Wednesday, January 21, 2009

What are Illiquid Assets Really Worth?

For the most part, I agree with Paul Krugman’s take on the “Bad Bank” proposal. But I think he takes the case a little too far:
It looks as if we’re back to the idea that toxic waste is really, truly worth much more than anyone is willing to pay for it
But isn’t it obvious that the toxic assets are worth much more than anyone is willing to pay? The value of an asset depends on the rate at which one discounts its cash flows. For assets that are risky and illiquid, the discount rate includes a risk premium and a liquidity premium. By any measure I can think of, risk premia and liquidity premia today are stratospheric, which means that asset values in terms of reasonable risk and liquidity premia are much higher than in terms of the wild and crazy premia we’re seeing today.

Moreover, the toxic assets are particularly illiquid – and therefore demand a particularly high liquidity premium – because the technology for valuing them has proven faulty. Over time, presumably, the bugs will be fixed, and some of the liquidity will be restored. And by the way, what better way to fix the bugs than to create a buyer that has $350 billion to spend? Such a buyer – if its objective were to make a profit – could easily afford to spend a few hundred million on research to find out how much it should be paying for the assets.

There remains the philosophical question of how much an asset is inherently worth. But surely to the federal government – which can afford to be patient, and which can afford to absorb a lot of risk, and which can afford to sit on these assets until they mature or until someone is willing to buy them at a profitable price, and which doesn’t have to worry about capital requirements or even about solvency – these assets really are worth a lot more than any private entity is willing to pay for them.

Moreover, the government’s risk-free discount rate is probably negative. Today it can print all the T-bills it wants, and there will be no ill effects. At some point in the future (or so one hopes!), the government will once again have to pay for the money it borrows. For the private sector, a negative discount rate doesn’t make sense, because anyone can just hold assets in cash and receive zero interest. But the government cares about the effects its actions have on the economy as well as about its own financial health. It isn’t willing to hold its assets as cash, because that doesn’t help the economy. For the government, a negative discount rate does make sense. So add a negative risk-free rate to some reasonable risk and liquidity premia, and the government should be willing to pay quite a lot more for these assets than the private sector pays.

But should the government actually pay what it should theoretically be willing to pay? I’m inclined to say no, or at least, not necessarily. Demand curves slope downward, supply curve slope upward, and most people, under most circumstances, pay less for whatever they buy than what they would be willing to pay. In a competitive market, buyers pay only as much as the marginal seller is willing to accept. (Granted, the market for illiquid assets is, by definition, not competitive, but if a major buyer emerges, there will be competition among sellers.) If the government pays more than a similarly mandated private investor would have to pay, then it is merely transferring public wealth to the banks’ stockholders. And I’m confident that I speak for the majority of Americans when I say, “To hell with the banks’ stockholders!” What the government should be willing to pay for $350 billion worth of assets is whatever the market price would have been if there were additional $350 billion of private sector funds buying those assets.

And not even that, perhaps. Part of the reason these assets are so illiquid is that banks are reluctant to sell them because that would force them to own up to how little the assets are worth. If the government bid a little higher, presumably, more banks would be willing to sell, but there would still be an incentive for the banks to hold out for book value. My view is that banks should get the stick as well as the carrot. Instead of relaxing accounting standards, we should go the other way and be aggressive about forcing banks to write down their toxic assets, so they won’t have an incentive to hold out for unrealistic book values. When all is said and done, the government can recapitalize the banks that survive, and hopefully they’ll be willing to lend again.

I think the call that many economists made, when the original TARP came out, for recapitalization rather than reliquification, was misinterpreted. The idea, I think, was that banks need more capital because much of their existing capital will disappear once they write these assets down to a reasonable value. If you give them a token amount of capital without forcing them to write down the assets, it doesn’t solve the problem: their balance sheets may look good now, but they’re still afraid to lend if they’re uncertain about the value of their existing assets.

In any case, the whole enterprise should be, and can be, carried out in such a way as to be profitable – in an average expected return sense – for the government. The government can force banks to write down assets, and then it can buy those assets at a price that will leave a reasonable expected return. The banks that no longer meet capital standards will disappear. Of the remaining banks, many of them will need capital, and those will make up a substantial fraction of the banking sector. Banking – when one is willing to do it – is generally a profitable activity, and over time those banks should generate sufficient profits to compensate the public for the risk it is taking. If there’s anything left over for the stockholders, that’s gravy.

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, January 20, 2009

Oh, No, Not Again

Yes, I'm back with yet another post about the Fama/Stimulus issue. I promise this will be the last one...unless there are more.

In general, for an argument like Professor Fama's to work, there has to be some finite resource that is being fully utilized, so as to impose a binding constraint on the economy. That is, when the government borrows, it must be using up something – some actual, definite thing, not just a vague "funds" (which could mean any number of things depending on how we interpret it). The government must be using up some limited resource that is no longer available to businesses seeking to invest. What is that resource?

As I understand Greg Mankiw's interpretation, the limited resource is labor. In the classical model to which Greg refers, the availability of labor is what usually constrains an economy, the reason you cannot do more of one thing without doing less of something else. Now Professor Fama says explicitly that his argument applies "even when there are lots of idle workers." On the face of it, that would seem to contradict Greg's interpretation.

But perhaps Professor Fama is referring to frictional unemployment, and perhaps he believes in a theory in which recessions are associated with increased frictional unemployment. For example, today's unemployment could just reflect the difficulty in reassigning all the people that have been laid off in construction, finance, and other industries related to the mortgage boom. I can think of a number of empirical arguments as to why that's not the case, but the position is logically sound and does not rely on any assumptions that are inherently unreasonable. If that's what Professor Fama has in mind, I wish he would be clearer about it.

