“On money, debt, trust and central banking”

The central point of my Jacobin piece on the state of economics was meant to be: Whatever you think about mainstream macroeconomic theory, there is a lot of mainstream empirical and policy work that people on the left can learn from and engage with — much more than there was a decade ago. 1 

Some of the most interesting of that new work is from, and about, central banks. As an example, here is a remarkable speech by BIS economist Claudio Borio. I am not sure when I last saw such a high density of insight-per-word in a discussion of money and finance, let alone in a speech by a central banker. I could just say, Go read it. But instead I’m going to go through it section by section, explaining what I find interesting in it and how it connects up to a larger heterodox vision of money. 

From page one:

My focus will be the on the monetary system, defined technically as money plus the transfer mechanisms to execute payments. Logically, it makes little sense to talk about one without the other. But payments have too often been taken for granted in the academic literature, old and new. In the process, we have lost some valuable insights.

… two properties underpin a well functioning monetary system. One, rather technical, is the coincidence of the means of payment with the unit of account. The other, more intangible and fundamental, is trust. 

This starting point signals three central insights about money. First, the importance of payments. You shouldn’t fetishize any bit of terminology, but I’ve lately come to feel that the term “payments system” is a fairly reliable marker for something interesting to say about money. We all grow up with an idealized model of exchange, where the giving and receiving just happen, inseparably; but in reality it takes a quite sophisticated infrastructure to ensure that my debit coincides with your credit, and that everyone agrees this is so. Stefano Ugolini’s brilliant book on the prehistory of central banking emphasizes the central importance of finality – a binding determination that payment has taken place. (I suppose this was alsso the point of the essay that inaugurated Bitcoin.) In any case it’s a central aspect of “money” as a social institution that the mental image of one person handing a token to another entirely elides.

Second: the focus on money as unit of account and means of payment. The latter term mean money as the thing that discharges obligations, that cancels debts. It’s not evenb included in many standard lists of the functions of money, but for Marx, among others, it is fundamental. Borio consciously uses this term in preference to the more common medium of exchange, a token that facilitates trade of goods and services. He is clear that discharging debt and equivalent obligations is a more central role of money than exchanging commodities. Trade is a special case of debt, not vice versa. Here, as at other points through the essay, there’s a close parallel to David Graeber’s Debt. Borio doesn’t cite Graeber, but the speech is a clear example of my point in my debate with Mike Beggs years ago: Reading Graeber is good preparation for understanding some of the most interesting conversation in economics.

Third: trust. If you think of money as a social coordination mechanism, rather than a substance or quantity, you could argue that the scarce resource it’s helping to allocate is precisely trust.  More on this later.

Borio:

a key concept for understanding how the monetary system works is the “elasticity of credit”, ie the extent to which the system allows credit to expand. A high elasticity is essential for the system’s day-to-day operation, but too high an elasticity (“excess elasticity”) can cause serious economic damage in the longer run. 

This is an argument I’ve made before on this blog. Any payments system incorporate some degree of elasticity — some degree to which payments can run ahead of incomes. (As my old teacher David Kotz observes, the expansion of capital would be impossible otherwise.) But the degree of elasticity involves some unresolvable tensions. The logic of the market requires that every economic units expenditure eventually be brought into line with its income. But expansion, investment, innovation, requires eventually to be not just yet. (I talked a bit about this tension here.) Another critical point here is the impossibility of separating payments and credit – a separation that has been the goal of half the monetary reform proposals of the past 250 years.2

Along the way, I will touch on a number of sub-themes. .. whether it is appropriate to think of the price level as the inverse of the price of money, to make a sharp distinction between relative and absolute price changes, and to regard money (or monetary policy) as neutral in the long run.

So much here! The point about the non-equivalence of a rise in the price level and a fall in the value of money has been made eloquently by Merijn Knibbe.  I don’t think Borio’s version is better, but again, it comes with the imprimatur of Authority.

The fact that inflation inevitably involves relative as well as absolute price changes is made by Leijonhufvud (who Borio cites) and Minsky (who he surprisingly doesn’t); the non-neutrality of money is the subject (and the title) of what is in my opinion Minsky’s own best short distillation of his thought. 

Borio: 

Compared with the traditional focus on money as an object, the definition [in terms of means of payment] crucially extends the analysis to the payment mechanisms. In the literature, there has been a tendency to abstract from them and assume they operate smoothly in the background. I believe this is one reason why money is often said to be a convention, much like choosing which hand to shake hands with: why do people coordinate on a particular “object” as money? But money is much more than a convention; it is a social institution. It is far from self-sustaining. Society needs an institutional infrastructure to ensure that money is widely accepted, transactions take place, contracts are fulfilled and, above all, agents can count on that happening. 

Again, the payments mechanism is a complex, institutionally heavy social arrangement; there’s a lot that’s missed when we imagine economic transactions as I hand you this, you hand me that. Ignoring this social infrastructure invites the classical idea of money as an arbitrary numeraire, from which its long-run neutrality is one short step. 

