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

Tuesday, June 23, 2020

Why the Fed Should Create a Standing Repo Facility


In Uncertain Times, Cash is King - Adi Dehejia - MediumI was invited recently to take part on a panel discussion
on Modernizing Liquidity Provision as part of a conference hosted jointly by CATO and the Mercatus Center entitled A Fed for Next Time: Ideas for a Crisis-Ready Central Bank.  My post today is basically a transcript of the presentation I gave in my session. I'd like to thank George Selgin and David Beckworth for inviting me to speak on why the Fed should create a standing repo facility, an idea that Jane Ihrig and I promoted early last year in a pair of St. Louis Fed blog posts here and here.

In those posts, Jane I argued that the Fed should create a standing repo facility that would be prepared to lend against U.S. Treasury securities and possibly other high quality liquid assets (HQLAs). We distinguished the facility we had in mind from the discount window in two key respects. First, unlike the window, it would restrict collateral to consist only of HQLA; and second, it would grant access to non-depository institutions, in particular, to dealers and possibly even to all the counterparties that are presently permitted to access the Fed's ON RRP facility.

At the time, we motivated the facility as a way for the Fed to conduct monetary policy in a manner consistent with the FOMC's preferred operating framework of ample reserves together with its 2014 Policy Normalization Principles and Plans which stated, among other things, the desire to hold "no more securities than necessary to implement monetary policy efficiently and effectively."

Jane and I speculated that a significant source of the demand for reserves over other HQLAs came from the Global Systemically Important Bank's (G-SIB's) perceived need for resolution liquidity. We reasoned that these G-SIBs might be more inclined to hold higher-yielding HQLAs over reserves if it was known beforehand that the former could be readily converted into reserves on demand at a standing facility at pre-specified terms. At the same time, the facility would provide a ceiling on repo rates and eliminate the need to estimate the so-called "minimally ample" level of reserves. That is, the facility would automatically flush the system with the reserves it needed as reserve supply and demand conditions varied because of adjustments in the Treasury General Account or other economic factors. Finally, we doubted whether the facility would lead to any significant amount of disintermediation as some people feared. In our view, it would serve mainly to cap the terms of trade in a number of over-the-counter (OTC) repo transactions involving Treasury debt.

The title of this session is "Modernizing Liquidity Provision." We're here today, of course, because of the massive Fed-Treasury interventions in response to the COVID-19 pandemic. Jane and I didn't tout the standing repo facility as a crisis tool because we figured that in a crisis, investors were unlikely to have much difficulty in finding buyers of U.S. Treasury securities. Since the 2008-09 financial crisis, we've grown accustomed to the idea of USTs serving as a flight-to-safety vehicle. And, indeed, this seems to have been the case as the present crisis initially unfolded. Bond yields began to drop sharply in Februrary and then again following the Fed's rate cut on March 5, with the 10-year hitting a low of 54bp on March 9.

But then something happened that I don't think anyone was expecting (certainly, I was not). In particular, after March 9, there's clear evidence of selling pressure stemming from what looked like a repo run on treasury securities. That is, for a variety of reasons there was an enhanced demand for cash which, in this instance, led to sales of U.S. Treasuries, depressing their value as collateral--effectively evaporating a significant portion of the supply of safe assets--which led to margin calls, which led to further selling pressure, and so on.

When the Fed cut its policy rate to 10bp on March 16, bond yields continued to rise, with the 10-year hitting almost 120bp on March 18. Bond yields came down only after the Fed intervened first with its discretionary repo operations and then with $1.5T of outright purchases of securities. This episode reminds us again that cash is king in a crisis and that U.S. Treasury securities are not always considered cash-equivalent in a crisis.

A natural question to ask here is whether disruptions like this constitute a policy problem. After all, it's not like bond traders are unfamiliar with the notion of interest rate volatility. When I glance at the data, the absolute size of this volatility seems more or less stable since the mid 1980s. However, because interest rate levels are so much lower today, a 50bp move is quantitatively more significant in relative terms. This wouldn't be much of a problem, in my view, if treasury securities served merely as pure saving instruments. But for better or worse, the UST has evolved over time to become an important form of wholesale money. In particular, it is used widely as collateral in the repo market (the so-called shadow bank sector). Its value as collateral stems in large part from its perceived safety and liquidity. And most of the time, the U.S. Treasury market is liquid. Except for when it isn't, of course. And so the question is, when it isn't liquid, does it matter and, if so, should something be done about it?

My views on this questions are informed by both by theory and from what I know of the history of the U.S. Treasury market (e.g., Garbade 2016). Theory tells us that in a fiat money system, there's no fundamental difference between account entries at the Federal Reserve and (say) at Treasury Direct. They are both electronic ledgers containing interest-bearing accounts. There are legal differences, of course. Only depository institutions have access to Fed accounts, whereas treasury securities can be held much more widely. Treasury securities are more complicated objects because they differ from each other in terms of coupon, time left to maturity, and possibly other characteristics. For this reason, treasury securities, as with most bonds, trade in decentralized over-the-counter markets instead of centralized exchanges.

