On the want of U.S. government debt

In a recent article, Narayana Kocherlakota lays out the case for why, under present conditions, the U.S. government should be issuing more debt, using the proceeds to cut taxes, finance infrastructure spending, or both. It's a policy that many economists, including yours truly, have been advocating for some time. And while I generally support the policy, I thought it would be useful, nevertheless, to reflect on some possible counterarguments. It's not a slam dunk case, one way or the other, I think.

 

Kocherlakota does a good job explaining why a deficit-financed tax cut, or deficit-finance infrastructure spending is a good idea. I want to make it clear that the argument in favor of the policy hinges critically on the presumption that we can rely on Congress to manage the public debt over time in a responsible manner. Let's accept this assumption, provisionally at least, in order to understand the economic argument. I will come back to the political argument later.

While the debt-to-GDP ratio (D/Y) is presently high by historical standards, it's not unmanageable. The key is not the D/Y itself, but its trajectory over time. Clearly, D/Y cannot grow forever. And fortunately, market signals are available to monitor how the public perceives the likely path for D/Y over time. These market signals are: (1) the yields on U.S. treasury debt (at various maturities), and (2) inflation and inflation expectations. So what are these market signals telling us? The yield on U.S. treasuries is presently very low. Both inflation and inflation expectations are presently running below the Fed's 2% target and have done so for years now. So far, so good.

The large increase in D/Y since 2008 together with plummeting yields and low inflation may seem puzzling, but it's not really. Usually, a bad event that triggers a large increase in the public debt also triggers higher bond yields and the prospect of inflation. We can expect this to be the case in any experiment where the supply of debt increases in the face of a stable (or diminished) demand for the debt that is being issued. Think Zimbabwe or Venezuela.

But the U.S. is not Zimbabwe or Venezuela, or the Weimar Republic, for that matter. Rightly or wrongly, the U.S. treasury security is viewed by investors around the world as a safe haven asset. So when the financial crises hit in the U.S. and Europe 2008-10, investors moved en masse into U.S. treasuries (and other sovereign debt instruments viewed to be relatively safe). In short, while the supply of U.S. debt spiked up, the demand for U.S. debt increased by even more. We can infer this from the behavior of bond yields, which went down (the price of debt went up) at the time.
 

So the economic argument is simple. The U.S. government can presently borrow at essentially zero interest (more or less) even 10 years out and more. This effectively gives the fiscal authority the ability to print money (low-interest debt), so there's no need to rely on the Fed. To the extent that domestic real economic activity is still not firing on all cylinders, why not offer temporary tax cuts to stimulate demand? Why not re-build that crumbling infrastructure, putting people to work, all financed at zero-interest? It sounds like a no-brainer.

Alright, now for a couple of counterarguments, one economic and one political.

An economic argument against temporarily increasing the public debt further (and indeed, taking measures to reduce it) could be made on the basis of the Triffin Dilemma. The economist Robert Triffin noted back in the early 1960s that world reserve currency/debt status is a double-edged sword. On the one hand, it's great that the U.S. can just print paper that is coveted around the globe. If foreigners are willing to export their goods and services to us, expecting only paper in return, then we are extracting wealth from the rest of the world (in exchange for what ever financial service our paper is providing them).

One implication this power, if exercised, is that the world reserve currency issuer is likely to run persistent trade deficits. Triffin worried that the huge amount of U.S. currency held by foreigners exposed the U.S. to foreign risks. What might happen, for example, if foreigners suddenly decided they no longer wanted to hold USD or USTs? This could result in a sudden and dramatic change in the exchange rate, leading to domestic inflation and sharply higher bond yields.

There is also the trade-related argument that persistent trade deficits kill domestic industries and domestic employment. After all, if we can make the rest of the world work for us in exchange for paper, where is the need for us to work at all? The implied boom in domestic leisure consumption sounds good theoretically. But of course, in reality, the gains are not evenly shared. The rich gain by purchasing cheaper foreign goods. The poor are out of their jobs.

A political argument against more government debt could be made by challenging the assumption that it will be managed responsibly. This "we can't trust future politicians to do the right thing" argument is (sadly) not without empirical merit. I am reminded of the following quip by P.J. O'Rourke,

"The Democrats are the party that says government will make you smarter, taller, richer, and remove the crabgrass on your lawn. The Republicans are the party that says government doesn't work and then they get elected and prove it."

I can't help but note a certain irony here. There seems to be a strong presumption among people (Americans in particular) that the government should run its finances in the manner of a household. Economic theory is quite clear that this sentiment, however noble, is just plain wrong. The irony is that to the extent that this sentiment finds its way to being represented in Congress, it proves to be a very valuable "anchoring" device for the fiscal authority.

That is, I sometimes wonder whether US treasury debt is valued around the world the way it is precisely because it is known that Congress is impregnated with a large number of genetic "debt-ceiling" algorithms. It may not be an ideal situation from the perspective of pure economic theory, but then again, it's not hard to think of worse scenarios.

Interest Rates and Aggregate Demand Revisited

Nick Rowe has a nice post (written some time ago) that frames an old macroeconomic issue in a very nice (teachable) way.

In macro policy discussions, one often hears something like "lower interest rates stimulate aggregate demand.'' Many people view such a statement as self-evident. It's only when you think about it for a long time that you realize it's not self-evident at all (few things are when we are left to ponder them long enough, it seems).