The last clause introduces a deep new idea. In an important sense, trust is a kind of irrational expectation. Trust means that I am sure (or behave as if I am sure) that you will conform to the relevant rules. Trust means I believe (or behave as if I believe) this 100 percent. Anything less than 100 percent and trust quickly unravels to zero.  If there’s a small chance you might try to kill me, I should be prepared to kill you first; you might’ve had no bad intentions, but if I’m thinking of killing you, you should think about killing me first; and soon we’re all sprawled out on the warehouse floor. To exist in a world of strangers we need to believe, contrary to experience, that everyone around us will follow the rules.

a well functioning monetary system … will exploit the benefits of unifying the means of payment with the unit of account. The main benefit of a means of payment is that it allows any economy to function at all. In a decentralised exchange system, it underpins the quid-pro-quo process of exchange. And more specifically, it is a highly efficient means of “erasing” any residual relationship between transacting parties: they can thus get on with their business without concerns about monitoring and managing what would be a long chain of counterparties (and counterparties of counterparties).

Money as an instrument for erasing any relationship between the transacting parties: It could not be said better. And again, this is something someone who has read Graeber’s Debt understands very well, while someone who hasn’t might be a bit baffled by this passage. Graeber could also take you a step farther. Money might relieve you of the responsibility of monitoring your counterparties and their counterparties but somebody still has to. Graeber compellingly links the generalized use of money to strong centralized states. In a Graeberian perspective, money, along with slavery and bureaucracy, is one of the great social technologies for separating economic coordination from the broader network of mutual obligations.

The central banks’ elastic supply of the means of payment is essential to ensure that (i) transactions are settled in the interbank market and (ii) the interest rate is controlled. The interbank market is a critical component of our two-tier monetary system, where bank customer transactions are settled on the banks’ books and then banks, in turn, finally settle on the central bank’s books. To smooth out interbank settlement, the provision of central bank credit is key. The need for an elastic supply to settle transactions is most visible in the huge amounts of intraday credit central banks supply to support real- time gross settlement systems

“Two-tier monetary system” is a compressed version of Mehrling’s hierarchy of money. The second point, which Borio further develops further on, is that credit is integral to the payment system, since the two sides of a transaction never exactly coincide – there’s always one side that fulfills its part first and has to accept, however briefly, a promise in return. This is one reason that the dream of separating credit and payments is unrealizable.

The next point he makes is that a supply and demand framework is useless for thinking about monetary policy: 

The central bank … simply sets the desired interest rate by signalling where it would like it to be. And it can do so because it is a monopoly supplier of the means of payment: it can credibly commit to provide funds as needed to clear the market. … there is no such thing as a well behaved demand for bank reserves, which falls gradually as the interest rate increases, ie which is downward-sloping.

An interesting question is how much this is specific to the market for reserves and how much it applies to a range of asset markets. In fact, many markets share the two key features Borio points to here: adjustment via buffers rather than prices, and expected return that is a function of price.

On the first, there are a huge range of markets where there’s someone on one or both sides prepared to passively by or sell at a stated price. Many financial markets function only thanks to the existence of market makers – something Mehrling and his Barnard colleague Rajiv Sethi have written eloquently about. But more generally, most producers with pricing power — which is almost all of them — set a price and then passively meet demand at that price, allowing inventories and/or delivery times to absorb shifts in demand, within some range.

The second feature is specific to long-lived assets. Where there is an expected price different from the current price, holding the asset implies a capital gain or loss when the price adjusts. If expectations are sufficiently widespread and firmly anchored, they will be effectively self-confirming, as the expected valuation changes will lead the asset to be quickly bid back to its expected value. This dynamic in the bond market (and not the zero lower bound) is the authentic Keynesian liquidity trap.

To be clear, Borio isn’t raising here these broader questions about markets in general. But they are a natural extension of his arguments about reserves. 

Next come some points that shouldn’t be surprising to to readers of this blog, but which are nice, for me as an economics teacher, to see stated so plainly. 

The monetary base – such a common concept in the literature – plays no significant causal role in the determination of the money supply … or bank lending. It is not surprising that … large increases in bank reserves have no stable relationship with the stock of money … The money multiplier – the ratio of money to the monetary base – is not a useful concept. … Bank lending reflects banks’ management of the risk-return tradeoff they face… The ultimate anchor of the monetary system is not the monetary base but the interest rate the central bank sets.

We all know this is true, of course. The mystery is why so many textbooks still talk about the supply of high-powered money, the money multiplier, etc. As the man says, they just aren’t useful concepts.

Next comes the ubiquity of credit, which not only involves explicit loans but also any transaction where delivery and payment don’t coincide in time — which is almost all of them. Borio takes this already-interesting point in an interestingly Graeberian direction:  

A high elasticity in the supply of the means of payment does not just apply to bank reserves, it is also essential for bank money. … Credit creation is all around us: some we see, some we don’t. For instance, explicit credit extension is often needed to ensure that two legs of a transaction are executed at the same time so as to reduce counterparty risk… And implicit credit creation takes place when the two legs are not synchronised. ….

