Employment, Interest, and Money

Kelly Evans on NGDP Targeting and Sustainable Growth

2011-10-27T15:54:00.000-07:00

Kelly Evans of The Wall Street Journal has taken a lot of heat from advocates of nominal GDP targeting over her Monday column on the subject. (To her credit, she has engaged with Scott Sumner on the subject in the comments section of his blog post responding to her column.) While I’m also an advocate of NGDP targeting, and I agree with many of their criticisms, I think there are certain points on which her argument is being too quickly dismissed. In particular, both Scott Sumner and Karl Smith point to the following passage:

One worrying aspect of GDP growth prior to 2007 was that it came even as real household incomes stagnated. Assuming that boom-era growth rates were sustainable, and not fueled by a surge in house prices and a credit boom that simply pulled forward demand from the future, is a huge leap in logic.

I think there is some confusion on both sides regarding this point, and to clear it up we need to make a distinction between the demand side and the supply side. Usually when economists talk about “sustainable” growth, they’re referring to the supply side: some growth rates are not sustainable because they deplete the supply of resources too quickly. (In particular, an output growth rate is not sustainable if it exceeds the sum of population growth and labor productivity growth, because we would eventually run out of willing and qualified workers and end up in a wage-price spiral.) But here Kelly Evans seems to be referring to demand sustainability rather than supply sustainability.

Is demand sustainability, in this aggregate sense, a meaningful concept? Many economists would say no, because aggregate demand – demand for everything except money itself – is really just the inverse of the demand for money (or for financial assets in general), and there is no limit on the sustainability of the supply of money: we can always print more. And indeed we can always print more money, but the problem is, will we? Aggregate demand sustainability isn’t meaningful in an absolute sense, but it is meaningful if we condition on the growth of some nominal quantity such as the money supply, the price level, or nominal GDP. A certain level of aggregate demand may not be sustainable at a given rate of inflation, or at a given rate of NGDP growth, and thus there is no guarantee that the trajectory of nominal aggregate demand prior to 2007 was sustainable.

When Kelly Evans refers to a “boom that simply pulled forward demand from the future,” Karl Smith interprets this to mean that people were living above their means. But this is a supply-side interpretation: their means (supply) were not sufficient to sustain the pattern of consumption. I believe that the relevant interpretation is a demand-side one: people were choosing (demanding) a certain pattern of consumption based on false information. To say that their demand was “pulled forward from the future” is to say that they would, had they known the truth, have preferred to consume in the future rather than in the present (or in some cases, that their lenders, had they known the truth, would have preferred that the borrowers consume in the future instead of borrowing from them and consuming in the present)

The underlying problem over the past decade is excessive patience: everyone (by which I mean, mostly, the Chinese) wants to defer their expenditures into the future at the same time. But everyone can’t do that at the same time. In a perfect world, we would solve this problem by allowing prices to drop temporarily, far enough to convince enough people to take advantage of the low prices by spending today instead of in the future. But in the real world, price adjustment doesn’t happen quickly, and it often causes more problems than it solves.

So how do you get people to shift their expenditures into the present? One way is by fooling them. Make them think they’re richer than they really are. Make them think there are ultra-safe assets available to safeguard their future spending capacity. Find the people who want to spend today but don’t have any money, and make someone else think it’s safe to lend them money. But this solution is…unsustainable.

The sustainable solution, in theory at least, is to generate an expected inflation rate high enough that – at some positive interest rate – enough people will choose to spend money today instead of in the future. But that solution may not be on the table. Inflation rates much higher than 2% are heavily frowned upon by…just about everyone, it seems, except a few economists. Is 2% high enough? Who knows?

NGDP targeting is another solution, but is it sustainable? As I discussed at the end of my last blog post, and as Nick Rowe expands upon, NGDP (level) targeting would eventually succeed in raising demand, because every time it failed, it would then promise a yet more aggressive (and therefore more inflationary) policy. But what happens after it succeeds? Unless people have become less patient, we’re back where we started: everyone tries to shift expenditures into the future at the same time. The economy gets depressed again, and the cycle repeats.

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. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.

Can Knut Wicksell Beat Up Chuck Norris?

2011-10-24T09:53:00.000-07:00

Nick Rowe argues that NGDP targeting is a way of dealing with coordination failure. Businesses don’t want to hire if nobody’s buying, and households don’t want to buy if nobody’s hiring. So they’re all hoarding money instead. The way to fix it is that you have Chuck Norris threaten to beat up anyone who hoards money. Then businesses start hiring and households start buying (or else they both buy riskier assets, and the people who sold those assets do the hiring and buying, because they also don’t want to be beat up for hoarding the proceeds).

In the simplest version of the argument, beating people up is a metaphor for inflation. But if you don’t believe the Fed can produce more inflation (as many economists believe that the Bank of Japan has tried and failed to produce a positive inflation rate over the past 20 years), you can take beating people up as a metaphor for reducing asset returns. Even if the Fed can’t produce inflation, it can bid down the returns on a lot of assets until people get fed up and start buying riskier assets that can finance new expenditures. Some people don’t even think the Fed can do that, because maybe people have such a strong need for safety that they will only hoard more cash if other safe asset returns go down. I’m not 100% sure myself, but, for the sake of argument, I’m going to assume that the Fed can, if it is aggressive enough in buying safe assets, convince people to buy enough risky assets to get the economy going again.

Nick’s point, though, is that the Fed can do this without actually reducing the return on safe asests (and presumably without producing a lot of inflation either). Chuck Norris can clear a room without actually beating anyone up. The threat is enough. Similarly, in Nick’s view, the Fed can fix a coordination failure by threatening to reduce the return on safe assets, but it won’t have to carry out that threat if it’s credible. In fact, asset returns will go up, because the improved economy will make businesses more profitable, thus raising the return on risky assets and inducing people to abandon safe assets even if the yields go up. Paradoxically, by credibly threatening to push asset returns down, the Fed succeeds in pushing them up.

OK, fine. I’ll note that Ben Bernanke is no Chuck Norris, but perhaps President Romney will replace him with Chuck Norris, or with the antimatter counterpart of Paul Volcker (who was the Chuck Norris of inflation fighting). I’ll also note that Chairman Norris will enter with a considerable handicap, given that many are uncertain about the Fed’s ability to succeed in convincing people to abandon safe assets. If the threat were credible and everyone knew it to be credible, then everyone would know that stock prices are going up and they really ought to sell their bonds as quickly as they can, and we’d immediately be on the path to the good equilibrium. But even with Chuck Norris as Fed Chairman, a lot of people are going to think, “What if the Fed fails? At least cash is safe.” The threat alone quite possibly won’t be enough: Chuck Norris may well have to beat up a bunch of people – QE, Walker style – before the room clears.

But OK, I’m not opposed to violence, when it’s the only way to get something done. Only here’s my concern: how do we know that coordination failure is the real problem?

Flash back to 2006. There was no coordination failure then. Firms were hiring. Households were buying. Commerce was functioning smoothly. Very smoothly, too, in the sense that the economy was neither overheating (no rising inflation, no labor shortage) nor driving interest rates abnormally high. (The 10-year TIPS yield ranged from 1.95% to 2.68% in 2006, consistently below the perceived long-run real growth rate of the US economy.)

Yet that smoothness was based on being completely out of touch with reality – or at least out of touch with what most people today regard the reality to have been. By most accounts, housing prices were inflated, making people feel wealthier than they really were, and lots of seemingly safe assets were available, which, as it turned out, were not at all safe. Even with interest rates relatively low, this deception was apparently necessary in order to get households to buy and firms to hire in sufficient quantities to achieve full employment. Since the deception is no longer feasible, interest rates will presumably have to be a lot lower – even if we rule out coordination failure – in order to induce enough buying and enough hiring today to achieve full employment.

But how much lower? We can’t say exactly. Today 10-year TIPS are yielding close to zero. Is that low enough, if it weren’t for coordination failure? Maybe. Maybe not. Your guess is as good as mine. I can certainly imagine that could we fix the coordination failure (if there is one) and still end up producing well below our capacity.

That’s where Knut Wicksell comes in. Wicksell was the early 20th century economist who argued that prices would tend to go up or down depending on whether the interest rate was below or above its “natural” level (which varied over time). Modern interpretations allow for sticky prices and wages, so instead of falling prices, you get unemployment when the interest rate is too high. As I suggested in a post last year, and in the paragraph above, the “natural interest rate” could be negative, in which case a higher inflation rate is the only way to achieve full employment.

For practical purposes I advocate the same policy that Nick does – nominal GDP targeting – but I’m a bit less optimistic about how quickly and smoothly we could approach the target. And, given a choice, I’d probably favor a more aggressive target than Nick would. One of the implications of the Wicksellian analysis (which is not so clear if you think coordination failure is the only problem) is that more aggressive targets are easier to hit, because they imply higher inflation rates and therefore a lower floor on the real interest rate.

The important thing is to set a target path and stick to it even if you keep missing the first few targets by larger and larger margins. If the natural interest rate is negative, the early targets may be impossible to hit, but if you continue trying to hit the subsequent targets, those targets will imply higher inflation rates. Suppose your target path rises by 5% per year. A 10% increase in NGDP over two years may not imply enough inflation to get the real interest rate down to its natural level, but if NGDP doesn’t rise at all in those two years, the target path will now imply 20% NGDP growth over the subsequent two year period. That would require a lot of inflation – certainly enough to be consistent with a very negative natural real interest rate. Chuck Norris may take his hits in the first few years, but Knut is eventually going down.

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. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.

Fixing What’s Wrong with the Taylor Rule

2011-05-13T11:58:00.000-07:00

I see four problems with the original Taylor rule:

It’s not really a rule at all. The Taylor rule depends on an estimate of potential output. In practice, most of the discretion that goes into central banking is in the estimate of potential output. Even “discretionary” central bank policy is effectively constrained by the consensus of what would be considered reasonable policy actions, and any of those actions can be rationalized by changing your assumption about potential output. Usually, a central bank that has committed to following a “strict” Taylor rule has roughly the same set of options available as one that is ostensibly operating entirely on its own discretion.
It doesn’t self-correct for missed inflation rates. Since the inflation rate in the Taylor rule is over the previous four quarters, the rule “forgets” any inflation that happened more than four quarters ago. This is a problem for four reasons:
- It leaves the price level indeterminate in the long run, thus interfering with long-term nominal contracting and decisions that involve prices in the distant future.
- It leaves the central bank without an effective tool to reverse deflation when the expected deflation rate exceeds the natural interest rate.
- It reduces the credibility of central bank attempts to bring down high inflation rates, because the bank always promises to forgive itself when it fails.
- It aggravates the “convexity” problem described below, because the central bank effectively ignores small deviations from its inflation target, even when they accumulate.
It doesn’t allow for convexity in the short-run Philips curve. If the estimate of potential output is too low, for example, and the coefficient on output is sufficiently low, then, if the short-run Philips curve is convex, the central bank will allow output to persist below potential output for a long time before “realizing” that it has made an error. In the extreme case, where the short-run Phillips curve is L-shaped, the central bank may allow actual output to be permanently lower than potential output. More generally, the convexity problem can be aggravated by hysteresis effects, in which lower actual output leads to lower potential output, so that the central bank’s wrong estimate of potential output becomes a (permanently) self-fulfilling prophecy.
It can prescribe a negative interest rate target, which is impossible to implement. This appears to have been the case for at least part of 2009 and 2010, although there is disagreement about the details.

So how do we fix these problems? I suggest the following solutions:

Adopt a fixed method for estimating potential output. (One might allow future changes to the method, but they should be implemented only with a long lag: otherwise, they’ll interfere with the central bank’s credibility, since they can be used to rationalize discretionary policy changes.) Since I like simplicity, I suggest the following method: take the level of actual output in the 4th quarter of 2007 (when most estimates have the US near its potential) and increase it at an annual rate of 3% (the approximate historical growth rate of output) in perpetuity.
Replace the target inflation term with a target price level term. In other words, express it as a deviation from a target price level that rises over time by the target inflation rate. To be clear what I mean by the “target inflation term,” take Taylor’s original equation
r = p + .5y + .5(p - 2) + 2 (where p refers to the inflation rate)
and note that I am referring to the “p – 2” term but not to the initial “p” term, which is not really a target but part of the definition of the instrument (an approximation of the real interest rate). In my new formulation, “p – 2” becomes “P – P*,” where “P is (100 times the log of) the actual price level and P* is (100 times the log of) the target price level (i.e., what the price level would be if the inflation rate had always been on target since the base period).
Increase the coefficient on output. If you wish, in order to avoid a loss in credibility, you can also increase the coefficient on the price term by the same amount. What we have then is a more aggressive Taylor rule. It doesn’t solve the convexity problem completely, but it does assure that, when output is far from target, the central bank will take aggressive action to bring it back (unless the price level is far from target in the other direction). That way at least you don’t end up with a long, unnecessary period of severe economic weakness. (John Taylor claims that, according to David Papell’s research, there is “no reason to use a higher coefficient, and…the lower coefficient works better.” But that research only looks at changing the coefficient on the output term without either changing the coefficient on the inflation term or replacing it with a price term, as I suggest above. Having a too-small coefficient on the output term, as in the original rule, is only a second-best way of achieving the results that those other changes would achieve.)
“Borrow” basis points from the future when there are no more basis points available today. In other words, if the prescribed interest rate is below zero, the central bank promises to undershoot the prescribed interest rate once it rises above zero again, such that the number of basis-point-years of undershoot exactly cancel the number of basis-point-years of (unavoidable) overshoot. This method will only work, of course, if the market knows what rule the central bank is following, hence (among other reasons) the need for a rule that really is a rule. If the rule is well-defined, the overshoot will be well-defined, the market will expect the central bank to “pay back” the “borrowed” basis points, and the central bank will be obliged to do so in order to maintain its subsequent credibility.

OK, let’s look at the big picture. What have I proposed? I have proposed nominal GDP targeting (along with a specific method for how to implement it). When the price level term and the output term have the same coefficient and both are specified as a deviation from target, the Taylor rule can be simplified by combining the price level target with the output target. Combining Taylor’s original 2% inflation target (re-expressed as a price level path target as per my suggestion) with my suggested method for estimating potential output, we arrive at a 5% nominal output growth path as the target.

If you wish, you can go further by making the rule forward-looking (using a forecast of nominal GDP instead of a lagged observation) and increasing the coefficient to a very high number. And you can enforce the credibility of the forecast by requiring the central bank to use the forecast implicit in a publicly traded nominal GDP futures contract, so that the market is putting its money where the central bank’s mouth is. You end up with the proposal that Scott Sumner has already made. People seem to think that Scott Sumner’s ideas about monetary policy are far out of the mainstream. But I’m not proposing anything radical here, just trying to fix some problems with the very orthodox Taylor rule.

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. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.

Inflation Target Debate at The Economist

2011-05-08T19:03:00.000-07:00

I have been featured as a guest expert in an online debate about inflation targeting on The Economist's website. The topic: "This house believes that a 2% inflation target is too low." The debate is between Brad DeLong and Bennett McCallum, with Ryan Avent as the moderator.

Not Inflation

2011-03-27T18:55:00.000-07:00

I’m sick of hearing people complain about inflation. Unless your income comes from long-duration fixed-income investments, inflation has nothing to do with how much groceries and gasoline you can afford. Inflation is a pattern of increase in the general price level. What matters for affording stuff is a relative price, not the general price level. Specifically in this case it is the price of groceries and gasoline relative to the price of labor. And whether or not you like to eat iPads, the broader problem (for people with jobs) is not that the nominal price of groceries and gasoline is going up but that the real price of labor is going down.

In fact, when measured in terms of how much that labor can produce, even the nominal price of labor is going down, as illustrated by the last part of this chart from the Bureau of Labor Statistics:

Look at the last two years compared to the rest of the chart. As someone who thinks people are more important than gasoline, I’d say this looks a heck of a lot more like deflation than inflation.

And people are more important than gasoline – not just in the ethical sense implied by my snide suggestion, but in a cold, economic sense: labor is more important than energy as an input to the goods and services that get produced. Therefore if the price of labor is falling while the price of energy is rising, the pressure on the prices of goods and services is likely to be downward rather than upward.