While OTC markets may have their advantages (they evidently displaced the centralized exchange of bonds in the 1920s), their decentralized structure can be problematic. When investors become fearful, bond dealers and other traders may become unwilling or unable to execute trades, so that meaningful price information is lost. Safe assets may trade at significant discounts or premia, not for any fundamental reason, but simply because liquidity (market participation/communications) has vanished. Such events have implications that extend beyond the treasury market because, as is well-known, the yield on Treasury debt serves as a benchmark for many other financial assets. Unnecessary and avoidable problems in the treasury market can spillover into other financial markets, bringing grief to the broader economy.

From this perspective then, I am led to ask the question: in what world does it make sense to permit risk-free claims to fiat money like treasury securities to suddenly become illiquid? (This question is distinct from the one that asks whether risk-free claims to fiat money should be made illiquid--as in, the issuance of non-marketable debt; see here, for example) There is really no good reason, as far as I know.

I therefore continue to believe that a standing repo facility makes a lot of sense for the U.S. economy. And I again want to stress that this is not an hypothetical proposal. Many of the world's leading central banks operate such facilities. The Fed has had its ON RRP facility in place since 2013. Indeed, the Fed even implemented a repo facility (called the FIMA repo facility) in March of this year where foreign central banks can borrow funds at 25bp above IOER by presenting U.S. Treasury securities as collateral. The same type of facility set up for domestic purposes (ideally with Treasury support) could simultaneously help the FOMC achieve interest rate control, shrink the size of its balance sheet, and prevent unnecessary violent disruptions in the treasury market by setting a corridor around treasury yields at different maturities. The size of the corridor could ultimately be adjusted to help achieve yield curve control if desired. But this is a separate issue, so let me end here. Please feel free to comment below. 

Thursday, February 6, 2020

Kalecki on the Political Aspects of Full Employment

Michal Kalecki 1899 - 1970
Sam Levey reminded me of Kalecki's 1943 article on the political aspects of full employment. This a very interesting and thought-provoking paper. I enjoyed it enough to offer my critique of it.

The paper starts by taking as given what Kalecki calls the doctrine of full employment. The basic idea is that the private sector, left to its own devices, is prone to Keynesian aggregate demand failures (see here for game-theoretic interpretation). The remedy for these spontaneously-occurring "coordination failures," is a government spending program that acts, or stands ready to act, as private demand begins to falter.

Kalecki starts his paper off by asserting that by 1943, the doctrine was widely accepted by most economists. It seems clear that Kalecki views the doctrine to be self-evidently true.

But if this is the case, then this poses a problem. If the doctrine is so obviously true, why then are there still economists who oppose it? And if the idea is so self-evident, why are so many "captains of industry" reluctant to accept it? As Kalecki admits (pg. 324), this attitude is not easy to explain. After all, depressions are bad for business and businesses collectively should welcome any intervention that restores the economy to full employment.

The problem, as he sees it, is a political one. While the "economic experts" that disavow the doctrine may believe in their own theories, however poor they may be, he notes that "obstinate ignorance is usually a manifestation of underlying political motives." He doesn't say exactly what these political motives are, but he notes that these "economic experts" are, or have been, closely connected with banking and industry. But if this is the case, then the question turns to what motivates industry leaders to block interventions that they know will be good for industry?

He lists the following three reasons.

[1] Absent full employment policy the "state of confidence" will produce business cycles. Under laisser-faire then, industry leaders can credibly use this fact to exert a powerful indirect control over government policy.

[2] Supporting obviously beneficial public sector investments leads to a slippery slope. The government may wish to encroach in other areas in competition with private enterprise.

[3] In a perpetually full employment economy, the threat of unemployment vanishes as a discipline device for employers (see also here). As well, the social position of the boss would be undermined and the self assurance and class consciousness of the working class would grow, leading to political instability.

What to make of this? Well, I'm not sure. The first reason asserts that "business leaders" are willing to plumb the depths of economic depression every once in a while in exchange for political power. He doesn't actually say what this political power buys them. But whatever it buys them, I wonder whether it might not be purchased more cheaply through more conventional means?

The second reason doesn't seem plausible to me. Why wouldn't the private sector be willing to support infrastructure projects that benefit their interests directly? Was there any serious industry opposition, say, to the Federal Highway Act of 1956? And if there was, was it because of a fear that the project might succeed too well, an outcome that would encourage the government to become more adventurous in other arenas?