In fact, the role of credit in monetary systems is commonly underestimated. Conceptually, exchanging money for a good or service is not the only way of solving the problem of the double coincidence of wants and overcoming barter. An equally, if not more convenient, option is to defer payment (extend credit) and then settle when a mutually agreeable good or service is available. In primitive systems or ancient civilisations as well as during the middle ages, this was quite common. … It is easier to find such examples than cases of true barter.

The historical non-existence of barter is the subject of the first chapter of Debt . Here again, the central banker has more in common with the radical anthropologist than with orthodox textbooks, which usually make barter the starting point for discussions of money.

Borio goes on:

the distinction between money and debt is often overplayed. True, one difference is that money extinguishes obligations, as the ultimate settlement medium. But netting debt contracts is indeed a widespread form of settling transactions.

Yes it is: remember Braudel’s Flanders fairs? “The fairs were effectively a settling of accounts, in which debts met and cancelled each other out, melting like snow in the sun.”

At an even deeper level, money is debt in the form of an implicit contract between the individual and society. The individual provides something of value in return for a token she trusts to be able to use in the future to obtain something else of value. She has a credit vis-à-vis everyone and no one in particular (society owes a debt to her).

In the classroom, one of the ways I suggest students think about money is as a kind of social scorecard. You did something good — made something somebody wanted, let somebody else use something you own, went to work and did everything the boss told you? Good for you, you get a cookie. Or more precisely, you get a credit, in both senses, in the personal record kept for you at a bank. Now you want something for yourself? OK, but that is going to be subtracted from the running total of how much you’ve done for the rest for us.

People get very excited about China’s social credit system, a sort of generalization of the “permanent record” we use to intimidate schoolchildren. And ok, it does sound kind of dystopian. If your rating is too low, you aren’t allowed to fly on a plane. Think about that — a number assigned to every person, adjusted based on somebody’s judgement of your pro-social or anti-social behavior. If your number is too low, you can’t on a plane. If it’s really low, you can’t even get on a bus. Could you imagine a system like that in the US?

Except, of course, that we have exactly this system already. The number is called a bank account. The difference is simply that we have so naturalized the system that “how much money you have” seems like simply a fact about you, rather than a judgement imposed by society.

Back to Borio:

All this also suggests that the role of the state is critical. The state issues laws and is ultimately responsible for formalising society’s implicit contract. All well functioning currencies have ultimately been underpinned by a state … [and] it is surely not by chance that dominant international currencies have represented an extension of powerful states… 

Yes. Though I do have to note that it’s at this point that Borio’s fealty to policy orthodoxy — as opposed to academic orthodoxy — comes into view. He follows up the Graeberian point about the link between state authority and money with a very un-Graeberian warning about the state’s “temptation to abuse its power, undermining the monetary system and endangering both price and financial stability.”

Turning now to the policy role of the central bank, Borio  starts from by arguing that “the concepts of price and financial stability are joined at the hip. They are simply two ways of ensuring trust in the monetary system…. It is no coincidence that securing both price and financial stability have been two core central bank functions.” He then makes the essential point that what the central bank manages is at heart the elasticity of the credit system. 

The process underpinning financial instability hinges on how “elastic” the monetary system is over longer horizons… The challenge is to ensure that the system is not excessively elastic drawing on two monetary system anchors. One operates on prices – the interest rate and the central bank’s reaction function. … The other operates on quantities: bank regulatory requirements, such as those on capital or liquidity, and the supervisory apparatus that enforces them.

This is critical, not just for thinking about monetary policy, but as signpost toward the heart of the Keynesian vision. (Not the bastard — but useful  — postwar Keynesianism of IS-LM, but the real thing.) Capitalism is not a system of real exchange — it shouldn’t be imagined as a system in which people exchange pre-existing stuff for other stuff they like better. Rather, it is a system of monetary production — a system in which payments and claims of money, meaningless themselves, are the coordinating mechanism for human being’s collective, productive activity. 

This is the broadest sense of the statement that money has to be elastic, but not too elastic. If it is too elastic, money will lose its scarcity value, and hence its power to organize human activity. Money is only an effective coordinating mechanism when its possession allows someone to compel the obedience of others. But it has to be flexible enough to adapt to the concrete needs of production, and of the reproduction of society in general. (This is the big point people take form Polanyi.) “You can’t have the stuff until you give me the money” is the fundamental principle that has allowed capitalism to reorganize vast swathes of our collective existence, for better or worse. But applied literally, it stops too much stuff from getting where it needs to go to to be compatible with the requirements of capitalist production itself. There’s a reason why business transactions are almost always on the basis of trade credit, not cash on the barrelhead. As Borio puts it, “today’s economies are credit hungry.” 