Nick Rowe has a different interpretation. He thinks the finite resource is money. If that's the intended interpretation, then there is an overwhelming empirical case against Professor Fama, as he will perhaps realize if he clarifies what he is trying to say. Money is not a finite resource today: there is nothing to stop the Fed from printing more money to finance any additional federal deficit, thus leaving plenty of money for those who want to use it for investment. (The argument goes beyond this, and I'm going to retell, in different words, the story I take Nick to be telling. Our argument shall be all things to all men, that we might by all means save some.)

Even if the Fed refuses to finance the deficit, and the money supply is fixed, the empirical case is still overwhelming, once you appreciate the nature of money and the relevance of a zero interest rate. The critical point is that money, even if it is limited in quantity, is a reusable resource. Money isn't like paper towels, where you use them once and then have to throw them away, and if my wife uses up all the paper towels and I can't get to the store then the dishes will have to sit in the drainboard. Money is more like cloth towels. If my wife uses up all the cloth towels, I can just put them in the washing machine and the dryer and use them again. Similarly, my wife can use money to buy a hamburger, and to the burger cook, it is as if the money had already been cleaned and dried. (Ah, yes, laundered money!) Even though my wife has already used the money, the cook can immediately go and use it again to buy something else.

Arguments that the quantity of money matters rely on some mechanism that limits the number of times money can be reused in a given year. The usual assumption (a controversial one, to say the least, but one we can accept for the sake of argument) is that people will hold money in proportion their incomes, regardless of the interest rate. In that case, if you try to raise aggregate income (for example, by a stimulus program), there won’t be enough money to go around. The excess demand for money will cause interest rates to rise until someone reduces their demand. The classic example is a business that is contemplating building a factory. When the interest rate rises, the factory becomes more expensive to finance, building it is no longer profitable, and the business decides not to build it. As that sort of thing happens across the economy, the demand for construction is less than it would have been, construction workers are laid off, and aggregate income goes back down to where it was before the stimulus program. Since we have assumed that the supply of money is fixed, and the demand for money is proportional to income, aggregate income has to go down to exactly where it was before the stimulus program in order to equate supply with demand.

But the critical point now is that the process also works in reverse, but it runs up against a brick wall when the interest rate gets to zero. Suppose incomes drop for some exogenous reason (like, for example, that housing prices collapse and throw the banking system into disarray). When incomes drop, the demand for money goes down. Therefore interest rates go down, and a bunch of businesses suddenly want to build factories.

So far, so good, but suppose that demand for commercial construction (and all the other demand that results from lower interest rates) doesn't create enough income to replace that which was lost. In theory, interest rates should go down even further, but suppose the interest rate goes all the way down to zero, and there still isn't enough aggregate income. There could be a very large excess supply of money, but interest rates can't go down any further, and thus incomes won't go up any further, and there is nothing to increase money demand and relieve that excess supply. (And please note that the interest rate on 3-month T-bills today is approximately zero.)

Now suppose the government institutes a stimulus program to raise incomes. As incomes rise, the demand for money increases. And then what happens? Well, nothing. There is an excess supply of money, and part of that excess supply gets used up by the new demand, but some of it remains – provided the stimulus program is not too large – and the interest rate remains at zero, and there is no reason for anyone to reduce investment, and there is no offsetting decline in income: aggregate income has risen; the stimulus has worked.

But suppose the stimulus program is too large. In that case you can think of the stimulus as being in two parts. The first part is just enough to use up the excess supply of money, and that part will raise incomes by some amount. The second part will create an excess demand for money, and ultimately it won't raise incomes any further. Overall, therefore, incomes will rise to a certain level and no further. But that certain level is still higher than where they were before the stimulus program. Thus the stimulus program has again been successful in raising incomes.

QED, if Professor Fama is using the word "funds" to mean "money" in the literal sense. I wonder if he will explain what he does mean.

I'll conclude with another point concerning the savings-investment equation that Professor Fama uses. In the National Income and Product Accounts, that equation holds more or less by definition. To the extent that there is causation involved, that causation seems to go from investment to savings rather than the other way around. In other words, any increase in investment immediately and automatically creates the increase in savings to finance it. In the national accounts, savings is a residual calculated by subtracting consumption from income. Consumption comes from the product side of the accounts; income comes from the income side. When an increase in investment takes place, it is entered as an increase in income on the income side, and it is entered as an increase in investment on the product side. In other words, income increases, but consumption does not. By definition, therefore, savings increases. So whenever a business chooses to invest, savings must necessarily increase as a result.

I'll leave you to ponder that argument. To be honest, I don't really buy it. I think there is an inherent flaw in national income accounting that allows a bit of Keynesian sophistry, and perhaps I'll write about that in the future. I'd rather fall back on my earlier argument about how the people in the chain from those who receive the government stimulus end up saving the total amount of the stimulus. I don't see how that argument can be refuted – again, unless Professor Fama means something different from what he says. And if he means money, I think Nick and I have pretty much buried his argument.

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, January 16, 2009

More about Stimulus and Eugene Fama

Continuing from my previous post to address subsequent arguments...

Eugene Fama acknowledges a point that Brad DeLong made about inventories (that much or all of the reduced investment from a fiscal stimulus is unintended inventory investment, which is technically counted as investment but which is not useful). Professor Fama argues that the amount of unintended inventory investment is not very large.

But again I take issue with both the original Fama argument and the DeLong counterargument. First, consider the latter. The Keynesian model does not depend on inventories. Economists often teach the model to undergraduates without mentioning inventories. And yet in the Keynesian model (in the simple version, or when there is a liquidity trap), private investment does not get displaced by the increased federal deficit. Rather private savings increases just enough to finance the increased deficit.

For example, suppose there is $100 billion tax cut, and suppose the marginal propensity to consume is 0.8. The people who receive the cut save $20 billion. The people in the first round of multiplier effects get $80 billion in extra income and save $16 billion of that. And so on. As I hinted in my previous post, if you calculate the infinite sum (or estimate it by simulation, if you don't like calculus), it comes to exactly $100 billion. It's no accident that the additional savings exactly compensates for the government's additional borrowing.

