QE3 and Inflation Expectations

Some interesting data here on the TIPS measure of expected inflation following the Fed's QE3 announcement (courtesy of my colleague, Kevin Kliesen).

The first chart shows that the announcement had a significant impact on inflation expectations at short and long horizons.

Here's the same data, together with the 10-year inflation forecast, and for a longer sample period.

The impact on real yields, especially at the short end, seems significant (but let's see how long this lasts). 

 
Here's the same data over an even longer sample period.

 
And here's a truly remarkable graph...

Notes: Inflation-Indexed Treasury Yield Spreads are a measure of inflation compensation at those horizons, and it is simply the nominal constant maturity yield less the real constant maturity yield. Daily data and descriptions are available at research.stlouisfed.org/fred2/. See also Statistical Supplement to the Federal Reserve Bulletin, table 1.35. The URL for MT is: http://research.stlouisfed.org/publications/mt/

Paul Krugman's Baltic Problem

Well, since I'm writing about the K-man today, I thought I'd link up to this interesting piece by Swedish economist Anders Aslund: Paul Krugman's Baltic Problem.
 
Seems like Krugman's little IS-LM model made a few wrong predictions too. I guess the science isn't quite a settled as he would like us all to believe.

In any case, I haven't studied the Baltic region in any great detail. If there are any experts out there that would like to weigh in here, please do. My prior is that both Krugman and Aslund have some legitimate explanations for what is driving the Baltic recovery and expansion. But maybe one side is more persuasive than the other? What is the evidence? Would be interested to hear what people have to say, especially from those who know the area well. 

Not enough workers to meet demand for new homes

Wow, how's that for a headline?!

But it appears to be true, as Diana Olick reports here.

The shortage is across the spectrum, but especially in need are framers, concrete workers, plumbers, roofers and painters. The shortage is also felt most in areas where housing is coming back strongest, and permitting is easiest, like Texas and much of the West. 

Ms. Olick also links up to a column she wrote earlier US Homebuilders Begin to See Credit Thaw. 

Much of the demand is coming from potential buyers who have been shut out of the lower-priced, distressed market by avid, all-cash investors. The big public builders, almost across the board, reported huge jumps in new orders in the first half of this year. Smaller builders are still hampered by lack of credit to build and therefore meet the demand. Construction loans nearly ground to a halt after the latest housing crash.

I wonder whether these smaller credit-constrained  homebuilders are quantitatively important in holding back aggregate construction expenditure? 

In any case, it certainly looks like things are looking brighter for the homebuilders. Toll Brothers, for example, is up around 100% over the past year. Have we turned the corner here? 

Update: 07 Sept 2012: Help Wanted: Auto Makers Revving up Engineering Jobs

As the auto industry rebounds in the U.S. it is creating a strong demand for engineers. In fact, one recruiter said the auto industry is seeking more than a thousand engineers.

The demand is so great, applicants often have multiple job offers and not just for jobs in the auto industry. 

“The demand is as strong as I have ever seen it,” said Andrew Watt, CEO of the recruiting firm iTalent. “There is a huge shortage and anyone you can find with auto engineer experience of any kind will get an interview and probably get a job right now.”

Evil is the root of all money

For the love of money is the root of all evil.
1 Timothy 6:10

A basic question in the theory of money is "why does money exist?"  Or, put another way: where does the demand for money come from? 
  
The phenomenon of monetary exchange is so familiar to us that many may view the question ridiculous and/or the answer obvious. But if we stop and think about it, we'll discover that a surprising number of our everyday transactions are made without any reference to money at all. In particular, we regularly trade favors with family members, friends, and associates via implicit credit arrangements known as gift-giving economies. Indeed, the phenomenon seems quite prevalent in smaller (and more "primitive") communities throughout history. 

So if money is not necessary in transactions--even credit transactions--then why is it used? Monetary theorists have been asking this question for a long time. The standard answer to be found in virtually every undergraduate macro textbook is that "money solves the double coincidence problem."  That is, without money, trade is restricted to barter transactions. And because it is difficult to find a trading partner who happens to want precisely what you have to sell and vice versa (a double coincidence), barter exchange is inefficient. 