The talk next turns to criticism of conventional macroeconomics that will sound familiar to Post Keynesians. The problem of getting the right elasticity in the payments system — neither too much nor too little — is “downplayed in the current vintage of macroeconomic models. One reason is that the models conflate saving and financing.“ In reality,

Saving is just a component of national income – as it were, just a hole in overall expenditures, without a concrete physical representation. Financing is a cash flow and is needed to fund expenditures. In the mainstream models, even when banks are present, they imply endowments or “saving”; they do not create bank deposits and hence purchasing power through the extension of loans or purchase of assets. There is no meaningful monetary system, so that any elasticity is seriously curtailed. Financial factors serve mainly to enhance the persistence of “shocks” rather than resulting in endogenous booms and busts.

This seems right to me. The point that there is no sense in which savings finance or precede or investment is a key one for Keynes, in the General Theory and even more clearly in his subsequent writing.3 I can’t help noting, also, that passages like this are a reminder that criticism of today’s consensus macro does not come only from the professionally marginalized.

The flipside of not seeing money as social coordinating mechanism, a social ledger kept by banks, is that you do  see it as a arbitrary token that exists in a particular quantity. This latter vision leads to an idea of inflation as a simple imbalance between the quantity of money and the quantity of stuff. Borio:

The process was described in very simple terms in the old days. An exogenous increase in the money supply would boost inflation. The view that “the price level is the inverse of the price of money” has probably given this purely monetary interpretation of inflation considerable intuitive appeal. Nowadays, the prevailing view is not fundamentally different, except that it is couched in terms of the impact of the interest rate the central bank sets.

This view of the inflation process has gone hand in hand with a stronger proposition: in the long run, money (monetary policy) is neutral, ie it affects only prices and no real variables. Again, in the classical tradition this was couched in terms of the money supply; today, it is in terms of interest rates. … Views about how long it takes for this process to play itself out in calendar time differ. But proponents argue that the length is short enough to be of practical policy relevance.

The idea that inflation can be thought of as a decline in the value of money is effectively criticized by Merijn Knibbe and others. It is a natural idea, almost definitionally true, if you vision starts from a world of exchange of goods and then adds money as facilitator or numeraire. But if you start, as Borio does, and as the heterodox money tradition from Graeber to Minsky to Keynes to Marx and back to Tooke and Thornton does, from the idea of money as entries in a social ledger, then it makes about as much sense as saying that a game was a blowout because the quantity of points was too high.  

once we recognise that money is fundamentally endogenous, analytical thought experiments that assume an exogenous change and trace its impact are not that helpful, if not meaningless. They obscure, rather than illuminate, the mechanisms at work. … [And] once we recognise that the price of money in terms of the unit of account is unity, it makes little sense to think of the price level as the inverse of the price of money. … any financial asset fixed in nominal terms has the same property. As a result, thinking of inflation as a purely monetary phenomenon is less compelling.

“Not that helpful”, “makes little sense,” “is less compelling”: Borio is nothing if not diplomatic. But the point gets across.

Once we recognise that the interest rate is the monetary anchor, it becomes harder to argue that monetary policy is neutral… the interest rate is bound to affect different sectors differently, resulting in different rates of capital accumulation and various forms of hysteresis. … it is arguably not that helpful to make a sharp distinction between what affects relative prices and the aggregate price level…., not least because prices move at different speeds and differ in their flexibility… at low inflation rates, the “pure” inflation component, pertaining to a generalised increase in prices, [is] smaller, so that the distinction between relative and general price changes becomes rather porous.

In part, this is a restatement of Minsky’s “two-price” formulation of Keynes. Given that money or liquidity is usefulat all, it is presumably more useful for some things more than for others; and in particular, it is most useful when you have to make long-lived commitments that expose you to vagaries of an unknown future; that is, for investment. Throttling down the supply of liquidity will not just reduce prices and spending across the board, it will reduce them particularly for long-lived capital goods.

The second point, that inflation loses its defintion as a distinct phenomenon at low levels, and fades into the general mix of price changes, is something I’ve thought myself for a while but have never seen someone spell out this way. (I’m sure people have.) It follows directly from the fact that changes in the prices of particualr goods don’t scale proportionately with inflation, so as inflation gets low, the shared component of price changes over time gets smaller and harder to identify. Because the shared component is smaller at low inflation, it is going to be more sensitive to the choice of basket and other measurement issues. 20 percent inflation clearly (it seems to me) represents a genuine phenomenon. But it’s not clear that 2 percent inflation really does – an impression reinforced by the proliferation of alternative measures.

The Minskyan two-price argument also means that credit conditions and monetary policy necessarily affect the directiona s well as the level of economic activity.

financial booms tend to misallocate resources, not least because too many resources go into sectors such as construction… It is hard to imagine that interest rates are simply innocent bystanders. At least for any policy relevant horizon, if not beyond, these observations suggest that monetary policy neutrality is questionable.

This was one of the main points in Mike Konczal’s and my monetary toolkit paper.

In the next section, which deserves a much fuller unpacking, Borio critiques the fashionable idea that central banks cannot control the real rate of interest. 

 Recent research going back to the 1870s has found a pretty robust link between monetary regimes and the real interest rate over long horizons. By contrast, the “usual suspects” seen as driving saving and investment – all real variables – do not appear to have played any consistent role. 