Not that I’m expecting the prices of goods and services to start moving dramatically downward in the immediate future. After all, the price of energy has been rising faster than the price of labor has been falling. And the value of the dollar has been falling, while many of the goods Americans consume are produced abroad. And the price of labor is not necessarily going to continue falling. I will say, though, that I think the price of labor provides a strong anchor for the general price level: just as the gold standard provided assurances against runaway inflation, so the “labor standard” provides such assurances. In fact, the labor standard provides better assurances, because labor is the most important input into the production of many useful things, whereas gold is – well, just gold.

(You might object that we really aren’t on a labor standard, because unit labor costs could start rising at any time, and there is no guarantee that policymakers would resist such increases. All I can say is, if you think the gold standard provides a guarantee against changes in the whims of policymakers, you need to read about what happened in 1933 and 1971.)

I’m going to go further and say that I think the falling real price of labor is a good thing, at least in the short run. I’ll even say that rising food and energy prices, while not good in themselves, are symptomatic of something good that is happening and that I would like to see accelerate rather than decelerate.

The flip side of falling real wages is rising profit margins. In a simplified closed economy this would be trivially true: the profit margin for businesses in aggregate would be the difference between the prices they charge and the wages they pay, i.e., the inverse of the real wage. It’s also true to a lesser extent in the real world, although the situation is more complicated because there are imports and exports, and labor and capital are not the only inputs.

What we experienced in 2008 and 2009 can be seen as a dramatic decline in the willingness of aggregate business to produce more for any given level of the aggregate profit margin. (Obviously, the phrase “aggregate business” hides a lot of critical details: part of the problem was with banks’ willingness to lend; part was with hoarding of cash by large corporations; part was with investors’ preferences over public vs. private sector assets; and so on.) What we need to do to fix this problem (and what we are doing, to some extent) is to make profit margins so high that businesses are willing to expand despite their newfound conservatism.

And it should be noted that there is a continuum of price flexibility. At one end, wages are perhaps the least flexible; at the other end, commodity prices are the most flexible. But there is a whole range in-between. When demand picks up, commodity prices rise first, product prices rise more sluggishly (with varying degrees of sluggishness), and wages rise most sluggishly. If the objective is to raise profit margins, then product prices have to rise more quickly than wages, and an inevitable side effect is that commodity prices will rise even faster than product prices. To the (limited) extent that rising commodity prices represent domestic US demand, they are a sign of a process that needs to be encouraged, not discouraged.

In the intermediate run, the evidence is clear that real wages are procyclial. When a recovery really gets going, real wages eventually rise, presumably because the economy as a whole becomes more efficient and “a rising tide lifts all boats.” In the short run, though, we need to get the recovery going before this can happen, and the way to get the recovery going is to let real wages fall – or at least rise more slowly than productivity. Say what you like, I’m cheering for rising prices.

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. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.

There Is No Such Things As Monetary Policy

2010-12-10T08:26:00.000-08:00

In my last post, I argued that bank reserves, if they pay interest, are essentially a form of government debt. They’re issued by a different institution and have a different maturity than most government debt, but in their essential nature, they’re just a special case of government debt.

In that post, I was agnostic about whether bank reserves should be considered “money.” If bank reserves are government debt, then, to be consistent, we should either consider all government debt to be money or consider bank reserves to be something other than money. In particular, Ben Bernanke’s use of the phrase “printing money” is consistent if you consider all government debt to be money, in which case QE2 only exchanges zero-maturity money for high-maturity money whereas QE1 exchanges money for private sector assets. If you take the second option, however, then neither QE1 nor QE2 was “printing money.”

I want to explore that second option, which seems pretty reasonable in terms of the way I learned liquidity preference theory in school. In the simplest version of liquidity preference theory, money (1) pays no interest and (2) is controlled by policymakers. Obviously bank reserves no longer meet the first criterion, and bank deposits (as we learned painfully during the policy experiment of the early 1980’s) do not meet the second criterion. I’m increasingly coming to believe that the most reasonable definition of “money” is simply “cash” (negotiable central bank notes plus coins).

But the Fed does not attempt to control the supply of cash. Banks can withdraw reserves from the Fed, or deposit them, whenever they choose, and the Fed will normally compensate for aggregate net withdrawals or deposits by adjusting the total level of reserves to bring it back to where it was before the net withdrawals or deposits took place. Moreover, the amount of cash outstanding, as determined by the demand for cash, is not a significant factor in the setting of Fed policy. If “money” simply means cash, then the Fed’s “monetary policy” is unlimited accommodation. And moreover, nobody cares, or should care, about how this policy is going. For practical purposes, there is no such thing as monetary policy.

The Fed does do something active, and they call it monetary policy. But what is it really? The Fed does several things that usually come under the heading of monetary policy, but they can all be reasonably classified as something else. For one thing, it manages the level of bank reserves through open market operations. But this is really government finance policy, not monetary policy: it consists of substituting zero-maturity government debt (bank reserves) for higher maturity government debt (Treasury securities), or vice versa.

The Fed also sets the interest rate on reserves. This is also government finance policy. Suppose that, instead of auctioning off fixed quantities of securities, the Treasury were to sell as much as it could at a given interest rate and leave any excess cash in a vault. If we’re talking about, say, one-month T-bills, which have only slightly higher maturity than bank reserves, then the effect would be essentially the same as when the Fed sets the interest rate on reserves. (In particular, imagine that, starting from today’s near-zero interest rates, the Treasury were to start selling T-bills with a fixed 1% yield. That would be just like an increase on the interest rate on reserves, except that others besides banks could participate. That difference is really irrelevant except for the arbitrage opportunity provided to banks when the IOR rate exceeds the T-bill rate. If the IOR rate were to rise, banks – being in competition with one another for funds – would have an incentive to let others participate indirectly.)

Granted, this doesn’t work in reverse: the Treasury needs to borrow a certain minimum amount to finance its expenditures, so it can’t set an arbitrarily low interest rate. But it doesn’t work in reverse for bank reserves either. If the Fed sets the IOR rate far below the T-bill rate, it becomes irrelevant: banks will simply hold, for emergency purposes, a tiny amount of reserves over and above what is required, and the rest of their reserve assets they will hold as T-bills, which can easily be sold or repoed for federal funds if necessary.

The Fed also sets the reserve requirement, thereby compelling a demand for reserves, but this is not monetary policy either; it is regulatory policy. There is a regulation that requires banks to hold a certain quantity (set by the Fed) of zero-maturity government debt (reserves). There are other regulations that effectively require banks to hold certain quantities of more broadly defined safe assets to satisfy capital requirements. All these regulations create an increased demand for government debt; it’s only the maturity of the debt that is different. To the extent that such policies are used for macroeconomic demand management, they are essentially a form of taxation: the Fed can pay a lower rate of IOR than it otherwise would because it is compelling banks to hold reserves instead of using the money for profitable activities; it could achieve the same effect by raising IOR until those activities are no longer profitable (in risk-adjusted opportunity cost terms) and taxing the banks an amount equal to the difference in the interest they pay. To the extent that regulatory policy is used for macroeconomic demand management, it is just a form of fiscal policy.

Finally, the Fed lends (or purchases the assets from those who have lent) to the private sector, via its discount window, via various emergency programs in times of crisis, and in particular via QE1. But this isn’t monetary policy; it’s fiscal policy. It’s no different than what the TARP did: an exchange of government debt for private debt. Anything the Fed does through such programs could also be done by the Treasury, which could issue T-bills to obtain funding, and it would surely be considered fiscal policy. The Fed issues bank reserves instead of T-bills: a slight difference of maturity, not a fundamental difference of substance.

So there you have it: there is no such thing as monetary policy. There is “central bank directed stabilization policy,” and, for convenience, you can refer to that as monetary policy if you want. If so, recognize that you are using the term loosely, and let’s not get into arguments about whether some particular Fed action is “really” monetary policy. None of it is really monetary policy.

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. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.

What Does “Printing Money” Mean?

2010-12-09T10:23:00.000-08:00

When I heard Ben Bernanke on 60 Minutes Sunday, I was initially taken aback when he said that QE2 did not constitute “printing money.” Obviously it’s not physically printing money, but nobody ever uses that phrase literally. If creating bank reserves is not “printing money,” then what is? My first thought, maybe he means that the increase in base money is not expected to lead to an increase in bank deposits. But if that’s the case, why would they be doing it? It’s hard to imagine QE2 being effective without causing bank deposits to increase. Sure, they may not increase via the textbook money multiplier process, given that reserve requirements are not currently binding and reserve ratios are not expected to be stable. But that’s a cop out: the Fed is increasing bank reserves; it hopes this action will lead, by whatever process, to an increase in bank deposits. How is that not printing money?

Apparently it gets worse. I had forgotten what Bernanke said on his earlier 60 Minutes appearance, but Jon Stewart has a clip where, in reference to QE1, Bernanke essentially acknowledges that the Fed is printing money. Naturally, Jon Stewart was amused by this seeming inconsistency, as was I.

But I’ve been thinking about this a bit more, and I no longer think Bernanke’s statements are inconsistent. The problem is that the definition of the word “money” is not as clear cut as it seems. Indeed, one might argue that the whole concept of “money” is no longer useful (at least to economists) in a world where bank reserves pay interest and people pay bills with credit cards and with checks drawn on bond mutual funds.

Long, long ago, before I started graduate school, I used to think that the concept of money was fairly straightforward. There was cash (Federal Reserve notes, as well as coins), and there was money in the bank, and those were money. And OK, there were money market mutual funds, and those were “sort of” money. When I really started to think about it, I realized this framework was inadequate, especially given the concept of liquidity preference that I was trying to use, where the cost of holding liquid money was supposed to be the interest rate. (Money market funds pay interest, and they’re almost just like money, and even some bank accounts pay interest, so apparently you can hold liquid money without giving up the interest, so where’s the cost?)

At the time I had a solution: stop thinking of bank accounts and such as money and instead just think of “outside money,” money created by the central bank. This approach sort of seemed to work. If you wanted to hold “money” in this sense, you had to give up the interest, and a bank’s willingness to pay interest on deposits (no longer considered money) was influenced by the amount of actual money that the bank needed to hold in order to maintain that deposit. And policymakers actually had control over this kind of money, so the concept fit well with the simple assumption that the quantity of money is determined by policy.

But in 2008, the Fed started paying interest on bank reserves. (Some other central banks had already been doing so for a while, but, being a provincial American, I hadn’t really noticed.) To be honest, it didn’t occur to me at the time, but this change totally destroyed my concept of money. If bank reserves pay interest, then they aren’t money, because you don’t have to give up the interest in order to hold them. But surely they are money, because monetary policy consists primarily of manipulating the quantity of bank reserves. Epistemological fail!

So are bank reserves money or not? I don’t know. But here’s something to think about: what is the difference between bank reserves and Treasury securities? They both pay interest. They’re created by different institutions, but so what? They’re both ultimately obligations of the government: the interest paid on reserves comes out of the Fed’s profits which would otherwise go into the Treasury.

You might say that Treasury securities have to be paid back, while bank reserves don’t, but that’s merely a function of the banks’ willingness to hold reserves: if the banks (and their customers) want cash instead, the reserves have to be “paid back” to the banks/customers. And if Treasury security holders want to roll over their securities, then Treasury borrowing doesn’t have to be paid back. So there’s no real difference there. The maturity is different, it’s true: bank reserves have zero maturity, while Treasury securities have maturities ranging from one month to 30 years. But that’s not a fundamental difference: it just means that bank reserves are a special case, not that they’re a different kind of entity.

OK, bank reserves can be used to fulfill reserve requirements, and Treasury securities cannot, but again so what? Banks are subject to a number of regulatory requirements, which depend on various aspects of their asset structure. There’s really nothing special about the reserve requirement. Today capital requirements are closer to being a binding constraint than reserve requirements, so for most banks Treasury securities are just as good as reserves when it comes to fulfilling regulatory requirements. Maybe someday in the future banks will once again have a particular need for Fed-issued zero-maturity assets to fulfill a regulatory requirement, but I don’t see how that makes such assets a fundamentally different type. Show me junk bonds, T-bills, and bank reserves, and it seems to me that, if anything, the bonds are the fundamentally different type of asset.

I submit that bank reserves are essentially just zero-maturity government debt. You can call them “money” if you want, but the application of the term is pretty arbitrary. And if you’re going to call bank reserves money, why not call T-bills money as well? And for that matter, T-notes and T-bonds: those are just long-maturity money.

So back to Ben Bernanke. What is QE2? It’s an exchange of bank reserves for longer-maturity Treasury securities: both forms of government debt; the only substantial difference is the maturity. QE2 is not, in any important sense, “printing money” but merely a restructuring of the government’s debt.

And what was QE1? It was (largely) an exchange of bank reserves for private sector assets, essentially an exchange of government debt for private debt. It’s very important that QE1 involved “printing” substantial quantities of government debt that would not otherwise have existed. That government debt happens to be “money,” though, rather than what we usually think of as government debt. So, rather than go through a whole explanation of how bank reserves are really government debt, the simple and substantively correct way of explaining QE1 is that it constituted “printing money” in exchange for private sector assets.

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. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.

Profits, Interest, and Inflation

2010-12-01T11:35:00.000-08:00

US corporate profits set a record in the third quarter. As Matthew Yglesias points out, that’s not as impressive as it sounds: profits are measured in nominal dollars, and they normally rise during times of economic expansion, so there’s nothing at all unusual about seeing them make new highs. After taking a closer look at the data, Justin Fox is even less impressed: as a fraction of the national income, domestic nonfinancial corporate profits are nowhere near a new high; the big numbers are coming from financial corporations (which are bouncing back strongly from the losses they had a few years ago) and from foreign earnings of US corporations. Kevin Drum is not quite so unimpressed, though: he looks at the data and sees domestic nonfinancial corporate profits recovering nicely in any case.

Count me with the unimpressed, but for different reasons. It’s really not appropriate, in my view, to look at profits in isolation from the rest of the national income. Profits are a form of capital income. Capital income can be roughly divided into profits and interest, depending on how the capital was financed. If we’re interested in the general profitability of business activities, rather than the narrow question of whether current stockholders are getting rich, we should be looking at total capital income. You might have noticed that interest rates are way down from where they were a few years ago, which probably means that there has been a substantial decline in the interest portion of capital income. So total capital income from domestic nonfinancial operations is almost certainly lower than it was before the recession.

It’s true that, even if capital returns are not very high, they can still be conducive to a recovery if the required return on capital has fallen. Indeed, the lowness of interest rates partly reflects attempts by the Fed to reduce the required return on capital. To that extent, we can be impressed by rising profits.

But the lowness of interest rates also reflects a decline in the expected inflation rate. This factor is not reflected in the raw profit statistics, and it does make them less impressive. In nominal terms, before the recession, corporations were expecting to see rising product prices, so, for any given nominal rate of profit, they were more likely to invest in new projects and more likely to hire. Today, product prices are not expected to rise very much, so today’s nominal profit has to “stand on its own,” as it were, as an indicator of how profitable any new project will be. So, by comparison, things are not going as well today as they might appear. As Justin Fox says, members of the domestic business community “have every right to be cranky.”

I do, however, concur with Matthew Yglesias’ conclusion that the trends are in the right direction. An increasing number of indicators suggest that things are improving, but I don’t expect the improvement to be rapid.

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. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.

I Didn’t Realize How Influential I Was :)

2010-11-29T15:09:00.000-08:00

I noticed this chart in David Beckworth’s blog. Here’s what I see. On June 16, I warned of the danger of deflation. The expected inflation rate immediately began to fall, and it fell by a total of about 50 basis points over the next two-and-a-half months. Then on September 1 (with the expected inflation rate near its low), I urged the Fed to take quick action as bond yields were getting dangerously low, leaving increasingly little margin for the potential effectiveness of monetary policy. The Fed then began hinting at policy changes (partly realized in the QE2 announcement), largely as a result of which the expected inflation rate has since risen by about 40 basis points.

OK, I can see I’m going to have to start writing some more blog posts, so you all will know what to do next. (By the way, Mr. Bernanke, I second what David Beckworth said in the post where the chart appeared.)