The Keyensian model is a reasonable special case in which the compensation is exact. More generally, I think it would be unreasonable to expect private savings not to rise at all in response to an increased deficit, and indeed, in the case where there is a liquidity trap, I think the exact compensation in the Keynesian model is a very good approximation to what would actually happen.

Per Professor Fama:
I want to restate my argument in simple terms.
  1. Bailouts and stimulus plans must be financed.

  2. If the financing takes the form of additional government debt, the added debt displaces other uses of the funds.

  3. Thus, stimulus plans only enhance incomes when they move resources from less productive to more productive uses.
Are any of these statements incorrect?
As to the first point, it depends on what you mean by "financed." Certainly the government needs to obtain cash, but that's a rather trivial matter. The Fed can create any cash the government needs, and as I argue elsewhere, such money creation isn't even necessary when the interest rate is zero, because T-bills have become essentially equivalent to money. In the purely monetary sense of the word "finance," the Treasury can effectively finance the stimulus by printing its own money.

But I don't think the argument is about financing in the strictly monetary sense. The savings-investment equation, which is presented as central to the argument, says that
in any given year private investment must equal the sum of private savings, corporate savings (retained earnings), and government savings (the government surplus, which is more likely negative, that is, a deficit)...
The issue is whether the government has reduced its savings in the sense of having reduced its net assets. The answer depends on whether you believe in Ricardian equivalence (as an underlying fact about government borrowing, not necessarily as a description of household behavior). If you do, then the government is using its future power of taxation to create a new asset called "deferred revenue," which it can set off against its new liability, leaving its net assets unchanged. It's like when someone borrows money to buy stock on margin: they haven't reduced their savings, they've merely added an offsetting asset and liability to their balance sheet. In that case, government savings (or rather dissavings) is unaffected by the stimulus. If you don't believe in Ricardian Equivalence, then yes, the deficit does need to be financed, but...

As to the second point, it depends on what you mean by "displaces." If you mean there is displacement ceteris paribus for the changes in the total amount of funds available, then yes, it does displace other uses of funds. But my point is that it is unreasonable to assume that the total amount of funds available will be constant. Rather, it is almost certain to rise significantly, as the government's debt is itself a vehicle for net private savings (in contrast, for example, to personal debt, which is savings for one private party and dissavings for another). In the absence of Ricardian Equivalence, new wealth has been created, so there is more to save. To avoid saving more, people would have to increase their consumption dramatically.

Thus, as to the third point, no:   unless people behave in accordance with Ricardian Equivalence, the stimulus almost certainly also mobilizes idle resources, by increasing total income (i.e. adding to total wealth), thus allowing private saving to rise even as consumption also rises. Aside from Ricardian Equivalence, and excluding the very special and unlikely case where private savings do not rise, the only way the stimulus would fail to mobilize resources is if those resources were not really idle in the first place (in which case the stimulus would only cause inflation).

UPDATE: More from Brad DeLong, and the story is starting to sound a little bit more like one I recognize:
...increases in government spending lead to unexpected declines in inventories and unexpected declines in inventories lead to firms to expand production, which leads to increases in income and saving.
The initial inventory disinvestment (in response to demand created by the stimulus) is only a minor part of the story. And inventories only matter at all because they happen to be the way firms get products to market. My logic would work even in a world without inventories, where firms could instantaneously change production in response to demand. In real terms, the new demand would result immediately in more production, which would raise real incomes and lead to more real saving out of those incomes.

That's the "real" story, but I understand Professor Fama to be telling a financial story rather than a "real" one. He uses words like "funds" that have meaning only in a financial world. The nominal national income accounts are compiled in financial terms -- based on accounting statements and the like -- so the national income identity must hold in financial terms, and I take that to be the basis of Professor Fama's argument.

Therefore I state my counterargument in financial terms: financially speaking, the increase in income occurs as soon as money changes hands. The most straightforward case is a tax rebate. As soon as people receive the money, it is income, whether or not anything new has been produced, and whether or not any change in inventories has occurred. (Certainly the people who receive the rebate think it is already income, as do their accountants, as do the people who compile the income side of national accounts.) They have a choice whether to save or spend that income. Any income they spend will go to someone else, who will have the same choice, and so on until it all gets saved. Technically, some of what I call saving will take the form of inventory disinvestment, but that's a minor point. It would work the same way if all production were done on the spot.

UPDATE2: Leigh Caldwell's comment makes me realize that I have exaggerated the importance of the government's creation of new wealth, because my same logic applies when the source of the increased consumption is a change in consumer behavior. The general principle is that every act of consumption by one entity (household or government) is an act of saving (or inventory reduction) by someone else.

When I take money out of savings to purchase something from a company, the company records part of the purchase as a profit and part as a reduction in inventory. The profit immediately becomes part of retained earnings and thus corporate savings. If the firm hires another worker in order to replenish its inventories, the cost of replenishing those inventories becomes the worker's income. Any part of that income that the worker chooses to spend becomes part of someone else's income (or someone else's inventory reduction), and so on until there is an overall increase in savings just large enough to offset exactly the original reduction in my savings. (I'm assuming all inventories are eventually replenished. Otherwise part of my purchase becomes not savings but a reduction in unproductive inventory investment, but the funds available for productive investment are unchanged.)

Ultimately, the only way to change the quantity of savings is by investment. For example, suppose a company decides to hire a programmer to develop a major piece of custom software that it will use in its business. The programmer's pay becomes part of his or her savings (until it is spent and becomes part of someone else's savings), but there is no reduction in retained earnings (savings) on the part of the company, because the company records the software as a capital asset. Thus the company's decision to make an investment has resulted in an increase in total savings. The same process works in reverse, if the company decides to lay off a programmer that would have been developing software. In the more general case, investment typically involves purchases from other businesses, and then the same logic in the paragraph above applies, except that purchaser does not reduce its savings, since it books the investment as a capital asset.