The third reason also seems weak to me. It is true, Kalecki writes, that profits would be higher under full employment, "but 'discipline in the factories' and 'political stability' are more appreciated by the business leaders than profits." First, the idea of unemployment as a discipline device only needs a constant low level of unemployment to work (Shapiro and Stiglitz, AER 1984 "Equilibrium Unemployment as a Worker Discipline Device;" see their reply here to a critique.) A decade-long Great Depression seems like an awfully high price to pay for "worker discipline." And as for promoting political stability, I think it is understood that events like the Great Depression, or even the Great Recession for that matter, promote political instability (which even Kalecki mentions in the article).

To sum up, Kalecki asks a great question. Collectively, we are all better off materially in the absence of economic depressions. We know--in principle, at least--how to prevent major economic depressions (I'm not talking about regular "small time" business cycles here.) But if so, why are interventions like the Obama stimulus program met with such bitter opposition in some quarters? For that matter, the TARP intervention--a "bailout" program aimed at stabilizing the financial sector--was also met with vocal opposition, especially from Main Street. Is this really all just a concern over "moral hazard?"

Maybe there's just a suspicion that these interventions, however good they may sound on paper, work out in practice simply as ways to redistribute income to undeserving, but squeaky wheels. I overheard a political commentator on NPR the other day remark that in economic and political negotiations, "if you're not at the table, then you're likely on the menu."  I suppose it's easy to say what we need in this case is better representation at the table. How to do this? I'm all ears.

Wednesday, September 4, 2019

A conversation with Eric Tymoigne on MMT vs SMT

There are a lot of moving parts to the MMT program. I want to focus on one of these parts today: the relation between monetary and fiscal policy. One thing I find appealing about MMT scholars is their attention to monetary history and institutional details. I've learned a lot from them in this regard. But as is often the case with details, one has to worry about whether they help shed light on a specific question of interest, or whether they sometimes let us not see the forest for the trees. And in terms of the broader picture, since I grew up in that branch of macroeconomics that tries to take money, banking, and debt seriously (i.e., not standard NK theory), I sometimes have a hard time understanding what all the fuss is about. Much of standard monetary theory (SMT) seems perfectly consistent with some of the ideas I seen discussed in MMT proponents; see, for example, The Failure to Inflate Japan
This post is devoted to better understanding a contribution by Eric Tymoigne. Eric is one of the people I go to whenever I want to learn more about MMT (if you're interested in MMT, you should follow him on Twitter @tymoignee). In this post, I discuss his article "Modern Monetary Theory, and Interrelations Between the Treasury and Central Bank: The Case of the United States." (JEI 2014). Passages quoted from his paper are highlighted in blue. The working paper version of the paper can be found here. Eric has kindly agreed to respond to my comments and let me post our conversation. We had to some editing, hopefully this did not disrupt the flow too much. In any case, I hope you find it interesting. And, as always, feel free to join in on the conversation in the comments section below. -- DA


DA: Eric, let's start with the opening paragraph:

One of the main contributions of modern money theory (MMT) has been to explain why monetarily sovereign governments have a very flexible policy space. Not only can they issue their own currency to spend and to service their public debt denominated in their own unit of account, but also any self-imposed constraint on budgetary operations can be easily bypassed. 

I'm curious to know what the contribution is here relative to standard monetary theory (SMT). In SMT, the government can also issue its own currency to spend and to service the public debt denominated in its own unit of account. So this degree of "flexibility" is already accounted for. As for "self-imposed constraints on budgetary operations," SMT takes several approaches to this issue, depending on the purpose of the analysis. One approach is to take these constraints as given and then to study their implications. But it is also common to consolidate the central bank, treasury and government into a single authority, which implies no self-imposed constraints on budgetary operations. 

Perhaps what is meant is that MMT shows how existing self-imposed constraints on budgetary operations can be (or are) bypassed in reality.  This leads us to question, however, concerning what those self-imposed constraints are doing there in the first place. Are they there by design and, if so, why? Or are they there by accident (and, if so, how in the world did this happen)?

ET: Yes consolidation is not unique to MMT as we have said repeatedly. Not only is it used quite commonly in the economic literature, but also it is a common rhetorical tool in economic talks, discourse, etc.

DA: Right, so everyone understands this (at least, they should)--it's perfectly consistent with standard monetary theory. So far, so good.

ET: Most economists, politicians and the public don’t understand this or its implications. They will interpret the above as saying that it is obvious that the government can create money but it is not a normal way to proceed and it is inflationary. MMT just pushes consolidation to its logical conclusions and shows that institutional details do back those conclusions. In a consolidated framework, the federal government can only implement spending by creating money, this is not abnormal and it is not inflationary by itself. There is no other way to find the necessary dollars to spend. Here is what consolidation means in terms of balance sheets:
For the federal government, taxes destroy currency (L1 falls) and claims on non-fed sectors falls (A1 falls) (an alternative offsetting operation is net worth of government rises). When US spends, it credits accounts (L1 rises). Similarly, bond issuance does not lead to a gain of any asset for the government; all it does is replace a non-interest earning government liability (monetary base) with an interest-earning government liability (Treasury securities).

