 percent of the in-sample variance of (detrended) output which, as the authors point out, is an estimate that is at least as large as the contribution of other popular candidates for business cycle impulses. In short, something that should be taken seriously!

A reply to David Beckworth

If potential GDP is what the CBO says it is, then the U.S. economy seems to be stuck in a rut. Proponents of NGDP targeting generally believe this to be the case. They also believe that were the Fed to adopt a credible NGDP target right now (with the NGDP path targeted back to its original path), then this NGDP path would become self-fulfilling. Moreover, they believe that the transition path back to normality would mostly take the form of RGDP growth (with perhaps a temporary blip up in the inflation rate).

I wish I could believe this too. But before I can, I have to find out what combination of logic and evidence underlies this belief. David Beckworth, a strong proponent of NGDP targeting, has kindly directed a reply to my query here. I'd like to offer a quick reply to the defense that he offers.

Theory

David quickly outlines two creditor-debtor problems that a NGDP target would help overcome.

The first problem is restoring the expected relationship between creditors and debtors that prevailed prior to the economic crisis. This is the 'risk sharing' problem recognized by David Andolfatto that a price level or strict inflation target cannot address. A NGDP level target would solve this problem by restoring nominal incomes to their expected pre-crisis paths when debtors signed their nominal debt contracts.

This is the "fairness" issue that talked about in my previous post here. In that post, I suggested that this problem may not be so significant because the price-level seems to be pretty close to its pre-crisis path (at least, if one draws the log linear trend beginning in 1990). But maybe I am missing something because evidently this "is a problem that price-level targeting cannot address." I presume this means that what is needed (given the current price-level) is more RGDP--and more RGDP in the form of greater employment, not productivity. Sure, but how is a nominal target supposed to increase RGDP? And what does restoring RGDP have to do with this "risk-sharing" argument? Of course creditors would like to see their unemployed debtors get back to work and service their debt. This has nothing to do with risk-sharing, as far as I can see.

The second problem is that there is a massive coordination failure among creditors now. Creditors could increase their spending to offset the debtor's drop in spending as the latter deleverages. The reason creditors have not--non-bank creditors are sitting on money assets while bank creditors are destroying them as they are acquired from the deleveraging debtors--is because they are uncertain about future economic activity. These actions by creditors create an excess demand for money or, equivalently, a shortage of safe assets.

David is not being as careful with his language as he should be: he cannot be anywhere near certain that the coordination failure he alludes to actually exists. It is only one of many different interpretations of current events. (An interpretation to be taken seriously, but not stated as if it were obviously true, and the reader obviously dense should he/she not see its veracity. Sorry, just a pet peeve of mine.)

As David knows, I have a lot of sympathy for the "asset shortage hypothesis" (I have written about it here, for example). In fact, any model that has a limited commitment friction that gives rise to debt constraints has a version of this idea embedded in it (this includes all New Monetarist models). The policy prescription coming out of these models is to expand the supply of "high quality" assets to meet the shortage. (Note, however, I have not seen anyone employ sticky nominal debt in these frameworks--would be worth exploring). The most obvious candidate here are U.S. Treasuries, which are used extensively as collateral in repo arrangements and as stores of value. Precisely how the Fed could improve this situation by removing these assets from the market (replacing them with assets that are roughly equivalent -- zero interest cash) needs to be spelled out more clearly. (David possibly has in mind the purchase of private assets, but this is not generally permitted under the Federal Reserve Act. In any case, why not have the Treasury issue bonds to finance the same purchases? Not sure what any of this has to do with a NGDP target).

Evidence

Okay, so what is the empirical evidence that a higher level of NGDP would make a difference now? The most obvious answer is that those advanced economies currently doing the best are the ones where aggregate nominal spending has remained on or near its pre-crisis trend. Case in point is Germany.

It is true that Germany largely escaped the world recession. But was this because agents around the world believed that German NGDP would not depart significantly from its path? Or was it because Germany had no real estate boom/bust episode? This is not evidence that stable NGDP prevents a crisis; it is evidence that avoiding a crisis prevents a decline in NGDP. We need to establish a direction of causality here, before making strong claims about what is happening.

A final but important piece of evidence is FDR's very own QE program in 1933. He had publicly called for the price level to return to its pre-crisis trend and then backed up the rhetoric with a devaluation of the dollar (relative to gold). As Gautti Eggertson shows, this policy dramatically altered expectations and sparked a robust recovery in 1933. This implicit price level target of FDRs was no different than a NGDP level target in this case.