The purpose of this post is to add a bit of formalism to Nick's discussion. (Sorry for the wonkish display, but I think it's necessary at this point to make things clear.) To this end, let's begin with an off-the-shelf bare-bones macro model. There is a representative agent (this is not necessary, but makes things easy) with additively-separable log preferences defined over consumption sequences {c(t), t = 0,1,...,∞}, with discount factor 0 < β < 1. Let R(t) denote the gross real rate of interest (risk-free) earned on a bond held from date t to date t+1. Assume that all individuals can borrow/lend freely at the risk-free rate.

Now, consider the cost-benefit calculation associated with the consumption-savings choice. Suppose an individual refrains from consuming one unit of consumption today. The marginal utility cost of this sacrifice is given by 1/c(t). This one extra unit of saving delivers R(t) units of extra consumption tomorrow. The marginal utility benefit of this extra consumption is R(t)β/c(t+1). Individual optimization requires equating marginal cost to marginal benefit:

[1] 1/c(t) = R(t)β/c(t+1) for t = 0,1,...,∞

Condition [1] is sometimes called the consumption-Euler equation, or just the Euler equation, for short. (Noah Smith has a nice post on the Euler equation here.)

One can do a lot with the Euler equation. Here is how it is used to derive "aggregate demand." First, assume that all output is (for simplicity) in the form of nonstorable consumer goods and services. Let N denote population size. Then C(t) = Nc(t) denotes aggregate consumption or GDE (gross domestic expenditure). Now rearrange [1] as follows,

[2] c(t) = [ 1/(R(t)β) ]c(t+1)

Thus, if we hold c(t+1) fixed, then equation [2] traces out a negative relationship between c(t) and R(t). That is, an increase in R(t) results in a decrease in planned present day consumer spending (aggregate demand). This negatively related locus of consumption and interest rate pairs is sometimes called an IS curve (IS = "investment-saving" where investment is fixed at zero in this model). The economic intuition is simple: raising R(t) makes it more attractive to save (lower current consumption). [Never mind for now that any extra saving is likely to boost c(t+1).]

Let me consider an endowment economy where each individual is endowed with a deterministic sequence {y(t), t = 0,1,...,∞}. Usually, y(t) is thought of as an individual's output or income at date t, so that Y(t) = Ny(t) represents GDP (gross domestic product) or GDI (gross domestic income). But more generally (and this is what the General refers to in the General Theory) we can think of y(t) as a maximum production capacity. "Full employment" refers to the special case where Y(t) is the GDP.

The standard neoclassical assumption is that the economy is always at full employment. Maybe calling this property an assumption is not quite accurate. We can derive the property as a result of some deeper assumptions relating to the ability of individuals in an economy to coordinate their activities in an efficient and socially desirable manner (this is the force behind Says' Law, that "supply creates its own demand.") In any case, the upshot is that Y(t) represents the GDP. And since GDE = GDP, we have C(t) = Y(t), or c(t) = y(t), at every date t. Each person consumes his value-added, the economy consumes what it produces.

Suppose that real income grows at rate α, so that, y(t+1) = αy(t). Since c(t) = y(t) for all t, condition [2] can be used to deduce the equilibrium real rate of interest:

[3] R*(t) = α/β

The real interest rate is predicted to be high when growth (α) is high. The real rate of interest is low when growth is low. The intuition here is as follows. An increase in α means that people are expecting higher levels of future income. People will want to bring some of that future income forward in time. They will try to do so by borrowing, or saving less. Either way, the effect is to put upward pressure on the interest rate.

Alright, it's time to do some "textbook" aggregate demand analysis. Actually, I don't like the way textbooks usually do this. The usual assumption is a "sticky wage" that mucks up the labor market (here is my critique on that idea). This idea is certainly not Keynesian:

"There is, therefore, no ground for the belief that a flexible wage policy is capable of maintaining a state of continuous full employment..." [General Theory, 1936 Chp. 19]

Indeed, Keynes (1936) wrote that flexible wages could make things worse, not better (consistent with my Figure 2.12 here.) The best representation of "what Keynes actually meant" is, in my view, expressed formally in the game theoretic notion of multiple Bayes-Nash equilibria (a tool that was not available to Keynes in his lifetime). See Cooper and John (1988), Howitt and McAfee (1990) and Roger Farmer for example.

How to proceed? There are many ways, but I don't want to get bogged down in the details here (although I should stress that the details are critical for other questions). One way to proceed is to embed my static high/low equilibrium model into the model above. In that model, aggregate demand C(t) can be either high or low, and the equilibrium level of output can correspond to the high or low level of demand as a self-fulfilling prophecy.

Here's another way to think about it. Peter Howitt would explain it to me this way. Imagine that the people in our model do not like the smell of their output (any reason to motivate intratemporal trade here will do). So they will want to swap their goods with others. If everything works well here (the neoclassical assumption), then all goods will be traded at par. The real GDP is Y(t).

Now, suppose that trading is costly. Suppose that it is prohibitively costly to sell any output beyond some level k(C), where C is aggregate demand. Assume that k(C) is increasing in C. The idea here is that it is easier to sell larger quantities of output when demand is high. In fact, we could just assume k(C) = C/N. Next, consider an arbitrary 0 < C/N < y. Then the most anyone can expect to sell (and buy) at a given date is c = C/N. In this model, there is a continuum of equilibria, each indexed by an expectation defined over C/N. If everyone expects a thickly traded market, it is individually rational to trade a large volume and, collectively, this is what transpires. "Animal spirits" determine which of these equilibria actually prevail.

Alright, back to Nick's point. Assume that in the "long run," the economy returns to full employment forever. For simplicity, assume that the long-run is expected to occur tomorrow. In this case, c(t+1) = y(t+1) and R(t+1) = α/β for every date t going forward. Now let's take a look at today, t = 0, using condition [2].

[2a] c(0) = [ 1/(R(0)β) ]y(1)

Assume that c(0) is determined by an animal spirit (as described above) such that c(0) < y(0). Then condition [2a] can be used to solve for the equilibrium interest rate,

[4] R(0) = (1/β)y(1)/c(0) > R*(0) = (1/β)y(1)/y(0)

That is, the economy is presently in recession and the interest rate is too high. And if the interest rate is too high, well, then, why not take policy actions designed to lower it? The recession is like diabetes and low interest rate policy is like insulin, as Kocherlokota argues here.

And the argument makes sense IF full employment lives somewhere in the foreseeable future. Lowering the interest rate in this model has the effect of stimulating consumer demand as people try to bring future output closer to the present. But future output here is fixed at full employment. So, to the extent that lowering the real rate of interest increases C(0), the effect is felt entirely in the contemporaneous depressed period in the form of higher real GDP.

But what justifies the assumption that the economy will somehow find its way back to full employment? This is the missing piece in our conventional models.

This leads Nick to ask: what if people do not expect a return to full employment in the near future? Indeed, what if? As it turns out, there are many, many other equilibria in the model above. One such equilibrium path satisfies

[5] C(t+1) = R*βC(t)  where C(t) < Y(t)  for all  t = 0,1,...,∞

That is, the economy can be permanently stuck in a "secular stagnation." Moreover, the equilibrium interest rate is exactly where it should be: it is neither too high  nor too low. Consumption and GDP are growing at rate α. It's just that the level of GDP is permanently below its full employment level.

The real interest rate measures the relative price of output across time. In the equilibrium described by [5], the relative scarcity of output across time is just right. Its the contemporaneous level of output that's off at each date. How is a change in the interest rate supposed to fix this problem?

The short answer is that it can't. In fact, it's easy to construct examples where attempting to lower the interest rate could make things worse (perhaps this is an overdose of insulin, in Kocherlakota's example).

Suppose we're in a situation described by condition [2a], for example. In that exercise, I assumed that y(1) is fixed at full employment and that c(0) is depressed. This is what justified lowering R(0) to stimulate contemporaneous consumer demand. But suppose that animal spirits keep contemporaneous consumer demand fixed, and that the effect of lowering R(0) is to reduce future consumer demand to c(1) < y(1)? There is no a priori reason to expect c(0) to do all the "equilibrating" here. And so, in this manner, the effect of low interest policy could be to cause future recessions, possibly a secular stagnation.

***

I think most of what I said above can be shown in a conventional 2-period economy (a current and future period). Here are some diagrams.

Consider first the neoclassical general equilibrium (full employment at both dates). Condition [1] states that the slope of the indifference curve is the same as the slope of the intertemporal budget constraint (the real rate of interest). The full employment assumption means that the equilibrium lies on the budget constraint. This is point A in the following diagram.

Suppose now that the economy is expected to be at full employment in the future; i.e., fix c(2) = y(2), but that the economy is presently depressed; i.e., c(1) < y(1). The interest rate is too high, R' > R*. This is point B in the following diagram.

Lowering the interest rate in the diagram above (making the budget line flatter) moves the economy from B back to A. But suppose we instead forecast a future recession, so that c(2) < y(2). Then condition [5] prevails, and the economy moves to point S (secular stagnation) in the diagram below.

And finally, here's how to depict a future recession caused by an artificially low interest rate  policy (point F).

How old were the inventors of major inventions?

I came across this fun column the other day listing a number of Famous Inventions, like the airplane, the camera, electricity, the car, etc, along with their inventors. A thought crossed my mind: how old were these inventors when they invented these inventions? Were they young like Marconi, who invented the radio in his early 20s? Or were they old like Gutenberg, who invented the printing press in his early 50s? In short, is there an age demographic that is responsible for producing major innovations?

Let's take a look at the data based on 34 major inventions listed in the article I cited above (thanks to Michael Varley for organizing the data).

Here is what the data looks like for the full sample:

I have to admit, I was a little surprised--the median age is 40 (I was expecting younger). In what follows, I report the age distribution for different centuries. I'll save any commentary for another time and let you draw your own conclusions. Feel free to send me links to any literature related to this issue.

Postscript: The demographics of innovation in the United States. Reports that the median age for an innovator is 47 years. It's also interesting to note the disproportionate share of innovation attributable to immigrants and the children of immigrants. 

Postscript April 16, 2016. 

Interesting comment thread here. 

Is Bitcoin a Safe Asset?

You're probably thinking no, of course not. The dollar price of bitcoin can be quite volatile (see here). One can easily gain or lose 50% over a very short period of time. So if we're talking about an asset that offers a stable rate of return, Bitcoin ain't it.

Except that this is not what I mean by a safe asset. 

I'm not even sure how to precisely define what I mean by safe asset. Loosely speaking, I'm thinking about an asset that people flock to in bad or uncertain economic times. In normal times, it's an asset that is held despite having a relatively low rate of return, perhaps because of its use as a hedge, or because of its liquidity properties.

U.S. dollars (USD) and U.S. treasuries (UST) are examples of safe assets today. Now, you might think that they're safe because they're close to risk-free in terms of what they promise in the way of a nominal rate of return. A paper USD promises a zero nominal interest rate and you'll be sure to get that if you hold on to the note over time (USD in the form of central bank reserves presently earn 1/2%, but only depository institutions get this rate.). A UST bill also promises zero nominal interest and you can be sure to get that with full principal repayment upon maturity. The coupon payments associated with a UST bond are virtually risk-free.

But that's not a complete way to think about the risk associated with a security. First, economists (rightly) focus on the real rate of return on an asset. Investors don't care how many paper dollars are promised to them in the future. They (presumably) care about the purchasing power of those future dollars. If inflation turns out to be high, that future purchasing power will be low. The opposite holds true if inflation turns out to be low.

As for the "risk free" UST bill, its market price will generally fluctuate between the issue date and maturity date. This is sometimes called "interest rate risk." If you buy a bill that promises $100 a year from now for $99, you will make about 1% if you hold the bill to maturity. But if market interest rates spike up in the interim, and if you are forced to sell your bill to raise cash, you're likely to realize a substantial loss.

That's the thing about a safe asset. It's return can appear to be stable for long periods of time and then--bam--something happens. (Something always happens.) Interest rates may spike up--a sudden sell-off in bonds may occur. What might trigger such an event? All sorts of news. Foreign banks may need to liquidate their foreign reserves consisting of USTs for political or economic reasons. A sudden increase in inflation expectations would lower the expected real rate of return on nominal bonds, inducing a sell-off. A bond sell-off might even be triggered by a good news event. An increase in productivity growth increases the expected return on private capital investment, inducing portfolio substitution out of bonds, for example.

Another thing to keep in mind is that the asset classes that constitute safe assets can change over time. In my recent piece on secular stagnation, I noted that a "flight to safety" seems to occur near regime changes that imply productivity slowdowns. In 1974, investors flocked to gold and real estate--they ran away from USD (rapidly rising price-level) and UST (rapidly rising nominal interest rates). In 2008, the situation was quite a bit different--both USD and UST were highly sought after safe havens (with investors fleeing real estate).

The observations above suggest that the monetary policy regime matters a great deal for whether a fiat currency is perceived to be safe or not. When Nixon and his advisers chose to abandon the gold standard (against the recommendation of Fed chair Burns) in 1971, monetary policy appeared to lose its nominal anchor. So when the oil price shocks and productivity slowdown hit in the early 70s, investors ran away from cash. Gold is often credited as being a safe asset because of its supply "policy." But there must be more to it than this because, like gold, the supply of real estate is not very elastic. And yet real estate was not a safe asset in 2008.

Patience, Grasshopper. I will get to Bitcoin soon. Before I do, I want to ask "what makes an asset safe?" According to Gary Gorton, it has a lot (perhaps everything) to do with information asymmetry:

A "safe asset" is an asset that can be used to transact without fear of adverse selection; that is, there are no concerns that the counterparty privately knows more about the value of the asset. (Safe Assets, Working Paper, March 2016).

In other words, a safe asset is an object with attributes that traders can mutually agree on very quickly and at little cost. Objects with this property tend to become monetary instruments or, to use a more broad term -- exchange media (which includes objects commonly used as collateral to support lending arrangements). Safe assets tend to be "simple" assets. Historically, commodities such as salt, precious metals, or coined tokens. It's easy to verify your salary in salt (just taste it). It's a bit more difficult to assay gold. The whole purpose of coinage was to make objects easily recognizable without much effort. 

  

It goes without saying that most financial instruments are complicated objects. Consider your life insurance policy, which is relatively simple as far as financial products go. The reason you can't buy your morning latte with a slice of that asset is because it's simply too costly for the vendor to do the necessary due diligence. So you pay in cash. Everyone knows what cash is. Cash may be "junk" (i.e., unbacked), but at least everyone can agree that it's junk. There's nothing complicated about cash. (The same principle holds true for UST, which are used extensively as collateral in overnight lending arrangements.)  

  

Cash and gold are "simple" objects. The fact that they pay no interest makes them even simpler. In particular, there's no need to spend time investigating the reliability of a dividend paid by "barren" asset--everyone can agree right away that the dividend is zero. This type of informational symmetry appears to be in high demand in times of financial uncertainty (when nobody knows for sure what other people know about the securities they're selling.) Of course, the situation is somewhat more complicated when counterparties (intermediaries) are involved, but this is true of any asset.

This brings me to Bitcoin. I think that Bitcoin could be the world's next great safe asset. At least, it certainly seems to have all the properties that are desired in a safe asset.

Importantly, it is a "simple" asset. It's simple in the sense that it's a pure fiat object--the monetary objects (called bitcoin) constitute no legal claim against anything of intrinsic value. Bitcoin is simply a record-keeping technology (and economists have known for a long time that money is memory). It pays no interest. Possession corresponds to ownership (unless counterparties are involved). The ledger has proven itself secure (not a guarantee that is can never be compromised, of course). 

Now one might object that Bitcoin is not that simple, not to the average person on the street, at least. Bitcoin consists of 30MB of C++ code. And the algorithm that governs the accuracy and security of the ledger can be hard to understand. But I liken this to the way most people understand how their car engine works. We have a vague notion of how internal combustion works, how power is transmitted through the drive train, blah, blah, but all we really know for sure is that our collective experience with the technology has proven useful. We also know that there are mechanics out there that do know how a car engine works. Because the Bitcoin code is open source software, attempts to modify the code for personal gain at communal expense are easily detectable through expert eyes. And we trust that there are many expert eyes on the watch.

Finally, Bitcoin has a very simple monetary policy. Essentially, the policy is to keep the money supply fixed (actually, it will grow asymptotically to a fixed number, 21 million units). Although this money supply rule could potentially be modified by communal consent, there are reasons to believe that this is unlikely to happen. And even if it does happen, it can only happen if it somehow serves the community of Bitcoin users in some broad sense.

As is well known, there's been a bit of a civil disturbance in the Bitcoin community as of late. The issue, as I understand it, concerns a proposed amendment to the Bitcoin constitution (see blocksize controversy). People fear that if the amendment does not pass (and it does not look like it will), then Satoshi Nakamoto's original vision of a low-cost, high-speed, high-volume P2P payment system may fail to materialize. Others are confident that a solution, in some form, will eventually be found. (These people breathe optimism, remember. It's the fuel that powers entrepreneurship.)

But suppose that the original vision doesn't pan out. Suppose instead that Bitcoin hits a hard limit on the volume of transactions it can process (presently far below what Visa can accomplish). Suppose further that as the subsidy on block rewards (the seigniorage revenue used to finance book-keeping costs) becomes negligible. Then a fixed transaction fee (and possibly a substantial one at that) will have to be paid, since someone has to finance the book-keeping costs. If this were to happen, then it would only make sense to hold Bitcoin for large-value transactions (the fixed cost associated with each transaction would make small-value transactions uneconomical.) 

This "Bitcoin as a large-value transfer system" does not destroy my thesis: Bitcoin can remain a desirable safe asset. (Smaller players could presumably get involved by investing in Bitcoin ETFs, although doing so would introduce counterparty risk.)

I've argued before that Bitcoin makes for lousy money. I still believe this. If it isn't the unit of account, users are subject to extreme exchange rate volatility. In a world where it is the unit of account, a "flight to safety" event would cause an unexpected and severe deflation. We have the experience of the early 1930s to show us what a Bitcoin monetary policy can lead to. (And while a Bitcoin monetary system may free people from the inflation tax, it won't free them from more general forms of taxation.)

However, even if Bitcoin is not, in my opinion, a particularly ideal monetary instrument, this does not preclude it from serving as a safe asset or longer-term store of value. Once market penetration is complete, its return behavior is likely to mimic the return behavior of any other safe asset. Safe assets generally earn a low expected return (that is, they are priced dearly). Investors can expect to earn unusually high returns in a crisis event. But if you buy at the top, you can expect to realize unusually high losses when the crisis subsides. In short, it's a great investment -- assuming you can predict when a crisis will occur and when it will end!

There are a host of issues related to safe assets that I think deserve some attention. Let me offer a few that come to mind here. First, it's not even clear that safe assets are socially desirable. Bryant (2005) demonstrates that the existence of a safe asset can induce coordination failure. Is this an argument to be taken seriously? Second, I think that policymakers should be aware that the class of safe assets may change over time. Should policy be conditioned in any way on the existing set of safe assets? Third, how should we think about "close-to-safe-asset" substitutes that seem to proliferate in periods of prolonged economic tranquility? Barren assets like cash, gold and Bitcoin generate no income. It is evidently very tempting to construct "safe senior tranches" of private interest-bearing debt to compete with these low-return barren assets--a practice that sometimes gets out of hand--and with disastrous consequences. Should a central bank issue its own interest-bearing digital cash to discourage the practice?

Pasqua 2016

Does the Fed have a credibility problem?

Former Minneapolis Fed president Narayana Kocherlakota thinks that the Fed's recent communication strategy has resulted in an unforced "credibility dilemma." (The Fed's Credibility Dilemma.) What is the nature of this dilemma?

The message coming out of the Fed recently is one of "gradual normalization." Normalization refers to returning to the state of affairs that prevailed prior to 2008, when the Fed's balance sheet was much smaller and the policy interest rate (short term nominal interest rate) was much higher. "Gradual normalization" means that the Fed's policy rate is likely to move slowly and in an upward direction over the indefinite future.

But what "gradual normalization" means and how it is interpreted by market participants can be two different things. Kocherlakota is worried that the market is interpreting the phrase as meaning the Fed will raise its policy rate slowly and in an upward direction. While this may very well be the case, it should be clear that this is not what Fed officials mean to say. Consider, for example, this report on a recent speech delivered by Boston Fed president Eric Rosengreen.

He [Rosengreen] added that the Fed’s policy committee stated it “expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate.”

This is obviously not a commitment to raise interest rates gradually and in an upward direction. It is merely a forecast of the economic conditions that are likely to prevail in the near future, together with a statement of how the Fed is likely to react to these conditions should they be realized. Again, and from the same speech,

The future path of rates, he said, will depend on incoming economic data, and how that data affects policymakers’ outlook for the economy.

This is a statement about state-contingent policy, together with a gratuitous forecast of the conditioning factors. These are two conceptually distinct objects that, when combined, give financial market participants the information they seem to crave: a statement about the likely path of interest rates over the foreseeable future.

Kocherlakota's concern is that this type of communication is misinterpreted by market participants as a commitment to a deterministic policy path. I think he's correct that some (perhaps many) people do misinterpret in this manner. If so, then the Fed faces a "credibility dilemma" because, well, what happens if the conditioning factors turn out not exactly as forecast? If future inflation comes in high above target, then the Fed will be forced to raise rates sharply and prematurely--reneging on its "commitment" to raise slowly--thereby "losing credibility." Or, if the economy turns south, the Fed may be forced to lower its policy rate--again, reneging on its "commitment" and "losing credibility." The apparent dilemma is that commitment along some dimension must necessarily be sacrificed.

Kocherlakota concludes with this:

So what, if any, plans should the Fed communicate? For one, officials must recognize that their expectations for the economy, like all forecasts, are likely to prove wrong. As a result, they should be much clearer about their willingness to make large and rapid changes in monetary policy. Instead of talking about gradual normalization, they should stress that they are ready to do “whatever it takes” to keep employment up and inflation near target.

I mostly agree with this suggestion. The part I disagree with (slightly) is where he says "they should be much clearer about their willingness to make large and rapid changes in monetary policy." I think--although I could be wrong--that the public is already generally aware that the Fed will make large and rapid changes in monetary policy should economic conditions dictate. Look at how the Fed reacted in 2008. Ask yourself: if inflation was to spike up to 5% tomorrow, how do you think the Fed would react? We all know how the Fed would react!

That is, I do not think that the issue Kocherlokota raises has anything to do with credibility. In 1971, the executive branch temporarily hampered the Fed's low-inflation credibility by abandoning the gold standard. [Take note, you End-the-Fed types--Fed chair Arthur Burns argued strongly against abandoning the gold standard.] But that reputation was won back (at a terrible price) by Paul Volcker in the early 1980s. Since that time, inflation has been relatively low and stable. Maybe it's not perfect, but it's an inflation record that many countries would envy. Consider this, for example.

To the extent that we can count on anything, I think we can count on the Fed defending its record of low and stable inflation. It is arguably the only real credibility that a central bank has. On the plus side, it's the most important dimension of credibility. (There is also the second part of the dual mandate but a central bank's influence on long-run labor market conditions is more tenuous than its influence on long-run inflation.)

What about "forward guidance?" Yes, it works great in theory, if one assumes that a central bank can commit to take actions at future dates that are not in the best interest of the economy when that future time arrives (economists call this time-inconsistent policy). But let's just face it -- the reality is that commitment along this dimension does not likely exist. Does anyone really believe that the "commitment" made by FOMC voting members today will bind a future FOMCs comprised of completely different people with different points of view? Convince me otherwise.

The Fed is credible where it matters most: its commitment to keep inflation low and stable, and to do whatever it can, within its legislated powers, to help the economy function in the best manner possible for the good of the country at large. Is it a perfect institution? No. Can policies be improved along various dimensions? Almost surely. We're all in this together. Let's try to figure it out.

In the meantime, Kocherlakota is probably correct in suggesting that communications which imply (or are wrongly interpreted) as commitments that cannot possibly be met in most states of the world are not likely to be very useful. They may even prove counterproductive. But would taking an unexpected policy action necessarily whittle away at Fed credibility? I don't think so--not along the dimensions that matter. There is no credibility dilemma here. And it does little good to cast the issue in this light.  

***

Postscript. Friday, March 25, 2016. Tim Duy weighs in here claiming that there are two types of credibility (hard and soft) and that the Fed cares about both of them (when it should perhaps only care about one). 

Mabel Frances Timlin (1891-1976)

I had the honor and pleasure of delivering the 30th Timlin lecture in economics at the University of Saskatchewan last Wednesday. My talk was on Secular Stagnation, a topic I think Professor Timlin would have approved of. I enjoy giving public lectures. It's fun to connect economic theory to real world policy issues in a public forum. I think I often learn more from the interaction with the audience than they do. It was also an opportunity to learn more of Mabel Timlin and her remarkable story.

Mabel Frances Timlin was born in Wisconsin in 1891. It's not clear what motivated to move to Saskatoon in her youth. In 1921 she found employment as a secretary at the University of Saskatchewan. Evidently unimpressed with the papers she was typing for the economics faculty, she decided to study the subject in her spare time. She eventually completed her PhD at the University of Washington and become an assistant professor at the University of Saskatchewan in 1941, at the tender age of 50. 

Her PhD thesis Keynesian Economics was published in 1942. I had our library order a copy so that I might read it before my lecture. I have to say that I was thoroughly impressed with it. Her book did not consist of a simple regurgitation of Keynes (1936). Instead, it was a courageous attempt to distill some of his most important ideas and extend them using dynamic general equilibrium theory. According to David Laidler (in a personal correspondence):

I think her 1942 book was the very first "Keynesian" text and, among other things, included the first drawing of a demand for money-interest rate curve showing a liquidity trap. Modigliani cited her in 1943, but inadequately. [Correction: Modigliani "Liquidity preference and the theory of interest and money" Econometrica Jan 1944.]

She evidently transformed the Canadian macroeconomics profession in terms of its application of formal economic modeling. She became Canada's first female full professor of economics, the first woman to serve as president of the Canadian Political Science Association, the first woman outside the natural sciences elected a Fellow of the Royal Society of Canada, and one of the first ten women to serve on the executive committee of the American Economic Association. 

I include a piece below, sent to me by Robert Dimand, that provides a few more details of her career. I think it's quite an inspiring story.  

Timlin, Mabel Frances (1891-1976)

     The Keynesian economist Mabel Timlin was the first tenured woman among Canadian economists, first woman elected president of the Canadian Political Science Association (which then covered all social sciences, including economics), the first woman outside the natural sciences elected a Fellow of the Royal Society of Canada (1951), and one of the first ten women to serve on the executive committee of the American Economic Association (1958-60), despite becoming an assistant professor only in her fiftieth year, after a long career as an academic secretary. She was born in Forest Junction, Wisconsin, on 6 December 1891, and, after studying at the Milwaukee State Normal School, taught in Wisconsin and rural Saskatchewan. She became a secretary at the University of Saskatchewan in 1921, while studying for a BA there. At first Timlin intended to study economics there, but after seeing the Department of Economics and Political Science she decided (probably correctly) that she could learn more economics on her own. She took a BA with great distinction in English in 1929, and then directed the university’s correspondence courses in economics. Mabel Timlin became an instructor in economics at the University of Saskatchewan in 1935, after completing graduate course work in economics at the University of Washington during summers and a six-month leave. Her doctoral dissertation at the University of Washington, supervised by the much younger Raymond Mikesell, was accepted in 1940 and published as Keynesian Economics (1942). In 1941, Timlin became an assistant professor of economics at the University of Saskatchewan (associate professor 1946, full professor 1950) and a member of the executive committee of the Canadian Political Science Association (vice-president 1953-55, president 1959-60).

     Keynesian Economics did more than introduce Keynesian theory into Canadian academic life. Timlin offered one of the early general equilibrium interpretations of John Maynard Keynes’s General Theory, and was particularly noteworthy in treating it as a system of shifting equilibrium, presented with innovative diagrams on which she collaborated with the eminent geometer H. S. M. Coxeter. Timlin began work on Keynesian Economics in 1935, before Keynes published his General Theory: Benjamin Higgins had come to Saskatoon from the London School of Economics in 1935 for a one-year appointment, carrying a copy of the summary of Keynes’s Cambridge lectures that Robert Bryce had presented in Friedrich Hayek’s LSE seminar.

     Beyond her work on Keynes, Timlin also expounded international developments in welfare economics and general equilibrium analysis to a Canadian audience more used to historical and institutional economics than to formal theory (e.g. Timlin 1946). Timlin (1953) sharply criticized the Bank of Canada for failing to follow Keynesian countercyclical stabilization policies during the Korean War inflation. Much of her later work (e.g. Timlin 1951, 1958, 1960) concerned immigration policy, emphasizing the economic benefits of freer immigration.

     Mabel Timlin never married. Generations of former students were her extended family. She remained active as a scholar long after her official retirement in 1959, publishing a major report on the social sciences in Canada in 1968. She remained devoted to the University of Saskatchewan despite job offers from such institutions as the University of Toronto, and died in Saskatoon on 19 September 1976.

                                                                                                                 Robert W. Dimand

Selected works

1942. Keynesian Economics. Toronto: University of Toronto Press.

1946. General equilibrium analysis and public policy. Canadian Journal of Economics

   and Political Science 12, 483-495.

1947. John Maynard Keynes. Canadian Journal of Economics and Political Science 13,

   363-365.

1951. Does Canada Need More People? Toronto: Oxford University Press.

1953. Recent developments in Canadian monetary policy. American Economic Review:

   Papers and Proceedings 43, 42-53.

1955. Monetary stabilization policies and Keynesian theory. In K. R. Kurihara (Ed.),

   Post-Keynesian Economics, London: George Allen & Unwin, 59-88.

1958. Canadian immigration with special reference to the post-war period. In

   International Economic Association, International Migration, London: Macmillan.

1960. Presidential address: Canada’s immigration policy, 1896-1910. Canadian Journal

   of Economics and Political Science 26, 517-532.

1968. The social sciences in Canada: Retrospect and prospect. In M. F. Timlin and A.

   Faucher, The Social Sciences in Canada: Two Studies, Ottawa: Social Science Research

   Council of Canada, 25-136.

1977. Keynesian Economics, with biographical note by A. E. Safarian and introduction

   by L. Tarshis. Toronto: McClelland and Stewart, Carleton Library.

Bibliography

Ainley, M. G. 1999. Mabel F. Timlin, 1891-1976: A woman economist in the world of

   men. Atlantis: A Women’s Studies Journal 23, 28-38.

Spafford, S. 2000. No Ordinary Academics: Economics and Political Science at the

   University of Saskatchewan, 1910-1960. Toronto: University of Toronto Press.

Secular stagnation then and now

Secular stagnation refers to a prolonged and indefinite period of slow growth and high unemployment (or subnormal factor utilization). When was the last time this happened in the United States? Most people are likely to say the 1930s. In fact, it was the 1970s.

The 1970s were tumultuous years. There was the Vietnam war, oil supply shocks, and Watergate. The anchovies had disappeared off the coast of Peru. Clothing styles ranged from dreadful to appalling. Disco music was in. It was an awful time for those of us who lived through it.

The seventies are also known for a significant slowdown in measured productivity growth. (See Cullison 1989 for a useful review of issues related to measurement and interpretation). The most common measure of aggregate productivity is called Total Factor Productivity, or TFP for short (See Hulton 2000.)

Aside: What is TFP?  Let Y denote the value of what is produced in an economy over the course of a year. Let (K,L) denote measures of the capital and labor services used to produce Y. Let F(K,L) denote an "aggregator function" that specifies the manner in which capital and labor are combined to form output. Given an assumed F and measurements on (Y,K,L), the TFP is computed as the residual TFP = Y/F(K,L). That is, the TFP measures the value of output unaccounted for by K and L. (Alternatively, think of TFP as measuring the average product of a list of factor inputs aggregated in a particular way.)

The San Francisco Fed produces its own "utilization-adjusted TFP" series here. This is what  what their measure of TFP looks like since 1960.

The shaded episodes were constructed using my eyeball metric, but I think that most people are likely to identify similar regions. 

There is the matter of just how to interpret the productivity dynamic above. Personally, I find it hard to believe that productivity just grows in a straight line that the undulations we see above constitute measurement error. My own inclination is to interpret this pattern through a Schumpeterian lens (see here).  Productivity growth appears in the form of growth-regimes. A productivity slowdown occurs when the economy switches from a high-growth regime to a low-growth regime. The economic shock is most pronounced in the first few years following a growth slowdown. (Related to this, see Zeira 1997.) 

Economic theory suggests that the real rate of interest should (ceteris paribus) be low in a low-growth regime (and high in a high-growth regime). Let me compute a measure of the real rate of interest by taking the annual nominal yield on U.S. treasury debt and subtracting annual PCE inflation. Here is what the data looks like. 

Well, not a perfect fit (remember the ceteris paribus part) but close enough, I think, to be intriguing. In particular, note that both low-growth regimes identified above are associated with significantly negative real interest rates. The early 1980s look odd by this view but, of course, we know that this era was associated with another type of regime change. In particular, Fed policy moved from a high-inflation regime to a low-inflation regime, with this regime change occurring in 1980 under Fed chair Paul Volcker. 

Here is how the unemployment rate correlates with the real interest rate and growth regime.

Low-growth regimes beget low real interest rates and high unemployment rates. This seems consistent with Alvin Hansen's secular stagnation hypothesis (see my earlier post here). The pattern is evident in the most recent episode, as it is in the 1970s. Except nobody called it secular stagnation back then.  

The 1970s may not be viewed as an era of secular stagnation because nominal interest rates and inflation were rather elevated in that episode. Secular stagnation, with its Depression-era origin, is more naturally related with low nominal interest rates and low inflation.  But as the following diagram shows, secular stagnation can occur in high-inflation regimes as well as low-inflation regimes. 

The 1970s episode was called stagflation (an era of high inflation and high unemployment).

The two low-growth regimes above were different in an important way. When the economy transitions from a high to low-growth regime, the shock of regime change produces uncertainty. Investors will naturally move resources out of capital expenditure and into safer asset classes. Here is a critical question: What are the safe asset classes when a productivity slowdown occurs? The answer to this question seems to vary across episodes.

In the 1970s, the USD and UST securities were not among the set of safe assets. This was in large part due to the "unanchoring" of U.S. monetary policy following the breakdown of the Bretton Woods fixed exchange rate system. In August 1971, President Nixon announced that the USD would no longer be pegged to gold. More importantly than this, the public likely did not believe that monetary policy would keep inflation in check through other means (it took Volcker to convince the public of this several years later). The added fiscal pressures of the Vietnam war and the Great Society spending could not have helped this perception. As a result, the safe assets back then did not include government securities. Instead, investors flocked to assets outside the direct control of government, like gold and real estate.

In the most recent episode, real estate was most certainly not considered a safe asset. Investors began to walk away from real estate in 2006. They then ran way in 2008. Ironically, it was the USD and UST securities that proved to be among the most highly regarded assets this time around. This is no small part attributable to the fact that U.S. monetary and fiscal policies are presently perceived to be "anchored" (unsustainable paths for money and debt are viewed as temporary departures from a long-run stable anchor).

It's worth thinking about just how large the worldwide demand for U.S. money/debt must have grown since 2008. We can infer this enhanced demand from two observations. First, the supply of debt was increased substantially. Second, the price of that debt went up, not down (safe bond yields generally declined). What might have happened had the Fed/Treasury not intervened in the way they did?

To answer this latter question, we can look to the "hard money, tight fiscal" policy regimes in place when a low-growth regime hit the U.S. economy in 1929. In the early 1930s, short-term bond yields plummeted as today, and CPI inflation ran close to negative 10%.  The unexpected and dramatic deflation--produced by an elevated demand for money against a fixed money supply--almost surely exacerbated the depth of the contraction through well-known channels.

The lesson here is that responsible monetary and fiscal policy "anchors" a regime, rendering its money/debt a safe asset. But anchoring a policy regime does not require strict adherence to a fixed asset supply rule, like the gold standard, or year-over-year balanced budgets. A credible regime will permit the supply of safe assets to expand "elastically" when the demand for the product is enhanced. Doing so can help stabilize inflation around its expected value. Of course, it is important to let the elastic snap back should economic conditions dictate. The experience of the 1970s demonstrates what can happen when a policy regime becomes unanchored.

The optimal conduct of monetary and fiscal policy over the longer term when a productivity slowdown hits is much less clear. Alvin Hansen expressed skepticism that expansionary monetary and fiscal policy could do much of anything beyond the initial shock period. If anything, it might even do some harm if, for example, such policies led to a very large public debt. Instead, Hansen favored what today we would label "pro-growth policies." His conclusions stemmed from the fact that he viewed growth slowdowns as the byproduct of slowing innovation and population growth--phenomena that monetary and fiscal policies are ill-equipped to deal with.

The situation is slightly different today in that, unlike in Hansen's time, there is presently a huge worldwide demand for U.S. treasuries. This demand stems from three major sources. First, the UST is used widely in the shadow banking sector (in repo and credit derivatives markets) as collateral, a sector that has grown significantly since the 1980s. Second, many emerging market economies want to hold USTs as a safe store of value. And third, there has recently been an added regulatory demand for USTs stemming from financial reforms like Dodd-Frank and Basel III. Because of these factors, it is likely that the U.S. economy can sustain a much higher debt-to-GDP ratio than it has in past.

Much of what one might recommend in terms of optimal policy stems from what is assumed to drive productivity (and population growth). For economies operating below the technological frontier (e.g., EMEs), productivity slowdowns might be avoided, in principle at least, through some type of policy change.  However, the case is much less clear (to me) for economies operating near the technological frontier, where the Schumpetrian dynamic is more likely to govern the productivity dynamic. Some may point to the innovations produced during the second world war as example of how expansionary fiscal policy might enhance productivity growth. But surely, basic research and development can be better subsidized in a more targeted manner, without appealing to a massive and broad-based fiscal expenditure.