DA: I am not going to argue against your accounting. As for bond-issuance, in SMT, an open-market operation is modeled as a swap of zero-interest reserves for interest-bearing treasuries. The interest on treasuries is explained by their relative illiquidity (another self-imposed constraint). The economic consequences of such a swap depends on a host of factors, which I'm sure you're familiar with. 

ET: Sure, in addition, self-imposed financial constraints (e.g. debt ceiling, no direct financing by the Fed, no monetary power for treasury) have been put in place at various times with the argument that they impose discipline in public finances. MMT argues, these financial constraints are not necessary and are bypassed routinely through Treasury-Central Bank coordination.

DA: Sure, the standard view is that these self-imposed constraints are designed to impose discipline in public finance. The proposition that these financial constraints are or are not necessary, however, must be based on a set of assumptions that may or may not be satisfied in reality. (The fact that these constraints may be bypassed through Treasury-Central Bank coordination does not seem relevant to me -- the conflict emphasized by SMT is between an "independent" central bank and the legislative authority (e.g., the Fed and Congress, not the Fed and Treasury). I'm not sure why a new theory is needed here. We know, for example, that if the legislative branch of government fully trusts itself (and future elected representatives) to behave in a fiscally responsible manner, the notion of an "independent" central bank (and other self-imposed constraints) makes little sense. 

ET: Remember that MMT emphasizes the irrelevance of financial/nominal constraints for monetarily sovereign governments (bond vigilantes, risk of insolvency of social security, etc.). One can do that by using the consolidated government (taxes don’t finance, bonds don’t finance, government spends by crediting accounts, etc.) or by using the unconsolidated government (the central bank helps the Treasury, the Treasury helps the central bank). The second method conforms to actual federal government operations but it is much less easy to use rhetorically and it waters down the core point: government finances are never a financial issue as long as monetary sovereignty applies.
Given that point, as you note, financial constraints are not only irrelevant, but also disruptive and used for political games. MMT wants to make government financial operations as smooth and flexible as possible. Once society has decided how, and to what degree, government should be involved in solving socioeconomic problems, finding the money should not be an issue when monetary sovereignty prevails. That means demystifying and eliminating financial barriers to government operations so the political debate can focus on solving real issues (environment issues, socio-economic issues, etc.). Fearmongering about the public debt and fiscal deficits makes for poor political debates and policy prescriptions.

There is a view, expressed by Paul Samuelson, that if we tell policymakers and the public that there are no financial limits to government spending, policymakers will spend like mad; therefore, economists need to lie to policymakers and the public (and themselves). This is nonsense. We ought to discuss policy choices not on the basis of Noble Lies but rather on the basis of sound and informed premises. Economists needs to make sure that policymakers focus on resource constraints.

In addition, political constraints on government should be geared toward improving the transparency and participatory aspects of government (e.g. limit role of big money in elections, limit wastes, etc.). We already have a government that passes a budget (it needs to do so for transparency and accountability purposes), we already have an auditing process, and we already have some (limited) democratic process, so aim at improving these aspects. MMT proponents are not naive, we know that some politicians are self-interested, we know that policy implementation may lead to mistakes, we know people may try to game the system (“free riders”); however we trust that a transparent and democratic government can (and does) get through these issues. MMT does not see financial constraints as helping in any ways, rather they inhibit the democratic process.

Of course, MMT proponents also have a policy agenda (Job guarantee, financial regulation based on Minsky, etc.) because we do not see market mechanisms as self-promoting full employment, price stability and financial stability. As such, as you said, MMT proponents favor alternative means to achieve these goals through direct government intervention. We don’t see the central bank as an effective means to promote price stability. The central bank should focus on financial stability through interest-rate stabilization and financial regulation (an area where the Fed has not performed well).

Finally, yes independence of the central bank is seen as a big deal but MMT disagrees for two reasons. First, MMT emphasizes the lack of effectiveness of monetary policy in managing the business cycle and, second, and probably more importantly, MMT notes that central-bank independence in terms of interest-rate setting and goal settings does not mean independence from the financial needs of the Treasury.

DA: I think it's fair to say most people want to see government operations run smoothly, and would welcome a sober debate over the issues at hand without the fear-mongering that some like to promote. The broad objective seems the same--the debate is more over implementation--how monetary and fiscal policy is to be coordinated--given human frailties. 

Having said this, I think you go too far by asserting that "government finances are never an issue as long as monetary sovereignty applies." Of course, technical default on nominal debt is not an issue (we all understand this). But SMT also recognizes the importance of economic default on nominal debt. True, a government can always print money to satisfy its nominal debt obligation, but if money printing dilutes the purchasing power of money, this is a de facto default. 