This conflation of the “real”  (inflation-adjusted) interest rate with a rate determined by “real” (nonmonetary) factors, and therefore beyond the central bank’s influence, is one of the key fissure-points in economic ideology.4 The vision of economics, espcially its normative claims, depend on an idea of ecnomic life as the mutually beneficial exchange of goods. There is an obvious mismatch between this vision and the language we use to talk about banks and market interest rates and central banks — it’s not that they contradict or in conflict as that they don’t make contact at all. The preferred solution, going from today’s New Keynesian consensus back through Friedman to Wicksell, is to argue that the “interest rate” set by the central bank must in some way be the same as the “interest rate” arrived at by agents exchanging goods today for goods later. Since the  terms of these trades depend only on the non-monetary fundamentals of preferences and technology, the same must in the long run be true of the interest rate set by the financial system and/or the central bank. The money interest rate cannot persistently diverge from the interest rate that would obtain in a nonmonetary exchange economy that in some sense corresponds to the actual one.

But you can’t square the circle this way. A fundamental Keynesian insight is that economic relations between the past and the future don’t take the form of trades of goods now for goods later, but of promises to make money payments at some future date or state of the world. Your ability to make money promises, and your willingness to accept them from others, depends not on any physical scarcity, but on your confidence in your counterparties doing what they promised, and in your ability to meet your own commitments if some expected payment doesn’t come through. In short, as Borio says, it depends on trust. In other words, the fundamental problem for which interest is a signal is not allocation but coordination. When interest rates are high, that reflects not a scarcity of goods in the present relative to the future, but a relative lack of trust within the financial system. Corporate bond rates did not spike in 2008 because decisionmakers suddenly wished to spend more in the present relative to the future, but because the promises embodied in the bonds were no longer trusted.

Here’s another way of looking at it: Money is valuable. The precursor of today’s “real interest rate” talk was the idea of money as neutral in the long run, in the sense that a change in the supply of money would eventually lead only to a proportionate change in the price level.5  This story somehow assumes on the one hand that money is useful, in the sense that it makes transactions possible that wouldn’t be otherwise. Or as Kocherlakota puts it: “At its heart, economic thinking about fiat money is paradoxical. On the one hand, such money is viewed as being inherently useless… But at the same time, these barren tokens… allow society to implement allocations that would not otherwise be achievable.” If money is both useful and neutral, evidently it must be equally useful for all transactions, and its usefulness must drop suddenly to zero once a fixed set of transactions have been made. Either there is money or there isn’t. But if additional money does not allow any desirable transaction to be carried out that right now cannot be, then shouldn’t the price of money already be zero? 

Similarly: The services provided by private banks, and by the central bank, are valuable. This is the central point of Borio’s talk. The central bank’s explicit guarantee of certain money commitments, and its open ended readiness to ensure that others are fulfilled in a crisis, makes a great many promises acceptable that otherwise wouldn’t be. And like the provider of anything of value, the central bank — and financial system more broadly — can affect its price by supplying more or less of it. It makes about as much sense to say that central banks can influence the interest rate only in the short run as to say that public utilities can only influence the price of electricity in the short run, or that transit systems can only influence the price of transportation in the short run. The activities of the central bank allow a greater degree of trust in the financial system, and therefore a lesser required payment to its professional promise-accepters.6 Or less trust and higher payments, as the case may be. This is true in the short run, in the medium run, in the long run. And because of the role money payments play in organizing productive activity, this also means a greater or lesser increase in our collective powers over nature and ability to satisfy our material wants.

 

Five, Ten or Even Thirty Years

Neel Kashkari is clearly a very smart guy. He’s been an invaluable voice for sanity at the Fed these past few years. Doesn’t he see that something has gone very wrong here?

Kashkari:

When people borrow money to buy a house, or businesses take out a loan to build a new factory, they don’t really care about overnight interest rates. They care about what interest rates will be for the term of their loan: 5, 10 or even 30 years. [*] Similarly, when banks make loans to households and businesses, they also try to assess where interest rates will be over the length of the loan when they set the terms. Hence, expectations about future interest rates are enormously important to the economy. When the Fed wants to stimulate more economic activity, we do that by trying to lower the expected future path of interest rates. When we want to tap the brakes, we try to raise the expected future path of interest rates.

Here’s the problem: recession don’t last 5, 10 or even 30 years. Per the NBER, they last a year to 18 months.

Mainstream theory says we have a long run dictated by supply side — technology, demographics, etc. On average the output gap is zero, or at least, it’s at a stable level. On top of this are demand disturbances or shocks — changes in desired spending — which produce the businesses cycle, alternating periods of high unemployment and normal growth or rising inflation. The job of monetary policy is to smooth out these short-term fluctuations in demand; it absolves itself of responsibility for the longer-run growth path.

If policy responding to demand shortfalls lasting a year or two, how is that supposed to work if policy shifts have to be maintained for 5, 10 or even 30 years to be effective?