Well, O.K. Although, I'm not sure one would want to compare the decline in the price-level in the early 1930s with what just happened recently; again; see the diagram here.
 
More theory

A NGDP level target would do the same today. It would commit the Fed to buying up as many assets as needed to restore aggregate nominal spending to some pre-crisis trend. Just the expectation of the Fed doing that may itself cause the market to do much of the heavy lifting.

The Fed is currently restricted to purchasing U.S. government bonds and agency debt. As such, the Fed has control over the composition of the total U.S. government debt outstanding (the composition between low-interest cash and higher-interest bonds). Under present conditions, I do not think that this composition matters very much (though I could be wrong). Perhaps David is urging Congress to expand the set of securities available for open market operations? If so, does he see any potential political problems with that?  (The answer should be "yes")

And what about this idea that the expectation of higher NGDP itself bringing about its own fulfillment? I know that Nick Rowe has gone on about this here and elsewhere. I think I'll need a separate post to investigate this claim.

In the meantime, here's a question for the NGDP proponents. I think that most people might agree that the Fed has built up a big stock of reputational capital designed to anchor a 2% inflation target. It may not be the perfect policy rule, but most societies around the world could only wish for such credibility in their monetary authorities. What if the Fed decides to adopt the proposed NGDP target, and fails? What then? What does that do to Fed credibility? Have you worked it out? Or does the solution concept you employ always rely on a self-fulfilling rational expectation?

There is something else. Whether we like it or not, policymakers are not indifferent to the composition of NGDP.

Adopting a NGDP target implies that policymakers can commit to (say) a 5% NGDP growth rate. But what if inflation turns out to be 4% and RDGP growth turns out to be 1%? (Or how about 7% inflation and -2% RGDP growth?) A credible NGDP target implies that policymakers remain committed to the 5% NGDP growth rate. But ask yourself this: Do you really believe that policymakers would leave policy unchanged in this circumstance? 

Is higher inflation really the answer?

A lot of people, including those who favor NGDP targeting, want the Fed to raise the rate of inflation; at least, temporarily. Three questions immediately come to mind: [1] What is the theoretical mechanism linking economic prosperity to the rate at which nominal prices rise; [2] Exactly how is the Fed, given the tools at its disposal, supposed to generate higher inflation under current economic circumstances; and [3] What is the evidence to support the belief that more inflation will reduce unemployment (or increase real GDP)?

There are so many different views out there that it's hard for me to keep track of them all. My last couple of posts dealt with the idea of a NGDP target, and it's close cousin, a price-level target. I'm no expert in the area, but if I understand the logic correctly, the idea is for the Fed to reverse what was a sharp and unanticipated decline in the price-level that occurred in late 2008. The presumption is that because debt is denominated in nominal terms, an unexpected permanent decline in the price-level path increase the real value of the stock of outstanding nominal debt. In turn, this imposes a real burden on all debtors, including households with mortgages and the government sector.

There seem to be two aspects to the "price level" surprise shock. First, there is a "fairness" issue. The shock evidently resulted in a redistribution of wealth from debtors to creditors, and it is only fair that this wealth transfer be reversed. (And since the Fed was the agency responsible for letting the price level drop, it should do the undoing -- even if the same might be accomplished by the fiscal authority). Second, there is an "efficiency" issue. Somehow, this wealth transfer has manifested itself as "deficient aggregate demand." I am not exactly sure how this last part works--maybe somebody can enlighten me (in a language that I can understand--a mathematical model!).

In any case, I am not entirely sure I can believe in the quantitative importance of this mechanism. The prescription presumes a sharp and persistent decline in the price-level path, something that I have trouble seeing in the data. In particular, the follow diagram plots the (log) PCE price-level for the U.S. since 1990; the red line is a (log) linear trend. According this data, we are essentially back on the original price-level path (I think the same roughly holds true when the price-level is measured by the CPI or the GDP deflator).

Of course, the "wealth channel" I described above is not the only way in which higher inflation might stimulate economic activity. Here is Paul Krugman for example: Krugman: Fed Should Tolerate More Inflation to Reduce Unemployment.  

"The main thing the Fed can do is promise that they will be very slow to step on the brakes, that as the economy recovers that they will let inflation rise, not to high levels, but to 3 or 4 percent from two percent," Krugman suggested. "That would move the markets quite a lot. It would lead people who are making plans to think that sitting on cash is not a good idea.

I have no doubt that people would think that sitting on cash is not a good idea. The question is: how would people seek to transform their cash holdings? Krugman seems to think that people will want to go out and spend the cash on goods and services. But what if they instead decide to buy gold or Caribbean real estate? There is also the possibility that nominal rates might rise (perhaps not one for one) with higher expected inflation via a Fisher effect, leaving the real return on "safe haven" assets relatively unchanged. Who really knows what might happen?

At the same time, one has to ask how the move to a higher rate of inflation might affect different members of society. Those on fixed nominal incomes are likely to suffer; at least, in the short run (or however long it takes to index those incomes to the higher inflation rate). What about those who have no bank accounts--those people who rely on cash transactions--the poorest segment of the population? This could, in principle, be rectified by cash disbursements to those deemed to be in need, but...well, good luck with that.

And, in any case, just how is the Fed supposed to engineer this smooth ride up from 2% to 4% inflation? Jim Hamilton has a nice post today explaining why it might not be as easy as people generally think it might be; see here: Should the Fed Do More?

I haven't even touched on my third question here, the one dealing with the inflation-unemployment relationship (for long-run evidence, see the data in here). So many questions, so little time...

NGDP Targeting: Some Answers

I want to thank everyone who replied to my previous blog post NGDP Targeting: Some Questions. It will take me some time to digest all of the information sent to me. In the meantime, let me report on a few of the answers I received.

First, some background information. I do not believe that sticky nominal prices or wages matter (at least as far as explaining years of sub par recovery dynamics). I explain why here: The Sticky Price Hypothesis: A Critique. Consequently, Nick Rowe's reply to my post does nothing for me (although I still love the man and his blog!). On the other hand, I am not so sure about "sticky" nominal debt. I am more sympathetic to Evan Koenig's view:

The analysis presented here is completely orthogonal to the literature. It does not involve goods-market or labor-market pricing frictions in any way. As our most severe economic downturns have been characterized by widespread default on financial obligations and disastrous breakdowns or near breakdowns in lending, an analytical framework that puts debt and the distribution of risk at center stage arguably has something to say about optimal policy. 

One of the main proponents of NGDP targeting sent me this article, so I took it to represent a main theoretical justification for NGDP targeting. And indeed, a lot of people seem to be talking about a "debt overhang" problem and a "balance sheet recession." I sort of figured (perhaps incorrectly) that the idea of getting the Fed to commit immediately to (say) a 5% NGDP target was to generate a credible temporary inflation to reverse the effect of the unanticipated and sharp decline in the price-level path (in 2008).  The mechanism people have in mind, I think, is essentially to reduce the real debt burden of debt-constrained households, to get them to start spending, and to increase aggregate demand.

In my previous point, I raised the question of how strong and how desirable this mechanism might be now that we are 3 years out from the 2008 price level shock. Surely, a lot of the debt negotiated prior to the shock has been either reneged, renegotiated, or retired. At the same time, a lot of new debt has presumably been issued under the expectation of the new price-level path (given that people generally believe that the Fed will stick to its 2% inflation target). If the "turnover" rate is high (i.e., if there are large gross flows of debt being created and destroyed), and if the economy remains under "potential" for a long time, then one would have to question the quantitative importance of this mechanism; and also, the desirability of reversing the price-level path.

Well, I have to thank Mark Sadowski for taking the time to dig up some statistics for us. You can refer to the comments section of my previous post for details, but Mark's back of the envelope calculation is summarized here:

At the end of 2011, there was some $13.2 trillion in household debt outstanding. Of that nearly three quarters, or about $9.8 trillion, consisted of home mortgages  

... 

Thus a total of perhaps $5 trillion in debt has been originated/refinanced since the new NGDP trend has been established. Which means that about $8.2 trillion or approximately 64% was negotiated before the new trend was established. 

Assuming that the rate of origination/refinancing is linear (dubious) then it will take a least another five years before all household debt conforms to current NGDP growth expectations. 

So, it seems that there is still a lot of "old" debt out there, negotiated under the old price-level path. But there is also $5 trillion in new debt, negotiated under a new price-level path. And the longer we wait, the more this number will grow. Granted, this problem may have been avoided if the Fed went into the crisis with a credible NGDP target. But this is not the world we live in. What would Scott Sumner do right now? Who is he willing to make angry and why? Scott offers a hint here: Can we confident about the benefits of more NGDP?  

2. But does it still make sense to go back to the pre-2008 trend line? Probably not, recently I’ve been calling on the Fed to go about 1/3 of the way back to that trend line, and then start a new policy trajectory (hopefully explicit in this case.)

In any case, it seems that Scott believes that "more NGDP right now would modestly reduce the unemployment rate."  I confess that I am not entirely sure what mechanism he has in mind here. I really do need to read his 1000 blog posts on the subject one day!

I still have a lot of reading to do before forming an opinion on this subject. There were a lot of really good comments on my post that I haven't mentioned here--I need some time to think them through. Before I sign off though, some of you may be interested in these two links (h/t Prof J):

First, here is George Selgin: Wide off the mark, or, Nonsense about NGDP targeting. This seems like an extreme view, but I think it deserves some attention. 

Second, we have Mark Carney (Governor of the Bank of Canada) speaking here on why he believes a "flexible inflation target" is superior to an NGDP target. 

NGDP Targeting: Some Questions

Let me start by saying that the idea of a NGDP target does not sound outlandish to me. But I feel the same way about price-level and inflation targeting. The first order of business for a central bank is, in my view, is to provide a credible nominal anchor. Probably not  much disagreement about this out there.

  

Proponents of NGDP targeting, however, like Scott Sumner and David Beckworth, for example, seem to believe very strongly in the vast superiority of a NGDP target--not just as a policy that would mitigate the effects of future business cycles--but also as a policy that should be adopted right now by the Fed to cure (what they and many others perceive to be) an ongoing "aggregate demand deficiency." 

What I am curious about is not that they believe this, but how strongly they believe in it. I respect both of these writers a lot, so naturally I am led to ask myself how they came to hold such a strong belief in the matter. What is the theoretical underpinning for NGDP targeting? And what is the empirical evidence that leads them to believe that an NGDP target right now is a cure for whatever ails us right now?

One way to seek answers to these questions is to spend hours perusing their past blog posts. I'm sure they must have answered these questions somewhere. But I figure it will be more efficient for me to just state my questions and have them (or somebody else) point me in the right direction for answers.

First, let us consider the (or a) theoretical justification for NGDP targeting in general. Actually, David was kind enough to point me a nice paper on the subject: Monetary Policy, Financial Stability, and the Distribution of Risk (Evan F. Koenig). Here is the abstract:

In an economy in which debt obligations are fixed in nominal terms, but there are otherwise no nominal rigidities, a monetary policy that targets inflation inefficiently concentrates risk, tending to increase the financial distress that accompanies adverse real shocks. Nominal-income targeting spreads risk more evenly across borrowers and lenders, reproducing the equilibrium that one would observe if there were perfect capital markets. Empirically, inflation surprises have no independent influence on measures of financial strain once one controls for shocks to nominal GDP.

Alright, fine. The argument hinges on the existence of nominal debt obligations. Well, not just debt that is stated in nominal terms, but debt that is fixed in nominal terms (renegotiation is ruled out). This is, of course, a story that goes back at least to Irving Fisher (1933): The Debt-Deflation Theory of Great Depressions.

I've always liked the Fisher story. And it obviously has an element of truth to it. But admitting this is different than asserting that the mechanism is quantitatively important, especially for generating decade-long recessionary episodes.

First of all, as I alluded to above, people can and do renegotiate the terms of nominal debt obligations if things get too far out of whack. True, renegotiation (including outright default) is costly and imperfect, but it happens nevertheless. And to the extent it does, nominal debt is not as "fixed" as some make it out to be. It would be good to know how much renegotiation does or does not happen out there.

Second, even if renegotiation is quantitatively unimportant, we should consider the dynamics of debt creation and retirement. At any point in time there is an outstanding stock of nominal debt, with terms negotiated in the past on the basis of future price level paths (among other things, of course). We should also keep in mind that new debt agreements are being formed, and old agreements are being retired and modified (refinanced) continuously throughout time. How big are these flows relative to the outstanding stock of debt?

I think the answer to the previous question is important for understanding how long the real effects of a "negative price-level shock" can be expected to last. If "debt turnover" is high, then such a shock cannot reasonably be expected to generate a decade of subnormal economic performance.

We are presently more than 3 years out from the sharp decline in the price-level that occurred in the fall of 2008. How much new nominal debt has been issued since then--debt that would have presumably been negotiated with expectations of a new price-level path? Does anybody know?  In particular, if one is advocating a return to the old price-level path right now, what does this mean for the creditors who have extended loans over the past 3 years? Should we care? Why or why not?

I have not even touched upon the practical feasibility of NGDP targeting--I'll save this for another day. But for now, I'd like to know the answers to my questions above. Who knows, I too may become one of the faithful! 

A good weekend to all. 

The income tax, then and now

Mark Perry entertains us with a comparison of the U.S. income tax form that filers were required to fill out in 1913: see all 4 pages here.  

Almost 100 years later, the instructions alone (1040 in total) take up 189 pages.

How will it look, I wonder, 100 years from now?