On a related issue, SMT asks "what are the limits to seigniorage?" The fact that a government can print money does not give it the power to command resources without constraint. People can (and do) find substitutes for government money (they may also substitute out of taxed activities into non-taxed activities). SMT treats the limits to seigniorage as a financial constraint. Maybe MMT has a different label for this constraint? Perhaps it is related to what I hear MMT proponents call an "inflation constraint." Maybe one way to reconcile MMT with SMT on this score is by recognizing that SMT usually assumes (sometimes incorrectly) that the inflation constraint is always binding. If this is the case, a monetarily-sovereign government does have a financial constraint, even according to MMT. 

ET: Yes, ability to create a currency does not mean ability to command resources because there may not be a demand for the currency. That is where tax liabilities and other dues owed to the government become important (cf. the chartalist theory of money, a component of MMT). That’s also why taxes, monetary creation and bond issuance are not conceptualized by MMT as alternative financing means but rather as complementary. The government imposes a tax liability, spends by issuing the currency necessary to pay the tax liability, then taxes and issues bonds. Spending may be inflationary indeed and so there is an inflation constraint; but it is not a financial constraint, it is a resource constraint.

About the “printing” of money by government, inflation and economic default. Regarding the first two, there is no evidence of an automatic relation between money and inflation. In a consolidated view, government always spends by monetary creation but controls the impact on inflation via taxes and the impact on interest rates via bond issuance. In an unconsolidated view, the central bank routinely finances and refinances the Treasury by helping some of the auction bidders and by participating in the auction.
Finally, regarding economic default, governments routinely “default” in that sense with no problems. I don’t see that as a relevant concept unless someone can show that economic default raises interest rates or generates rising inflation (it does not); here again, there is no automatic link between inflation and interest rates. That link depends on how the central bank reacts; if it does not then market participants don’t either.

DA: Let me return to the manner in which the Fed/Treasury/Congress are consolidated (or not) in SMT and why this matters, in your view. In some SMT treatments, Congress decides spending and taxes, which implies a primary deficit. It's up to the Treasury to finance that deficit, with the Fed playing a supporting role (by determining interest rate and issuing reserves for treasury debt). What's wrong with this approach?
ET: That goes in the right direction with an understanding that the government really has no control over its fiscal position. All this, which relates to the implementation of monetary sovereignty, helps understand why the financial crowding out is not operative, why monetary financing is not by definition inflationary, why i > g is normal. It helps explain why the hysterical rhetoric surrounding the public debt and deficits in nonsense. I recently wrote a piece for Challenge Magazine on that topic. Surpluses are celebrated, governments implement austerity during a recession to “live within our means”, Social Security needs to be fixed to avoid bankrupting it, governments need to save more, etc. All of this is incorrect.

DA: I'm not sure why you claim SMT leads to the idea of i > g. The case i < g is perfectly consistent with SMT (see Blanchard's 2019 AEA Presidential address, and also my posts here and here). The correct criticism (I think) is that mainstream economists have assumed i > g as being the empirically relevant case (it is not).

ET: That is what I meant. MMT links that to monetary sovereignty.

DA: I think that's correct. I should like to add that mainstream economists (apart from a small set of monetary theorists) have not appreciated the role of high-grade sovereign debt as an exchange medium in wholesale financial markets and as a global store of value, which in my view likely explains a lot of the "missing inflation." But as for "surpluses being celebrated," you are now talking about individual viewpoints and not SMT per se. There were plenty of calls out there for countercyclical fiscal policy based on standard macroeconomic principles. But I do agree virtually all mainstream economists are (perhaps overly) concerned about "long-run fiscal sustainability." The view is that at the end of the day, stuff has to be paid for -- and that having the ability to print money, while granting an extra degree of flexibility, does not get around this basic fact. 

DA: I'd like to ask you about this statement you make:

In (the unconsolidated) case, the Treasury collects taxes and issues securities before it can spend. However, federal taxes and bond offerings also serve another highly important function that is overlooked in standard monetary economics. Specifically, federal taxes and bond offerings result in a drainage of funds from the banking system, and MMT carefully analyzes the implication of this fact. From that analysis, MMT argues that federal taxes and bond offerings are best conceptualized as devices that maintain price and interest-rate stability, respectively (of course, the tax structure also has some important role to play in terms of influencing incentives and income distribution; something not disputed by MMT). 

DA: Well, yes, taxes serve both as a revenue device (permitting the government to gain control over resources that would otherwise be in control of the private sector) and as a way to control inflation. I'm not sure about the idea of the Treasury offering bonds for the purpose of achieving interest-rate stability (though this may happen to some extent when the treasury determines which maturity to offer). I don't think this is the way things work in the U.S. today.

ET: Taxes and issuance of treasuries drain reserves and so raise the overnight rate. Hence, on a daily basis, a fiscal surplus raises the overnight rate and a fiscal deficit lowers it. There has been significant Treasury-Fed coordination to smooth the impact of taxes (and treasury spending) on the money market.

DA: Fine, but so what? We all understand "coordination" between Fed and Treasury exists at the operational level. 