If the Fed is faced with rising inflation in 2005, is it supposed to respond by committing itself to keeping rates high even in 2010, when the economy is sliding into depression? Does anyone think that would have been a good idea? (I seriously doubt Kashkari thinks so.) And if it had made such a commitment in 2005, would anyone have worried about breaking it in 2010? But if the Fed can’t or shouldn’t make such a commitment, how is this vision of monetary policy supposed to work?

If monetary policy is only effective when sustained for 5, 10 or even 30 years, then monetary policy is not a suitable tool for managing the business cycle. Milton Friedman pointed this out long ago: It is impossible for countercyclical monetary policy to work unless the lags with which it takes effect are decidedly shorter than the frequency of the shocks it is supposed to respond to. The best you can do, in his view, is maintain a stable money supply growth that will ensure stable inflation over the long run.

Meanwhile, conventional monetary policy rules like the Taylor rule are defined based on current macroeconomic conditions — today’s inflation rate, today’s output gap, today’s unemployment rate. There’s no term in there for commitments the Fed made at some point in the past. The Taylor rule seems to describe the past two or three decades of monetary policy pretty well. Now, Kashkari says the Fed can influence real activity only insofar as it is setting policy over the next 5, 10 or even 30 year’s based on today’s conditions. But what the Fed actually will do, if the Taylor rule continues to be a reasonable guide, is to set monetary policy based on conditions over the next 5, 10 or even 30 years. So if Kashkari takes his argument seriously, he must believe that monetary policy as it is currently practiced is not effective at all.

In the abstract, we can imagine some kind of rule that sets policy today as some kind of weighted average of commitments made over the past 5, 10 or even 30 years. Of course neither economic theory nor official statements describe policy this way. Still, in the abstract, we can imagine it. But in practice? FOMC members come and go; Kashkari is there now, he’ll be gone next year. The chair and most members are appointed by presidents, who also come and go, sometimes in unpredictable ways. Whatever Kashkari thinks is the appropriate policy for 2022, 2027 or 2047, it’s highly unlikely he’ll be there to carry it out. Suppose that in 2019 Fed chair Kevin Warsh  looks at the state of the economy and says, “I think the most appropriate policy rate today is 4 percent”. Is it remotely plausible that that sentence continues “… but my predecessor made a commitment to keep rates low so I will vote for 2 percent instead”? If that’s the reed the Fed’s power over real activity rests on it, it’s an exceedingly thin one. Even leaving aside changes of personnel, the Fed has no institutional capacity to make commitments about future policy. Future FOMC members will make their choices based on their own preferred models of the economy plus the data on the state of the economy at the time. If monetary policy only works through expectations of policy 5, 10 or even 30 years from now, then monetary policy just doesn’t work.

There are a few ways you can respond to this.

One is to accept Kashkari’s premise — monetary policy is only effective if sustained over many years — and follow it to its logical conclusion: monetary policy is not useful for stabilizing demand over the business cycle. Two possible next steps: Friedman’s, which concludes that stabilizing demand at business cycle frequencies is not a realistic goal for policy, and the central bank should focus on the long-term price level; and Abba Lerner’s, which concludes that business cycles should be dealt with by fiscal policy instead.

The second response is to start from the fact — actual or assumed — that monetary policy is effective at smoothing out the business cycle, in which case Kashkari’s premise must be wrong. Evidently the effect of monetary policy on activity today does not depend on beliefs about what policy will be 5, 10 or even 30 years from now. This is not a hard case to make. We just have to remember that there is not “an” interest rate, but lots of different credit markets, with rationing as well as prices, with different institutions making different loans to different borrowers. Policy is effective because it targets some particular financial bottleneck. Perhaps stocks or inventories are typically financed short-term and changes in their financing conditions are also disproportionately likely to affect real activity; perhaps mortgage rates, for institutional reasons, are more closely linked to the policy rate than you would expect from “rational” lenders; perhaps banks become more careful in their lending standards as the policy rate rises. One way or another, these stories depend on widespread liquidity constraints and the lack of arbitrage between key markets. Generations of central bankers have told stories like these to explain the effectiveness of monetary policy. Remember Ben Bernanke? His article Inside the Black Box is a classic of this genre, and its starting point is precisely the inadequacy of Kashkari’s interest rate story to explain how monetary policy actually works. Somehow or other policy has to affect the volume of lending on a short timeframe than it can be expected to move long rates. Going back a bit further, the Fed’s leading economist of the 1950s, Richard Roosa, was vey clear that neither the direct effect of Fed policy shifts on longer rates, nor of interest rates on real activity, could be relied on. What mattered rather was the Fed’s ability to change the willingness of banks to make loans. This was the “availability doctrine” that guided monetary policy in the postwar years. [2] If you think monetary policy is generally an effective tool to moderate business cycles, you have to believe something like this.