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.

Is He Serious?

Eugene Fama, a giant in the world of financial economics, argues against a stimulus (hat tip: Greg Mankiw) for reasons put it politely, I don’t understand. Maybe he is trying to satirize the way Keynesians often ignore or dismiss alternative theories – giving the Keynesians a taste of their own medicine. Or maybe he is deliberately making a wrong argument, as a pedagogical technique, to see if we spot his error. Or maybe (as Greg suggests) he is actually arguing something different from what he is literally saying, but he thinks that the rigorous argument is too complicated to discuss in a short article. Or maybe he just hasn’t thought through the issue. Or...your guess is as good as mine, but, as far as I can tell, if you take his words in their plain sense, they don’t make any.

In a nutshell:
...bailouts and stimulus plans are funded by issuing more government debt. (The money must come from somewhere!) The added debt absorbs savings that would otherwise go to private investment. In the end, despite the existence of idle resources, bailouts and stimulus plans do not add to current resources in use
Which makes perfect sense if you assume (as he seems to) that bailouts and stimulus plans have no effect on the total amount of private savings. I understand the need to make simplifying assumptions in any discussion of economic phenomena, but there is a difference between the usual “not quite true but perhaps close enough to make a reasonable argument” assumption and one so far from reality as to be thoroughly ridiculous. The aforementioned assumption is in the latter category.

Bailouts (usually) and stimulus plans (almost by definition) raise someone’s disposable income. Is it even remotely plausible that an increase in disposable income would not have a significant effect on someone’s savings? (By “someone” I mean the generic, average person who might be receiving funds from a bailout or stimulus plan; I don’t deny that there may exist some individuals for whom the assumption would almost be valid, but the funds from bailout and stimulus plans seldom go to a single, unusual individual.) Think about it. Suppose you received an unexpected check for $1000. Would you go out and spend the entire $1000 immediately?

That fact is, even if you wanted to, you couldn’t. Perhaps, with today’s technology, you could spend it within a few seconds, but the instant after you receive the funds, your savings necessarily increase. More likely, though, even if you intended to spend all of it quickly, it will take at least a matter of days to do so. In the mean time, there are more savings to finance the government deficit.

But what happens when you do spend it? Someone else must be receiving the money from you as income. And just like you, they won’t be able to spend it instantaneously. Your savings have been reduced, but the savings of the vendor have increased by the same amount. The vendor has received income and is saving that income in the form of money. And the vendor will either save it or spend it, and in the latter case it will immediately become part of someone else’s savings, and so on. So the very act of implementing the bailout or stimulus plan creates the savings that are necessary to finance it.

One might try to argue that, since the money necessary to finance the stimulus must come from somewhere, someone’s savings must be reduced by the amount of that money. But that argument is wrong. When the government sells, for example, a T-bill, the purchaser of the T-bill has the same savings as before. It’s just that some of the savings they were previously holding in the form of money, they now hold in the form of a T-bill. The T-bill itself is a form of newly created wealth, so by the very act of issuing it, the government causes personal (or corporate) savings to rise.

You might argue that the T-bill is not in fact net wealth, because people will realize that the government borrowing raises their future tax obligations, and they will accordingly consider their wealth to be reduced by the amount of the T-bill, thus offsetting the increase in wealth resulting directly from the issuance of the T-bill. (This is what some economists call Ricardian Equivalence.) In that case, though, those people will choose to save more of their income to provide for the increased future taxes, so private savings will still rise in response to the stimulus.

Granted, in that case the stimulus doesn’t work, since people will have to reduce their consumption by the amount of the stimulus, thus offsetting its effect. That argument is theoretically valid, although the empirical evidence tends to indicate that people do not generally behave in accordance with Ricardian Equivalence. In any case, that is not the argument that Professor Fama is making. According to him (using the example of a tax cut),
Suppose the recipients of the tax reduction from the stimulus don't know about Ricardian Equivalence, and they use the windfall to buy consumption goods. Does this increase economic activity? The answer is again no. The composition of economic activity changes, but the total is unchanged. Private consumption goes up by the amount of the new government debt issues, but private investment goes down by the same amount.
And here he is clearly wrong. Private investment does not go down. When he says that “recipients...don't know about Ricardian Equivalence,” that is equivalent to saying that government debt is (from their point of view) net wealth. By consuming more, people have indeed reduced what they save out of their old income. But by issuing debt securities (new wealth) and using the proceeds to cut taxes, the government has given people new income, so their total quantity of savings has remained the same. Therefore, for any private investment that was financed out of that savings, it can still be financed.

Greg Mankiw and Brad Delong have been discussing this issue, and I disagree with both of them. Brad says:
Fama mistakes the NIPA savings-investment accounting identity for a behavioral relationship that constrains the behavior of investment
As I see it, Professor Fama has simply got the accounting wrong: he is ignoring the fact that newly issued government securities constitute new wealth and therefore new savings. (Or, if you want to look at it in terms of Ricardian Equivalence, he is ignoring the deferred revenue asset that the government “saves” to offset the increase in the deficit.)

It has nothing to do with behavioral relationships. You can see this by considering a simple Keynesian multiplier model: the amount of private saving created by an increase in the government deficit is independent of the behavioral parameter. (lf you don’t believe the algebra, do the calculus: calculate how much new saving is done by each individual in the chain of income recipients, and take the infinite sum. Or just do a finite sum, and recognize that the remainder must be saved. Or take it far enough out and ignore the remainder.)