ET: I think you are too kind to other economists and policymakers. On taxes as price-stabilizing factors, there is indeed some similarities here. On the role of treasuries for interest-rate stability, it does work like this today. It may not be obvious because of the current emphasis on treasuries as Treasury's budgetary tools, but Treasury has issued securities for other purposes than its budgetary needs. In the US, this occurred most recently during the 2008 crisis (SFP bills). In Australia, in the early 2000s, the Treasury issued securities while running surpluses in order to promote financial stability.

DA: But even if this is not the way things actually work (in my view, it's the Fed that stabilizes interest rates, possibly through OMOs involving U.S. Treasuries), I'm not sure what point is being made. I think we can all agree that monetary and fiscal policy can be thought of as being consolidated in some manner. What would be good to know is how a specific MMT consolidation matters (relative to other specifications) for a specific set of questions being addressed. There is nothing in the abstract or introduction of this paper that suggests an answer to this question.  
ET: The point being made is that in a consolidated government, tax and bond issuance lose the financial purpose they have for the Treasury but keep their price and interest-stability purposes.

DA: In standard monetary theory, tax and bond issuance keeps its funding purposes for the government and at the same time can be used to influence the price-level (inflation) and interest rates. Is this wrong? I don't think so. At some level, taxes (a vacuum cleaner sucking up money from the private sector) must have some implications for the ability of government to exert command over real resources in the economy. What we label this ability (whether "funding" or ''finance" or whatever, seems inconsequential). 

ET: Ok here comes the crucial difference between financial and real sides of the economy. In financial terms, taxes do not increase the capacity of the government to spend, i.e. the government does not earn any money from taxing; taxes destroy the currency. In financial terms, there is no reason to fear a fiscal deficit; deficits are the norm, are sustainable and help other sectors grow their financial net wealth. As such, it is not because a government wants to spend more that it must tax more or lower spending somewhere else. That is the PAYGO mentality. This mentality makes policymakers think of spending and taxing in terms of how they impact the fiscal balance instead of their impact on employment, inflation, incentives, etc. While deficits may have negative consequences, they are not automatic. If one takes a look at the evidence, deficits have no automatic negative impacts on interest rates, tax rates, public-debt sustainability, or inflation.

In real terms, the necessity to increase tax rates to prevent inflation, and so move more resources to the government, depends on the state of the economy and the permanency of the increase in government spending relative to the size of the economy. In an underemployed economy, the government can spend more without raising tax rates. In a fully employed economy, shifting resources to the government without generating inflation does require raising tax rate and/or putting in place other measures such as rationing, price controls, and delayed private-income payment. Here Keynes’s “How to Pay for the War” provides the roadmap. Standard economics is full-employment economics so opportunity costs are always present. MMT follows Kalecki, Keynes and the work of their followers (have a look at Lavoie’s “Foundations of Post Keynesian Economic Analysis”) and note that capitalist economies are usually underemployment and economic growth is demand driven. Put in a picture, the economy is usually at point a.

Put succinctly, the real constraint is conditionally relevant, the financial constraint is irrelevant if monetary sovereignty prevails. That is the proper way to frame the policy debates and to advise policymakers; don’t worry about the money, worry about how spending impacts the economy.

ET: Moving to another topic, consolidation of the government brings to the forefront forces that are operating in the current system but that are buried under institutional complications. Namely that a fiscal deficit lowers interest rates and treasuries issuance brings them back up, that spending must come before taxing and treasuries issuance, that monetary financing of the government is not intrinsically unsound and does not mean that tax and treasuries issuance don't have to be implemented. 

DA: The statement that "deficit lower interest rates" needs considerable qualification. Among other things, it depends on the monetary policy reaction function. As for the claim that spending *must* come before taxes, this is not a universally valid statement (even if it may be true in some circumstances. But even more importantly, who cares? Mainstream theory does not suggest that monetary financing is intrinsically unsound (seigniorage is fine, if it respects inflation ceiling). As for money, taxes and bonds not being alternative "funding" sources, I worry that this semantics. You can call X a "funding" source or not -- it's just a label. The real question is: what are the macroeconomic implications of X? 

ET: Let me emphasize where I agree. Yes, evidence shows the central role of monetary policy for the direction of interest rates, fiscal policy is at best a very small driver. And yes, one ought to focus on the real implications of government spending and we ought to forget about the financial implications. A fiscal deficit is not unsustainable nor abnormal; deficits are the stylized fact of government finances and are financially sustainable if monetary sovereignty is present. So don’t try to frame the policy debate and set policy in terms of household finances, bankruptcy, fixing the deficit, etc.
To conclude I see three reasons why the "taxes/bonds don't finance the government" rhetoric is helpful:

1- It is strictly true for the federal government (i.e. consolidation).

2- it brings to the forefront some lesser-known aspects of taxes and treasuries issuance: impacts on money market, role of central bank in fiscal policy, role of treasury in monetary policy.

