Wednesday, December 16, 2009

The Treasury’s Monetary Policy

For decades, many economists have argued that the effectiveness of fiscal policy is limited because public borrowing “crowds out” private investment. There are several versions of the “crowding out” story. One version goes something like this:

There is a certain amount of money in circulation, which people are holding in their portfolios along with other assets. Money is a special kind of asset, because it’s the only one that can be used to make payments. Therefore people like to hold a certain fraction of their assets in the form of money. (For simplicity, let’s take the plausible case where it’s a constant fraction, independent of their total quantity of assets.)

When the government borrows, it introduces new non-money assets (government securities, in this case) into the system. That means that the fraction of money in people’s portfolios is now too small, since their total assets have increased but money has not. They will compensate by reducing the quantity of other non-money assets. Therefore, businesses will have trouble raising money for capital spending by issuing bonds or by selling new stock, and private investment will have to decline.

In this simple “constant-fraction” version of the story, the crowding out is 100%. People will not be happy with their portfolios until the amount of outstanding private-sector non-money assets declines by exactly the amount of the increase in public sector debt. Thus there is no net stimulus from public spending, because it is offset by reductions in business spending by the amount that businesses can no longer raise in capital markets.

About 30 years ago, Harvard economist Benjamin Friedman asked a question which turned the whole “crowding out” debate on its head. What if people treat government securities in their portfolios more like money than like private-sector assets? (After all, government securities are highly liquid. You can’t normally use them directly to make payments, but you can sell them quickly whenever you have a payment to make, and you can usually have some confidence about the price at which you will be able to sell them, at least in comparison with most private sector assets.)

If so, then, when the government borrows, it is increasing the fraction of “money and money-like assets” in people’s portfolios. Instead of buying less of the (non-money-like) private-sector assets (to get the fraction of money their portfolios back up), they will buy more such assets – to get the fraction of “money and money-like assets” back down. Instead of “crowding out” private investment, public borrowing will “crowd in” private investment.

He also pointed out that some government securities are clearly more like money than are others. Perhaps 30-year Treasury bonds are very much like corporate bonds, in that their prices can fluctuate dramatically with interest rates. But 3-month Treasury bills are a whole lot like money. Whenever you need actual money to make a payment, you can sell your Treasury bills quickly at a reliable price. Most likely, when the government issues Treasury bills, it makes people’s portfolios safer, and thus it increases, rather than decreases, the incentive to purchase private sector assets. Accordingly, Professor Friedman concluded, the Treasury can expect its financing policy to have macroeconomic effects: the more short-term financing the Treasury does, the larger economic stimulus it provides.

When I first read the paper (in a graduate school course taught by Ben Friedman, about 10 years after it was written), I found the idea intriguing, but it seemed not to have a whole lot of relevance at the time. In those days the US inflation rate was still higher than most economists preferred, and the burning issue was not how to provide the most (or the least) stimulus but how to get the inflation rate down without causing a recession. Moreover, there was little question as to the efficacy of conventional monetary policy in providing any stimulus or restraint that might be needed. Treasury financing was at most a minor side show.

Times have changed. The inflation rate is now lower than most economists prefer, and the economy remains extremely weak despite the recent upturn in the business cycle. The burning issue is how to find the most cost-effective and politically feasible way to stimulate the US economy, and conventional monetary policy is not an option.

And today Treasury bills are not just more like money than like other assets; from a portfolio point of view, on the margin of new issuance, Treasury bills are exactly like money. Holders of short-term Treasury bills are willing to hold them without receiving interest. Anyone who is willing to hold them is placing no value whatsoever on any liquidity or safety advantage that might be had from holding those assets in the form of money.

Issuing more short-term Treasury bills will have exactly the same effect as issuing more money, since people are indifferent between the two. For practical purposes, as long as their interest rate remains at zero, short-term Treasury bills are part of the money stock. A Treasury bill is a million-dollar bill in the same sense that a Federal Reserve note with Abraham Lincoln on it is a five-dollar bill. Conventional monetary policy, which exchanges money for Treasury bills, is ineffective because it is no policy at all: it simply exchanges one form of money for another.

To put it another way, since the Treasury can issue bills that are exactly like money, it is now the Treasury that is in charge of monetary policy. And whatever one may think of the policy it chooses to follow, we should be holding the Treasury responsible. If you’re worried about “exit strategy” and the possibility of inflation in the near future, then perhaps you should congratulate the Treasury for its policy of financing more of its debt long-term. If you’re worried (as I am) about the persistence of a weak and potentially deflationary economic environment, then you should be critical of the Treasury’s policy. By increasing its maturities the Treasury is essentially following a tight-money policy exactly when a loose-money policy is needed.

The Treasury, of course, has its reasons. Officials expect interest rates to rise over the next several years and would like to lock in today’s low rates, to limit how much it will cost to service the national debt over a longer horizon. I’m skeptical, however, of the assumptions underlying these reasons.

Are interest rates going to rise over the next several years? Perhaps, but if so, then why are people being foolish enough to hold longer-term Treasury securities when they could be holding bills and waiting for a better deal? If it’s just a matter of the future course of interest rates, then it’s a zero-sum game. If the Treasury wins, bondholders lose – and bondholders usually make a point of trying not to lose. Are Treasury officials so much smarter than bondholders?

You might argue that it’s a matter of risk. When the Treasury locks in today’s low interest rates, it may not end up paying less (since it gives up even lower short-term rates), but it makes the payments more predictable. Even if the Treasury is likely to end up paying more, the hedge is worth the price, because the Treasury receives some insurance for the worst case, where rates rise more than expected.

But are rising interest rates really the worst case? Interest rates will rise when and if the economic recovery gains enough speed and traction to give the Fed and bond markets reasonable confidence in its eventual convergence toward our potential growth path. As an ordinary citizen, that’s not an outcome against which I would feel a need to hedge. I don’t want to buy insurance against good news. I’d rather hedge against the opposite outcome, where the recovery peters out and interest rates fall.

The US economy has been knocked far off its potential growth path, and it will take fairly rapid growth, for a fairly long period of time, to get back to it. (Either that, or we’ll remain so far off the path for so long that potential will be significantly reduced, in which case we likely have many of years of low interest rates ahead of us before we get to that point.) With rapid and persistent growth, federal revenues will rise, government “bailout” investments will perform well, benefit payments will decline, and the primary federal deficit will fall. Because of higher interest rates, the government will be paying more to service its outstanding debt, but because of an improving economy the government will be accumulating less new debt, compared to the alternative case. So it’s not clear to me that rising rates would be a “worst case” even for Treasury finances, let alone for the general national interest.

It is also argued that, by increasing the maturity of its debt, the Treasury is reducing the risk of default, thereby improving its credit profile and allowing it to finance at lower interest rates than otherwise. If that’s true, I’m not sure it’s a good thing. When the private sector is having such difficulties as it has now, wouldn’t it be better to make Treasury securities more risky and thereby encourage people to put their money in private sector assets instead?

In any case, I’m not sure it’s even true. For Treasury investors, inflation risk is much more important than credit risk. By refusing to be kept on a short leash, the Treasury is increasing the future incentive for the US to “inflate away” its debts. That might make Treasury securities less attractive rather than more so. Of course, as I said, making Treasury securities less attractive wouldn’t necessarily be a bad thing, since it would help the private sector: but if the Treasury does so by issuing more long-term securities, the benefit gets lost, because the Treasury is then also competing with the private sector for funds.

Be that as it may, I know I’m not going to convince everyone about the specific policy that I think the Treasury should follow. I hope, however, that I have at least convinced some readers that, in today’s environment, the decision is a macroeconomically important one that deserves a great deal more attention than it has gotten. I second Rajiv Sethi (hat tip: Mark Thoma), who finds it “a bit surprising that while the size of the deficit is a topic of endless controversy, there is such little debate about the manner in which the deficit is financed.”

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

Monday, November 23, 2009

Investment Makes Saving Possible

Over any period of time, in any nation, the total quantity of investment that takes place must equal the total quantity of savings that are generated.

In the simplest case, where there are no inventories, depreciation, government, or foreign trade, it is trivial to prove that “savings equal investment.” It starts from the premise that all income is earned by producing something, so that the total of everyone’s income equals the total value of everything that gets produced. That “income equals output” (at the national level, though technically only when net foreign income is zero) is a very basic truism in macroeconomics. (As I recall, by the time I had attended my third class in the subject, I had already forgotten that there was a conceptual difference between output and income, and even today, outside occasional spells of lucidity, I labor under the delusion that the two terms are synonyms.) Everything produced is valued either for benefits it has in the present (“consumption”) or for benefits it will have in the future (“investment”). Thus “output equals consumption plus investment.” Savings are defined as unconsumed income. Thus “savings equal income minus consumption.” You do the algebra.