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. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.

Bond Market Instability in a Liquidity Trap

2010-09-01T10:18:00.000-07:00

For simplicity, let’s assume that the Fed’s policy instrument (now that the federal funds rate is stuck near zero) is the 10-year Treasury note. As an example, suppose the yield is 4%. In that case, it’s all but certain that the Fed, if it chooses, can do something to stimulate the economy and raise the inflation rate.

For example, suppose the Fed were to bid the 10-year note yield down from 4% to 1%. It would take out a whole slew of marginal noteholders in the process. Banks that had been satisfied with a 4% return would be unsatisfied with a 1% return and would lend more aggressively. Domestic investors that had been satisfied with a 4% return would be unsatisfied with 1% and would bite the bullet and buy stock. International investors would be unsatisfied and would shift their investments into foreign assets, thus weakening the dollar and making US products more competitive. Households would refinance their mortgages and spend some portion of the increased cash flow. Others who previously couldn’t afford houses could now afford them, so demand for houses and home furnishings would go up. And so on. With such a huge policy action, it’s virtually certain that business activity would accelerate enough to reverse any deflationary pressure.

One way to think about that example is in terms of the natural rate of interest, the rate at which the prospective scenario theoretically crosses the line between disinflation and inflation. Suppose the expected inflation rate is 1.5% and the natural real interest rate on the 10-year note is 1%. Then, with a 4% yield, there is a disinflationary gap of 1.5% (that is, 4% nominal yield, minus 1.5% expected inflation, minus 1% natural real interest rate). If expectations remained constant, the hypothetical policy action – reducing the nominal yield to 1% – would reverse the 1.5% disinflationary gap into a 1.5% inflationary gap, thus switching the prospective scenario from one of disinflation to one of inflation.

However, expectations would not remain constant. Naturally, if the prospective scenario switched from disinflation to inflation, the expected inflation rate would rise. Moreover, since the inflationary scenario involves an economic recovery, the natural real interest rate would rise too. When disinflationary stagnation was expected, there wasn’t much reason to borrow money, or to invest the money one already had in any productive project, so it would require a very low interest rate to get an inflationary scenario going. When inflationary recovery is expected, there are much better investment opportunities, so even a relatively high interest rate could justify the kind of demand that would lead to recovery and inflation. Perhaps the natural real interest rate would rise to 2% and the expected inflation rate would rise to 2.5%, leaving a very large (3.5%) inflationary gap at a 1% nominal yield.

Indeed, these expectations would even create an inflationary gap (of 0.5%) if the yield were still at 4%. Thus the Fed could let the yield go back up to 4% and still produce the desired effect of stimulating recovery and raising the inflation rate. In fact, the Fed wouldn’t even need to bid down the yield in the first place. If the Fed had enough credibility, all it would have to do is threaten to bid down the yield. It’s even possible to come up with a plausible example where the Fed’s threat to bid down the yield causes the yield to go up. That’s the magic of expectations. And that’s why, when the yield begins at 4%, it won’t be very sensitive to disinflationary shocks. A disinflationary shock will push down the yield a little bit, but the Fed can make a credible threat to push it down further, and, paradoxically, the result will be a that it won’t have to go down further. Consequently, a yield of 4% is fairly stable.

But now let’s take another example. Suppose the yield starts out at 1%. The economy is expected to be weak, so the natural real interest rate (for the 10-year note) is 0%. Say the expected inflation rate is 0.5%, leaving a disinflationary gap of 0.5% even at the 1% nominal yield. What can the Fed do?

Theoretically, given the parameters that I’ve imagined, the Fed can still shift the scenario from disinflation/stagnation to inflation/recovery by bidding the yield down to zero. That would leave an inflationary gap of 0.5%. But in reality, we never know exactly what the natural real interest rate is. If the yield were 1% and the economy still appeared to be stagnating, bond market participants would rightly question the Fed’s ability to revive the economy. A drop in the yield from 1% to 0% might do the trick, or it might not. Given this lack of confidence in the Fed’s ability to revive the economy, the threat to do so (by hypothetically bidding down the yield) would no longer be credible. The only way the Fed could potentially revive the economy would be by actually bidding down the yield.

And what if the Fed chose not to do so? Since I’ve assumed a disinflationary gap, the inflation rate would, in the absence of policy action, tend to decline. To the extent that this decline were unanticipated, yields would then tend to fall. Thus, no matter what the Fed does or doesn’t do, the fact that the yield is low (and thus the Fed lacks a credible threat to revive the economy) creates a reason why the yield should go even lower.

Of course, in equilibrium, this decline should have been anticipated and should already have happened. But suppose there is a disinflationary shock. It has the direct effect of lowering the yield because it is disinflationary in its own right. But then it has the indirect effect of reducing the Fed’s ability to make a credible threat to revive the economy. This indirect effect causes the yield to decline more than it otherwise would. Thus, the lower bond yields go, the more unstable they become in response to shocks.

(Note that the process also works in reverse. If bond yields are low, and we are in an disinflationary environment, but we get an inflationary shock, not only does it raise the yield by increasing inflation directly, it also increases the Fed’s ability to stimulate the economy, thus adding an additional inflationary component and raising the yield still further. Conversely, when bond yields are high, there is little question of the Fed’s ability to stimulate the economy, so an inflationary shock does not alter that perceived ability, and it has only its direct effect on the yield.)

So what does all this mean? Well, for one thing, it suggests that, with bond yields having fallen significantly over the past few months, the Fed ought to get off its ass and start making credible threats to revive the economy before bond yields fall even more and reduce its ability to do so. For another thing, it means that we shouldn’t be too surprised to see the bond market behaving oddly. Whether or not one can reasonably call it a bubble (and the term may not be entirely inappropriate), it is quite normal for the bond market to react strongly to disinflationary shocks when the yield is already low.

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. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.

The Real Activity Suspension Program

2010-08-26T13:08:00.000-07:00

(Think of this as a guest post by the Cynic in me. I’m not sure my Cynic is entirely right on either the facts or the economics, but he has a provocative point. And I apologize for the fact that he misuses the word “recession” to include the period since our inadequate recovery began.)

Americans got angry when the federal government tried to bail out banks by buying assets or taking capital positions. Whatever you may think of those bailout programs, they at least had the advantage that taxpayers were getting something in return for their money. There is another bank bailout program going on now – one that allows the federal government to recapitalize banks with public money, receive nothing at all in return, and somehow escape criticism for doing so. That bailout program is called the Recession.

How does the Recession allow the government to bail out banks? With the recession going on, people are afraid to do anything risky with their assets, so they keep them deposited in banks, earning no interest. Banks can then invest these deposits in Treasury notes and credit the interest on those Treasury notes to their bottom line, thus improving their balance sheets. So the government pays to recapitalize banks while receiving nothing in return.

Now this bailout program is not without its risks. The biggest risk is that the economy will recover, which would be a disaster for the program. Suddenly, not only would banks be holding losses on their Treasury notes, but their cost of funds would go up, as depositors realized that there were more attractive investments available than zero-interest bank deposits.

Another risk, with similar implications, is an increase in the expected inflation rate. That would also lead to capital losses on the banks’ Treasury note holdings and an increase in their cost of funds.

Finally, there is reinvestment risk. Treasury notes mature and need to be rolled over, the coupon payments need to be reinvested, and banks have new inflows of funds that need to be invested. A substantial decline in the yields on Treasury notes (perhaps a continuation of what we are seeing now) would benefit banks in the short run because of the capital gains involved, but ultimately it would effectively terminate the bailout program, since banks would no longer be able to earn a large spread on their safe investments.

So the success of this bailout program depends on avoiding recovery, avoiding increases in inflation expectations, and avoiding major declines in Treasury note yields. Now do you understand why the Federal Reserve Bank presidents – representatives of the banking sector – are the most hawkish voices at the FOMC’s policy meetings?

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. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.

Do Umbrellas Cause Rain?

2010-08-24T12:50:00.000-07:00

In a recent speech Minneapolis Fed President Narayana Kocherlakota argues that low interest rates could ultimately be dangerous in that they could lead to deflation. His argument seems bizarre to me. I’ll go through it piece by piece.

The fed funds rate is roughly the sum of two components: the real, net-of-inflation, return on safe short-term investments and anticipated inflation.

OK, so far, so good. This is just the definition of the real return: it’s the return that’s anticipated after accounting for inflation.

Monetary policy does affect the real return on safe investments over short periods of time. But over the long run, money is, as we economists like to say, neutral.

I’ll agree to that, although I shall subsequently quibble with his definition of “neutral.”

This means that no matter what the inflation rate is and no matter what the FOMC does, the real return on safe short-term investments averages about 1-2 percent over the long run.

Not necessarily true. (The long-run real return on safe short-term investments depends on a lot of things besides what the FOMC does, and we can’t say a priori that it will remain in that range.) But I’ll accept it for the sake of argument.

Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition.

True, as far as it goes, but in his subsequent statement he’s actually talking about superneutrality – the proposition that the growth rate of the money stock (rather than its absolute size) doesn’t affect real activity – which is not entirely uncontroversial. But let’s grant superneutrality, for the sake of argument.

In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative. Why? It’s simple arithmetic. Let’s say that the real rate of return on safe investments is 1 percent and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25 percent. The only way to get that is to add a negative number—in this case, –0.75 percent.

Here Kocherlakota seems either disingenuous or irrational. It’s true that, in a long run equilibrium where the funds rate remains near zero, it also must be the case that there is negative inflation (provided that money retains any value at all). But how do we get to that long run equilibrium? And would we ever get to that equilibrium?

Suppose that the Fed were to keep the funds rate near zero but people began to be dissatisfied with that rate and began anticipating the 1% to 2% long-run real rate. What would happen? People would stop lending short-term money to the government at the near zero rate and instead start lending money elsewhere – for longer terms and to riskier borrowers. The more this continued, the easier it would get to borrow money. The easier it got to borrow, the more people would buy with the borrowed money, and the higher the prices of those purchases would go. And prices would continue going higher until...when?

Prices would continue going higher until they were so high that they were expected to fall. At that point, there would be expected deflation, and we would be at the long run equilibrium. There would be deflation, but it would necessarily be preceded by rising prices – that is, inflation.

However, there is no reason to expect that we would ever get to that long run equilibrium. Instead, if the Fed kept interest rates too low, we would move toward another long-run equilibrium – which Kocherlakota ignores – where money becomes worthless. In that case, the Fed could continue targeting near zero interest rates, but the rates would be meaningless, since nobody would be willing to sell anything, so there would be no reason to borrow money. Now I doubt we would actually get anywhere near that long-run equilibrium, because I think the Fed would raise interest rates long before money became worthless. But the dynamics of market responses will tend to drive toward the worthless-money equilibrium rather than the deflation equilibrium. Why would people ever start to think prices will fall after they start rising rapidly?

To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation.

OK, that is (almost) pure nonsense. It’s true that a low fed funds rate can exist, in long run equilibrium, only if people expect deflation (or if money is worthless). But the causation goes in the opposite direction. People lend at a low interest rate because they expect deflation. People carry umbrellas because they expect rain. An equilibrium with umbrellas must include a significant possibility of rain, but we don’t say that carrying umbrellas must “lead to” rain. If we take away people’s umbrellas, it will not prevent rain, and if we require people to carry umbrellas, it will not cause rain.

The good news is that it is certainly possible to eliminate this eventuality through smart policy choices. Right now, the real safe return on short-term investments is negative because of various headwinds in the real economy. Again, using our simple arithmetic, this negative real return combined with the near-zero fed funds rate means that inflation must be positive. Eventually, the real economy will improve sufficiently that the real return to safe short-term investments will normalize at its more typical positive level. The FOMC has to be ready to increase its target rate soon thereafter.

That sounds easy—but it’s not. When real returns are normalized, inflationary expectations could well be negative, and there may still be a considerable amount of structural unemployment. If the FOMC hews too closely to conventional thinking, it might be inclined to keep its target rate low. That kind of reaction would simply re-enforce the deflationary expectations and lead to many years of deflation.

That is pretty much the same nonsense as above, except for one thing: perhaps people believe that the Fed knows more about the likely inflation rate than outside forecasters do. If so, people could interpret the continued low interest rates as a signal that the Fed expects deflation, and the deflation could become a self-fulfilling prophecy. If that’s what Kocherlakota means, then he isn’t insane – but he’s still wrong.

The Fed does have a little more information than the public does. For example, it has a better idea of how its own policies will react in the future. And perhaps it has slightly better forecasts than the public. And maybe it has a little bit of inside information about the economy. People may take Fed policies as a signal of its expectations for future inflation, and may react accordingly, but this effect is likely to be far outweighed by the actions of people who disagree with the Fed – or who find the Fed’s expectations irrelevant to their own projects – and want to take advantage of its low interest rate policy.

What does it mean to say that “the real economy will improve sufficiently that the real return to safe short-term investments will normalize at its more typical positive level”? It means there will be opportunities for real investment that have more attractive expected returns. Even if the Fed’s actions lead people to increase slightly their expectations of falling prices, people will also notice these real investment opportunities and will start investing in those rather than in safe short-term investments. Or they’ll take money and spend it on consumer purchases in anticipation of continued employment. Either way, there will be more purchases made, which will tend to drive up prices, and the deflation prophecy will not fulfill itself.

Ultimately, as people notice the economy improving, they will come to expect rising rather than falling prices, no matter what the Fed does. Ultimately, the effect of having the Fed keep interest rates too low for too long will be inflation, not deflation. Of course, the Fed will notice this and then raise interest rates to slow down the economy and stop the inflation rate from rising further, so it shouldn’t be a big problem.

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. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.

What Housing Bubble?

2010-08-19T16:42:00.000-07:00

How does the world economy adjust when the propensity to save exceeds the propensity to invest? It has to adjust somehow, since total saving has to equal total investment. Broadly speaking, there are two mechanisms by which it can adjust. The first is that incomes can fall, held down by weak demand from firms choosing not to invest or households choosing not to spend. (This leaves less income available for saving and thus forces total saving to fall.) The second is that asset prices can rise, bid up by savers looking for a place to put their savings. (This increases the incentive to invest and decreases the incentive to save.) Over the past decade, the world has consistently faced an environment in which the propensity to save exceeded the propensity to invest, and various nations, at various times, have adjusted by one mechanism or the other. It should be obvious – and used to be obvious, at least to mainstream economists – that the latter mechanism is preferable.

During the recent US housing boom, I was of the school that believed rising house prices were an example of that preferred mechanism taking effect. At the time, I had plenty of company. Today – now that we have transitioned to the less preferred mechanism for equating saving and investment – my cohorts all appear to have deserted. Apparently it is now generally accepted that the rise in house prices was an aberrant bubble, justified only in the minds of irrational buyers who ignored the fundamentals and expected house prices to keep rising simply because they were already rising.

But what were the fundamentals? Certainly, if one had foreseen today’s circumstances, it would have been clear that housing was not a good investment. If one had been able to say, “In a few years, the unemployment rate will rise to 10%, the inflation rate will fall to nearly zero, and policymakers will be too timid to undertake the policies necessary to reverse those trends,” then it would have been clear that 2005 was not a good time to buy a house. But that’s not what most housing bears were saying at the time. And in any case, while investors must of course do their best to anticipate actual policies, it is hardly appropriate for economists to consider the anticipation of future policy timidity as part of the intrinsic fundamentals. It is hardly reasonable to declare an episode a bubble just because investors failed to anticipate the timidity of policymakers.

Less timid policies – which are indeed advocated today by a great many of the erstwhile housing bears – would have two salient features: a commitment (in some form) to higher inflation rates over the medium run and (in pursuit thereof) an aggressive attempt to reduce interest rates across the yield curve. Under those circumstances, houses – a classic inflation hedge that could be purchased with ultra-cheap financing – would seem like a very good thing to own. If such policies were undertaken, and housing prices were to rise once again to their former level, would the bears once again declare the housing market to be a bubble? Perhaps housing prices wouldn’t rise quite so much, but some asset prices would have to rise quite a lot to bring about full employment and moderate inflation. It seems to me that if one advocates such policies but is inclined to describe the result as a bubble, then one is taking a rather self-defeating attitude.