3- It changes the narrative in terms of policy and political economy: government does not rely on the rich to finance itself, taxes should be set to remove the "bads" not to finance the government (e.g. one should not set tax rates on pollution with the goal of balancing the budget but with the goal of curbing pollution to whatever is considered appropriate, that may lead to much higher tax rates than what is needed to balance the budget), PAYGO is insane, one should focus on the real outcomes of government policies not the budgetary outcomes.

1. I think this is semantics.
2. Not sure how it helps in this regard.
3. I think all of these positions are defensible without the statement "taxes/bonds don't finance the government", so if this is the ultimate goal (and I think it should be), perhaps we should set aside semantic debates and focus on the real issues at hand. 

ET: 1 is not semantic. I know you have in mind taxes as a means to leave resources to the government. MMT makes a clear difference between financial (ability to find the money) and resources constraint (ability to get the goods and services) as explained above. The financial constraint is highly relevant for non-monetarily sovereign governments so it should be noted and clearly separated from the real constraint. Too many policy discussions and decisions by policymakers operating under monetary sovereignty are based on an inexistent inability to find money and the imagined dear financial consequences of budgeting fiscal deficits. 2 helps to understand how monetary sovereignty is implemented in practice. On 3, yes focus on the real issues.

DA: We agree on 3! Thank you for an interesting discussion, Eric. There's so much more to talk about, but let's leave that for another day. 

ET: You are welcome and thank you too!

Saturday, July 27, 2019

Blanchard and Farmer on the Phillips Curve

In case you missed it, there's an interesting (and slightly wonkish) debate going on between Olivier Blanchard and Roger Farmer concerning the theoretical relevance of the Phillips curve. Roger fired the opening salvo by presenting a macroeconomic model he claims fits the data well and yet makes no use of the Phillips curve. Farmer, in Laplace-like fashion, declared "he had no use for that hypothesis." Blanchard predictably, and understandably, came to the defense of the orthodoxy:

If you've followed my writings over the years, you'll not be surprised to learn that I am sympathetic to Roger's position in this debate. Below, I explain why. I begin by summarizing the gist of the conventional view. I then present a simple model that has no "natural" rate of unemployment. It's not exactly Roger's model, but it captures what I think is the essential part of his argument.

Let me now review. According to conventional (e.g., New-Keynesian, but also other) theory, there exists a "natural rate of unemployment" that potentially moves around owing to "structural" factors. The long-run rate of inflation is assumed to be fixed by policy in some unspecified manner. In an economy free of any disturbances, actual (and expected) inflation correspond to the long-run inflation target and the unemployment rate corresponds to the natural rate of unemployment. There is also a "natural" (or "neutral") real rate of interest that corresponds to the natural rate of unemployment. Absent any economic disturbances, monetary policy is assumed to set "the" nominal interest rate to its natural rate (the natural real rate of interest plus the inflation rate).

The actual rate of unemployment fluctuates around this natural rate owing to "shocks" that influence the aggregate demand for goods and services. I like to think of these shocks as "news" shocks that cause expectations over the future profitability of investment to fluctuate over time (see, for example, here). It does not matter for my purpose here whether expectations react rationally or irrationally to this information flow. The important thing is when people collectively become more bullish over the future return to investment, the demand for investment rises (at the expense of other forms of storing value, like government paper). For this reason, I attach the conventional label "aggregate demand shocks."

In the conventional model, fluctuations in aggregate demand for fixed nominal interest rate generate a negative relationship between inflation and unemployment. Intuitively, if firms have a bullish outlook, they raise their product prices more aggressively against the higher expected demand, and they also recruit more aggressively as well, which sends the unemployment rate lower. Adjustments in the interest rate (via monetary policy) designed to stabilize the inflation rate would imply movements in the unemployment rate without any corresponding change in inflation. All of this is consistent with the model I present below.

What about the question posed by Blanchard above: "Does anybody doubt that if the Fed decreased (unemployment) to 1%, it would not lead to more inflation?"

It's not entirely clear what experiment he has in mind. An educated guess suggests he's thinking about the Fed temporarily reducing its policy rate, causing a temporary boom in aggregate demand, leading to a temporary increase in inflation and a temporary decline in unemployment, with everything returning to normal once the Fed returns its policy rate to its "neutral" level. My answer to his question is that probably few people doubt this is what is likely to happen. Accepting this, however, does not validate the notion that "low unemployment causes high inflation." (Note: I am not accusing Blanchard of suggesting this causal relation, but many if not most people interpret the Phillips curve in exactly this way).

What I would like to ask Blanchard is the following. What do you think would happen to inflation and unemployment if the central bank lowered its policy rate permanently? I think the answer to this question would illuminate the "natural rate" hypotheses assumed by theorists, as well as what they are implicitly assuming about the conduct of fiscal policy (i.e., how it reacts to the change in monetary policy).