Response three is to accept Kashkari’s premise, yet also to believe that monetary works. This means you need to adjust your view of what policy is supposed to be doing. Policy that has to be sustained for 5, 10 or even 30 years to be effective, is no good for responding to demand shortfalls that last only a year or two at most. It looks better if you think that demand may be lacking for longer periods, or indefinitely. If shifts in demand are permanent, it’s not such a problem that to be effective policy shifts must also be permanent, or close to it. And the inability to make commitments is less of a problem in this case; now if demand is weak today, theres a good chance it will be weak in 5, 10 or even 30 years too; so policy will be persistent even if it’s only based on current conditions. Obviously this is inconsistent with an idea that aggregate demand inevitably gravitates toward aggregate supply, but that’s ok. It might indeed be the case that demand deficiencies an persist indefinitely, requiring an indefinite maintenance of lower rates. There’s a good case that something like this response was Keynes’ view. [3] But while this idea isn’t crazy, it’s certainly not how central banks normally describe what they’re doing. And Kashkari’s post doesn’t present itself as a radical reformulation of monetary policy’s goals, or mention secular stagnation or anything like that.

I don’t know which if any of these responses Kashkari would agree with. I suppose it’s possible he sincerely believes that policy is only effective when sustained for 5, 10 or even 30 years, and simply hasn’t noticed that this is inconsistent with a mission of stabilizing demand over business cycles that turn much more quickly. Given what I’ve read of his I feel this is unlikely. It also seems unlikely that he really thinks you can understand monetary policy while abstracting from banks, finance, credit and, well, money — that you can think of it purely in terms of an intertemporal “interest rate,” goods today vs goods tomorrow, which the central bank can somehow set despite controlling neither preferences nor production possibilities. My guess: When he goes to make concrete policy, it’s on the basis of some version of my response two, an awareness that policy operates through the concrete financial structures that theory abstracts from. And my guess is he wrote this post the way he did because he thought the audience he’s writing for would be more comfortable with a discussion of the expectations of abstract agents, than with a discussion of the concrete financial structures through which monetary policy is transmitted. It doesn’t hurt that the former is much simpler.

Who knows, I’m not a mind reader. But it doesn’t really matter. Whether the most progressive member of the FOMC has forgotten everything his predecessors knew about the transmission of monetary policy, or whether he merely assumes his audience has, the implications are about the same. “The Fed sets the interest rate” is not the right starting point for thinking about monetary policy manages aggregate demand.

 

[1] This is a weird statement, and seems clearly wrong. My wife and I just bought a house, and I can assure you we were not thinking at all about what interest rates would be many years from now. Why would we? — our monthly payments are fixed in the contract, regardless of what happens to rates down the road. Allowing the buyer to not care about future interest rates is pretty much the whole point of the 30-year fixed rate mortgage. Now it is true that we did care, a little, about interest rates next year (not in 5 years). But this was in the opposite way that Kashkari suggests — today’s low rates are more of an inducement to buy precisely if they will not be sustained, i.e. if they are not informative about future rates.

I think what may be going on here is a slippage between long rates — which the borrower does care about — and expected short rates over the length of the loan. In any case we can let it go because Kashkari’s argument does work in principle for lenders.

[2] Thanks to Nathan Tankus for pointing this article out to me.

[3] Leijonhufvud as usual puts it best:

Keynes looked forward to an indefinite period of, at best, unrelenting deflationary pressure and painted it in colors not many shades brighter than the gloomy hues of the stagnationist picture. But these stagnationist fears were based on propositions that must be stated in terms of time-derivatives. Modern economies, he believed, were such that, at a full employment rate of investment, the marginal efficiency of capital would always tend to fall more rapidly than the long rate of interest. … When he states that the long rate “may fluctuate for decades about a level which is chronically too high” one should … see this in the historical context of the “obstinate maintenance of misguided monetary policies” of which he steadily complained.

Rogoff on the Zero Lower Bound

I was at the ASSAs in Chicago this past weekend. [1] One of the most interesting panels I went to was this one, on Advances in Open Economy Macroeconomics. Among other big names, Ken Rogoff was there, as the discussant for a rather strange paper by Pierre-Olivier Gourinchas and Helene Rey.

The Gourinchas and Rey paper, like much of mainstream macro these days, made a big deal of how different everything is at the zero lower bound. Rogoff wasn’t having it. Here’s a rough transcript of what he said:

The obsession with the zero lower bound is encouraging all kinds of wacko ideas. People are saying that at the ZLB, productivity increases are bad (Eggertsson/Krugman/Summers), protectionism is good (Eichngreen), price flexibility is bad, and so on.

But there is an emerging literature that says economists are taking the zero lower bound too literally. In fact, getting negative rates is not that hard. So before you take seriously these, let’s say, very creative ideas, it would be simpler to think about getting rid of the zero bound.

There are lots of ways to do it. I talk about some in my book, but people already understood this back in the 1930s. There was Robert Eisler’s proposal to have banks accept cash deposits at a discount, for instance, which would have effectively created negative rates. If Keynes had read Eisler, he might have gone in a different direction. [2] It’s a very old idea — Kublai Khan did something similar. There will be pushback from the financial sector, of course, who think negative rates will be costly for them, but fundamentally it is not hard to do.