I want to argue here that this familiar story is all wrong. (John Quiggin offers a related critique here.) Up until recently, I used to think that a lack of double coincidence was necessary--but not sufficient--to rationalize the use of money. I now question whether a lack of double coincidence is necessary at all. 

What does seem fundamental to the question is a lack of commitment. Kiyotaki and Moore label this friction an evil (hence, their play on Timothy, which I borrow as the title of this post). But the basic insight, as far as I can tell, seems attributable to Doug Gale (The core of a monetary economy without trust). 

Before I proceed, I should take a moment to define what I mean by monetary exchange.  I define money to be an object that circulates as payment instrument across a sequence of spot exchanges. In the models I describe below, money takes the form of a perfectly divisible and portable income-generating asset. Equivalently, it takes the form of perfectly divisible, non-counterfeitable, and enforceable claims to an income-generating asset. It is not even important what form these claims take--they can be paper or book-entry objects, for example. The only requirement is that the claims constitute well-defined property rights (the same assumption is made by the fact of possession of a physical asset). 

Wicksell's triangle

Consider an economy consisting of 3 people, Adam, Betty, and Charlie. There are 3 time periods: morning, afternoon, and evening. There are 3 (time-dated and nonstorable) goods: morning-bread, afternoon-bread, and evening-bread. 

Each person is endowed with an asset--a bread-making machine. Adam's machine produces bread in the evening, Betty's machine produces bread in the morning, and Charlie's machine produces bread in the afternoon. 

While each person values their own production "a little bit," they value someone else's production "a lot more." In particular, Adam wants morning-bread (from Betty), Betty wants afternoon-bread (from Charlie), and Charlie wants evening-bread (from Adam).

This economy features a complete lack of double-coincidence. That is, for any pairing of individuals, there are no bilateral gains to trade. On the other hand, this economy features a triple-coincidence of wants: there are multilateral gains to trade. The efficient allocation has everyone getting the good the value highly, and disposing of the good they value less.

Notice that each person is in a position to issue an IOU promising a bread delivery at some specified date (morning, afternoon, or evening). 

Just to start things off, imagine that our group meet at the beginning of time (just before morning) to arrange their affairs. If everyone is perfectly trustworthy, then everyone can just promise to "do the right thing" and that's the end of the story. That is, if people can commit to their promises, then monetary trade is not necessary, despite the lack of double coincidence. 

Suppose instead that our group is not so trustworthy. Suppose Adam takes his morning delivery of bread and consumes it, but then refuses to make his promised night-delivery (consuming it for himself)? Well, in this case, our traders could agree to swap bread-machines at the beginning of time or--equivalently--swap securities (IOUs) representing clear titles to machines and their produce. (This latter type of exchange is what happens in an Arrow-Debreu securities market). In this case too, there is no role for an asset to circulate as a payment instrument.

O.K., let me now give the double-coincidence problem more bite by assuming that people meet sequentially and bilaterally over time. In particular, assume that Adam meets Betty in the morning, Betty meets Charlie in the afternoon, and then Charlie meets Adam in the evening. In each pairwise meeting, there are no gains to trade. But as long as people are committed to "doing the right thing," then this should pose no problem. In the absence of evil, money is not necessary.  

But what if the members of this society are not so trustworthy? Then Adam asks for Betty's morning bread, Betty will demand a quid-pro-quo exchange of property. The only thing Adam has to offer is his night-bread machine--something that Betty has absolutely no taste for. Nevertheless, she will take it as payment because she expects to be able to use it as money at a later date. Indeed, Charlie should be willing to make his afternoon delivery to Betty in exchange for the night-bread machine because Charlie wants to consume at night. Evil--the lack of commitment--is a problem that can be solved here by the institution of monetary exchange. (Technical note: money is the unique solution if allocations cannot be conditioned on individual trading histories.)

Conclusion: A lack of double coincidence problem is not sufficient to explain monetary exchange. A lack of commitment is necessary to explain monetary exchange. 

Monetary exchange with no double coincidence problem

My ideas about monetary exchange and the role of exchange media in general began to evolve after reading Gary Gorton's informative paper Slapped in the Face by the Invisible Hand (I recall telling Gary that getting slapped in the face by the visible hand was no less painful, but he only laughed). 