Let me now describe a simple OLG model (a model taught to me by Blanchard via his textbook with Stan Fischer). I will keep the wonkishness to a minimum here. If you want the full-blown version, just email me and I'll send it to you.

Individuals live for two periods in a sequence of overlapping generations. There are young entrepreneurs and young workers. Young entrepreneurs expend recruiting effort to find suitable young workers. The probability of finding a match is increasing in recruiting effort. A match, if it is formed, produces output in the following period. In this sense, recruitment effort is like an investment: a current expense leads to an expected future payoff. For the entrepreneur, the expected payoff depends in obvious ways on the expected productivity of the match (news) and the worker's bargaining power.

Young entrepreneurs face a trade-off: they can devote their resources to recruitment investment, or toward purchasing an alternative store of value in the form of interest-bearing government money (or debt). For a given inflation rate and a given nominal interest rate (both determined by policy), the optimal recruiting intensity trades off the expected return to recruiting relative to the real (inflation adjusted) return on government debt. In a steady-state, the inflation rate in my model is determined by the rate of growth of nominal debt, which is injected into the economy as lump-sum social security payments. The interest expense on the debt is financed with a lump-sum tax on old entrepreneurs.

The aggregate recruiting effort (which I associate with job vacancies) determines the unemployment rate. The model generates a negatively-sloped Beveridge curve. The equilibrium unemployment rate is: (1) decreasing in the inflation rate; (2) increasing in the nominal interest rate; (3) increasing in the bargaining power of workers; and (4) decreasing in the level of "optimism."

There is no "natural" rate of unemployment in this model in the sense of the unemployment rate necessarily  reverting ("self-correcting") to a given "natural" rate over a long enough period of time. Monetary and fiscal policy in this model can result in many different "natural" rates of unemployment (and interest). So, in this model, it is indeed possible for policy to drive the unemployment rate to permanently low levels without any inflationary consequences (since inflation is determined by the rate of growth of nominal debt in the long-run).

I should add that the model can speak to the effect of worker bargaining power on inflation as well. A permanent increase in worker bargaining power has no effect on inflation--it simply increases the real wage (and unemployment). In terms of an impulse-response function following a surprise increase in bargaining power, the mechanism works as follows. The increase in bargaining power reduces the expected return to recruiting workers, hence reduces recruiting investment. There is a portfolio substitution out of private investment activities into government securities. The implied increase in the demand for real money balances has the effect of driving the price-level down (for a given stock of nominal debt and assuming no change in the policy rate). So, increased worker bargaining power is disinflationary in the short run, but has no effect on inflation in the long run.

Let me conclude. One purpose of this post was to demonstrate that models without a "natural rate" hypothesis are not that unconventional--I cobbled the model above based on what I learned from standard textbooks, after all. Roger has shown another way to do this that does not stray too far (in my view, at least) from conventional theory either. These models may or may not turn out to be useful ways for understanding basic elements of the macroeconomy and for informing policy--I do not yet know for sure. But I do believe they are worth exploring further and I commend Roger for leading the way!

Monday, July 15, 2019

Does the Phillips Curve Live in Europe?

There's been much talk about the Phillips curve lately, especially in the wake of Jay Powell's recent testimony before Congress. Many people are proclaiming the death of the Phillips curve. I think that many people making these proclamations are probably wrong--or, more likely--they are correct, but for the wrong reasons.

What exactly is being proclaimed dead here? Are people referring to the absence of any statistical correlation between inflation and unemployment? Or are they referring to the theory that the unemployment rate (beyond some "natural" rate) causes inflation? These are two conceptually different notions of the Phillips curve. The fact that the Phillips curve is "flat" does not in itself negate the Phillips curve theory of inflation. This is because monetary policy and other factors (like expected inflation) could shift the position of the curve over time.

My own preferred theory of inflation does not rely on the unemployment rate per se. I think that the long-run inflation rate is determined by monetary and fiscal policy and that fluctuations in "aggregate demand" can generate countercyclical movements in inflation and unemployment (or procyclical movements in inflation and employment in a "full-employment" economy). But this is not a post on the theory of inflation. It's just about the statistical properties of the Phillips curve in the European Monetary Union. (In my previous post I talked about the Phillips curve in the United States, see here.)

Restricting attention to the EMU is of some interest here because individual member countries do not have direct control over monetary policy (although some countries may have greater influence than others). If (say) the Austrian economy goes into recession, it's not like the ECB will cut its policy rate just for the sake of Austria. So, to the extent that unemployment rates across EMU members states are not perfectly correlated, one might be in a better position to identify a conventional Phillips curve relationship. Below, I report the Phillips curve for all 19 member states and for the EMU as a whole. In this data, the negative relationship seems apparent in all but a few cases. I'll leave it up to the reader to draw his or her own conclusions.

PS. Antoine Levy points me to his paper showing an even stronger relationship at the regional level; see here: