Inflation Targets and Financial Crises

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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



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

Investing in Semantics

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

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

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

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

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

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

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

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

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

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



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

Prose Hack

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

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

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

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

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

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

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




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

Job Losses Are Not the Problem

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

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

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




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



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

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

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

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

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

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

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




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

Savings Rate Could Stay High

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

Not much, thinks Brad DeLong:

I would guess that only a small part of the rise in the savings rate is permanent. Financial distress was and is much greater than in past post-WWII recessions, and financial distress is associated with transitory rises in the savings rate.

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

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

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

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

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

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

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



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


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