Greg says:
I think Fama's arguments make sense in the context of the classical model
I don’t see how that can be the case. For one thing, the reduction of investment is supposed to happen “despite the existence of idle resources.” In the classical model, market clearing would prevent those resources from being idle. (Unless by “idle” he means intentionally devoted to leisure.) Moreover, in the classical model, Ricardian Equivalence holds, but Professor Fama argues that investment will decline even in the absence of Ricardian Equivalence. (Unless he means to say that Ricardian Equivalence holds in fact even if people don’t act accordingly. But then, as I said above, he’s ignoring the government’s deferred revenue asset.)

Maybe Greg can explain this to me, but I find no way to make sense of what Professor Fama writes, unless he means something very different from what he says.

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, January 12, 2009

Dynamic Scoring

Suppose that, at the beginning of the fiscal year, Congress appropriates $100 billion extra for infrastructure projects. At the end of the fiscal year, how much higher will the deficit turn out to be, compared to what it otherwise would have been?

The obvious answer, and the one that usually seems to be implicitly assumed by the media and the pundits, is $100 billion. But if you think about it carefully, it should become obvious that the obvious answer is the wrong answer.

The government is going to use most of that money to hire people and to buy things. Many of the people it will hire are people who were previously unemployed. Many are leaving other jobs which will subsequently be filled by people who were unemployed. These previously unemployed people, who may have been collecting benefits, will now be paying taxes. Those taxes will reduce the deficit, as will the reduced benefit payments. Moreover, for the businesses from which the government purchases, their profits will rise, and they will pay additional taxes on those additional profits. And they may expand and hire new people, or retain people that would otherwise have been laid off. And (if you believe in a multiplier effect), all the newly employed people, as well as the owners of the businesses, will spend more money, thus providing more profits and more employment for others, who will also pay taxes and stop collecting benefits. And so on. The ultimate effect of the original expenditure on the budget deficit will be considerably smaller than $100 billion.

This is called dynamic scoring. When contemplating a change in the budget – a change in government spending or a change in taxes – an accurate analysis of the effect on the budget has to take into account the effects that the change has on the economy and thereby on other revenues and expenditures – to the extent that we can get reasonable (conservative) estimates of such effects.

In the past, dynamic scoring has met with a lot of skepticism – and with good reason. Under normal economic conditions (by which I mean those that prevailed from 1953 through 2007), it's not clear that budget changes have any significant indirect effects on revenues and expenditures. Supply-siders claimed that the incentive effect of tax cuts would increase incentives for economic activity and thereby result in increased revenues. (I mean, "increased" relative to the static estimate of the revenue loss, not increased relative to what would happen without the tax cut. The latter idea had a lot of play in the popular press, but it was seldom taken very seriously by economists.) Keynesians (the old-fashioned kind) claimed that tax cuts and expenditure increases would increase demand and thereby result in increased revenues (again, relative to the static estimate). But...

Mainstream economic analysis said they were both wrong. Many economists think there are major supply-side benefits to more efficient taxation, but most such economists think those are primarily long-run benefits (faster growth over a span of time) rather than benefits that would significantly affect revenues in the short run. The Keynesian argument would make sense if monetary policy were passive, but in fact, the Fed has its own goals, and its goals don't necessarily change in response to fiscal policy. And of course the Fed takes fiscal policy into account when deciding how to accomplish those goals. So if a tax cut or an expenditure increase were expected to create, say, a million extra jobs, then, under normal economic conditions, the Fed would simply raise interest rates enough (according to its best estimate) to destroy a million jobs. (If the Fed didn't think the demand for those million jobs would be potentially inflationary, then it would already have tried to create them.)

But today's economic conditions are not normal. The Fed, like most everyone else, is expecting the recession to be a severe one, a potentially deflationary one, but the Fed is running out of options for how to deal with it. Contrary to what happens under normal conditions, the Fed will make no attempt to offset the effects of fiscal policy; indeed, it will enthusiastically welcome the help. The old-fashioned Keynesians, whose advice about dynamic scoring was (properly, in my opinion) considered wrong or irrelevant for so long, can now dust off their computers and start giving meaningful dynamic estimates of the effects of budget changes.

No doubt there have been times in the past when advocates of dynamic scoring turned out to be right. For example, with respect to the Reagan tax cut, the supply-siders were probably right that some revenue was made up by people who devoted less effort to avoiding taxes. But there has never been a consensus beforehand about how dynamic scoring should be done, or even about the direction of the effects. In the past, the only conservative approach was to use static scoring – to ignore any indirect effects that budget changes might have on the ultimate deficit.

There is still no consensus about the details. But today one can hardly doubt that the indirect effects of stimulus policies on the budget will partly (if not entirely) offset their direct effects, or that the indirect effects will be large enough to be important. In today’s environment, static scoring is not just conservative, it's fundamentally unreasonable.

The details have to be negotiated: we should choose conservative parameters from among those estimated by various experts, and to avoid bias, we should probably do the scoring (at least) twice with two different sets of parameters, one that takes a comparatively more optimistic view of tax cuts and another than takes a comparatively more optimistic view of spending. And we should keep in mind the full range of projected outcomes, from those based on the most optimistic overall assumptions to those based on the most pessimistic.

As I said, the details have to be negotiated. But next time you think that an $800 billion stimulus plan will add $800 billion to the national debt, think 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.

Thursday, January 8, 2009

To Monetize or Not To Monetize: Who Cares?

Suppose the Treasury issues $100 billion worth of 3-month T-bills yielding approximately zero (as 3-month T-bills do today and likely will continue to do until some time in the unforeseeable future when the Fed raises its target rate). Does it make any material difference to anyone whether those T-bills are bought up by the Fed (i.e. monetized) or remain with the public?

First of all, does it make any difference to the public? To put that a little differently, does anyone care whether they personally are holding T-bills or cash? More precisely, not really anyone. After the Treasury sells $100 billion worth of T-bills (assuming that the Fed doesn’t buy them), there will still be millions of people who didn’t choose to buy those bills. Those people don’t matter: they obviously don’t care if the Treasury sells the bills to the public, because they won’t buy them either way. They might care about the possible economic and financial effects of monetization, but, as I will argue, there aren’t any effects to care about.

So let’s look at those people (let’s call them people, even though IRL they’re mostly institutions) who are currently holding money and who will buy up the $100 billion worth of T-bills if the Fed doesn’t do so. Does the Fed’s action or lack of action make any difference to those people? Obviously it must make at least a tiny bit of difference, or they wouldn’t have bothered to buy the T-bills.

But it makes only a tiny bit of difference. Money yields zero; T-bills yield zero. Money is slightly more liquid than T-bills. But only ever-so-slightly: the market for T-bills is extremely efficient, and the price variation is minimal (especially given the Fed’s policy of only changing its target in quarter-point increments). There is only the tiniest risk of being unable to sell a 3-month T-bill almost immediately at any time at a price close to the price you paid for it. Aside from liquidity, T-bills are slightly safer then money. But only ever-so-slightly: if you’re an individual, you can distribute your money across banks and have it 100% FDIC insured; if you’re a bank, you can hold deposits at the Fed, which are possibly even safer than T-bills. It makes no material difference in which form you hold your assets.

But if the monetization doesn’t make any difference to the public, does it make a difference to the Fed or the Treasury? Let’s take the Fed first. The Fed can create and destroy money at will. The Fed will be able choose, with no constraint or cost either way, whether to roll over the T-bills when they mature. Moreover, like the public, the Fed can sell the T-bills, very quickly and with little price risk, before they mature, if it should decide to do so. So the only way it would make a difference to the Fed is if the purchase of T-bills has some economic effect that the Fed cares about. But, again, as I will argue – as I am arguing – there are no economic effects.

What about the Treasury, the government? Surely the government cares whether it really owes money to someone out there in the world vs. merely nominally owing it to the Fed. Actually, no. As noted above, the Fed can create and destroy money at will. If the Fed does buy the T-bills initially, it will still be able to choose whether or not to roll over the T-bills when they mature, and it will be able to choose whether to sell the T-bills before they mature (in which case the Treasury would subsequently owe money to the public again). Unless (as I again deny) the monetization has some economic effect, the Fed will continue to be indifferent, as long as the conditions of my initial assumption hold (i.e. until the T-bill yield rises above zero, which would have to be the result of a choice by the Fed to raise its interest rate target). And since the yield is zero, the Treasury pays no interest on the T-bills either way.

Suppose we do get to the point where the Fed raises its target rate. First take the case where the Fed had not monetized the debt initially. Suppose, for example, that, to get the target rate up, the Fed has to sell $200 billion worth of T-bills. Fine. Now take the case where the Fed had monetized the debt. In that case, the Fed will now have to sell $300 billion worth of T-bills. After the transaction takes place, the Fed’s balance sheet, and everyone else’s balance sheet, will look exactly the same in one case as it did in the other. The only difference is in what those balance sheets looked like before the Fed decided to raise the interest rate. And that difference, as I have argued, is inconsequential to all the parties involved.

Except of course if it has some economic effect. But the only way it could have an economic effect is if it changes someone’s behavior. And, since it has no material consequence for anyone, it won’t change anyone’s behavior.

Well, OK, it might. The only way it might change someone’s behavior is if they expect it to have an economic effect. Then the existence of such an effect would become a self-fulfilling prophecy. That’s what economists call a “sunspot” (by the analogy that literal sunspots will have economic effects if and only if people expect such effects). I would suggest that, even in that case, the effect is likely to be quite small. If there is no fundamental reason to expect an economic effect, there should be plenty of people speculating against those who do expect an effect. Moreover, if there is no fundamental reason to expect an effect, while one can still imagine that someone might expect some effect, it’s hard to see how anyone could expect a large effect, unless their reasoning process is seriously screwed up (in which case they aren’t likely to have much wealth left to allocate). With some people expecting not-too-large effects and other people speculating against them, it’s hard to see how the net impact on markets could be significantly large.

Now you might say, so much for your example of short-term T-bills, but the subject of this essay was whether or not to monetize, and the Fed has been talking about the possibility of monetizing long-term Treasury debt as well. Won’t that have an effect?

But again the answer is no – as long as the Treasury is flexible enough to choose its preferred financing option in either case. How much of Treasury borrowing will be long-term and how much will be short-term? That is entirely the Treasury’s decision. Suppose the Fed decides to monetize long-term debt instead of short-term debt. If the Treasury’s preferences are unchanged, it will simply issue more long-term debt and less short-term debt, and there will be no difference in the quantity of each type of debt held by the public. The only difference will be what is held by the Fed. But that is no difference at all, since the Fed’s profits go directly into the Treasury. It is as if the Treasury owed the money to itself. Why should the Treasury care whether the money it owes to itself is booked as a long-term debt or a short-term debt? Moreover, since the Fed can buy and sell any amount at will at any time in the future, the Fed, counting on the Treasury’s indifference, should also be indifferent.

But, since the price of long-term debt is quite variable, what if, for example, the Fed’s future policy requires it to liquidate the debt at a loss? Won’t that have an effect? Again no, because, when the Fed liquidates the debt at a loss, the Treasury can buy back the debt and retire it at a profit. What if the Fed ends up liquidating at a profit? Yet again, no effect. If the Fed can liquidate at a profit, that means the Treasury’s borrowing costs have gone up, so, in present value terms, the Treasury has a loss to offset the Fed’s profit.

So there you have it: under present circumstances, except for possible technical and psychological effects (and the tiny effect they may have on those who are on the margin between holding T-bills and cash), the Fed’s decisions about monetizing government debt are entirely inconsequential. No doubt there will come a time in the future when such decisions will once again be consequential (as they have been during most of the past), but for all we know, that time may be a long way off.

So my advice is, ignore all the information you get about the Fed’s actions (and contemplated actions for the immediate future) with respect to the monetization of government debt. That does mean that you should ignore (or at least reinterpret) most of what I said in my earlier post on the subject. (I plan to expand on it in a future post, because I still think it has some potential substance.) Pay attention, perhaps, to what the Fed does (and it has been doing quite a lot) with private sector debt, since there we are no longer dealing with mere book-entries between the Treasury and the Fed, and real gains and losses are possible, with real effects on both public finance and private sector wealth.

But bear one thing in mind when you do pay attention to the Fed’s monetization of private sector debt – and the Treasury’s bailouts or speculative actions with respect to private sector entities. Consider the implications of the argument I have made here. The Fed’s decisions about monetizing Treasury debt make no difference. Therefore, when the Treasury does a so-called bailout, it would make no difference whether that bailout were financed by the public or by the Fed. Therefore it might as well be financed by the Fed. Therefore Treasury bailouts are no different than the Fed’s monetization of private sector assets directly. I plan, in a future post, to argue that those bailouts/monetizations are not as dangerous as some economists think (and certainly not as costly in “expected value” terms as much of “Main Street” seems to think). But bear in mind the equivalence. If you must worry about something, don’t worry about the $400 billion or so that the Treasury has used; worry about the trillions that the Fed is using.

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, January 7, 2009

In Case of Emergency Break Glass

The French economist Frédéric Bastiat, writing in 1850, proposed what is known as the Broken Windows Fallacy, the idea that naïve observers, examining a scene where something useful has been wasted or destroyed, consider the beneficial visible economic effects.(increased demand, to replace what is wasted or destroyed) while ignoring the indirect detrimental effects (reduced demand for other products). To put it in M. Bastiat’s own words – well, his translated words, anyhow, courtesy of the Library of Economics and Liberty:

Have you ever been witness to the fury of that solid citizen, Jacques Bonhomme, when his incorrigible son has happened to break a pane of glass? If you have been present at this spectacle, certainly you must also have observed that the onlookers, even if there are as many as thirty of them, seem with one accord to offer the unfortunate owner the selfsame consolation: "It's an ill wind that blows nobody some good. Such accidents keep industry going. Everybody has to make a living. What would become of the glaziers if no one ever broke a window?"

Now, this formula of condolence contains a whole theory that it is a good idea for us to expose, flagrante delicto, in this very simple case, since it is exactly the same as that which, unfortunately, underlies most of our economic institutions.

Suppose that it will cost six francs to repair the damage. If you mean that the accident gives six francs' worth of encouragement to the aforesaid industry, I agree. I do not contest it in any way; your reasoning is correct. The glazier will come, do his job, receive six francs, congratulate himself, and bless in his heart the careless child. That is what is seen.

But if, by way of deduction, you conclude, as happens only too often, that it is good to break windows, that it helps to circulate money, that it results in encouraging industry in general, I am obliged to cry out: That will never do! Your theory stops at what is seen. It does not take account of what is not seen.

It is not seen that, since our citizen has spent six francs for one thing, he will not be able to spend them for another. It is not seen that if he had not had a windowpane to replace, he would have replaced, for example, his worn-out shoes or added another book to his library. In brief, he would have put his six francs to some use or other for which he will not now have them.

I’ve always contended that M. Bastiat was wrong. Based on my own introspection, what would happen if someone broke one of my windows? Would I reduce my spending on something else in order to pay for the broken window? Not at all: I would “save” less, in the sense that, at the end of the month, the increase in my bank balance would be less than it otherwise would have been, but I would not feel a need to reduce my standard of living temporarily in order to pay for the glass. Moreover, when I was younger and didn’t make enough money to have savings left over at the end of the month, I would merely have let my credit card balance run up a little to pay for the glass. (If such losses proved frequent, I would – and in fact did, back in my poorer days – take out a home equity loan to pay off the credit card balances.) I imagine (perhaps wrongly) that most people, or at least many people, are like me in this respect.

This is old news, and M. Bastiat’s defenders have several counterarguments, none of which I find convincing. First they argue that, even if I don’t reduce my current consumption of other products to pay for the glass, I will have to reduce my future consumption because I will have less savings. This logic seems to presume that I intend to go to my grave with a net worth of zero, or with some net worth that I will decide beforehand independent of the window-breaking incident. That presumption is wrong. I intend to go to my grave with a positive net worth, because I am uncertain about when I will die, and I am averse to the possibility of running out of wealth before I die if I underestimate my lifespan. Nor is my intended net worth at my expected time of death a fixed number. As long as I expect that number to be positive enough to leave minimal risk of outliving my wealth, I will consume what I consume and not worry about the exact number. So no, I won’t reduce my future consumption.

Perhaps so, they may argue, but surely your heirs will then have to reduce their consumption. The problem there is that I expect my heirs to have a predisposition similar to mine, and to continue their lifestyle indifferently to a one-time bequest. The Bastiatites may then take the argument one step further and talk about the heirs of my heirs. And we can keep this argument going all day as I apply the same logic to each successive generation. At the end of time, perhaps, some distant heir will have to reduce their consumption – but perhaps not, because the usual rules of trade don’t apply when people believe that the end of the world is imminent. And if it comes as a surprise, it will obviously not reduce the heir’s consumption.

All of which is a red herring, because the real argument is that, even if I don’t reduce my consumption, someone else will have to reduce their consumption. If I don’t reduce my consumption, I will (as I acknowledged) have to reduce my bank balance by the end of the month, and there will be less for the bank to lend to others, who will thus have to reduce their consumption (or investment). Not really, though. If the bank has a disposition similar to mine, it will merely reduce its excess reserves in the same way that I reduce my saving. Or the Fed, which has a policy of targeting the interest rate at which banks borrow, will replenish the bank’s reserves in order to prevent that interest rate from rising.