It is of course conventional (but wrong, in my opinion) to regard the current malaise as the result of the housing bubble’s collapse, so perhaps it will be argued that such asset-boom-inducing policies are needed now only because that housing boom already took place. That argument makes little sense to me. Back in 2003, as the housing boom was already taking form, the US economy was weak enough to raise deflation concerns at the Fed. The housing boom (along with its collateral effects on things like consumer spending) was precisely what drove the subsequent recovery and alleviated those concerns. And even with the tremendous stimulus of the housing boom, that recovery barely reached full employment and stopped far short of a macroeconomic boom. Surely, without the housing boom, the US economy would have remained weak, and we would have ended up in much the same situation we are in today.

I would challenge those who believe there was a housing bubble (which is, today, nearly everyone) to come up with a coherent and believable scenario in which those supposed bubble prices would have proven unjustified without either (1) bringing back the macroeconomic weakness and disequilibrium from which the housing boom originally extracted us or (2) being replaced by a “bubble” in something else. I submit that the term “bubble” is inappropriate. What we had were the makings of an equilibrium that involved very high asset prices (and low subsequent asset returns), the only equilibrium that would have allowed saving and investment to equate at a level high enough to avoid foregoing potential aggregate income. Perhaps, in 2006, housing prices were a little bit overvalued relative to that equilibrium, while some other asset prices were a little bit undervalued; but in general, very high asset prices were a critical feature.

In any case we are far away from that equilibrium today. Asset prices are far too low to bring us anywhere near full employment. Relative to that “classical” equilibrium, asset prices are far below where they should be, and prospective asset returns are far above where they should be. That’s not to say that prospective returns are necessarily high in historical terms: in the classical equilibrium, when a lot of people (and nations and institutions) are trying to save, they bid down the returns that can be earned on those savings. And that’s just the thing: we need to get to the point where houses (and stocks and bonds and everything else that people hold for the future) are very expensive, not because prices are expected to keep rising forever but because people realize that low returns are the best deal they’re going to get. Along the way to that equilibrium, though, asset prices will have to rise. Unfortunately, current policies do not appear to be moving us in that direction – at least not very quickly.

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. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.

What Will Happen If the Fed Stops Paying Interest on Reserves?

2010-08-09T13:15:00.000-07:00

Banks will try, ultimately unsuccessfully, to get rid of their reserves by exchanging them for T-bills and other safe, liquid, short-maturity assets. Collectively, they will be unsuccessful because the previous owners of those assets will deposit the proceeds back in banks, leaving them with the same level of reserves. Some of the reserves that were previously excess reserves will now be required reserves, given the higher level of deposits. Most, however, will probably still be excess reserves, as banks will continue this process only until it has driven down the yields on T-bills and similar assets to the point where those assets are no more attractive than zero-interest reserves.
As a result, the yield on short-term T-bills (currently about 14 basis points for the 3-month bill) will go down to zero (approximately), and returns on similar assets (longer-term T-bills, top-grade commercial paper, repos, etc.) will go down to near zero. But no yields will drop by as much as 25 basis points (because none of those assets are perfect substitutes for reserves), and most will drop by considerably less.
As a further result, yields on nearly all assets will drop very slightly, depending on how closely they substitute for reserves and how long the zero interest rate on reserves is expected to be in effect (and to what extent it was already anticipated as a possibility).
Banks will make a few more loans. Loans are a high-return, high-risk asset, while reserves are a low-risk, low-return asset. They are not close substitutes at all, but they aren’t completely irrelevant, so banks will slightly lower the interest rates on loans (by less than 25 basis points) and probably slightly ease their credit standards and pursue lending business slightly more aggressively. Banks may also be willing to make more loans because they have more assets (due to deposits by those who sold them the T-bills and such), but this effect is also not likely to be large, since Banks’ primary constraint today is capital rather than liquidity.
Banks will stop borrowing from GSE’s in the federal funds market, since they will no longer be able to arbitrage with the interest on reserves.
As a result, the federal funds market will essentially disappear. Since banks are seldom, if ever, short of reserves in today’s environment, there will not be any reason for them to borrow.
Also, GSE’s will instead purchase T-bills and similar assets, thereby contributing to the already noted small declines in yields.
Because yields will now be far too low to cover their expenses, most money market funds will go out of business, and the few remaining will need to be subsidized heavily by their management companies (essentially operating the funds either as a courtesy to customers who use their other products or for the purpose of keeping the infrastructure and/or reputation alive so that it will be available at some future date when the funds are once again able to generate enough income to pay expenses). As implied by the first point in this list, banks will have taken over the role of money market funds. (Technically, this will amount to an increase in M-1, with little change in M-2. If there are still any M-1 fixated monetarists out there, they’ll get very excited.)
With a much larger deposit base than they need, banks will stop encouraging customers to make deposits. Fees will go up. New fees will be introduced. The quality of customer service will go down. Nonessential features will be eliminated. Banks will no longer try to make it easy to open an account. Large depositors will no longer receive any special treatment.
As a result, customers will, on average, hold a bit more of their cash in the form of currency rather than bank deposits. Marginal bank customers won’t bother to open accounts; customers who do have accounts will do fewer transactions; etc. (This implies an increase in the monetary base, assuming that the Fed accommodates the additional demand for currency. But note that this is not an economic stimulus, because it is demand-driven. The Fed will increase the supply of currency only enough to meet the increased demand, so there will be no change in the “value” of currency.)
Bank customers will also participate in the declines in yields described in the third point on this list. As bank accounts will be less convenient and more costly, while money market funds will be largely gone, customers will branch out into using other assets (such as short-term bond funds) for transactions.
Any number of other things will happen, which I haven’t thought of yet, and many of which nobody has thought of. Some will be good; some will be bad; many will be disruptive.
The Fed’s profits will go up slightly (and therefore the federal deficit will go down slightly), since it will no longer be paying the interest on reserves.

All in all, we get a mild economic stimulus at the price of some substantial disruptions to the financial system. On my list of priorities, when the two are in conflict, the convenience of a smoothly functioning financial system comes far below the need to create jobs and resist deflation, so if eliminating interest on reserves were the only monetary stimulus option on the table, I would support it. But it’s not the only option. Perhaps if the money the Fed saves from not paying interest on reserves were to be devoted to a well-targeted fiscal stimulus, this option would be more attractive. But that isn’t likely to happen. I won’t say I’m against eliminating interest on reserves, but I’m not particularly in favor of it. Better to do more asset purchases. Much better (in conjunction with asset purchases as necessary) to announce retroactively extrapolated nominal GDP or price level targets. But is any of this going to happen?

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. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.

Inflation Targeting When the Natural Interest Rate is Negative

2010-08-09T10:18:00.000-07:00

Over a century ago, in a theory that is still influential today, Swedish economist Knut Wicksell argued that, at any particular time, there is a certain “natural rate of interest” that is consistent with price stability. If the actual rate of interest falls below the natural rate, there is an incentive for entrepreneurs to borrow aggressively and demand more goods and more labor, driving prices up. If the actual rate rises above the natural rate, the incentive to borrow disappears, leading entrepreneurs to demand less goods and labor, driving prices down. Since the opportunities available to entrepreneurs are always changing, the natural rate is always changing, sometimes rising dramatically and at other times falling dramatically. Thus Wicksell argued that, relative to the natural rate, “the interest on money is, in reality, very often low when it seems to be high, and high when it seems to be low.”

As applied to the world we live in today, Wicksell’s original theory has several shortcomings, all widely recognized now. First, it doesn’t account for stickiness in wages and prices: as we observe, the short-run effect of a drop in demand is not so much a fall in wages and prices as a fall in employment. Second, it doesn’t account for the role of expectations in determining the price level and thus, the possibility of “inertial” inflation: it is now generally understood that (under a fiat money regime) a steadily rising price level, rather than a necessarily constant price level, is consistent with the equilibrium “natural” interest rate that Wicksell hypothesized. Third, it doesn’t fully account for the role of inflation expectations in defining the “real” interest rate: for example, a 2% nominal interest rate when prices are expected to be constant is equivalent to a 4% nominal interest rate when prices are expected to rise at a 2% rate. Finally, as I discuss below, it doesn’t account for the role of risk aversion in determining the behavior of entrepreneurs and those who finance them.

Wicksell argued that the natural interest rate was determined by the rate of return on capital. But in practice, the rate of return on capital is never known exactly in advance. Entrepreneurs require a compensation for the risk involved, and lenders (and buyers of stock and other forms of financing) require a compensation for the risk involved in financing them. As a result, particularly in times which are uncertain and when people are particularly risk-averse, there can be a very large wedge between the natural “risk-free” rate of interest and the rate of return on capital. One consequence of having such a large wedge is that, even if the return on capital is necessarily expected to be positive, the natural interest rate can be negative.

When the natural interest rate is negative, since it’s impossible to cut nominal interest rates much below zero, the only way to get back to normal is to create an expectation of inflation. If the nominal interest rate is zero and the inflation rate is positive, then the real interest rate is negative; thus it is possible, with a sufficient amount of expected inflation, to set the real interest rate down to the negative natural rate. But how can that inflation be achieved? Wicksell argues that prices rise when the actual interest rate falls below the natural rate, but in order for that to happen, prices must already be expected to rise. Can a central bank pull itself up by its own bootstraps?

The answer is almost certainly yes, since nearly everyone agrees that a sufficiently reckless central bank will always be able to produce a high inflation rate. (Imagine the Fed buying up the entire national debt, along with all the private sector’s offerings of commercial paper, mortgages, corporate bonds, and so on. Eventually, there will be inflation.) The problem is that it is hard to estimate in advance how aggressive monetary policy needs to be in order to produce the needed expectation of inflation. Not only doesn’t the central bank know what actions would produce a given “happy medium” target between too-low and too-high inflation expectations; it never really even knows what the natural interest rate is, so it doesn’t know how much inflation would be enough to get the real rate down to the natural rate.

If the central bank estimates wrong and overshoots, it risks a period of very high, and unnecessarily high, inflation. If (as seems infinitely more likely to me) it estimates wrong and undershoots, it risks reducing its credibility, so that it becomes more difficult, subsequently, to achieve the necessary inflation rate. (Note BTW that if you take the Mankiw Rule as an estimate of the natural interest rate, then the Fed’s current 2% inflation target is not high enough: the Fed is on a course to fail and thereby reduce its subsequent credibility.)

The solution is to aim not for an inflation rate but for a price level (or, as I suggested in my previous post, a level of nominal GDP). A series of price level targets that rises over time, but that does not get revised when the central bank undershoots or overshoots, allows for policy that automatically becomes more aggressive (or less aggressive) as necessary. If the central bank undershoots the first price level target, the second target is still in place, and this means it must aim for a higher inflation rate. If it undershoots the second target, the third is still in place, and it must aim for yet a higher inflation rate. And so on. Eventually, it will (automatically) find the inflation rate that works.

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. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.

Nominal GDP Targeting: the 24-7 Solution

2010-08-04T09:31:00.000-07:00

Though I’m skeptical of some of his specific proposals, Scott Sumner has convinced me that nominal GDP targeting is the way to go. I’d like to propose the following law:

The Board of Governors of the Federal Reserve System shall conduct monetary policy in such a way as to increase the nominal gross domestic product to approximately $24 trillion in the year 2017.

I choose 2017 because it’s 10 years after the end of the last growth cycle, and I choose $24 trillion based on an approximate extrapolation of the growth rate from 1997 to 2007. (You get why I like the numbers 7 and 24, right?) This is essentially a retroactive 10-year plan for monetary policy, but it leaves all the details up to the Fed.

I’m proposing this as a law to be passed by Congress, because it’s a little bit easier for me to imagine Congress passing such a law than the Fed making such a radical change on its own. Moreover, it would have more credibility if it were written into law rather than merely an announced policy of the Fed. It does take away a little bit of the Fed’s independence, but, as Dr. Phil might say, “How’s that independent central bank thing workin’ out for ya?” It fully retains the Fed’s operational independence, and it mandates an objective based on what the Fed was already achieving over the 10 years up to 2007 (and very roughly for the prior 10 years as well).

The law would need some sort of enforcement provisions, too, but these need not constrain any specific Fed actions. The Chairman would simply have to explain to Congress, on a regular basis, how the Fed plans to get from here to there. If the plan misses in the early years, it obviously has to become more aggressive in the later years – which is the whole point: the worse things get, the more dangerous it should become for banks, businesses, and individuals to keep sitting on cash instead of investing it. (If you want to give the Fed governors a bonus based on how close they come to the target, I’m down with that, too.)

After 2017, the Fed would be free to go back to its discretion in setting long-range policy goals. But it will have an incentive to continue nominal GDP targeting. It may even ask Congress to pass another law. What incentive? To make up for the abysmal performance of 2008-2010, the 2017 goal will almost certainly require the Fed to allow an inflation rate greater than 2% – possibly much greater than 2% – as 2017 approaches. The Fed will then need a credible way to bring the inflation rate back down. What could be more credible than a promise to continue the nominal GDP pattern of the past 20 years? (Remember, the $24 trillion goal for 2017 was based on an extrapolation of the 1997-2007 trend..)

I would hope that the Fed would then elect to continue with nominal GDP targeting. In the longer run, it’s a policy that solves the problem I discussed when I wrote about inflation targets and financial crises. A financial crisis will (if history is any guide) reduce expectations of real growth. If the Fed is targeting nominal GDP, then inflation expectations should automatically increase when real growth expectations decline. This automatically gives the Fed more room to cut the real interest rate so as to clean up the economic fallout from the financial crisis. And nominal GDP targets should also help prevent such crises by reining in real growth that is driven by speculation rather than actual improvements in productivity. In such cases, inflation may not accelerate, but nominal GDP will, and this will automatically lead to an expectation of Fed tightening. Aside from the arbitrary connection with the numbers 24 and 7, nominal GDP targeting is a 24-7 solution in the sense that it reliably provides help in a variety of circumstances.

I’m hoping my law will receive bipartisan – or even tetrapartisan – support. Progressives can see it as a way to make up for the inadequacy of fiscal policy initiatives. Mainstream Democrats can see it as way to consolidate the gains of fiscal policy. Republicans can see it as an acknowledgment that Democratic fiscal policy initiatives were the wrong solution in the first place. And Tea Partiers can see it as a way to get the Fed out of the business of micromanaging the economy. I don’t really care how you sell it; it’s just a good idea. And since all but about 535 of the members of Congress read my blog...

Yes, I’m hoping that Congress will pick up ideas like this from people like Scott Sumner and me, but I’m not expecting it. I’m still long the bond market in my personal accounts. For the sake of the country, though, I’m begging Congress and the Fed. Take my capital gains. Please.

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. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.

Stop Worrying About Structural Unemployment

2010-08-02T08:53:00.000-07:00

The economic blogosphere has suddenly become very concerned about the possibility that structural unemployment – resulting from a mismatch between the needs of employers and the capabilities of available job-seekers – has increased in the US. Paul Krugman is worried; Brad Delong is convinced; it’s obvious to Tyler Cowen; The Economist presents a variety of opinions; and any number of other bloggers and fora have been discussing the topic.

One major source of this newfound concern is a post by Dave Altig of the Atlanta Fed, who has detected a shift in the relationship between job openings and unemployment – the Beveridge curve. While the shift is unmistakable in his chart (see below), I have looked more closely at the data, and I have come to the conclusion that it does not represent a major increase in structural unemployment. Rather, I believe it represents the normal dynamics of the business cycle in the context of an incipient recovery from a historically severe recession that, in some ways, has not quite ended.

First, let’s get a clear idea of what’s going on in the chart:

Consistent with a common practice by people (including me) who plot economic data, Dave Altig has drawn a linear regression line to represent the general relationship between job openings and unemployment. But we should not therefore assume that the true relationship is a linear one. If you ignore the regression line, you can see a distinctly curved pattern to the points. We should expect a curved pattern: a strictly linear relationship wouldn’t make sense, because it would mean that, if there were enough job openings, unemployment could go below zero, and if there were enough unemployment, job openings could go below zero. In practice, when one of the series gets very low, it becomes less responsive to the other series. Thus the pattern in 2009, where the unemployment rate keeps rising while job openings become nearly flat at a very low level, is exactly what one might expect. It’s certainly what I expected, having plotted curves like this before.