It’s pretty straightforward to add inventories, depreciation, government, and foreign trade and show that the algebra still works. But I don’t find the algebra very enlightening. The algebra shows what must be the case, but it doesn’t explain how it gets to be the case. I mean, people make decisions about how much to save, and other people (businesses, mostly) make decisions about how much to invest. Does the Good Fairy come along with a magic wand and make sure that one side is deciding the same number as the other side?

I’m going to try to avoid exceeding my snark limit here, but the conventional explanation does seem to me, at least under today’s circumstances, to be more a fairy tale than an enlightening description of reality. The Good Fairy in this story is called the Loanable Funds Market, and her magic wand is called Market Clearing. Savers (households with income to save) bring their funds to market, and investors (firms with potential capital spending projects) bid on those funds until they are used up. If the firms are really determined to invest, maybe they can offer an interest rate so high that it will induce households to save more. If households are really determined to save, and firms aren’t very interested in investing, then the households can offer to lend at lower and lower interest rates, until they find one that clears the market.

Many economists enjoy telling their students this fairy tale. I gather that some economists even believe it almost as if it were literally true. But as a description of how savings actually do come to equal investment, it has some problems. First, as a theoretical point, what happens when households are willing to accept a zero interest rate and still can’t unload their savings? In a normal market, when it cannot clear and there is excess supply, the suppliers are out of luck. (The classic example is a worker who is willing to work for less than minimum wage but can’t get a job.) Is that how the loanable funds market works? Do households have to take those extra potential savings and go home and consume them instead, whether they like it or not? Does the Good Fairy force them to consume?

And more generally, empirically, do the institutions of the real world of saving and investing bear any resemblance to the abstract loanable funds market? In real life, funds can be saved but not lent (as when banks decide to use new deposits to increase their excess reserves). In the real world, funds can be lent without ever having been saved (as when the Fed makes loans with newly created money). What does the Good Fairy do to make sure that these discrepancies offset each other?

Even when the funds lent are exactly the same ones that were saved, there can be a substantial time lag between the saving and the lending, and an even longer lag until the actual investment of the borrowed funds. Nor are these just banking issues. When a company issues stock, it is also acquiring “loanable funds” (in the relevant sense), though not in the form of a loan. And just like banks, nonfinancial companies can sit on the cash rather than making immediate use of it. The Good Fairy may be busy forcing reluctant households to consume, but as the end of the quarter approaches, she will have to excuse herself and grab her cattle prod, so she can force businesses to invest quickly. Otherwise the investment may not take place until next quarter, and savings will not equal investment for the current quarter.

If I were the Loanable Funds Market, I would hand in my resignation as Good Fairy. It’s obviously quite an impossible job. (OK, I give up on the snark limit.) And yet, as a matter of algebraic certainty, over any time period, investment must equal savings. If this good fairy quits, we’ll have to hire a new one.

And so we will. Her name is the Definition of Saving, and she’s both more powerful and more subtle than I made her out to be in the second paragraph.

What does it mean to save? It could mean “to set aside part of one’s income for the future.” Only, that definition is deceptive, because it implies a positive act of “setting aside.” There can be positive acts – purchasing a certificate of deposit, for example – that represent the commitment to save, but the act of saving is itself entirely passive. If you get paid in cash and put all the cash in a box without spending it, your are saving. It is no different if you get paid in cash and put all the cash in your wallet without spending it. Like “to rest” or “to fast,” the verb “to save” is defined not by what you do but by what you don’t do. “To save” means “to receive income and not to spend it.”

Bearing in mind the passive nature of saving, think about the old joke where the tourist asks, “Lived here all your life?” and the crusty local replies, “Not yet.” By definition, you have saved if you have received income and have not spent it. Suppose that, a few seconds ago, you received your pay in cash and put it in your wallet. Have your received it? Yes. Have you spent it? Not yet. Like the crusty local, economics is precise. You may intend to spend every single dollar of your pay, but for now the answer to the question, “Have you spent it?” is “No.” Therefore, as soon as you receive your pay, you have already saved it. It has become part of your savings. When you do spend it, you will be dis-saving, taking money out of savings.

The New Good Fairy thus presents us with a bizarre but indisputable fact: all income is saved. If you make the time period short enough, the savings rate (out of newly earned income) is always 100%.

And that’s half the reason that savings always equal investment. The other half has to do with the source of the income. Whoever pays the income must be either making an investment (in which case the amount of that investment exactly matches the amount of the receiver’s new savings) or taking money out of their own savings (in which case that dis-saving offsets the receiver’s new savings, and there is no net change in either savings or investment).

How do we know that the payer must be either dis-saving or investing? The payer is purchasing something, and it must be either for consumption or for investment. If it is for consumption, then the payer is taking money out of savings to pay for it. If it is for investment, then the payer is investing.

To take a simple example, suppose you’re a freelance software developer, and a company pays you to develop some custom software for long-term use. From the company’s point of view, that’s investment. As soon as they pay you, they’ve made an investment, and you have saved the exact amount of the investment they just made. Savings equal investment.

And what happens when you spend the money? To take another simple example, let’s say you spend some of it on a haircut. You are taking money out of savings, so your savings are reduced by the cost of the haircut. But the payment is income for the barber, and all income is initially saved, so the barber is putting into savings the same amount that you are taking out. Total net savings are unchanged, and since there was no investment involved, net investment is unchanged.

The Loanable Funds story tends to give the impression that saving determines the amount of investment. (It’s not the only possible interpretation, but when I hear the story, I tend to think, “Savers decide how much to save, and that is the amount that can be invested.”) In the immediate time frame, however, it is the other way around: investment determines the amount of savings. In general, saving occurs whenever someone receives income. Net saving occurs whenever someone receives income that is not offset by the payer’s dis-saving. That can (and will) happen only when the payer is investing.

In the slightly-longer-than-immediate time frame, people make decisions about how much to save, but it is still investment that makes that saving possible. Suppose, for example, that all investment were to stop for an entire year. Suppose everyone completes or cancels any investment plans by the end of 2009 and nobody makes any new investments in 2010 – no new houses or factories built, no new equipment or software created, no net purchases of foreign securities, and so on. (Because inventories are a form of investment, you also have to imagine – and I’m being a bit tricky here – that manufacturers start 2010 with inventories at some kind of maximum and refuse to produce anything new except to replenish those inventories.) In that case, there can be no net saving in 2010. People will receive income, presumably, but only as the result of dis-saving by others, so the most net saving that can happen is zero.

And just as the decision not to invest can prevent net saving from taking place, so the decision to invest can force people, collectively, to save. Consider the converse thought experiment, where everyone resolves not to save in 2010. "Any income I get in 2010,” everyone says, “I'm going to spend before the end of the year." Then someone comes along and decides to build a factory (financed, let's say, with money that the builder was holding in a safe at the beginning of the year). So the builder hires construction workers to build the factory, and the workers now have income, which they have resolved to spend before the end of the year. So they spend it. Now someone else has income, which they have resolved to spend. When they spend it, yet someone else has income, which they have resolved to spend. And so on. The money keeps getting passed around like a hot potato. Or like a game of musical chairs. At the end of the year, someone will have the money and will not yet have spent it. Someone will have unspent income. Someone will have saved.

I grant you, I've left out a lot of details that could become important. In particular, I've ignored inventories, and I’ve ignored imports, and there are some possible loopholes there that might allow people to avoid saving the invested money in the last paragraph. But I think I’ve made a pretty good prima facie case that the causation normally runs from investment to savings.

You may object, however, that my assertion doesn’t make sense. There must be causation running from savings to investment, because an economy has limited real resources. If people choose to save less, more of those resources will have to be used for consumption, and fewer will be available for investment.

That’s a valid point, as far as it goes, but now you’re not talking about saving income; you’re talking about saving resources. Resources have to be “saved,” in the sense of “not used up by consumption,” in order for investment to take place. You could say, perhaps, that a certain part of our potential real income – the income we would have if we made use of our resources to the greatest sustainable extent – has to be “saved,” in that sense, to make possible a given amount of investment.

But it has become painfully clear that actual income can fall far short of potential. As of today, according to typical estimates such as that of the Congressional Budget Office, the US is (in the relevant sense, though not in the terminology the CBO uses) “saving” about a trillion dollars extra of its annual potential income, over and above any actual income it saves. The US is “saving” that potential income in the sense that, if there were another trillion dollars worth of investment to be done, the resources to do that investment would be available. Those “savings” aren’t being used for investment; they’re being more or less thrown away – held in reserve, if one may speak euphemistically. The unemployed, the idly-self employed, the discouraged workers, the involuntary part-timers, and everyone else who would be doing something more productive in a better-functioning economy – they are the human counterpart of banks’ excess reserves. In real terms, they represent the idle portion of our national savings.

That’s certainly a coherent way of thinking about savings, and it is one in which savings put a constraint on investment. But it doesn’t conform to standard semantics. In practice, nobody counts those extra “savings” as savings. If you want to increase the savings that count, you have to find a way to increase investment.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

Investing in Semantics

“The reason we have such a comfortable relationship, is that we both know, there is no chance of our ever having a relationship.”

I hate words that can mean two different things even in the same context. Right now I’m thinking of the word “investment.” As a macroeconomist working in an asset management business, I feel obliged to contradict myself when I use that word.

It’s kind of like the way soft core adult performers use the word “porn.” I don’t do investment. No, never. Not me. If you saw a picture of me building a factory, I guarantee you it was Photoshopped!

And just like with porn, there are gradations. After all, buying bonds is just a way of lending money. Right? Not really investment. Just cheesecake. But stocks, on the other hand.... It doesn’t matter what they’re doing or not doing; if the financial statement’s naughty bits are exposed, then it’s investment!

Leaving aside the analogy, though (because I’m still hoping for a G rating), I do see some logic to the ambiguity of the word “investment.” In general, to invest means to acquire an asset that is expected to provide returns or benefits in the future. The difference is in your frame of reference.

If your frame of reference is the individual household, then stocks and bonds are investments. When a household purchases a stock or a bond, they do so because they expect it to provide returns in the future.

If your frame of reference is the whole world, then stocks and bonds are not investments. Clearly, the world as a whole does not expect to receive future returns simply because one entity borrows money from another entity. And the world does not expect to receive future returns simply because one entity expands itself by selling a partial interest to another entity. And the world certainly doesn’t expect to receive future returns just because our client purchases that partial interest from the entity to whom it was originally sold.

In the global frame of reference, for something to be investment, it must involve actually creating some new value. If someone builds a house or a factory, the world as a whole has accumulated some wealth in the form of a new asset. Or if an existing factory turns out machines to be used in other factories or offices. That’s “hard core” investment. (Am I risking my G rating by noting that even software is a hard core investment?)

If you take countries – rather than households or the planet – as your frame of reference, then stocks and bonds are sometimes investments and sometimes not. Japan isn’t accumulating new wealth when Mr. Fujimoto buys shares in Sony. But Japan is accumulating new wealth when Mr. Fujimoto buys a US Treasury bond. (Theoretically, anyhow. I know there are those who would argue that buying dollar-denominated assets amounts to throwing away wealth rather than accumulating it.)

In my position, unfortunately, I’m occasionally obliged to shift frames of reference in mid-sentence. Oh, well. I have more than one relationship with the word “investment.” Everyone knows you have to be very careful if you’re trying to be in two relationships at once.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

Friday, November 20, 2009

Prose Hack

The US is in a depression. It is rather a mild depression, as depressions go, but if I may use the terms “recession” and “depression” in accordance with their verbal roots, although US economic activity is no longer receding, it is still depressed. (It is depressed by any standard, I think, but particularly, my own criterion would be, in comparison with what we know the US economy is capable of producing.) And it will remain so, even in the best case, “for a considerable period of time.” You don’t go from a doubling of the unemployment rate, back to normal business activity, without experiencing a great deal of melancholia along the way.

Most observers blame the economic collapse on the humungous housing and credit boom, which went bust in a particularly unpleasant manner. But what would have happened if the boom had never taken place? That very boom, even with war spending as an additional stimulus, and with households that were willing to consume their entire income, was, it seems to me, barely enough to forestall depression. Despite having such considerable help, the financial boom did not produce an economic boom. It barely created enough demand to bring US economic activity up to its potential for a year or so.

The bigger they come, the harder they fall, and this one was huge – but not huge enough, not strong enough, even in its days of glory, to fully hoist the boulder by which we are now being crushed. Blame this decade’s financial excess for the acuteness of the recession, but don’t blame it for the existence of a depression. It’s not clear exactly what it is, but we are dealing with some sort of “long wavelength” economic phenomenon whose underpinnings were a pre-existing condition. Today, one or two powerful shots of temporary fiscal stimulus may help chase away the worst of the blue devils, but they won’t be sufficient to restore health.

As I see it, there are only two ways the US can end this depression. One is by deliberately, intentionally, publicly, and resolutely engineering a moderately high inflation rate (in the future) by promising to use whatever monetary policy is necessary to achieve a mercilessly escalating series of price level targets once that policy finally acquires traction. That approach would force people (and businesses) to abandon “safe” investments and start building something that will allow them to take advantage of the inflation by selling the products at higher prices than they cost to create.

The other way is to risk (but probably not create) a very high inflation rate (again, in the future, not in the present) by means of massive deficit spending sustained to the point of recklessness. This deficit spending could take the form either of increased government purchases, which stimulate economic activity directly, or of “helicopter drop” tax cuts financed by creating money, which, if done on a sufficiently large scale, will eventually make people (and/or businesses) feel wealthy enough to start spending more.

Neither of these things is going to happen. Not in the current political climate, and not in any political climate that I can imagine over the next decade. I conclude that, when this depression ends, it will not be the US that ends it. This depression will end when the rest of the world (considered collectively) decides that it wants more than it is able or willing to produce, and when it approaches the US, bearing its accumulated IOU’s, offering to retire them at a substantial discount (a discount enforced by the foreign exchange market, not by renegotiating the instruments themselves), and asking the US to produce the remainder of what it wants.

Or else this depression will just continue. Eventually, some day, America’s capital stock will have deteriorated to the point where it cannot even supply the depressed level of demand that it will still be experiencing. (I mean demand “depressed” relative to what the US would have been capable of producing if growth had somehow proceeded normally, making efficient use of available resources. I’m optimistic that the US will experience growth over the next decade, just not enough growth. In my lexicon, if, for example, growth of demand were just sufficient to absorb labor force and productivity growth while leaving 10.2 percent of the labor force unemployed and 17.5 percent of the broadly defined labor force either unemployed or under-employed, as they are today, that would definitely still qualify as a continuing depression, though, by the way, it wouldn’t necessarily leave investors feeling depressed.) And once our capital stock does deteriorate sufficiently – in the future, but not in the foreseeable future – we will have to start building something again.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

Friday, August 28, 2009

Job Losses Are Not the Problem

It is sometimes argued that recessions benefit the economy by allowing the destruction of old, inefficient economic structures so that newer, better ones can be created to replace them. On the surface, this story might seem to apply to the recent recession: ostensibly, a lot of useless jobs in finance, real estate, and construction were destroyed, as well as perhaps old manufacturing jobs that hadn’t caught up with the latest technology, and jobs in retail trade that needed to be replaced by the Internet, and so on. But there’s one problem with that point of view: overall (at least during the first four quarters of the recession, up through the end of 2008, for which we have the relevant data), there weren’t an unusually large number of total jobs being destroyed.

But...but...but...haven’t we been hearing about large numbers of job losses month after month since the recession began? Sort of. We’ve been hearing about large numbers of net job losses. That is, the number of jobs that have been lost has been a lot more than the number that have been created. And a lot of job losers have ended up collecting unemployment insurance for a long time, sending the figures for continuing claims up to records, instead of getting new jobs. But the gross number of jobs being destroyed has not been unusually large. In fact, relative to the overall level of employment, job destruction was happening at a faster rate during the boom of the late 1990s than it was during the last quarter of 2008.

How can that be? For one thing, when you take out the business cycle, there seems to have been a general downward trend in the rate of job destruction over the past 10 years. More important, the rate of job creation also had a downward trend, and it dropped to new lows during the recession of 2008. If you lost a job in 1999, you weren’t actually all that atypical, but it wasn’t a big problem, because typically, you could find a new job fairly easily. If you lost a job in 2008, you were (typically) out of luck.

source: Business Employment Dynamics data from the Bureau of Labor Statistics

The fact is, job creation and job destruction take place during booms at rates that are not dramatically different from the rates during recessions. It’s just the difference between the two that changes. In a typical boom quarter, about 7 million jobs are destroyed, and about 8 million are created. In a typical recession quarter, about 8 million are destroyed and about 7 million are created. There just isn’t much support for the idea that recessions give us a special ability to reallocate resources more intensely than we do during a boom or a period of normal growth. “Creative destruction” is a dynamic process that continues all the time, not one that occurs in separate phases of creation and destruction.

And the most salient feature of the current episode is that there has been unusually little creation. From the 1990’s to the 2000’s, the quarterly job creation rate fell from about 8% to about 7%. Since 2006, it has fallen to about 6%.

Some might argue that this type of slowdown in job creation is inevitable during times of structural change and that it is useless to try to oppose it with monetary and fiscal policy. It takes a long time (Arnold Kling, for example, would argue) for the economy to come up with ideas for new, productive uses of resources when the old uses are no longer productive. Monetary and fiscal policies can’t do much to speed up this process. They can’t make entrepreneurs more creative.

I’m skeptical of that view: entrepreneurs were plenty creative during the 90’s, once the booming stock market gave them a reason to apply their creativity. Monetary policy really did help speed up the process of finding new uses for resources: low interest rates led to high equity prices, which made it easy to raise capital and thereby made it advantageous to find new ways of using capital. Some would say the process went too fast in the end, with a large fraction of the uses proving ultimately unproductive, but statistics show aggregate productivity rising rapidly and continuing to rise during the subsequent years, even (atypically) during the recession that immediately followed the boom. There may have been a lot of froth, but there was plenty of good beer underneath, and monetary policy is what opened the tap.

In any case, even if I were to concede that monetary and fiscal policies don’t help speed up the adjustment process, they do help us get the most out of the economy in the mean time. With nearly 10 percent of the labor force unemployed, there are a lot of resources being wasted – people spending their time looking for jobs that many of them just aren’t going to find until we get a lot more economic activity. There are plenty of useful things that those people could be doing in the mean time.

Perhaps more important, monetary and fiscal policies help us reduce the risk that a weak economy – too weak for too long – will fall into a deflationary spiral. As long as job creation remains weak, employers have little incentive to raise wages, and competition will tend to push down prices. Even an “artificial” stimulus, one that doesn’t accelerate the structural adjustment process, will create a demand for labor and force employers to compete somewhat for workers. That competition, in turn, will prevent them from competing too aggressively in product markets and keep prices reasonably stable.

There is, of course (in theory, at least), the risk that policies will go too far and not just prevent deflation but produce excessive inflation. As I have argued before, we are nowhere near that point right now. I made the case against inflation using mostly the unemployment rate, but the case becomes even stronger when you consider the job creation statistics. This unemployment is specifically being induced by a slowdown in job creation. Job creation is specifically what leads to inflation: it’s when companies want to hire aggressively that they start raising wages excessively and competition becomes unable to keep prices in check. If unemployment – which arguably has a more tenuous relationship to inflation – is far, far away from the danger point, job creation – which has a direct relationship to inflation – is even further away.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

Wednesday, July 29, 2009

Savings Rate Could Stay High

Mark Thoma shows us a historical chart of the personal savings rate since 1960 and asks how much of the recent increase (from an average of about 0.5% from 2005 through 2007 to a peak of almost 7% in May of this year) is permanent? One must, of course, take the May figure with a grain of salt: the savings rate rose in May largely because tax withholding was reduced; unless that attempt at a stimulus is completely ineffective, we should expect the savings rate to decline as people start taking advantage of the new disposable income. But even before May the savings rate this year was running consistently above 4%, which is a dramatic change from a few years ago. Let’s use the April figure – 5.6% – as a guesstimate of what the “true” savings rate is right now and ask how much of that will be permanent.

Not much, thinks Brad DeLong:
I would guess that only a small part of the rise in the savings rate is permanent. Financial distress was and is much greater than in past post-WWII recessions, and financial distress is associated with transitory rises in the savings rate.

I’m inclined to disagree. Undoubtedly the savings rate will fall somewhat as the degree of financial distress declines, but I think there’s a good case to be made that much of the increase is permanent.

For one thing, from the point of view of households, “financial distress” may be extremely slow to lift. If the Japanese experience is any guide, it is a very slow process to get a severely distressed banking system to start lending normally again, and it’s not clear that things are going to be any easier for the US. Meanwhile, most forecasts expect the unemployment rate to remain quite high for several years. It could take 3 years, or 5 years, or 10 years, or 20 years before the financial distress lifts.

Granted, even 20 years is not forever, and 3 years is certainly not forever, but it’s long enough to stop thinking about household behavior as being continuous over time. We can reasonably surmise that, even without so much financial distress, the savings rate would have trended upward over time. Presumably households would gradually have come to recognize that they weren’t saving enough. (Can zero be anywhere near enough?) And as baby boomers’ children settle into their own careers, they would cease to be a drag on their parents’ savings, and at the same time those parents would have to start worrying seriously about retirement. The financial distress messed up this scenario (or maybe just speeded it up), but the underlying trend should still be going on “beneath the surface.” By the time the distress lifts, there will be other reasons for the savings rate to be higher than it was in 2006.

That argument is rather speculative, I admit, but there are more solid reasons to expect the savings rate to remain high. While the current, comparatively high savings rate may reflect the effects of financial distress, the low savings rates of the 2005-2007 period did not merely represent the absence of financial distress. What is the opposite of financial distress? Financial ease? The degree of financial ease during that period (which was the culmination of a process that had been building on and off for a couple of decades) was well beyond normal, and well beyond what we can expect in the coming years, even if recent sources of distress are resolved fairly quickly. Consumption was supported (and aggregate saving accordingly reduced) by a fountain of credit that will not re-emerge with such force unless people in Washington and on Wall Street make some big mistakes.

The ready availability of credit to consumers was in large part the result of lax regulation, careless investing, and the assumption that home prices would never decline significantly on a nationwide basis. With respect to regulation, the pendulum is clearly swinging in the other direction now. Careless investors have learned their lesson for a generation. And housing prices have disproven the earlier assumption.

After the collapse of housing prices, not only will lenders be more cautious: borrowers also won’t have as much collateral. It will be quite a while before typical homeowners have as much equity as they did in 2006.

Moreover, the meltdown may have shaken confidence in the concept of securitization to the point where it will take a decade or more to restore even healthy securitization markets (if they can be restored at all), let alone the severely intoxicated ones that we were seeing in 2006. It won’t be easy for households to borrow money for consumption in the coming years. The ones that had negative savings rates will be much less common, while the ones that had positive savings rates will still be there. I expect we’ll be seeing savings rates noticeably higher than zero for years to come.

UPDATE: With today's revisions, the increase in the savings rate is much less dramatic, from an average of 1.8% during 2005-2007 to 5.2% in the second quarter of 2009. (Revised monthly data are not yet available.) My guess is that the rate going forward will be higher than the 3.5% average of 2002-2004 but probably not as high as the second quarter, when the lower tax withholding begins to appear in the denominator.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

Tuesday, June 16, 2009

A Long Way to Inflation

Most of the media seem to have interpreted today’s lower-than-expected increase in the producer price index as good news. I’m not so sure. If you were worried that 5% inflation was just around the corner, then naturally you will have felt relief. Personally, I was more worried about deflation, and I still am. The inflation risk, if it exists at all, is in the distant future, and you could even argue that deflation in the short run increases the risk of high inflation in the long run. It’s hard for me to see how falling prices today are good news at all. And prices – excluding food and energy – did fall in May according to the PPI.

You might worry about energy and commodity prices feeding through to the broader price level. I’m worried about that too, but not in the way you might think. Undoubtedly some of that feed-through is already happening, and it hasn’t been enough to keep core producer price growth on the positive side of zero. I’m worried about what happens when commodity prices (1) stop rising (which they must do eventually) and/or (2) start falling again (which they may well do if the recent increases have been driven largely by unsustainable forces such as stockpiling by China). If core prices are already falling, and only energy prices are keeping the overall PPI inflation rate positive, what happens when energy prices stop rising?

What worries me particularly is that about 70% of the costs of production go to labor, and the forces of deflation work very slowly in the labor market. The data that are coming out today are only the tip of the iceberg. We’re already seeing evidence of the loss of upward inertia in compensation. Wage growth is decelerating, and, based on all historical experience, the deceleration is likely to continue – in this case, to continue to the point where it becomes deflationary.

I’m not talking about what will happen in the next 6 months; I’m talking about what will happen over the next 5 years. “Green shoots” – however green they may be – do not presage an imminent end to deflationary wage pressure. And they certainly don’t presage the beginning of inflationary wage pressure. Consider everything that has to happen before the wage pressure reverses and becomes inflationary:
  1. Output must stabilize.

  2. Output must start growing.

  3. Output must grow faster than trend productivity.

  4. Firms must slow layoffs to the normal rate.

  5. Firms must remobilize slack full-time employees (workers who are still on the full-time payroll but aren’t being asked to produce much, because businesses have been trying to reduce inventories).

  6. Firms must bring part-time employees back to full time. (This recession in particular has been characterized by the tendency to reduce hours rather than laying off employees.)

  7. Hiring (which has been falling rapidly) must stabilize.

  8. Hiring must rise to the point where it equals the normal rate of layoffs, to get total employment to start rising.

  9. Hiring must become rapid enough that employment starts to grow faster than the population.

  10. Hiring must become rapid enough that employment growth is faster than the sum of the population growth & labor force re-entry. In other words, net hiring has to be fast enough to absorb all the workers who will start looking for jobs again once there are more jobs around to look for.

  11. The unemployment rate must start declining.

  12. The unemployment rate must decline by 4 or more percentage points, which, by historical experience, will take a matter of years.

  13. Firms must start competing for labor.

  14. Firms must start raising wages.

  15. Firms must raise wages faster than trend productivity growth.

Maybe – just maybe – we have already reached step 1. Step 2 may be just around the corner. There is no evidence thus far that we are approaching step 3. As for steps 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, and 15......that show may come to town eventually, but...I don’t see much need to start reserving tickets in advance.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

Tuesday, April 21, 2009


Up until now, Paul Krugman’s writings on the current economic crisis have always made sense to me. Not that I always agreed with him, but I understood the logic of what he was saying.

He has suddenly lost me. In a New York Times op-ed column on Sunday, he argues that, in a worst-case scenario, the US could become like Ireland: unable to stimulate its economy out of recession/depression because fiscal policy is constrained by the need to satisfy the government’s creditors. I understand why this is happening in Ireland. I don’t understand how it could happen in the US.

There are a couple of huge differences between the US and Ireland, macroeconomically speaking – differences which, to my mind, render the two nations not even remotely comparable, even under an extreme hypothetical scenario. First, the US is much larger than Ireland, a much larger part of the world economy and much more self-sufficient. Second, the US has its own currency, in which its debts are denominated. Paul Krugman, as much as anyone (if not more), must be aware of the implications of these differences; yet he writes as if they could be ignored.

If our debt-to-GDP ratio rises too high, Prof. Krugman suggests, “we might start facing our own problems with the bond market.” But what problems is he talking about? We surely won’t face the same problem that Ireland faces: namely, that, in order to get enough euros to run our government, we would have to offer high interest rates and engage in austere fiscal policies. We won’t have that problem because we don’t need any euros to run our government and never will. If international lenders lose confidence in the US, the result will be a decline in the value of the dollar, not (unless the Fed and the Treasury allow it to happen) an increase in the interest rate that the Treasury must pay.

We might worry about the declining value of the dollar if there were a problem with inflation in the US. But there’s not, and, as I argue in an earlier post, there isn’t likely to be any time soon. As it is, a decline in the value of the dollar would do for the US exactly what Ireland is unable to do for itself with fiscal policy: it would stimulate the economy and get us out of the recession.

Professor Krugman may disagree with the arguments I made in the earlier post, and he may think that inflationary recession could be a problem for the US. But in that hypothetical event, we’d be dealing with a very different problem than what Ireland is experiencing right now.

The closest analogy I can see would be between leaving the euro (in the case of Ireland) and inflating the dollar (in the case of the US). But the analogy isn’t a close one at all, since the former decision is discrete and nobody thinks it’s going to happen, whereas the latter is a continuum and there are varying opinions on the degree to which it might happen. And if this analogy is what Prof. Krugman has in mind, it seems to me that it is incumbent on him to make it explicit, since it’s hardly something that would be obvious to most readers.

I can imagine a worst-case scenario, one where all the arguments I made in my earlier post turn out to be wrong and the Fed ends up having to choose between serious inflation and serious depression, but that scenario doesn't remind me of what is happening in Ireland.

It’s also worth noting that a lot more has to go wrong in the US, as compared to Ireland, before the US gets to that worst case scenario. In the case of Ireland, it was the collapse of the banking system and the government’s lack of resources in reacting to that collapse (an outcome that Prof. Krugman fears for the US, should current policies prove ineffective). In the US that would just be the beginning. Before we reach the worst case scenario, (1) the rest of the world would have to decide that their sovereign investments are more important than their economic recoveries, so that they would refuse to support a collapsing dollar and instead accept a deterioration of trade with the US; (2) foreign producers would have to pass on most of their increased costs to the US (in contrast to what they did, for example, in the late 1980’s); (3) Americans, despite their newfound thrift, would have to accept most of those increased prices rather than substituting cheaper domestic goods; and (4) US producers would have to raise prices rapidly in spite of weak economic conditions, and keep raising prices despite weakening economic conditions. It’s not impossible, but personally it’s not something I spend much time worrying about.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

Thursday, April 16, 2009

Oil Futures: Money for the Taking?

Maybe someone who knows more about oil than I do can explain this to me. As best I can tell, there is money for the taking, at virtually no risk, available in the oil futures market right now. As an economist, I have a hard time imagining how that can be: when there is money for the taking, we usually assume that someone will already have taken it.

Physical oil is selling for about $50 a barrel today. Just for a specific example, the contract for May delivery of light, sweet crude closed at $49.88 on the NYMEX Thursday. Distant futures contracts, however, are trading at much higher prices, a situation known as contango. Ordinarily contango can be explained by the costs of financing and storage, but today’s contango seems too extreme to admit of that explanation. For example, the December 2010 contract closed at $66.68 Thursday – more than 33% higher than the May 2009 contract.

It seems like a no-brainer: buy some oil, put it in a tank, sell the distant futures, and then just wait. Some time between now and December 2010, either the price of the oil has to go up, in which case you make money by selling the oil, or else the price of the futures has to come down, in which case you make money by buying back the futures contract. The costs of financing and storage can’t be anywhere near large enough to eat up the profit that you’re locking in with these transactions, and the basis risk – the risk that the oil you buy won’t sell for exactly the price of the deliverable oil for the futures contract – has got to be tiny compared to the available profit.

If you annualize the difference in the futures contracts, it comes to 20.1% or $10,036 for 1000 barrels of oil. Admittedly knowing little about the market, I just can’t imagine that it costs more than a few thousand dollars to store 1000 barrels of oil for a year. So we’re looking at an implied financing rate in the high teens. If you can finance, say, at 10% (which shouldn’t be too hard for a well-established institution that can offer 1000 barrels of oil as collateral and show that the futures contract will assure the ability to pay back the loan), you can pocket the difference.

Anyhow, we don’t really need to talk about the financing and storage costs for a hypothetical arbitrageur that needs to borrow the money and store the oil. There are plenty of oil producers that have the option of storing the oil in the ground at zero cost. Unless they’re desperate for cash (which seems unlikely given the amount that many of them piled up when oil prices were high), it’s a puzzle why they continue producing at over 90% of capacity. Why not just sell the futures, put off the extraction until late next year, and either sell the oil at a higher price or buy back the futures at a lower price?

And even if they are desperate for cash, it’s still a puzzle. Given the huge amount of highly liquid US Treasury bills in circulation, it’s clear that not everyone is desperate for cash. Some are just highly risk-averse and don’t want to invest their cash right now. But this arbitrage offers them a risk-free investment with a return much higher than that of T-bills: pay an oil producer today for some oil to be delivered in December 2010, sell the futures contract, and then wait. You can offer the producer more than today’s price of oil, so it will certainly be in the producer’s interest to accept your offer: they get the cash now, and they don’t have to send the oil until later. Meanwhile you’re assured of making money come December of next year: you either re-sell the oil at a higher price as soon as it gets delivered, or you buy back the futures contract at a lower price.

Everything I know about economics says that there ought to be so many people trying to do these transactions that they would already have driven up the price of oil or driven down the price of the futures contract to the point where no obvious risk-free transaction is possible. So why hasn’t it happened?

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

There Will Be No Inflationary Episode...Unfortunately

Rapid money creation usually results in rapid inflation. That point is hardly disputable. It is indisputable that the Fed has been creating money rapidly over the past six months, and there is every indication that it intends to continue doing so in the immediate future. Will this rapid money creation result in rapid inflation?

In the immediate time frame – say over the next 12 months – the answer is clearly “no,” for two reasons. First, the Fed’s money creation is designed in part to offset money (and credit) destruction by the banking system. Second, the demand for money is unusually high, and the increase in the demand for money offsets the increase in supply, leaving the value of money approximately constant.

But both these factors are at least partly temporary. Eventually, the condition of the banking system will improve, and it will start creating more money and credit, multiplying the money already created by the Fed. And eventually, households and institutions will get more comfortable and stop wanting to hold so much of their assets in the form of money, thus reducing money demand and causing the value of money to go down (i.e., inflation). At least that’s the way the story is typically told. And the usual version of the story suggests that, in order to prevent this inflation, the Fed will have to scamper very quickly to destroy much of the money it has recently created. It is often argued that losses on assets, or market inefficiency, or political pressure, will prevent the Fed from doing so, thus making an inflationary episode likely.

I’m extremely skeptical of that argument. In particular, I’m skeptical of the premise that the Fed will ever have to scamper quickly to prevent an inflationary episode. To see why I’m so skeptical, consider what “inflation” means: inflation is an ongoing pattern of rising prices. For the moment, let’s leave aside the “ongoing pattern” issue and just say that inflation means rising prices. In a modern economy, what is the immediate cause of rising prices?

In a commodity market, of course, the immediate cause of rising prices would simply be an excess of buyers over sellers at the current price. But most goods and (especially) services (which are more important than goods today) in a modern economy do not trade in commodity markets. Rather, their prices are set by sellers. The only immediate cause of rising prices is that sellers decide to raise them.

So why would sellers decide to raise prices? It boils down to two possibilities: an increase in actual or anticipated demand, so that they can (or think they can) get away with raising prices without losing customers, or an increase in actual or anticipated costs, so that they are forced to raise prices to keep their profit margins positive. The impact of money creation on prices must operate through one of these two channels.

We saw this process operating during the 1960’s and 1970’s. Over the course of the 1960’s, the Fed began to create money more rapidly than it had in the past. Gradually, over several years during the late 1960’s, the increase in actual demand induced sellers to start raising prices more quickly than in the past. Then gradually, over the course of the 1970’s, sellers began to anticipate higher and higher levels of (nominal) demand and higher and higher levels of (nominal) costs, so they started raising prices even before the demand materialized. Under the circumstances, the only way to keep the economy growing was to create enough money to realize the anticipated level of demand, so the inflation rate remained high until Paul Volcker’s Fed finally decided to stop the economy from growing for a while.

But that whole process took a long time. The inflation rate rose from 1% (in 1964) to 10% (in 1980), but it took 16 years to do so. And it took a series of policy errors, not just a one-time failure. William Martin’s Fed (along with the Johnson administration) made errors in the late 1960’s; Arthur Burns’ Fed (along with the Nixon administration) made errors in the early 1970’s; William Miller’s Fed (along with Carter administration) made errors in the late 1970’s; and OPEC took several unprecedented moves to restrict oil production over the course of the 1970’s. And the whole process began with a huge economic boom. The unemployment rate fell from 5.7% in 1963 to 3.5% in 1969. The inflationary pressure didn’t happen overnight: boom conditions, with the unemployment rate below 4%, lasted for about four years, from 1966 through 1969.

For whatever reason – misguided economic theories, pressure from the Johnson administration, inexperience with policymaking during boom conditions, timorousness about restricting credit too much, political bias, concern about the war effort in Vietnam, or come up with your own reason – the Fed repeatedly chose to allow the boom to continue, until sellers learned to anticipate rapid growth of nominal demand. And once the Fed finally did put its foot on the brake, President Nixon took the first opportunity to replace the Fed chairman with one who promptly put his foot back on the accelerator.

The unemployment rate remained at or below 4% from December 1965 through January 1970. Most economists expect the unemployment rate to be above 9% in 2010 and to fall only slowly thereafter. We will not get a late-1960’s-style boom any time soon, certainly not in 2010, 2011, or 2012. Over the next few years, the pressure will be on workers to accept flat wages at best. If actual demand, or actual domestic costs, are going to induce rapid price increases, it is going to happen in the distant future, and one will hardly be able to blame today’s rapid money creation.

The are two ways in which high inflation could conceivably happen in the not-too-distant future, but both seem highly unlikely to me. The first is that costs of foreign products and inputs could rise so quickly that they have a large effect on the overall price level and anticipated future costs. That’s the typical “emerging market” scenario that some fear for the US.

But the US is not at all like a typical emerging market country. The US is a large country, and though it may seem otherwise at times, statistics show that the vast bulk of the value consumed in the US is produced in the US. The ratio of imports to GDP is only about 16%. If the foreign exchange value of the dollar were to fall by half, theoretically doubling the prices of foreign products (under the unrealistically pessimistic assumptions that foreign sellers fully pass on the increased cost and that Americans continue to buy the same foreign products), the resulting increase in the domestic price level would only be about 16%, and that would likely be spread over several years. That’s inflation (by some definitions) but hardly the runaway inflation that some are worried about.

In any case the foreign exchange value of the dollar is not going to fall by anywhere near half, because the consequences would be disastrous for the rest of the world’s economies. China won’t let that happen; Japan won’t let that happen; Europe won’t let that happen. Until today’s weak conditions are completely reversed and turn into a major boom, every other country or currency area will find it in their national interest to buy huge quantities of dollars, if necessary, to prevent a dollar crash. In all likelihood, the dollar will fall slowly over the next decade, imparting only a tiny amount of inflation, certainly not making the difference between a high-inflation economy and a low-inflation economy.

The other theoretical inflationary possibility is that, even if actual domestic demand rises only slowly, anticipated nominal demand will rise quickly due to the observation that the money supply has risen quickly. If so, theoretically, inflation could become a self-fulfilling prophecy.

But there’s a problem with that scenario. If sellers raise prices in the face of high anticipated demand, actual demand will come in far below their expectations, forcing them to cut prices again. In the slow recovery that is likely over the next several years, no matter what the Fed does, sellers will not be able to make large price increases stick. Eventually, presumably, the recovery will run its course and we’ll arrive at the point where demand expectations could be validated by a sufficiently loose monetary policy. But by the time we get to that point, sellers will have been kicked in the face repeatedly and are unlikely to have the courage to implement large price increases.

The Fed will have years to unwind the positions wherewith it has created money so quickly in recent months. Egged on by economists of all stripes, the Fed has stated in no uncertain terms its intention to do so. I have every confidence that it will.

But “confidence” may not be quite the right word. It’s kind of like being confident that someone’s blackjack hand is not going to go bust. You can be confident that a particular bad outcome is not going to happen, but that doesn’t mean being confident that the actual outcome will be a good one. Unless it’s feeling particularly daring, the Fed is going to stand on 12, and history shows that to be a losing strategy.

It’s what the US did in 1937, when 3% inflation was too much. It’s what Japan did in 2006, when 1% inflation was too much. The US subsequently went into the second dip of the Great Depression. Japan became part of the international downturn that we’re all experiencing today.

The next chapter of Japan’s story has yet to be written. The story of the US in the 1930’s eventually has a happy ending (at least for those who survived World War II without crippling injuries), but it’s an ending that involves a lot of inflation. With the excuse of the war, the Fed let the inflation rate rise to an average of about 6% during the early years of the war, before inflation was tamed by price controls. After wartime price controls were lifted, the inflation rate rose to around 10% for a couple of years, making the average inflation rate between 1933 and 1948 a little higher than 4%. Ultimately, the US had chosen to err on the side of too much, rather than too little, inflation – and it was that error that conclusively ended the Great Depression.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

Thursday, April 2, 2009

Time for a Strong Euro Policy

In ordinary times – times when interest rates are positive, inflation is a greater concern that deflation, and recovery from recessions is a foregone conclusion – the effect of a fiscal stimulus is usually to strengthen the currency of the country involved. It might reduce confidence in the currency, which would make the currency less valuable at any given interest rate, but it will normally cause the interest rate to rise enough to offset that effect.

In a sense this has to be true. A country running a fiscal deficit needs to attract enough capital to finance that deficit. By whatever means – generally by raising interest rates – it must make its currency attractive enough to attract that additional capital, and the value of the currency will rise as the demand for it increases.

Granted, there are other options. In theory, a country can finance an increased deficit internally, but this requires households or businesses to increase their saving enough to offset the deficit, which usually doesn’t happen. Or a country can try to create the necessary capital out of thin air by using monetary policy. In ordinary times that’s usually considered a bad idea because it tends to lead to inflation.

Needless to say, these aren’t ordinary times. Households and businesses are suddenly all too eager to save, and inflation risks are for the moment outweighed by deflation risks. The “natural” effect of a fiscal stimulus – to raise the value of the currency – doesn’t happen, because the stimulus is fully accommodated internally by monetary policy. In the absence of an explicit exchange rate policy, the value of the currency depends on the market’s judgments about what the uncertain future might hold.

There’s a certain poetic justice, though, in the behavior of exchange rates during ordinary times. If a country is spending recklessly and overstimulating the world economy, it gets punished with reduced export demand, the result of a strong currency. If a country is saving heavily and thereby facilitating investment throughout the world, it gets rewarded with increased export demand, the result of a weak currency.

In a time like the present, when real investment is out of favor and the demand for it is insufficient to absorb what the world wants to save, poetic justice would call for a reversal of the usual effects. Fiscal spending is good; fiscal spending is, in a sense, altruistic: the benefit accrues to the world economy – spending produces an international stimulus that helps absorb the world’s excess savings and avoid an economic implosion – but the cost is borne by the spending country, which (theoretically anyhow) will have to pay back the debt in the future. Poetic justice would ask that deficit spending be rewarded.

Fortunately, if some country – or let’s say some currency area – pigheadedly refuses to do its part to stimulate the world economy, the rest of the world may be in a position to supply the just punishment. Or, to put it in less moralistic terms, if one player refuses to give a stimulus voluntarily in the form of fiscal policy, the rest of the world may be able to take that stimulus in the form of exchange rate policy. Moreover, after insisting that an additional stimulus is not necessary, the resistant player will hardly be in a position to object to a policy that excludes them from the benefit of such additional stimuli arising elsewhere. If they are forced to provide a stimulus for themselves to offset the stimulus they are not receiving from the rest of the world, so much the better.

Abstractions aside, it’s time for the rest of the world – particularly the US – to start buying euros aggressively. By itself, the effect of the US fiscal stimulus will be to increase the demand for European products: governments in the US will buy machinery from Germany; the newly employed can celebrate with French wine; Americans who escape job loss won’t have to cancel their Italian vacation. It can hardly be considered unfair if we try to offset that effect by weakening our currency and encouraging some Americans to visit the Grand Canyon instead of the Colosseum.

Unfortunately this isn’t likely to happen. That old mantra, “A strong dollar is in our national interest,” still echoes through the air in the District of Columbia. Never mind that the strong dollar was largely responsible for the housing boom that led to the current bust. It was: the strong dollar encouraged Americans to buy from abroad and discouraged those abroad from buying from the US; as a result, the only way the Fed could induce a recovery was by cutting interest rates to levels that sparked a boom in housing. The rest, unfortunately, is history.

A strong dollar is not in our national interest. It is not in the world’s interest. It is not in the interest of justice. It is just wrong.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

Monday, March 16, 2009

Absolute Confidence?

Not just the Chinese government, but every investor can have absolute confidence in the soundness of investments in the U.S.
– President Barack Obama, March 14, 2009, as reported in Bloomberg.

Statements like this one are causing me to lose confidence in the Obama administration’s economic policies. The particular investments about which the Chinese have been concerned are US Treasury securities. Absolute confidence in US Treasury securities is exactly what we don’t need. Absolute confidence in these securities is precisely the problem. The problem – for the US, anyhow – is that everyone wants to hold US Treasury securities instead of investing their money in productive activities (or spending it on the output of productive activities).

This is not just true of Americans; it is true of the world, including the Chinese. China has four choices:
  1. It can buy US Treasury securities.

  2. It can buy other US securities that represent productive uses of money.

  3. It can buy non-US securities, in which case the value of the dollar will fall and make US products more attractive, thereby encouraging Americans to invest in productive activities.

  4. Or it can buy no securities at all, in which case the value of the Yuan will rise, making non-Chinese products more attractive, thereby encouraging non-Chinese (including Americans) to invest in productive activities to replace the Chinese products that have become more expensive.
China has been choosing the first of these four options, and if it has “absolute confidence in the soundness of investments in the US,” then it will continue to choose that option, and Americans will continue not to invest in productive activities.

There is a common but misguided belief – to which President Obama, as one may surmise from his statement above, apparently subscribes – that a loss of confidence in US assets would have disastrous consequences for the US economy. In a boom time, or an inflationary time, that would be the case, but in a deflationary environment like the present, the consequences are more likely to be good. The Wall Street Journal, as an example, gives a typical statement: of the “loss of confidence would be a disaster” point of view:
In the worst-case scenario, a significant new aversion to U.S. investments could drive down the dollar and drive up interest rates, worsening the U.S. recession.
First of all, driving down the dollar would not worsen the recession; the direct effect would be to mitigate the recession by making US products more attractive. As for rising interest rates during a recession, that would indeed be a worst-case scenario, but it would not be the result of the aversion to US assets. It would be a result of a bad US policy response to that aversion.

My logic should be fairly clear:
  1. The Treasury has a choice whether to finance long-term or short-term

  2. The Fed has a policy – until further notice – of holding the federal funds rate below 0.25%, which policy requires it to purchase enough T-bills to keep short-term US Treasury rates near zero.

  3. Therefore, there is no limit on the Treasury’s choice of financing. It can issue as many or as few long-term securities as it chooses. What it does not finance long term, it will be able to finance short term at a near-zero interest rate, since the Fed will purchase enough T-bills to assure this.

  4. Therefore, the Treasury controls the supply of long-term Treasury securities.

  5. Therefore (assuming that the demand curve for such securities has the usual downward slope in the relevant range), the Treasury controls the price of long-term Treasury securities.

  6. Therefore (since bond yields – i.e., interest rates – depend inversely on prices), the Treasury controls the interest rates on its long-term securities.

  7. During a time of potentially deflationary recession, it will not be in the nation’s interest for the Treasury to allow interest rates on its long-term securities to rise, nor will it be in the nation’s interest for the Fed to allow short-term rates to rise.

  8. If they do so – whether or not they do so in response to a drop in demand for those securities – it is simply bad policy. Bad policy is not the result of declining confidence in US securities; it is the result of bad choices by policymakers.
So which interest rates are we talking about? Short-term Treasury interest rates? Those are controlled by the Fed and will not rise unless the Fed allows them to rise. Long-term Treasury interest rates? Those are controlled by the Treasury and will not rise unless the Treasury allows them to rise.

Or are we talking about private sector interest rates? Corporate bonds, as an example, are priced according to risk spreads over Treasury bonds. Those risk spreads depend on the amount of additional risk involved in owning corporate bonds and the amount of compensation that investors require for accepting that additional risk. The key word here is “additional.” A loss of confidence in US assets would most likely make US assets in general more risky. But how would it increase the additional risk of corporate bonds relative to government bonds? If anything it would do the opposite: the loss of confidence would weaken the dollar, making it easier for US corporations to sell their products, thereby increasing their profitability and their creditworthiness and reducing the additional risk from owning their bonds.

So – subject to exogenous changes in risk and in the price of risk – private sector interest rates will not rise either, unless policymakers allow them to rise. The only good reason to allow rates to rise would be if excess demand begins to lift the US out of its deflationary recession and to threaten it with excessive inflation – a scenario inconsistent with “worsening the US recession.” Loss of confidence in US assets is not the worst-case scenario; bad policy is. Under current circumstances, encouraging excessive confidence in US Treasury securities is itself an example of bad policy. It’s not the worst case, but it’s far from the best.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

Tuesday, March 10, 2009

Targets vs. Projections

There is a widespread view that the Fed’s “longer run projections” for the inflation rate can be interpreted as targets that the Fed will attempt to hit. The logic goes something like this. Suppose (as we shall presume) that the Fed has some target for the inflation rate but that it does not announce that target explicitly. The Fed will do its best to hit that target. It may not hit the target exactly: it may undershoot the target, or it may overshoot the target. Since the Fed is aiming directly for the target, the Fed is equally likely to undershoot the target by any given amount as to overshoot the target by the same amount. Therefore the target itself is also the Fed’s best “average” guess as to what the actual inflation rate will be. Thus, if the Fed makes a forecast (or a “projection”), we can conclude that the forecast is equal to the target.

Unfortunately, there is a flaw in this logic. The fact that the Fed is aiming directly for the target does not imply that the Fed is equally likely to undershoot as to overshoot the target by any given amount. If you’re driving directly down the middle of a lane but the right side of the lane is more slippery than the left, you’re more likely to skid to the right than to the left. From the Fed’s point of view, the possibility of undershooting its target should be considered more “slippery” than the possibility of overshooting the target.

If the Fed overshoots its target, it can tighten policy and push the inflation rate back toward its target, just as, if you start to veer to the left, you can turn the steering wheel to the right and get back in your lane. If the Fed undershoots its target, it may find itself in the same sort of liquidity trap that it is in today. In that case, policy may become ineffective, and the Fed may not be able to correct the undershoot. If you skid to the right, where the road is icy, then turning the steering wheel to the left immediately will not help you get back in your lane. So while your “target” is the middle of the lane, an “average forecast” would have to account for the fact that you’re more likely to miss that target on the right than on the left. Similarly, the Fed is more likely to undershoot its target than to overshoot.

So a target and a forecast are not the same thing. If the Fed were to release both a set of targets and a set of forecasts for future inflation rates, the targets should be higher than the forecasts. And if (as it has in fact done) the Fed releases only forecasts (or projections) and not targets, then, if we are to take the Fed at its word, and if the Fed agrees with the logic of my last paragraph, then we should conclude that its implicit inflation targets are higher than the inflation rates that appear in its projections.

Unfortunately, even if the Fed does agree with my logic, I don’t think we can take the Fed at its word. My impression is that the Fed is playing a language game in which all parties have implicitly agreed that the word “projection” will be used to mean “target.”

If this is true, then it’s bad news, because it means that the average expected inflation rate over the “longer run” will be less than the Fed’s projected “central tendency” of 1.7% to 2%. And more specifically, it means that the risk of deflation will never be entirely gone. If you’re on a four-lane highway and the right shoulder is icy, you’re better off driving in the left lane, where there is minimal risk of veering onto the icy part. But the Fed has declared its intention to keep driving in the right lane – at less than 2% inflation, right next to that icy place where a severe recession (much like the one we are currently experiencing) could render policy ineffective.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

Friday, February 13, 2009

Price Level Targeting: An Example

In my previous post, I tried to make a case for using price level targets as a way to overcome the problem of money hoarding (which, under present circumstances, should be understood to include T-bill hoarding, and perhaps Treasury security hoarding in general). In this post I’m going to give an example of what a set of price targets might be and how it would work. You might even consider this a recommendation – although I wouldn’t recommend myself as the best person to recommend a specific set of price level targets.

In general, there are four characteristics that a good set of price level targets should have:
  1. It should be realistic. We might love to see a 3 percent inflation rate for 2009, but that’s not going to happen, no matter what the Fed does. To be credible, the targets must allow for a couple of years of low inflation, simply because we know that the Fed has little influence over the inflation rate in the short run. In general, the targets should be reasonably conservative relative to what might be possible, because, if the early targets are not hit, the Fed will have more difficulty hitting the later targets. We don’t want to set the Fed an impossible task in the case where things go badly at first.

  2. It should target prices high enough to make people nervous, even if they don’t think the Fed can hit those targets. This is where my poker game analogy (as discussed in the previous post) comes in. You may think that the player with the four hearts up is probably bluffing, but if she throws enough blue chips into the pot, and if you’re a conservative player, you’re going to fold your three aces anyway. These days almost everyone is a conservative player. So if the Fed sets the price level target high enough, just the risk that it might hit that target should be enough to motivate investors to hold nonmonetary assets. The choice today is between risky assets with a high expected return (stocks, high-yield bonds, etc.) and safe assets with a low expected return (cash, Treasuries, etc.). Set a price level target high enough, and the choice – even if you don’t have much confidence in the Fed’s ability to hit its targets – will be between two risky assets, one with a high expected return and the other with a low expected return.

  3. It should transition to a “normal” rate of inflation in the long run. A normal rate of inflation used to be 2 percent, but recent experience shows that 2 percent is dangerously close to zero. I think 3 percent is the lowest reasonable target for a long-run inflation rate, and that’s what I will assume in my example, because it’s close to what most people would think of as normal. If it were up to me, I would choose a long-run inflation target of 4 or 5 percent. (I’m using the phrase “inflation target” loosely. I mean the inflation rate implied by long-horizon price-level targets.) It’s an open question how long exactly the long run is. In my example, I’m choosing a set of targets that implies a 3 percent inflation rate starting in year 14 (2022, since 2009 is year 1). Note that the 3 percent implication is conditional on earlier targets being met. If the Fed falls short of the price target for the end of 2021, the inflation rate will have to remain higher than 3 percent for a while thereafter in order to catch up.

  4. It should target prices low enough that they don’t imply ridiculously high inflation rates. After a while it should be technically feasible for the Fed to engineer an inflation rate as high as, say, 20 percent, and if that were expected to happen, it would certainly discourage people from holding monetary assets. But at some point the cure becomes worse than the disease. If we’re targeting a long-run implied inflation rate of 3 percent, the transition from 20 percent to 3 percent would likely be very unpleasant. And at some point also, it becomes too unfair to ask today’s long-horizon creditors and fixed income recipients to bear such a large part of the burden for fixing the economy. The targets in my example imply a maximum annual inflation rate of 10 percent (conditional on earlier targets being met), a maximum (conditional) 5-year average inflation rate of 8.4 percent, and a maximum (conditional) 10-year average inflation rate of 6.7 percent. I would say that those are high (as point 2 requires) but not ridiculously high. (Others may have a different opinion.)
The targets in my example are for the core CPI (Consumer Price Index excluding food and energy), and there is a target for each December over the next 20 years. The targets may be understood relative to the actual reported core CPI (216.1) for December 2008. The table below shows the targets and their implications:

year zero5 years10 yearsyear 5
2011230.43.0%2.2%year 0
2012239.74.0%2.6%to year 5

These targets imply a 5.8 percent average annual (compound) inflation rate over the next 10 years. (See the entry for December 2018 in column D.) Suppose the Fed were also to target the 10-year Treasury yield at zero (a target the Fed could certainly achieve by intervening directly in the longer term Treasury market, although meeting that target could conceivably require the Fed to buy up almost all of the national debt). The result, if the Fed were to hit its price level targets, would be a real (inflation adjusted) 10-year Treasury return of -5.8 percent.

Markets would not have full confidence in the Fed’s ability to hit its price targets, but the threat of a -5.8 percent real return, even with only limited credibility, should be enough to make people nervous. And the more nervous people get about holding monetary assets (in which term I mean to include Treasury notes), the more they will invest in real assets (or just spend money), and the easier it will be for the Fed to hit its target. It might not be necessary to set the target real return as low as -5.8 percent (i.e. to target the 10-year Treasury yield at zero), but the price level targets would give the Fed room to maneuver.

To get an idea of how the “catch up” process would work with these targets, consider the case where the average inflation rate over the first 5 years is zero. In December 2013, the Fed will miss the target by a factor of 0.85 (the actual core CPI of 216.1 divided by the target of 254.0). The Fed will then have to make to make up that 15 percent “deficit” over the subsequent years by pushing the inflation rate above the original “planned for” inflation rates. Column G shows the average annual inflation rates that would be necessary to make up the deficit in a given number of years. To make it up in one year (obviously unrealistic) would require an inflation rate of 27 percent. To make it up in five years (fairly realistic) would require an inflation rate of 12 percent.

To get an idea of the overall pattern of inflation rates implied by this set of targets, we can divide the next 20 years into 5-year intervals and look at what the average inflation rate would be in each of those intervals if all targets are hit:
  • Dec-2008 to Dec2013   3.3%
  • Dec-2003 to Dec2018   8.4%
  • Dec-2018 to Dec2023   4.2%
  • Dec-2023 to Dec2028   3.0%
So the major “push” comes in the second five-year period. The inflation rate over the first 5 years has to be relatively low just because the inflation rate is currently low, and it’s difficult or impossible to increase the inflation rate very quickly. Over the following 5 years, the inflation rate rises to its peak of 10 percent in 2015 and then gradually comes down thereafter.

The hope is that the transition from high to normal inflation (after 2015) will not be too difficult, because it will be fully anticipated. Individual businesses will expect a slowdown in the overall inflation rate and will therefore slow down their own price and wage growth, allowing the anticipated monetary policy to support a normal level of output and employment. That’s the theory, anyhow.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.