But, the Bastiatites may contend, eventually, if enough windows get broken and enough people reduce their savings, the Fed will have to raise interest rates to reduce the additional demand (as the demand for glass increases while the demand for other things initially remains constant), lest it stress the economy’s resources and produce inflation. My window could, as likely as any other, be the straw that breaks the camel’s back. (I’m trying to imagine a window made of straw.) The general principle is, Fed or no Fed, and no matter how profligate I may be personally, the economy has limited resources, and if some of those resources are diverted to produce more glass, fewer resources will be available to produce everything else.

But here they are wrong again. (I will skip the argument about inventories here, since I probably lose that one.) The logic of limited resources only applies when the economy is using most of those limited resources. If there are slack resources, we need merely mobilize some of the slack resources. If the economy is operating below full employment, as is often the case, then there is no need for the Fed to raise interest rates. The window-breaking incident will indeed create additional net employment, just as the naïve onlookers thought.

Here the argument becomes more subtle. M. Bastiat’s defenders will argue that there is no fixed point of full employment. Rather, one can merely say that one state of employment is, as it were, “fuller” than another. In the terminology of contemporary Keynesians, there is a “Phillips curve” or an “aggregate supply curve,” which is not flat, and which, econometricians typically assume, is roughly a straight line. Moreover, there is a certain point on that curve that corresponds to the non-accelerating inflation rate of unemployment (NAIRU). If the unemployment rate is higher than the NAIRU (which, they will argue, is what I must mean by “slack resources”), then the inflation rate will decline, and the Fed (assuming its long-run inflation target is unchanged) will then allow unemployment to fall below the NAIRU in the future, to bring us back to the original inflation rate. If my glass purchase reduces unemployment, then the initial decline in the inflation rate will be smaller. There will therefore be less room to increase the inflation rate in the future. Thus, in the future, the Fed will not allow the unemployment rate to go down as far as it would have if the glass had not been broken. The additional employment today will be offset by reduced employment in the future.

But yet again they are wrong. If the Phillips curve were actually a straight line, their argument would be valid. But the Phillips curve is not a straight line. That’s pretty obvious. The unemployment rate can’t go below zero, so either the curve has a kink at zero (where it becomes vertical), or it has some convexity as it approaches zero. The latter possibility seems infinitely more likely to me, since I cannot imagine that a decline in the unemployment rate from 10% to 9.01% has the same effect on inflation as a decline from 1% to 0.01%. When the number of available workers becomes extremely small, the difficulty in obtaining workers becomes extremely large, and even a little bit of additional demand will necessitate a huge increase in prices, if only to cover the incredibly large recruitment costs.

I contend that the Phillips curve has considerable convexity throughout. Does one really believe that reducing the unemployment rate from 20% to 19% would involve any noticeable change at all in the pattern of prices, let alone a change as large as, say, reducing the rate from 5% to 4%? Does it make any sense that the curve would be vertical on one end, almost horizontal on the other end, but a straight line on the range in between? Not to me.

In particular, I am convinced that, when the unemployment rate is below the NAIRU, the Phillips curve is steeper than when the unemployment rate is above the NAIRU. When the unemployment rate is above the NAIRU (as it surely is now, for example), a certain increase in employment (due, for example, to broken windows) will be associated with a smaller – by a certain amount – decline in the inflation rate. When it comes time to make up that decline by allowing unemployment to fall below the NAIRU, the necessary decline in the unemployment rate will also be smaller – but by a smaller amount.

Perhaps an example will make this a little clearer. Suppose that the unemployment rate is 10% and that the inflation rate falls from 5% to 2% – in accordance with a hypothetical Phillips curve – over the course of a year, and let’s say 2% is the target. Then the unemployment rate falls gradually but remains “too high” for some time, and the inflation rate continues to fall. Suppose inflation falls to zero by the time the economy gets back to equilibrium, and let’s say this corresponds to an unemployment rate of 5%. To bring inflation back up to the target, the Fed now allows unemployment to fall from 5% to 2.5% for a year, and let’s say this is just sufficient. That is our baseline case.

Now, going back to the beginning of the example, suppose an epidemic of broken windows causes the unemployment rate to be 9% instead of 10%. Inflation will fall more slowly, so let’s say it falls from 5% to 2.5% over the course of a year. Subsequently, following a path roughly parallel to the baseline case, the inflation rate falls to 0.5% instead of 0.0%. Again, the Fed wants to bring inflation back to the 2% target by allowing the unemployment rate to fall below 5% for a year. How far below? Not as far as in the baseline case. Maybe to 3% this time instead of 2.5%. The broken windows originally caused an additional 1% of the labor force – about 1,500,000 people – to be employed for a year. The reversal process has caused an additional 0.5% of the labor force – about 750,000 people – to be unemployed for a year. Jacques Bonhomme’s son and his fellow vandals have created a net 750,000 jobs.

(I have left some I’s undotted and some T’s uncrossed in the example above. But you see it is already getting complicated and not so easy to follow. If I’m going to avoid writing a whole book here, you’ll have to take my word for it: qualitatively, the argument works, as long as you believe in a Philips curve that is convex in the region of the NAIRU.)

I’m not advocating that the stimulus package include funding for slingshots. The window-breaking solution does involve some net loss of production (750,000 person-years worth, in my example – without dotting the I’s). There are certainly more productive ways to stimulate the economy. Jf you can create 750,000 jobs without foregoing the additional production, that’s obviously better. That is, in fact, one sense in which the so-called Broken Windows Fallacy is indeed fallacious: While the observers may be right to conclude that the broken window will increase employment, they would clearly be wrong if they thought it would create a quantity of employment that could not be created more profitably by other means.

Under normal circumstances, anyhow. When serious deflation becomes an issue, there is a case to be made (which I did make) that the emergency might call for breaking windows as a preferred stimulus compared to something more productive. I don’t think that’s where we are right now. But I do think, when putting together an economic stimulus, there is no great need to worry about how many windows get broken in the process. If someone insists on building a bridge to nowhere, I say build it.

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.