I was intrigued by Gorton's description of how the shadow banking sector worked hard to create high-grade assets (e.g., senior tranches of diversified pools of mortgage debt) that ended up playing an important role in the payments system. The activity looks a lot like standard banking, i.e., issuing a set of senior liabilities backed by a diversified portfolio of assets. In standard banking, these senior liabilities (whether in the form of banknotes or book-entry items) circulate as money. The shadow banking sector's liabilities seem to have "circulated" as collateral in repo markets. The stuff sort of looked like money. And yet, it did not seem to be solving any double coincidence problem. 

So here is my little model. There are only two people this time, Adam and Betty, but still 3 periods. Each person is in possession of two assets: a human capital asset, and some other asset (K) that produces some specialized product that only the original owner values. 

Assume that Adam is good at working in the afternoon and that Betty is good at working in the morning. Moreover, Adam wants a morning service, while Betty wants an afternoon service (so Adam is impatient, Betty is patient). Assume that the special asset K delivers output only in the evening for both parties.

The efficient trading pattern should be clear enough: Betty makes a morning delivery to Adam, Adam makes an afternoon delivery to Betty, and then both parties retire in the evening to consume the fruit of their special asset K. 

As before, if people could commit to their promises, then a credit market implements the efficient allocation: Adam borrows bread from Betty and pays her back in the afternoon. 

But what if people cannot be trusted to keep their promises? If I replaced "human capital" with the earlier bread machines, then a simple swap of bread machines would do the trick. But suppose it is impossible to transfer human capital in this way (indentured servitude is legally prohibited). What can be done?

Well, it would seem that one solution would be for Adam to use his special asset K to pay for his morning service. But why would Betty agree to such a transfer? After all, she does not attach an intrinsic value to Adam's special asset. 

The answer seems clear. Betty could use Adam's K asset as money in the afternoon. In particular, she could offer to return the asset to Adam in exchange for the afternoon service she desires. Adam should be amenable to such an exchange as he attaches an intrinsic value to this special asset. 

Conclusion: A lack of double coincidence of wants is not necessary to explain monetary exchange. A lack of commitment is necessary to explain monetary exchange. 

(Technical notes: the monetary object here cannot be playing any record-keeping role. Also, I realize that bilateral credit relationships can be sustained via the threat to suspend all future trade in the event of default. Understanding this does not diminish the role played by the special asset above--it can still be used to increase the threatened pain of default, thereby expanding the supply of credit.)

Relation to the repo market

Another way to implement the efficient allocation above is via a sale and repurchase agreement (repo) or, what amounts to be the same thing--a collateralized loan. 

Note that the fundamental role played by Adam's special asset is that of a hostage. Betty is saying "you better pay me back, or you'll never see your beautiful asset again!" 

And so, Adam and Betty might agree beforehand to a repo transaction: Betty agrees to buy the asset in the morning and resell back to Adam in the afternoon. Equivalently, Adam borrows a morning service using his special asset as collateral. In all of these transactions what is important is that property rights are transferred to Betty (the creditor). 

How these rights are most efficiently transferred would seem to dictate the method of payment--i.e., whether by quid pro quo exchange, a repo agreement, or as a collateralized credit arrangement. In all of these cases, the asset is playing the same economic role--it is being used to support an intertemporal credit arrangement in the absence of commitment. In this sense, we could legitimately label the asset an exchange medium, even if it is not literally circulating from hand-to-hand (it is circulating from account-to-account, however). 

Conclusion

A lack of double coincidence is neither necessary or sufficient to explain the demand for money. Evil appears to be the root of all money. The sermon is now concluded!

Is wage rigidity the problem?

Many economists claim that wage rigidity plays an important role in the (mis)allocation of resources in the labor market. Both "Keynesian" (Krugman) and "Monetarist" (Sumner) thinking emphasizes sticky nominal wages. "Labor Search" theories (Hall and Shimer) emphasize real wage stickiness; see here.

I've always been somewhat skeptical of these stories (note: Keynes himself did not emphasize stick wages in the GT--in fact, he argued that wage flexibility makes matters worse!).

My skepticism is fueled by stories like the one I read today: Majority of New Jobs Pay Lower Wages, Study Finds. An excerpt:

The report looked at 366 occupations tracked by the Labor Department and clumped them into three equal groups by wage, with each representing a third of American employment in 2008. The middle third — occupations in fields like construction, manufacturing and information, with median hourly wages of $13.84 to $21.13 — accounted for 60 percent of job losses from the beginning of 2008 to early 2010.  

The job market has turned around since then, but those fields have represented only 22 percent of total job growth. Higher-wage occupations — those with a median wage of $21.14 to $54.55 — represented 19 percent of job losses when employment was falling, and 20 percent of job gains when employment began growing again.  

Lower-wage occupations, with median hourly wages of $7.69 to $13.83, accounted for 21 percent of job losses during the retraction. Since employment started expanding, they have accounted for 58 percent of all job growth.

Seems to me that even if nominal wages appear to be sticky within occupational groups, there is a high degree of de facto flexibility via occupational choices (on both the supply and demand sides).
   
My gut feeling is that theories that rely on some "wage stickiness hypothesis" are barking up the wrong tree. The assumption of wage stickiness is often supported by appealing to the empirical evidence. But as I explain here, wages that appear to be sticky to an econometrician may not be sticky in any economically meaningful sense. And as the evidence above suggests, there seems to be much more wage flexibility out there than is commonly assumed. But I'm willing to listen to the other side of the story...

Kotlikoff Speaks Out

Laurence Kotlikoff

I haven't had much time to blog lately, but I thought I'd link up to this piece by Laurence Kotlikoff, which caught my eye: Economists Risk Labeling as Political Hacks. An excerpt:

Professional Rot 

The decision of the 500 U.S. economists, many from the leading ranks of the profession, to trade in their credentials as economists for that of campaign workers is just the latest sign that something’s rotten in economics. The documentary “Inside Job,” demonstrated how prominent economists failed to disclose, as standard ethics require, when they are being paid for their professional opinions. 

Then there is the increasingly nasty op-ed war pursued by political economists, such as Paul Krugman and Glenn Hubbard, who have so closely aligned themselves with one of the two parties that it’s impossible to know where their politics stop and their economic analyses begin. 

The worst part of all this is that the new political economics routinely diverges so far from economic theory and fact.

Agree? Disagree? (Please -- no mindless drivel -- I will delete) 

The Microfoundations Windmill

Well done, Don Paul!

I can't help it. I just have to say something about  Paul Krugman's latest complaint (in a series of seemingly never-ending laments) concerning yet another "problem with the economics profession." See here: Making Ourselves Useless.

A well-aimed critique constitutes an important step in helping us understand things better. In this case, however, I think he is largely making things up--methinks our fair knight is chasing windmills.

Krugman begins by quoting Simon Wren-Lewis (who I happen to find quite sensible most of the time, just not in this case) in reference to the profession's alleged obsession with "microfoundations:"

If you think that only ‘modelling what you can microfound’ is so obviously wrong that it cannot possibly be defended, you obviously have never had a referee’s report which rejected your paper because one of your modelling choices had ‘no clear microfoundations’. One of the most depressing conversations I have is with bright young macroeconomists who say they would love to explore some interesting real world phenomenon, but will not do so because its microfoundations are unclear.

Oh, please. Papers are rejected all the time and for all sorts of reasons. That goes even for papers with microfoundations. And as for those "bright" young economists, they sound truly misguided. Not sure who's to blame for that, however. 

It is true that "microfoundations" are valued in the profession (and Wren-Lewis has several excellent pieces explaining why). But just what are these pesky "microfoundations," anyway?

  

A narrow view of  "microfoundations" is reflected in the idea that the methodology of microeconomic theory (specifying individual preferences, information sets, endowments, constraints, together with an equilibrium concept) can and should be brought to bear on macroeconomic questions. This is in contrast to an earlier methodology that specified and estimated behavioral relations at the aggregate level. (One can legitimately weigh the pros and cons of these (and other) methodologies.)

Not many macro models are "microfounded" in a pure sense. Almost all models make at least some assumptions that may be viewed as ad hoc and provisional (subject to further investigation). I think of an ad hoc assumption as a restriction on behavior that is inconsistent with other aspects of the model, like maximizing behavior.

To give an example, in most "microfounded" models of money there are ad hoc restrictions placed on the set of assets that might serve as exchange media. Consider a model with money and bonds. The modeler typically assumes that money is used to buy things and that bonds are not. While a "cash-in-advance constraint" of this sort may be descriptively accurate, it does not explain why bonds cannot be used to buy things. In short, liquidity is assumed and not derived. It is generally understood that shortcuts of this sort may matter for some questions and not for others. Understanding where and how these assumptions matter for the particular question at hand is part of the skill set that defines a good economist.

Sticky nominal wages is another popular example. Actually, in this case, I think it's rather worse. As I explain here, sticky nominal wages are likely only relevant if one adopts the questionable assumption that the labor market operates as a sequence of  anonymous spot markets.

Anonymity is a very bold assumption. In particular, it rules out the formation of relationships--something that most of us would recognize as being an important element of most labor market transactions. If the labor market works more like a marriage market, then spot wages (whether real or nominal) are inconsequential for resource allocation. What matters is the manner in which surplus is divided. And generally, there are many wages paths (real and nominal) that are equivalent to dividing the surplus in a particular manner. (This is something Barro (1977) pointed out long ago.)

So why do I mention this? Well, let's see what Krugman has to say:

And this [Lucas Critique] is fair enough. But what if you have an observed fact about the world — say, downward wage rigidity — that you can’t easily derive from first principles, but seems to be robust in practice? You might think that the right response is to operate on the provisional assumption that this relationship will continue to hold, rather than simply assume it away because it isn’t properly microfounded — and you’d be right, in my view. But the profession, at least in its academic wing, has largely chosen to take the opposite tack, insisting that if it isn’t microfounded — and with all i’s dotted and t’s crossed, no less — then it’s not publishable or, in the end, thinkable.

Can you spot what's wrong in that passage? No, it's not the first sentence--it's everything that follows.

First, I see a lot of other facts in the labor market that I might like to model, like the coexistence of large gross flows of workers into and out of employment--something, sticky nominal wage models frequently ignore. So maybe I want to ignore sticky nominal wages because I'd rather model worker flows--not because I can't "microfound" the phenomenon.

Second, and more important, it is clear that he is just making things up here. Why do I say this? Well, just take a look at one of the dominant paradigms in macroeconomic theory--the New Keynesian framework. As anyone who is familiar with the paradigm knows, it is built around models that embed ad hoc assumptions reflecting the alleged costs associated with nominal wage and price adjustments in auction-like settings. It seems to me, on the basis of this (and plenty other) evidence, that the profession cannot be obsessed with microfoundations in the way that Krugman suggests. On the whole, the profession is much more pragmatic than he makes it out to be.

By the way, I like to take a broader view of "microfoundations;" or, rather, the search for microfoundations. Microfoundations does not, in my mind, mean stopping at preferences and technology, or anywhere else, for that matter. It simply means seeking a deeper understanding. (My colleague, Arthur Robson, for example, is exploring the "microfoundations" of preference formation.) I certainly hope that this search for deeper understanding is not the "obsession" that Paul Krugman is concerned with.

What I find puzzling is that I'm pretty sure that the K-man knows all this. But if so, then what motivates his insatiable desire to tar-and-feather the profession as a whole in this manner? I find the following passage illuminating:

Now we’re having a crisis that makes perfect sense if you’re willing to accept some real-world behavior that doesn’t arise from intertemporal maximization, but none at all if you aren’t — and to a large extent the academic macroeconomics profession has absented itself from useful discussion.

Well, maybe not that illuminating. I mean, he can't literally believe this given that he has a paper with Gauti Eggertsson that makes use of use of intertemporal maximization that purports to explain recent events.

At root, I think the source of the man's bitterness toward the profession is that in his view, we are doing this stuff called "research" into questions for which we already know the answers (the answer is to increase G, something I partially agree with here). We are fiddling like Nero while the economy burns.

I would like to ask Krugman whether he believes there is anything left to learn about how an economy functions in the aftermath of a financial crisis. Is the profession wrong in devoting a good part of its time searching for a deeper understanding ("microfoundations") of how monetary and fiscal policies work using its best available tools? How would he rather we spend our professional time?

Or is the science now settled?