But the point labeled “2010 Q2” breaks the pattern. It appears that we’ve suddenly moved off the old Beveridge curve onto a new one that has yet to be traced and that promises to associate a significantly greater amount of unemployment with any given number of job openings. But have we, really?

To answer this question, we need to think about how job openings (as well as other factors) affect the number of unemployed workers. Take a look at the actual numbers: in 2010 Q2 there were about 15 million unemployed workers and just over 3 million job openings. If all 3 million job openings were filled, it would (other things equal) reduce unemployment to about 12 million. But if you were to plot that hypothetical point on the chart, it would still be above the old Beveridge curve. So even with what seems a rather optimistic assumption about the matching process, it was inevitable, given the appearance of a comparatively large number of job openings in Q2, that they produced a point that was off the old curve. That result has nothing to do with structural unemployment; it’s just because there are many more available workers than openings.

My assumption is not really as optimistic as it seems, though, because in fact job openings fill very quickly. The May (most recent) JOLTS report, for example, shows 3.2 million job openings but 4.5 million new hires – which implies that the average job opening gets filled in less than a month. What about all those employers complaining that they can’t find people with the right qualifications? Apparently they are a minority – or else they end up settling.

If we’re looking for evidence of an increase in structural unemployment, we need to compare the rate at which openings fill today to the rate at which they filled in the past. When was the last time that there were this many job openings? In November 2008, there were 3.2 million openings but only 4.1 million hires. So job openings are filling faster now than then. You might expect them to fill faster, since there are more unemployed people with whom to fill them (15 million vs. 11 million). Indeed, the fact that they fill only a little bit faster could be taken as evidence that some of the additional unemployment is structural. But these data don’t support the idea that there has been a dramatic shift, that the pool of the unemployed is a significantly worse match for the available job opportunities than it was a few years ago. To find a point where actual hiring was happening as quickly as it is today, you have to go back to August 2008, before the fall of Lehman, when there were 3.7 million job openings.

So if 4.5 million people (equivalent to 30% of the unemployed) find jobs in a given month, how come so many people are still unemployed? Because people are losing jobs almost as quickly. That’s what I meant when I said that the recession, in some ways, has not quite ended. While the average rate of job losses during the recent recession was not particularly severe, those job losses continued for a long time (as it was a long recession) and pushed more and more people into unemployment, while there was an unusual lack of new jobs to get them out of unemployment. The new jobs are finally starting to appear, but the job losses are continuing. When I declared last year that “job losses are not the problem,” it hadn’t occurred to me how long the job losses might last. By the standards of a recovery, job losses are the problem today.

Well, part of the problem. Notice that even after the recent jump, there are fewer job openings than there were at any time during the 2001 recession, and only about as many as there were at the depth of the 2003 “job recession” that lingered after the official recession had ended. Whether you measure in terms of job losses or job openings, the job market is still depressed. There’s plenty of reason to expect persistent cyclical unemployment. Structural unemployment, not so much.

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.

The Opposite of Monetization

2010-07-26T12:19:00.000-07:00

One objection to the Fed’s erstwhile policy of purchasing longer maturity Treasury securities was that the Fed was “monetizing the debt.” I find this objection odd. The Fed had set a near-zero target for the federal funds rate, and it was already committed, if necessary, to maintain this target by purchasing an indefinite quantity of Treasury bills. In practice it hasn’t had to do many such purchases, because there are plenty of private sector buyers willing to “monetize the debt” on their own, and when the Fed purchases other assets, the sellers of those assets go ahead and buy T-bills with the proceeds. But generally, open market operations – consisting primarily of purchases and sales of T-bills – are the normal method by which the Fed enforces its interest rate policy, and accordingly, “monetization” of some sort is inherent in the zero interest rate policy that was already in place when the Fed began its longer-maturity Treasury purchases (and that remains in place today).

It will be objected that T-bill purchases – even if they were actually happening – are temporary. T-bills mature quickly, and if the Fed buys T-bills today, it is not obliging itself to roll over those purchases when the bills mature. Thus it is only temporarily monetizing the debt, for such a short period of time that it hardly matters. By contrast, when the Fed purchases longer maturity Treasuries, it is paying for government expenditures without requiring to Treasury to repay any time soon.

But this view is deceptive. Assuming that the Fed maintains its resolve to prevent the inflation rate from rising significantly above 2%, and assuming that the economy does recover before the aforementioned securities mature (because otherwise the question is moot anyhow), the Treasury will have to repay the money. How will it have to repay the money, if the securities are still outstanding? Since the Fed’s profits go into the Treasury, any reduction in the Fed’s profits is equivalent to a payment by the Treasury. And if the economy does recover, the Fed will, to prevent that recovery from overheating, either raise the interest rate it pays on excess reserves or liquidate the Treasury securities at a loss. Either way, its profits go down, and the Treasury loses, just as if the Treasury had had to repay the money directly.

The real issue is whether the Fed will be tempted to abandon its inflation target. So let’s imagine the Fed, say, 5 years from now, under two different scenarios where the Fed faces a dramatic increase in the velocity of money and has to choose whether to allow inflation. In the first scenario, the Fed’s portfolio is full of long-term Treasury bonds. In the second, it’s full of short-term bills. Under which scenario will the Fed be tempted to allow inflation?

Under the first scenario, the Fed would have to choose whether to liquidate its Treasury bonds at a loss. If the Fed were simple-minded, it would be tempted to avoid the loss by holding on to the bonds and allowing the economy to overheat. But the Fed isn’t so simple-minded: Fed officials will be well aware of the effect that inflation would have on the value of their bond portfolio. If they don’t liquidate, they will face the same decision a year later under worse conditions. And if they don’t liquidate then, they will face the same decision a year after that under yet worse conditions. In all likelihood, they will follow the logic through to its conclusion and realize that they have little choice: holding the bonds to maturity is not really an option (unless they want to risk hyperinflation, which we can presume they won’t), and the best alternative is to liquidate the bonds before inflation becomes an issue, because waiting would only increase their losses. So a Fed with a portfolio of long-term bonds is not one that is likely to tolerate inflation.

Now look at the other scenario. With a portfolio of short-term Treasury bills, the Fed faces the decision whether to allow the economy to overheat and produce inflation. There are no losses to worry about, so you might think the decision would be easy: just sell some of the T-bills, contract the money supply, and avoid inflation. But there’s another consideration. If the Fed didn’t buy bonds in the first place, then those bonds remained in the hands of the public. This means the government will have to repay those bonds, which means that it may have to raise taxes or cut public services. Inflation is one form of tax, and when the public debt is large, inflation is a tax that can generate considerable revenue while arguably producing only a minimal amount of distortion in the economy. With no losses of its own to worry about, the Fed may quite rationally decide that an inflation tax is better than the alternatives. So, if anything, the temptation to allow inflation is higher when the Fed’s portfolio doesn’t include long-term bonds.

In terms of its likely implications for future inflation, buying longer-term Treasury securities is not monetization; it is the very opposite of monetization. This conclusion is actually a little bit disturbing, because it means that asset purchases by the Fed may have just the wrong effect on the real interest rate. Rational markets will anticipate less, not more, inflation when the Fed purchases long-term bonds, and this will only serve to make real investment less attractive – just the opposite of the intended effect. On the other hand, Fed bond purchases would have a direct effect on the real interest rate by reducing the available supply of bonds, and my guess is that this effect would outweigh any adverse effect via inflation expectations.

In any case, the implications for bond investors are unambiguous: Fed asset purchases are good for you. Some caveats are needed, though. The likelihood of additional asset purchases (if you believe there is such a likelihood) does not necessarily imply a buying opportunity, since the rest of the market may also be anticipating it. And one has to take into account a couple of important risks. The Fed could come to its senses and announce higher inflation targets, which would clearly be bad for bond investors (at least at a certain horizon, though the dynamics could be complicated). And Fed asset purchases (indeed, even those that have already taken place) may end up having the intended effect by getting a more solid recovery going. The big risk is that things will go back to normal.

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.

The Phillips Curve Today: Beware the White Swan

2010-06-16T08:32:00.000-07:00

The theory, at its core, is pretty straightforward: businesses compete with one another, and they’re constantly looking for ways to cut costs so they can increase – or maintain – their market share. The bulk of their costs are labor costs – wages and benefits. When the unemployment rate is low, it’s hard to reduce labor costs. Businesses are constantly finding ways to make workers more productive, but during good times, those increases in productivity are eaten up by increases in wages and benefits, which are necessary to retain workers who face relatively abundant alternative opportunities and relatively little competition. When the unemployment rate is high, businesses continue to compete by increasing productivity, but they can also compete by keeping wages down. Under those circumstances, they undercut one another’s prices, and the general price level tends downward.

It gets more complicated, of course. The largest complication is that businesses have relationships – and often contracts – with both customers and employees, and unanticipated changes in prices and wages can disturb those relationships. Consequently, businesses anticipate changes in prices, wages, and market conditions, and they set their own prices accordingly, in the hope of minimizing future surprises. As a result, inflation tends to have momentum. If prices have been rising by 2 percent per year, businesses anticipate that price growth, and the actual inflation rate – under idealized “normal” conditions – comes out close to 2 percent per year. But if the unemployment rate is very low, competition for workers forces businesses to raise prices more quickly, and the inflation rate rises. And if the unemployment rate is very high, competition for customers forces business to raise prices more slowly, and the inflation rate falls.

So much for the theory. I could add a lot more complications – the supply and demand for money, the difference between flexible and sticky prices, the impact of different degrees of competition, the various ways businesses might form expectations about prices, the relationship between unemployment and job vacancies, the possibility of structural changes in the economy over time, and so on – but let’s just stop here and take a look at the evidence in its simplest form. (To produce the chart below, I first took the rate of change in the core CPI from December to December for each year. Then I subtracted the previous year’s rate of change from the current year’s rate of change, for each year in the sample, and I plotted the result against the average unemployment rate for the current year. The core CPI series starts in 1957, so the first observation for which I could compute the change in the inflation rate is 1959. All the underlying data are from the Bureau of Labor Statistics.)

The correlation isn’t perfect – and we wouldn’t expect it to be, since there are other factors that affect the inflation rate in the short run. But it’s strong enough to be quite statistically significant.

And under today’s circumstances, it’s strong enough to be disturbing. The core inflation rate for 2009 was 1.8 percent. If you take the regression line at face value and plug in an average unemployment rate of 9.6 percent – a little toward the low end of what most economists expect for the year – it implies a 1.8 percentage point decline in the core inflation rate. And if you look at the actual data for January through April 2010, we are right on target for a zero percent core inflation rate. I probably don’t have to point out that the unemployment rate will almost certainly still be quite high in 2011, and it won’t be low in 2012.

The May CPI comes out tomorrow morning. It’s expected to show a very slight increase in core consumer prices. If it does show only a very slight increase, or no increase at all, how many will report that “inflation is still under control” and describe it as good news? If you’re worried about the black swan of inflation, I guess it is good news each month that the black swan doesn’t appear. But under today’s circumstances, the white swan – the common species that past experience would lead us to expect – is deflation.

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.

Second Dip?

2010-06-11T13:14:00.000-07:00

As you might surmise from the conclusion of my previous post, I have been worried about the possibility of a second dip, a new recession beginning sometime in the next year or so, before the current recovery has had a chance to produce much improvement. I was surprised to read (hat tip to Mark Thoma’s twitter feed) that Macroeconomic Advisors is suggesting that there is no chance of a second dip. (I was particularly surprised because MA’s own estimates of the growth impact of the waning fiscal stimulus were one of the reasons I was worried.) After reading their case for zero chance, I have to say that I am still worried. Verbally-intuitively, the case for a second dip still seems pretty overwhelming to me. I take comfort in the knowledge that I tend to have a pessimistic bias, and in the fact that sophisticated quantitative models are generally putting the odds of a second dip quite low. On the other hand, successfully forecasting recessions has not been a strong point of quantitative models.

Here is what I see as the case for and against a second dip. As you will see, I am more skeptical about the case against. Maybe someone can tell me what I have overlooked or how I am being too pessimistic.

The Case for a Second Dip

The Fed’s policy of quantitative easing, which was temporarily buttressing demand, is over, and its impact will likely decline over time, imparting a downward bias to growth in the coming quarters.
This fiscal stimulus, which was temporarily buttressing demand, has been largely exhausted and has likely reached its point of peak impact (even if additional fiscal measures are taken), so that its impact will be declining in the coming quarters, imparting a downward bias to growth.
Pent-up demand from consumers (many of whom were worried about the losing their jobs last year but no longer are) has been largely exhausted, and its impact will likely decline over time, imparting a downward bias to growth in the coming quarters.
The process of inventory adjustment has run its course, and firms have been able to increase production again to maintain inventories at the new, lower level and to begin slightly increasing inventories in anticipation of a recovery. Significant increases in production are no longer necessary to maintain inventories, so that an upward bias that has been imparted to growth in recent quarters will no longer be present in future quarters.
With the dollar relatively strong again and the pace of world recovery expected to slow, export growth, which had offered the possibility of a robust recovery, no longer seems to offer that possibility.
Normally, the surge in productivity at the beginning of a recovery is followed by a surge in employment. They typical lag is about two quarters. Last year’s surge in productivity took place over the last three quarters of the year, which suggests that a surge in employment should have taken place beginning in the last quarter of last year and continuing through the current quarter. Aside from temporary census employment, the anticipated surge does not appear to be taking place. Meanwhile, productivity growth has settled back into the normal range, which dampens hope for a future surge in employment.
The Bush tax cuts expire at the end of 2010, creating an incentive for high-income individuals (and their corporate agents) to shift income out of 2011 into 2010. To the extent that they are successful in doing so, and to the extent that the shifted income is associated with actual economic activity taking place during the period in which it is declared, we should expect a downward bias to growth between 2010 and 2011. (This point comes from a recent Wall Street Journal op-ed by Arthur Laffer, to which a colleague referred me. People who know my work well know that I have had my quarrels with Arthur Laffer in the past, but in this case, I don’t see any fundamental flaw in his argument.)
Given all these negatives, there is no evidence of any positive stimulus to growth that would offset them. The financial panic of late 2008 subsided long ago, and the residual financial weakness is lifting very slowly, with no suggestion that the pace of improvement will accelerate, especially in the light of potential fallout from financial difficulties in Europe. With capital ratios still an issue, the current regulatory environment is not conducive to rapid increases in bank lending.

The Case Against a Second Dip

In the years since the Great Depression, there is no precedent for a long recession (longer than 8 months, in this case about 18 months) followed by a short recovery (shorter than 35 months). The two closest “double dip” examples (both with first dips lasting 8 months or less) are 1980 – when the second dip was essentially intentional on the part of the Fed – and 1960 – when the economy had already made nearly a full recovery by the time the new dip happened. On the other hand, double dips appear to have been fairly common in the years before the Great Depression, so the validity of this piece of evidence depends on the premise that something (the fixed gold standard?) fundamentally changed in the 1930’s and has not since reverted.
Recessions seldom begin when the unemployment rate is already high. In particular, since the end of the Great Depression, we have not seen a recession begin with an unemployment rate greater than 7.5 percent. (Today it is 9.7 percent.) Having said that, though, I should note that the second dip of the Great Depression began with an unemployment rate of over 14 percent. (Presumably the reason this happened in the 1930’s is that fiscal and monetary policy were tightened, whereas in subsequent cycles fiscal and monetary policy have generally been loosened when the unemployment rate remained very high. Unfortunately, in the light of the first two points adduced in favor of a second dip, this contrast doesn’t bode well for the immediate future.)
Recessions are normally preceded by stock market declines of greater severity than what we have seen recently. (Of course, if your concern is whether to own stock, the fact that the stock market has not yet had a large decline isn’t much of a comfort.)
Credit spreads do not suggest a high risk of recession. (Again, if your concern is whether to own bonds, this is not much comfort. But perhaps the stock and bond markets should find each other’s lack of severe concern reassuring.)
The price of oil has been reasonably stable, not exhibiting the sort of spike that has helped induce most of the post-WWII recessions. (However, since the second dip, if it happens, is likely to have deflationary characteristics, we need to be concerned that any lack of strength in commodities such as oil could be in anticipation of a second dip.)
The yield curve (difference between long-term and short-term interest rates) is unusually steep. Recessions normally begin with a flat yield curve. Short-term interest rates normally fall during a recession, whereas a steep yield curve suggests rather that short-term rates are expected to rise. However, as Paul Krugman points out, this usual interpretation doesn’t apply now. If there is a second dip, short-term rates will not fall, because there is nowhere down for them to go. Under these circumstances, the steep yield curve likely only indicates the possibility of a rise in short-term rates (without the offsetting possibility of a fall), not the likelihood of a rise. In fact, it could be argued that the steep yield curve is reason to worry more about a second dip: in linear models, a false signal from the unusually steep yield curve could easily outweigh other indicators that are showing valid, but less intense, signs of trouble. (For example, the stock market hasn’t declined dramatically, but it has declined. Should we be worried? Ordinarily, with such a steep yield curve, the answer would be an unambiguous “no.” Today, we’re likely to hear that “no” from linear models, but it could well be based on a single indicator giving a flawed signal.)

It’s possible that the case for a second dip is basically right but that we still don’t technically get one. With normal productivity growth and population growth, we could have a severe slowdown, involving maybe one quarter of negative growth, or two quarters of very slightly negative growth, or three quarters of very slightly positive growth, and it might not qualify as a recession. Obviously, it would still suck.

What worries me particularly is that, even if the case for a second dip is completely wrong, the employment picture going forward is still dismal, and there is still a case for deflation. Am I wrong in understanding that this is standard textbook macroeconomics? There is a non-accelerating inflation rate of unemployment (NAIRU). When the actual unemployment rate is above the NAIRU, the inflation rate declines. The further the unemployment rate is above the NAIRU, the more quickly the inflation rate declines. The unemployment rate is currently 9.7% and is not expected to fall rapidly, even under optimistic scenarios. Recent estimates put the NAIRU at about 5%. The current core CPI inflation rate is about 1%. You do the math.

FOOTNOTE: Well, OK, technically you can’t do the math, since I didn’t give you a Phillips curve coefficient. From what I can tell, Phillips curve coefficients are all over the map these days, with some people arguing that the coefficient is zero as long as monetary policy is credible. (But is monetary policy really credible?) At the other end of the spectrum, coefficients with magnitude as high as 0.5 (implying a half percentage point decline in the inflation rate each year for every percentage point that the unemployment rate is above the NAIRU) seem to be well within the mainstream. I recommend against doing the math with that coefficient if you have a heart condition.

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.

The Mankiw Rule with Quantitative Easing: Why is the Fed So Tight?

2010-06-10T13:15:00.000-07:00

In my last post, I suggested that the Fed – at least if it behaves in a reasonable manner consistent with its past practices – is not likely to raise its federal funds rate target any time soon. I argued that the Mankiw Rule (a.k.a. Greg Mankiw’s version of the Taylor Rule) has done a good job of tracking Fed policy in the Greenspan-Bernanke era and that it has now fallen well into negative territory, out of which it will take some time to climb. Some commenters pointed out that, while the Fed obviously can’t make interest rates go negative, it did continue to loosen during the period of zero interest rates, by means of “quantitative easing” or “credit easing” – attempting to pull down the level of riskier or higher maturity interest rates by acquiring unconventional assets. I don’t think this observation really affects the main point of my previous post, but it it’s interesting to take a closer look.

So I tried to come up with a simple measure of monetary policy stance that incorporates both the federal funds rate and quantitative easing. My first thought was to look at the growth of unconventional assets on the Fed’s balance sheet, but as it turns out, it’s not really necessary to specify “unconventional” assets, since the Fed had already reduced holdings of its conventional asset – Treasury bills – to near zero by the time Lehman Brothers failed. We can therefore measure the subsequent quantitative easing as an unusually rapid growth in the Fed’s total assets – or equivalently total liabilities, which is to say, the monetary base. To get a composite measure, we need to somehow graft a measure of this monetary base growth onto the federal funds rate. The simplest way is to subtract the monetary base growth rate from the federal funds rate. Here I have chosen to use the average monthly growth rate over 12 months, because it was a simple specification that gave vaguely reasonable results. Those results are summarized in the chart below.

If you take this chart at face value, it looks like the Fed initially far overshot the level of easing prescribed by the Mankiw Rule, but remember that my choice of equivalence between interest rate percentage points and monthly growth rate percentage points was arbitrary. I could have used a weekly growth rate, and the picture would look quite different. Moreover, I could have used a 3-month or 6-month average instead of 12 months, though I think such choices would only have made the picture look even more strange. The one conclusion that is robust to reasonable changes in specification is that the composite measure is now moving close to zero again, even as the Mankiw Rule interest rate remains well below negative 3 percent. (It will likely rise slightly above negative 4 percent based on the May data, but I’m waiting for the CPI report before I update.) Quantitative easing is over, but the economic conditions that justified it are still with us – at least if we measure retrospectively.

Basically, once we recognize that quantitative easing is an option – and one that is no longer being pursued – we can draw the conclusion that the Fed is much tighter today than what the Mankiw Rule would suggest. Indeed, relative to the Mankiw Rule, the Fed is much tighter than at any time during the Greenspan-Bernanke years. Since 1957, when the core CPI data series begins, there have only been two times when the Fed was as tight as it is today relative to the Mankiw Rule. One was in 1973, when the effect of Nixon’s price controls was artificially reducing the retrospective inflation rate used in the Mankiw Rule. The other was during the early 1980’s, when the Fed was targeting monetary aggregates rather than interest rates and attempting (with great success) to reduce the inflation rate dramatically.

So why is the Fed so tight? Here are some possibilities:

Fed policy is better described by a rule that is non-linear in unemployment. With the unemployment rate so tremendously high, perhaps marginal increases in the unemployment rate affect the Fed less than they would if the rate were closer to normal. But given the Fed’s mandate to pursue high employment, wouldn’t the need for more aggressive monetary policy in response to higher unemployment rates be even more acute when the employment situation is already so obviously out of whack? And wouldn’t the unusually high unemployment rate, in and of itself, tend to eliminate the risk of pushing the unemployment rate too low and thereby free the Fed to pursue more aggressive policies than it otherwise would?
The Fed is anticipating dramatic declines in the unemployment rate and/or increases in the inflation rate. Except that we don’t see those in the Fed’s forecasts.
The Fed is correcting for its earlier overshoot, for being too loose in 2009. Except we’re not seeing much evidence that the overshoot (if there was one) needs to be corrected. There is no economic boom. The inflation rate has continued to fall. If the Fed did overshoot on the ease side, recent economic data suggest that, in retrospect, the overshoot was a good idea and not one that should be corrected by a reversal in subsequent policy.
The Fed is passing the buck to fiscal policy. But fiscal policy is tightening too now, in relative terms. It doesn’t seem likely that the Fed is irresponsible enough to base its policy on hypothetical fiscal policies that aren’t actually happening.
The Fed has “abandoned the Mankiw rule” and is now setting its policy stance according to very different criteria than it has used over the past 23 years. But is there any evidence that Ben Bernanke has had some sort of conversion experience? And is there any reason why the Fed would be interpreting its mandate differently than it has in the past?
The Fed has dramatically altered the parameters of its “Taylor Rule.” But why?
The Fed is uncomfortable with quantitative easing and would like to minimize its use and reverse it as soon as possible, irrespective of Taylor Rule considerations. I think we have a winner. The long term effects of quantitative easing are uncertain and could be seen as potentially dangerous. (What will happen if, at some point in the future, the Fed has to choose between liquidating its unconventional assets at a loss, exacerbating an inflationary environment, or raising interest rates high enough to risk a fiscal crisis?) So there is arguably reason for the Fed to be uncomfortable with it. But the implications are disturbing, if you believe in a Philips curve or anything like it. Faced with an excessively high unemployment rate and an excessively low inflation rate, the Fed is choosing to risk exacerbating the situation (i.e., to take the intermediate-term risk of deflation) rather than to risk a very different type of difficult situation in the distant future. Maybe it’s the right decision, but it’s an awfully scary one.

Here’s one way to think about the situation. Fed policy typically affects output and employment with a lag of less than a year. Over the past year, the Fed has tightened dramatically. The super-duper-easy aggressive quantitative easing policy of 2009 (especially early 2009) has given the US economy enough monetary fuel to get it almost to an employment growth rate (exclusive of the Census) that could stabilize, but not significantly reduce, the unemployment rate. That policy is gone. In order to believe that the economy is going to strengthen from here, you have to believe either (1) that the lag associated with monetary policy is longer than usual or (2) that the underlying strength of the economy, holding monetary policy constant, has improved dramatically. Maybe one (or both) of those things is true. Or maybe not.

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.

US Monetary Policy in the 2010’s: The Mankiw Rule Today

2010-06-03T13:49:00.000-07:00

To make a short story even shorter, the Mankiw Rule suggests that the Zero Interest Rate Policy will continue for quite some time, barring dramatic changes in the inflation and/or unemployment rates.

“The Mankiw Rule” is what I call Greg Mankiw’s version of the Taylor Rule. “Taylor Rule” is now the general term for a rule that sets a monetary policy interest rate (usually the federal funds rate in the US case) as a linear function of an inflation rate and a measure of economic slack. Such rules provide a simple way of either describing or prescribing monetary policy. Unfortunately, there are now many different versions of the Taylor Rule, which all lead to different conclusions. Not only are there many different measures of both slack and inflation; there are also an infinite number of possible coefficients that could be used to relate them to the policy interest rate. In fact, if you ask John Taylor today, he will advocate a very different set of coefficients than the ones he proposed in his original 1993 paper (pdf).

Parsimony suggests that a good Taylor rule should have 3 characteristics: it should be as simple as possible; it should use robust, easily defined, and well-known measures of slack and inflation; and it should fit reasonably well to past monetary policy. Also, to have credibility, such a rule should have “stood the test of time” to some extent: it should fit reasonably well to some subsequent monetary policy experience after it was first proposed. The Mankiw Rule has all these characteristics. It uses the unemployment rate and the core CPI inflation rate as its measures, and it applies the same coefficient to both. This setup leaves it with only two free parameters, which Greg set in a 2001 paper (pdf) so as to fit the results to actual 1990’s monetary policy. As you can see from the chart below, the rule fits subsequent monetary policy rather well, although policy has tended to be slightly more easy (until 2008) than the rule would imply.

You will notice a substantial divergence, however, after 2008, between the Mankiw Rule and the actual federal funds rate. If the reason for this divergence isn’t immediately clear, you need to take a closer look at the vertical axis. Extrapolating from pre-Lehman experience, this chart suggests that the Fed is still doing the best it can to approximate the Mankiw Rule. When banks lend money to one another in the federal funds market, lenders stubbornly refuse to pay for the privilege of lending, and this perversity does limit the Fed’s options.

If we wanted to make a guess as to when the Fed will (or should) raise its target for the federal funds rate, a reasonable guess would be “when the Mankiw Rule rate rises above zero.” When will that happen? (Will it ever happen?) Nobody knows, of course, but the algebra is straightforward as to what will need to happen to inflation and unemployment. If the core inflation rate remains near 1%, the unemployment rate will have to fall to 7%. If the core inflation rate rises to 2%, the unemployment rate will still have to fall to 8%. Do you expect either of these things to happen soon? I don’t.

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.

Inflation Targets and Financial Crises

2010-01-14T10:33:00.000-08:00

There are basically four ways to deal with the possibility of severe financial crises. First, you can just cross your fingers, hope such crises don’t happen very often, and live with the consequences when they do. Second, you can publicly insure and regulate your economy heavily in an attempt to minimize the risk and severity of such crises. Third, you can have your central bank monitor the fragility of general financial conditions and “take away the punch bowl” when it thinks conditions are in danger of becoming too fragile. Fourth, you can have your central bank target an inflation rate that is high enough to give it a lot of room to respond to a crisis (or an incipient crisis) by cutting interest rates far below the inflation rate.

For most of the past 20 years, the first approach – supported by a liberal dose of optimism that was buttressed (in the US, anyhow) by the experience of several financial crises with only mild consequences – was in favor. It’s suddenly unpopular now that we have gone through a crisis with severe consequences.

The order of the day seems to be some combination of the second and third approaches. Congress wants to overhaul financial regulation, and the Fed is reconsidering its erstwhile rejection of the role of bubble-popper. I am by no means the world’s foremost opponent of government involvement in the economy, but I find myself rather uncomfortable with these approaches, for much the same reasons that such a minarchist might be.

Regulation is costly, and I am skeptical as to whether Congress is smart enough, or has the right motivation (or the right group dynamic), to produce a regulatory regime that will be successful in achieving the benefit (avoiding future severe financial crises) without imposing unduly large costs. Regulators are human, subject to blind spots, bouts of unwarranted optimism and pessimism, and the temptation to rationalize actions that benefit their own interests more than those of the public. Without denying that some aspects of our financial system have been under-regulated in recent years (particularly given the public’s direct financial interest via actual or implied insurance programs), I question whether regulatory reform will be a significant improvement. Some things that have been under-regulated will be regulated appropriately, no doubt, but some things that have been appropriately regulated will become over-regulated, and some things that have been under-regulated will remain so.

As to the punch bowl approach, my concerns are similar. Undoubtedly there have been times when the Fed – if it had seen that as part of its function – would have popped an incipient bubble and avoided a much larger pop in the future. But if the Fed considered itself to be in the bubble-popping business, it might well have popped some healthy expansions long before they began to pose severe systemic risk. In retrospect, we can all agree that the last phase of the 1990’s tech boom was “bubbly;” but overvaluation concerns were being raised long before it reached that phase. If Alan Greenspan had followed up immediately on his famous 1996 “irrational exuberance” remark by using monetary policy to beat down that exuberance, I dare say the cost to economic growth would not have merited the benefit to financial stability. And, as it happened, by the time things had gotten dangerously bubbly, a lot of his skepticism seemed to have disappeared. A bubble is mediated through the public consciousness and reaches its peak when normal skepticism has all but evaporated. Are central bankers somehow immune to that consciousness?

The only conservative approach to the possibility of financial crises – the only approach that minimizes the damage without relying on authorities to behave better or more presciently than they normally do behave – is the last of the four I mentioned: inflation. Of the four approaches, it’s probably the least popular right now, especially among those who consider themselves conservative. All alike, populists, traditionalists, and technocrats hold that inflation is bad, and that low inflation, once achieved (as it has been) is so precious that it must be not be risked, let alone intentionally tossed aside, for the sake of some imagined greater good. That attitude brings to my mind the perfectly cleaned and ordered living room in which nobody is allowed to sit, lest they mess it up again.

Low inflation does have its advantages, but economists have been hard pressed to come up with any big advantage. The typical economic argument would be that the disadvantages of low inflation are even smaller than the advantages. But in the light of recent experience, that argument no longer holds much water: the big disadvantage of a low inflation regime is that, by putting a floor on interest rates that is not far below the inflation rate, it ties the hands of monetary policy when responding to a severe financial crisis. Surely, to the 17 percent of the today’s broadly defined US labor force who are wishing vainly for full-time employment (not to mention the apparent majority of Americans with full-time jobs, who, according to polls, suddenly hate those jobs, probably because they’re being asked to do the additional work of those whom their employers can no longer afford to keep on payroll, or because they feel their own job security in jeopardy), that should seem rather a severe disadvantage!

Among the most well-informed of the most vocal advocates of a low-inflation regime, the advantage cited most vociferously is stability. Only by maintaining low inflation rates, we are told, can central banks instill confidence in their policies. Even just raise the unofficial target from 2% to 3%, and all Hell will break loose, because….well, if 3%, then why not 4%? and if 4%, why not 5%? and if 5%, why not 10%? and so on. It’s a variation on the old “slippery slope” argument: not that we would actually slide down such a slope (since most sophisticated economists wouldn’t want to be caught making a standard slippery slope argument), but that it would be hard to give credible assurances to the contrary. The idea, I think, is that unless you can maintain something that looks reasonably close to true price stability (0% inflation), nobody will know what to expect. (2% is apparently considered close enough to zero – essentially the highest you can go and still be “close enough” to zero – and some argue that, once we have fully accounted for quality improvements, changes in consumer choices, and other such distorting factors, a measured 2% is more-or-less the same as a true 0%.).

Some would also argue that, whatever the ideal might be, an expectation of 2% inflation (actually just above or just below, depending on which price index you use) is what we have, what has crystallized over the past 10-15 years, and that it is therefore the only inflation rate about which we can have stable expectations going forward. It’s much easier to have confidence in a well-established existing regime than in a new regime that has only just been announced. Of course, this argument relies on the premise that markets do in fact still have confidence in the 2% regime – a premise for which supporters present as evidence the average results of long-range inflation expectation surveys. I do not find such averages very convincing. More people than usual expect deflation, and more people than usual (compared to the last 10 years) expect high inflation. And even those who expect canonical low-but-positive inflation – as the most likely single outcome – are more worried than usual that their expectations may be wrong in one direction or the other. Confidence – in low, stable, positive inflation – is not what I am hearing or seeing. Or feeling.

But this is one of those situations where you thank your adversary for bringing up the most important issue. “Stability” is what we all want. And it is precisely the pursuit of stability – in the long run – that leads me to advocate higher inflation targets. Let me, for the moment, concede, for the sake of argument, that higher inflation targets today might increase uncertainty, and that this increase in uncertainty might damage the recovery more than the expectation of higher product prices would help. Even so, the world does not end when this recovery is complete. (I do rather fear, however, that the world may end before the recovery is complete, only because the world must end eventually, and – in the light of Japan’s experience – there is no guarantee that the recovery will ever be complete.) Let’s suppose that the “stable inflation” medicine proves fully effective, the economy makes a complete recovery, and growth resumes a normal path --- for a while. What will happen next time there is a severe financial crisis?

Let’s distinguish between financial stability and economic stability. Financial instability often – but not always – leads to economic instability. I recall from 1987 (when I was in my first year of graduate school) a certain episode of financial instability in the equity markets. It didn’t last long, but it was huge news for a couple of weeks. It did not induce economic instability: in fact, it turned out to be almost a complete non-event economically. By contrast, instability in credit markets, over the past couple of years, has induced the worst economic crisis most living Americans can remember. The financial crisis itself has been a particularly severe one, and it would not have been possible to avoid some economic impact. But surely we could have gotten off with a much milder recession (and a more robust recovery than we are likely to experience) if the Fed had been able to pursue conventional monetary policy more aggressively.

But the Fed’s hands were tied. The Fed dropped its federal funds rate target by 5 percentage points in the year and a half following the onset of the financial crisis, and that was as far as conventional monetary policy could go. If the inflation target had started out at 4% instead of 2%, and the federal funds rate had started out at 7.25% instead of 5.25%, the Fed would have had a lot more ammunition. Moreover, the market would have known that the Fed had more ammunition, and investors would have been more confident in the Fed’s ability to minimize the economic impact of the financial crisis, and this would have made financial instruments less risky and thereby ameliorated the financial crisis itself.

You may therefore add my name to the list of those who blame past Fed policies for the severity of the recent crisis – but not because the Fed allowed a bubble to develop. Quite the contrary. The Fed eventually popped the previous bubble – the tech bubble – not because it was a bubble but because the economy was nearing the overheating stage, and the inflation rate risked eventually rising back to levels of a decade earlier. In my opinion, the Fed was wrong to pop that bubble. The Fed should have let the economy overheat, for a while, and let the inflation rate rise. (Higher future product prices might, in fact, have turned out to justify stock valuations that proved to be, in the retrospect of the path actually taken, unreasonable: a bubble is a slippery thing.)

I’m not saying that anyone at the Fed made a mistake. Indeed, Alan Greenspan handled that episode quite a bit better than I (and most others) expected, and quite possibly better than any of us would have under the same circumstances. I haven’t changed my opinion on that point: the Maestro conducted a near-perfect performance; all the instruments were in tune with one another, they entered precisely on the right beats, at just the right tempo, with just the right amount of “personal touch.” But the whole performance was in the wrong key.

In real life, I don’t have perfect pitch, and if I were listening to the performance in my metaphor, I might not notice anything wrong. But experience can be a substitute for ability. I’ve heard Beethoven’s Ninth Symphony performed in D minor enough times that, if I heard an orchestra perform it in E minor, I probably would notice that it sounded too high. I have been skeptical of the low inflation consensus all along, but I won’t fault those who were playing in the wrong key in 1995 or 2000 or 2005. But after 2008, we have the necessary experience. We’ve heard, first hand, how bad it sounds when the vocal soloist has to strain to reach notes that were easy for him to sing from the original score.

Admittedly, his voice is not nearly as strained as my metaphor, so I will say it in plain English. A number of economists have suggested higher inflation targets as a way to strengthen the recovery. Conventionalists counter that such targets, once implemented, will be difficult or impossible to replace once they have fulfilled their promise. But now, of all times, we should be aware of just why we should never want to replace them. Low inflation is what got us into this mess. And yet the consensus among policymakers seems stronger than ever: “Low inflation is awesome!” Dude, it’s lame.

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.

The Treasury’s Monetary Policy

2009-12-16T11:37:00.000-08:00

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.

Investment Makes Saving Possible

2009-11-23T15:25:00.000-08:00

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

2009-11-23T09:53:00.000-08:00

“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.

Prose Hack

2009-11-20T05:58:00.000-08:00

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.

Job Losses Are Not the Problem

2009-08-28T09:16:00.000-07:00

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.

Savings Rate Could Stay High

2009-07-29T20:33:00.000-07:00

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.

A Long Way to Inflation

2009-06-16T12:53:00.000-07:00

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:

Output must stabilize.
Output must start growing.
Output must grow faster than trend productivity.
Firms must slow layoffs to the normal rate.
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).
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.)
Hiring (which has been falling rapidly) must stabilize.
Hiring must rise to the point where it equals the normal rate of layoffs, to get total employment to start rising.
Hiring must become rapid enough that employment starts to grow faster than the population.
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.
The unemployment rate must start declining.
The unemployment rate must decline by 4 or more percentage points, which, by historical experience, will take a matter of years.
Firms must start competing for labor.
Firms must start raising wages.
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.

Ireland?

2009-04-21T08:06:00.000-07:00

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.

Oil Futures: Money for the Taking?

2009-04-16T16:49:00.000-07:00

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

2009-04-16T09:17:00.000-07:00

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.

Time for a Strong Euro Policy

2009-04-02T12:48:00.000-07:00

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.

Absolute Confidence?

2009-03-16T18:11:00.000-07:00

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:

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

The Treasury has a choice whether to finance long-term or short-term
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.
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.
Therefore, the Treasury controls the supply of long-term Treasury securities.
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.
Therefore (since bond yields – i.e., interest rates – depend inversely on prices), the Treasury controls the interest rates on its long-term securities.
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.
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.

Targets vs. Projections

2009-03-10T20:32:00.000-07:00

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.

Price Level Targeting: An Example

2009-02-13T13:21:00.000-08:00

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:

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.
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.
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.
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:

A	B	C	D	E	F	G

	price	implied	implied	implied	implied	implied
	target	annual	average	inflation	inflation	average
	core	inflation	inflation	target	target	inflation
	CPI)	target	target	over	over	target
			from	prior	prior	from
			year zero	5 years	10 years	year 5
						assuming
2008	216.1					zero
2009	219.3	1.5%	1.5%			inflation
2010	223.7	2.0%	1.7%			from
2011	230.4	3.0%	2.2%			year 0
2012	239.7	4.0%	2.6%			to year 5
2013	254.0	6.0%	3.3%	3.3%
2014	274.4	8.0%	4.1%	4.6%		27.0%
2015	301.8	10.0%	4.9%	6.2%		18.2%
2016	329.0	9.0%	5.4%	7.4%		15.0%
2017	355.3	8.0%	5.7%	8.2%		13.2%
2018	380.1	7.0%	5.8%	8.4%	5.8%	12.0%
2019	403.0	6.0%	5.8%	8.0%	6.3%	10.9%
2020	423.1	5.0%	5.8%	7.0%	6.6%	10.1%
2021	440.0	4.0%	5.6%	6.0%	6.7%	9.3%
2022	453.2	3.0%	5.4%	5.0%	6.6%	8.6%
2023	466.8	3.0%	5.3%	4.2%	6.3%	8.0%
2024	480.8	3.0%	5.1%	3.6%	5.8%	7.5%
2025	495.3	3.0%	5.0%	3.2%	5.1%	7.2%
2026	510.1	3.0%	4.9%	3.0%	4.5%	6.8%
2027	525.4	3.0%	4.8%	3.0%	4.0%	6.6%
2028	541.2	3.0%	4.7%	3.0%	3.6%	6.3%

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.

A Con Game Too Successful for Its Own Good

2009-02-09T17:27:00.000-08:00

As long as you’re willing to assume that the world will end some day and that the end will be known in advance, it’s a simple matter to prove by induction that money is worthless.

Consider the last minute of the world. If you were living in that last minute, would you accept money as payment for anything? Of course not. You wouldn’t have time to spend it, so what good would it be to you? In the world’s last minute nobody will accept money as payment and therefore it will have no value to anyone: it will be worthless.

Now consider some minute in time where it is known that money will be worthless a minute later. If you were living in that minute, would you accept money as payment for anything? Of course not. You wouldn’t have time to spend it before it becomes worthless, so what good would it be to you? A minute before money is to become worthless, it will already be worthless.

Therefore, according to the principle of mathematical induction, money is always worthless. It will be worthless at the world’s last minute; it will therefore be worthless a minute before that; it will therefore be worthless a minute before that; and so on. Go back as many minutes as you need to go back, and you can get to any point in time and show that money is worthless at that point in time.

Thus, fundamentally, money is worthless right now. But even people like me, who are well aware of this proof, are willing to accept money as payment despite its fundamental worthlessness. Money is valuable to us because we expect it to be valuable to someone else. And since we are reasonably confident in the monetary authorities’ ability to recruit new generations of victims in this endless Ponzi scheme, we willingly allow ourselves to become victims. All of which is very convenient because it allows us to use money as a medium of exchange, a unit of account, and sometimes even a store of value. And it allows authorities to manage the supply of money so as to minimize the frequency and severity of economic downturns.

It’s a nice con game, one where we may rightly cheer the operators, given that the success of their game normally results in benefits for everyone involved. Sometimes, usually in small countries where monetary authorities have limited credibility, we see the con game fail, and generally we lament that failure.

But the other danger is that the game can be too successful. If people become too confident in the value of money relative to other assets, the result is hoarding of money and eventually deflation. And since money is neither productive (like a factory) nor useful (like food), the hoarding of something unproductive and useless supplants the creation of productive and useful things. Accordingly, the operators of the game always suffer from a very rational fear of success. And today, it would appear, their fear is coming true.

But this is crazy. There must be a way to stop rational people from hoarding endless amounts of an asset they know is fundamentally worthless. There must be a way to blow the whistle on this con game.

The solution, it seems to me, is to have the operators come clean – not come clean entirely, not admit that money is completely worthless, but declare in no uncertain terms their intention to cheat us out of quite a lot if we persist in having so much confidence in their scheme. Of course even that approach may not work – it’s possible that our collective gullibility has no limits – but it certainly seems worth a try.

What I’m suggesting is something that has already been suggested – in rather less shocking terms, perhaps – by various other economists (as for example in these posts by Greg Mankiw and Nick Rowe): the Fed should announce a price level target for some point in the future. And it should make that target high enough to scare people (and institutions) out of hoarding money.

It’s still a game of chance. Nobody can be sure that the Fed will be able to hit its price level target, or even get anywhere near it. As I said, in terms of the Ponzi scheme, there may be no limit to our collective gullibility. But let’s shift metaphors here: when you’re playing five card stud and you see that one of the other players has four hearts showing, even if you know the odds are against that player’s having a full flush, you’ve got to have a fair amount of guts to make a big bet on your three aces. And guts are in short supply these days. Nobody will know whether the Fed is bluffing; even the Fed itself won’t know whether it’s bluffing; but if the price level target is high enough, if the player with the four hearts throws enough blue chips into the pot, a lot of today’s ultra-risk-averse investors are going to fold.

And if enough of them fold – OK, here I have to shift the metaphor a little bit again, or maybe you have to think about hundreds of poker games being played at once, with some kind of arrangement where the house is allowed to pass cards from one game to another when the players in the first game fold – if enough investors fold, the game is over. If enough investors give up thinking that their three aces, a.k.a.money (or zero-yield T-bills), are a safe asset, if enough investors start instead buying assets that are productive or useful, then the slack in the economy will diminish and eventually give the Fed a chance to push up prices by creating excess demand. And then the Fed can hit its price target and win the pot.

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.

Why are the Fed and the Treasury Working Against Each Other?

2009-02-05T11:59:00.000-08:00

It seems like every other day the last couple of weeks I read about how long Treasuries are tanking because markets are “worried about supply.” Then I read about how the Fed is saying they plan to buy long Treasuries, and they’re trying like heck to convince the markets that it’s really gonna happen, but the markets don’t quite believe it.

Maybe there’s a good reason that the markets don’t quite believe it: it doesn’t make any sense. The Treasury is going to issue a crapload of new long bonds, and the Fed is going to buy them back on the open market? Why? If the Treasury just issued short-term bills, the Fed would buy them anyway. At least it would buy enough to keep the federal funds rate near zero, and after that it doesn’t matter. And when the recession, or the potentially deflationary episode, or whatever it is, ends and the Fed wants to stop rolling over the bills, the Treasury can replace them with long bonds if it so chooses.

Now, you might say, “Ah, but when the recession, or the potentially deflationary episode, or whatever it is, ends, long term interest rates will go up, and the Treasury will have to pay more to borrow than it does now, so why not issue them now while the rates are cheap?” That reasoning seems to make sense, until you realize that the Fed, when this episode ends, is going to want to liquidate its long-term bond portfolio, and if rates have risen, it will have to do so at a loss. Since the Fed’s profits go directly into the Treasury, the loss passes right through, and, in terms of present value, it’s (almost) exactly as if the Treasury had issued new debt at a higher yield. Or the Fed could decide to hold the bonds to maturity, in which case it will be just as if the Treasury had never issued them. (In that case, if the Fed wants to reduce the money supply, it could stop rolling over its T-bills, in which case the Treasury will have to issue new ones at higher rates, just as it would have if it had not issued the long bonds in the first place.)

There are only two differences I can see between, on the one hand, having the Treasury issue long bonds and the Fed buy long bonds, and, on the other hand, having the Treasury never issue the bonds in the first place. And neither difference is really a difference. The first difference is that the Fed might buy seasoned bonds in addition to (or instead of) on-the-run issues. The Treasury, by definition, can only issue on-the-run bonds. But this, as I said, is not really a difference: the Treasury can just as well decide to retire its old bonds as to refrain from issuing new ones. Although most Treasury issues are not callable, the Treasury can retire them at market prices, and it will be just as if the Fed had bought them. And in any case, how much difference is there really between on-the-run and seasoned issues? The maturities are slightly different – no big deal in the grand scheme of things – and on-the-run issues are more liquid – a little bit more liquid, but it’s not like seasoned Treasuries sit on your books unintentionally for months because you can’t catch a bid. It’s a technical difference – one that will affect the details that Treasury traders care about, but not the sort of thing that should make headlines.

The other difference is between current policy and future policy. If future policymakers will be somehow influenced by the distribution of securities between the Treasury and the Fed, then that distribution will of course make a difference. But why should they be influenced by it? I can understand that the Fed and the Treasury may perceive themselves as having different interests, but in this case it doesn’t matter, because each one can undo what the other one does. If the Fed sells off its long bonds 5 years from now, the Treasury can stop issuing long bonds. If the Fed holds onto its long bonds, the Treasury can issue more of them. And if the Fed never buys the long bonds in the first place, then the Treasury can do whatever it wants with its finance policy 5 years from now. Again, there are the technical questions about maturity and liquidity, but I don’t see how these are going to make a difference that macro policy makers or investors (as opposed to traders) should care about. And since the timing of these events is unknown, I’m not even sure anyone would be able to make a reasonable guess as to how these technical matters will play out, so perhaps noone at all should care about them.

So what’s going on here? I really don’t get it. Are the Treasury and the Fed really going to insist on working against each other? Is one of them bluffing? (And if so, which one?) Have the markets misinterpreted their signals? Have the markets, in fact, correctly interpreted their signals as being meaningless?

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.

What are Illiquid Assets Really Worth?

2009-01-21T08:44:00.000-08:00

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.

Oh, No, Not Again

2009-01-20T18:42:00.000-08:00

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.

More about Stimulus and Eugene Fama

2009-01-16T11:32:00.000-08:00

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.
Bailouts and stimulus plans must be financed.

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

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?

2009-01-16T10:14:00.000-08:00

Eugene Fama, a giant in the world of financial economics, argues against a stimulus (hat tip: Greg Mankiw) for reasons that...to 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.

Dynamic Scoring

2009-01-12T14:15:00.000-08:00

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.

To Monetize or Not To Monetize: Who Cares?

2009-01-08T14:56:00.000-08:00

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.

In Case of Emergency Break Glass

2009-01-07T11:54:00.000-08:00

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.

Deflation, Recession, and Aggregate Supply

2008-12-12T08:56:00.000-08:00

There has been a lot of talk (some of it from me) about the possibility of deflation in the US. Deflation would be a problem for a couple of reasons: first, deflation would make it more difficult to engineer an economic recovery; second, deflation could result in a “death spiral” like what happened (according to one interpretation) during the early 1930’s. The latter problem is a lot scarier, if you think it’s a serious possibility. There is, in my opinion, a good chance of some deflation, but, as I will argue, I don’t think the death spiral scenario is something we need to worry about today.

The death spiral would occur because of a positive feedback loop (vicious circle) between deflation and economic weakness. Even mild deflation deters long-term capital expenditures by making them less profitable. (Why build a factory, for example, if you expect product prices to go down year after year?) Moderate deflation deters even short-term capital expenditures. (Why buy a computer if declining revenues will barely allow you to recoup the cost?) When deflation becomes severe, even expenditures for consumer durables are significantly reduced. (Why replace your refrigerator this year, when it’s going to be cheaper next year?) Because of these effects, deflation reduces aggregate demand, and does so more rapidly as the deflation rate increases. Weaker demand, as everyone knows, tends to lead to lower prices. Thus it’s possible to imagine an economic implosion where deflation and economic depression feed on each other and become ever more severe.

As I said, that is, according to one interpretation, what happened (or began to happen) during the early 1930s. President Roosevelt managed to put an end (at least temporarily) to the deflation, in part by devaluing the dollar. It’s not clear whether devaluing the dollar would be an option today, because other countries might counter with intervention designed to nullify any US attempt to intervene against the dollar. Fortunately, however, there are many other tools we can use to avoid the kind of severe deflation that faced Roosevelt when he took office. Working against the positive feedback loop of deflation and depression, there is a negative feedback process: the worse the deflation becomes (or is expected to become), the more authorities will be willing to use unconventional policies to stop it.

Stopping deflation should not be very hard at all, if you’re willing to accept the side effects of your deflation cure. Most discussions of this topic have focused on the demand side: the Fed could get people to start buying things by dropping money from a helicopter; or it could buy stock and increase demand by corporations and stockholders; etc. But when it comes to stopping deflation, demand policies are the hard way. To continue my side effects metaphor: if you insist on using the less powerful drug that has fewer side effects, you may have to give ridiculously high doses before the patient responds. The easy way to stop deflation – the drug to try once hair loss and vomiting become less of an issue than the disease itself – is to reduce supply rather than increase demand.

During normal times, economists and policymakers spend a lot of time trying to figure out ways to increase supply. It’s not an easy task. Cut taxes, to improve incentives for private investment? Raise taxes, to stop consumer spending from crowding out private investment? Invest more in public infrastructure to make the economy more efficient? Invest less in public infrastructure, to make the resources available to the private sector? It’s a tough game.

The game gets a lot easier when your objective is to let the other guy win. One obvious way to reduce supply, for example, is to encourage the formation of cartels. That’s something that Roosevelt tried, though some of his programs were struck down by the Supreme Court. Scholars can debate what the overall effect was on economic growth, or whether, after already devaluing the dollar, such additional measures against deflation did more harm than good, but it’s hardly open to question that encouraging cartels will tend to raise – and in the context of a deflation, stabilize – prices.

One particular form of cartel encouragement, which would certainly go over well with some of the current government’s constituents, would be to strengthen labor unions (one thing that Roosevelt did). Under normal conditions, some economists might argue that labor unions, despite their cartel aspect, often increase supply by such means as improving morale and decreasing unnecessary turnover. But it’s certainly true that unions are particularly loath to accept cuts in wages. In the context of a deflation, the stabilization of wages would tend to stabilize prices, since it would make it unprofitable for firms to cut prices. (Paul Krugman touches on this issue in some recent blog entries. He mentions a recent academic paper, but I like to give credit to Brad DeLong and Larry Summers – in a paper that I read nearly 20 years ago before it was published – for making intellectually respectable the idea that labor unions can help the economy by helping protect against deflation. I should also acknowledge James Tobin, who worked out the theory underlying the “death spiral” concept as discussed above.)

Another way to reduce aggregate supply is by inducing inflationary expectations to replace deflationary ones, so that producers are less willing to sell at low prices. This is largely a psychological issue, but if the Fed shows a willingness to take demand-side policies to extremes, even if the extremes are still not enough to solve the demand problem, they may affect supply. For example, when James Hamilton suggests (somewhat whimsically and just for the sake of argument) that the Fed could buy up the entire national debt, one might think of it as a demand-side policy, but I would suggest that its supply-side impact would be more important. With Treasury interest rates, even for long-term bonds, already quite low, it’s not clear that reducing them to zero would have much effect on demand. But when people observe the Fed buying up the entire national debt, the perception that “Helicopter Ben has gone wild” can’t help but make an impact.

And so on. Figuring out ways to produce less, rather than more, shouldn’t be very difficult. Naturally, reducing aggregate supply – trying to make the economy produce less at any given price – is not going to be directly conducive to economic recovery. But by reversing deflation and thereby making traditional demand-side tools more effective, it could be indirectly beneficial.

The death spiral should be pretty easy to avoid. The problem is that, once you get to the point where you have to make avoiding the death spiral a priority, you end up with this conflict between policies that reverse deflation and policies that increase production. It’s not the 1930’s, but it’s an experience I would hope to avoid.

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.

Blogkeeping

2008-12-10T11:34:00.000-08:00

Just some notes about this blog:

Thanks to Greg Mankiw for linking to me.
Against my better aesthetic judgment, I have bowed to presbyopic pressure and inverted the text and background colors from white-on-black to black-on-(almost)-white. As a note of protest, I am retaining an ever-so-slight bluish tint in the background color and changing the navigation bar from blue to black. Personally, despite having outlived the days when I could read a menu in a dimly lit restaurant while wearing unifocal contact lenses, I don’t find black-on-white or black-on-almost-white-with-a-very-slight-bluish-tint any easier to read than white-on-black, but OK: as the new kid on the block, I’m not in a position to resist the prevailing social ethos.
I do hope to respond to at least some of the comments on this blog, but there may be institutional delays involved, so if you’re interested in my possible responses, you might want to check back a few days afterward.
I have now signed an agreement with Seeking Alpha, whereby they will be copying some of my blog entries to publish on their site. You can view my profile there if you wish, but if you’re already reading this blog, there’s probably not much point.
At the suggestion of some commenters on my first post, I have registered a new domain blog.andyharless.com, which will hopefully point to this blog once the DNS records propagate. (Yeah, I don’t know why I didn’t think of “andyharless.blogspot.com” in the first place.) Links to the original blog URL should still work.

Will Monetizing the Federal Deficit Cause Inflation?

2008-12-08T14:56:00.000-08:00

Only if we’re lucky.

I sometimes joke that the old dispute between the Monetarists and the Keynesians was resolved when the Keynesians conceded all the substantive points and the Monetarists agreed to be called Keynesians. Like most jokes, it’s not quite true. The one thing the Keynesians never conceded was the raison d’etre of the Monetarists, the Quantity Theory of Money – the idea that nominal national incomes, and ultimately prices, are determined (in some reasonably simple and predictable way) by the quantity of money. By the mid-1980’s, financial innovation had made the quantity of money in the US very hard to measure, and so the theory – whether right or wrong – became largely irrelevant. And in August 2008, it still seemed largely irrelevant.

But that has all changed in the past three months. While it is still quite difficult to measure the “true” quantity of money, it is easy to measure the quantity of base money –the money created directly by the Fed. When the quantity of base money shoots up in a way that dwarfs all prior experience, it’s fair to say that the “true” quantity of money – whatever that may mean empirically – is also rising more quickly than usual. And some monetarists, clinging to empirical relevance over the period since the 1980s, would argue that the quantity of base money is the true quantity of money.

If this latter group is right – both about the validity of the Quantity Theory and about using base money as the true measure – then we are in for one hell of an inflation. Fortunately (or, alas, perhaps unfortunately) they’re wrong. At least I’m convinced they’re wrong. But let’s examine what has happened. On September 1, the monetary base was $846 billion. On December 1, it was $1.483 trillion. As an annualized rate of increase, that would come to more than 800%. It’s an increase of $637 billion, enough to finance the whole federal deficit for fiscal year 2008, cut every household in America a $1000 check, and have plenty left over for everyone in Washington to spend on whores and liquor – and I’m talking Glenfiddich and Ashley Dupré here.

OK, I apologize to Miss Dupré (who I imagine doesn’t even like being called a “former sex worker,” let alone a “whore”), and for that matter, to everyone in Washington (many of whom are scrupulously monogamous teetotalers, and many of whom, indeed, are in categories to which the escort business doesn’t even market itself). I was using a conventional figure of speech to make a point: the Fed has created a huge, huge, huge amount of money in the past few months. And with T-bill rates already at zero and no danger of their going lower, it’s easy to imagine that the Fed will be able to finance the entire 2009 federal deficit, gargantuan though it is projected to be, and perhaps 2010 as well, without having much immediate effect on anything.

But in the long run, will it cause inflation? This is where I declare (in case you had any doubt) with the Keynesians. I’m not even sure that two years of fully monetized deficits would be enough to stop deflation, if it should happen, let alone cause inflation. In the textbook Keynesian model – the one in today’s textbooks, not the one Keynes would have put in if he had written a textbook – the case is pretty clear: there is a non-accelerating inflation rate of unemployment (NAIRU) – an idea, by the way, derived from the Natural Rate Theory associated with Milton Friedman, the leader of the Monetarist school. When the unemployment rate goes below the NAIRU, the inflation rate rises, and it keeps rising until unemployment goes back up. When the unemployment rate goes above the NAIRU, the inflation rate falls, and it keeps falling until unemployment comes back down.

One of the problems with the NAIRU is that nobody ever knows exactly what it is. But recent estimates have tended around 5 percent, and just about any economist will agree that it can’t be much higher than 6 percent. The unemployment rate for November was 6.7 percent, comfortably above anyone’s estimate of the NAIRU. A nearly universal consensus holds that it will rise from here, and some very reputable economists are talking casually about double digits. Moreover, the experience of recent business cycles suggests that, once it rises to its peak, it will come down only very slowly. So if you’re even just a little tiny bit Keynesian, you won’t be expecting much inflation for quite a while. If you take the textbook model as gospel and have confidence in recent empirical estimates of the NAIRU, you probably expect deflation, and you may be worried that the deflation could become quite severe.

I don’t take the textbook model as gospel, but I think it’s a pretty good way of looking at things, and I’m confident that the NAIRU – to the extent that the concept is valid – is not too far from 5 percent. Moreover, the 65 percent drop in the price of oil, which would have been considered wonderfully good news during most of the last 40 years, is not encouraging under today’s circumstances. Things could get quite ugly, and the ugliness will not resemble that of the 1970’s.

Now you might say, “So much for the short run, but in the long run, monetization today will cause inflation in the future.” When I start to see double-digit inflation in Japan, maybe I’ll believe you, but that long run is starting to look very, very long. Even if the US recovery comes fairly quickly (like the middle of 2009, rather than the end of 2010 or the beginning of 2015), the Fed will have plenty of opportunity to demonetize the federal debt before the unemployment rate starts to fall to a normal level.

But I’m skeptical as to whether much if any demonetization will even be necessary. Back in the old days, the four decades after World War II, we used to have sharp recessions – mostly the manufacturing sector would contract quickly, then turn around and expand quickly. That doesn’t happen any more. Today’s service economy doesn’t expand and contract quickly. Recessions begin more slowly, and recoveries are painfully slow. Even in a best-case scenario, the unemployment rate is likely to be above the NAIRU for quite some time. It strains my crystal ball to try looking ahead to the time when any demonetization at all will be necessary.

No, we won’t have to give back the $637 billion (or even the trillions that may follow). It was a Christmas present from the Weak Economy. The biggest Christmas present the US has ever gotten. Unfortunately, it’s not the one that was at the top of my wish list.

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.

The Etymology of Macroeconomics

2008-12-03T22:05:00.000-08:00

When I was setting up this blog, I had a devil of a time coming up with a URL that wasn’t already taken. Google wanted me to use “employmentinterestandmoney.blogspot.com” but I just couldn’t ask people to type in that whole thing. I ultimately settled on “andytheeconomist” for the bottom level name because it was easy to remember and not too long, but my mind went to some strange places along the way. It’s just as well that I thought better of “makronoikonnemo.blogspot.com” – not too long, but who is going to remember it?

Nonetheless, I can’t purge “makron oikon nemo” from my mind, so, since I need something for a first blog entry, that’s going to be my topic. Literally, provided I haven’t made a mistake in the morphology, “makron oikon nemo” (μακρον οικον νεμω) is Classical Greek for “I manage a large house.” That might seem to have very little to do with anything, but the words μακρον, οικον, and νεμω are also the etymological roots of the word “macroeconomics.” (By the way, I’m an economist, not a linguist, so you shouldn’t necessarily trust anything I say about etymology. But then again, I’m not sure you should trust what I say about economics either.)

“Oikon” (οικον) is an inflected form of “oikos” (οικος), which means “house.” “Nemo” (νεμω) – which by the way is usually pronounced with the “e” as in “bed,” not as in “Finding Nemo” – means “I manage.” (It is conventional to identify Greek verbs in the first person form rather than the infinitive. If we were talking about the English verb, we would probably say, “to manage” rather than “I manage.”) In Classical Greek, the two words were combined into the word “oikonomos” (οικονομος), which means “house manager.” The etymological meaning survives to some extent in English phrases like “home economics,” which they used to teach in grade school when I was young. (Do they still teach Home Economics?)

Anyhow, a house manager for a man of substance had a lot of coordination to do – a lot of arranging and buying and selling and making sure things would be in the right place at the right time – to keep the house running smoothly. A similar art could, in principle, be applied at the level of the city-state, or “polis” (πολις). And someone who practiced that art at the level of the state would be a “house manger of a state” or “state house manager” – “politikos oikonomos” (πολιτικος οικονομος). I have no idea whether the ancient Greeks actually used that phrase, but somehow it showed up in Modern English as “political economy” – the study of how to manage a state’s production and consumption, or something to that effect.

Somehow “political economy” turned into “economics.” How that happened I don’t know, but the phrase “political economy,” to the extent that it is used today (other than in the title of an academic journal), usually refers to a specific branch of economics which deals with the political context of economics (in the modern sense of the word “political”). Once upon a time, however, there was no “economics” at all, just “political economy.”

And then there is the prefix “macro,” which occurs so often in English that its meaning needs no discussion. The canonical form of the Greek adjective is “makros" (μακρος), which of course means “large.”

...and so on....I could go on about this, but I have to get back to managing a large house.