These rather striking comments crystallized something in my mind. What is the big deal about the ZLB? For mainstream macroeconomists, including Gourinchas and Rey in this paper, the reason the ZLB matters is that it prevents the central bank form setting an interest rate low enough to keep output at potential. [3] It’s precisely this that makes inapplicable the conventional analysis of a nonmonetary problem of allocating scarce resources between alternative ends, and requires thinking about other entry points. If the central bank can’t solve the problem of aggregate demand then you have to take it seriously, with all the wacko and/or creative stuff that follows.

In the dominant paradigm, this is a specific technical problem of getting interest rates below zero. Solve that, and we are back in the comfortable Walrasian world. But for those of us on the heterodox side, it is never the case that the central bank can reliably keep output at potential — maybe because market interest rates don’t respond to the policy rate, or because output doesn’t respond to interest rates, or because the central bank is pursuing other objectives, or because there is no well-defined level of “potential” to begin with. (Or, in reality, all four.) So what people like Gourinchas and Rey, or Paul Krugman, present as a special, temporary state of the economy, we see as the general case.

One way of looking at this is that the ZLB is a device to allow economists like Krugman and Gourinchas and Rey — who whatever their scholarly training, are aware of the concrete reality around them — to make Keynesian arguments without forfeiting their academic respectability. You can understand why someone like Rogoff sees that as cheating. We’ve spent decades teaching that the fundamental constraint on the economy is the real endowment of resources and technology; that saving boosts growth; that trade is always win-win; that money and finance matter only in the short run (and the short run is tolerably short). The practical problem of negative policy rates doesn’t let you forget all of that.

Which, if you turn it around, perhaps reflects well on the ZLB crowd. Maybe they want to forget all that? Maybe, you could say, they take the zero lower bound seriously because they don’t take it literally. That is, they treat it as a hard constraint precisely because they are aware that it is only a stand-in for a deeper reality.

 

[1] The big annual economics conference. It stands for Allied Social Sciences Association — the disciplinary imperialism is right there in the name.

[2] This was an odd thing for Rogoff to say, since of course while Keynes didn’t discuss Eisler as far as I know, he talks at length about the similar proposals for depreciating cash of Silvio Gesell and Major Douglas. Notoriously he says these “brave cranks and heretics” have more to offer than Marx.

[3] Gourinchas and Rey are reality-based enough to say “the policy rate,” not “the interest rate.”

 

EDIT: Added the seriously-but-not-literally phrasing as suggested by Steve Roth on Twitter.

Thoughts and Links for December 21, 2016

Aviation in the 21st century. I’m typing this sitting on a plane, en route to LA. The plane is a Boeing 737-800. The 737 is the best-selling commercial airliner on earth; reading its Wikipedia page should raise some serious doubts about the idea that we live in an era of accelerating technological change. I’m not sure how old the plane I’m sitting on is, but it could be 15 years; the 800-series was introduced in its present form in the late 1990s. With airplanes, unlike smartphones, a 20-year old machine is not dramatically — is not even noticeably — different from the latest version. The basic 737 model was first introduced in 1967. There have been upgrades since then, but to my far from expert eyes it’s striking how little changed tin 50 years. The original 737 carried 120 passengers, at speeds of 800 km/h on trips of up to 3,000 km, using 6 liters of fuel per kilometer; this model carries 160 passengers (it’s longer) at speeds of 840 km/h on trips of 5,500 km, using 5 liters of fuel per kilometer. Better, sure, but probably the main difference you’d actually notice from a flight 50 years ago is purely social: no smoking. In any case it’s pretty meager compared that with the change from 50 years earlier, when commercial air travel didn’t exist. The singularity is over; it happened on or about December 1910.

 

Unnatural rates. Here’s an interesting post on the New York Fed’s Liberty Street blog challenging the ideas of “natural rates” of interest and unemployment. good: These ideas, it seems to me, are among the biggest obstacles to thinking constructively about macroeconomic policy. Obviously it’s example of, well, naturalizing economic outcomes, and in particular it’s the key ideological element in presenting the planning by the central bank as simply reproducing the natural state of the economy. But more specifically, it’s one of the most important ways that economists paper over the disconnect between the the economic-theory world of rational exchange, and the real world of monetary production. Without the natural rate, it would be much hard to  pretend that the sort of models academic economists develop at their day jobs, have any connection to the real-world problems the rest of the world expects economists to solve. Good to see, then, some economists at the Fed acknowledging that the natural rate concepts (and its relatives like the natural rate of unemployment) is vacuous, for two related reasons. First, the interest rate that will bring output to potential depends on a whole range of contingent factors, including other policy choices and the current level of output; and second, that potential output itself depends on the path of demand. Neither potential output nor the natural rate reflects some deep, structural parameters. They conclude:

the risks associated with monetary easing are asymmetric. That is, excessive easing can be reversed, but excessive tightening may cause irreversible damage to the economy’s potential output.

In the research described in this blog, we focus on the effect of recessions on human capital. Recessions may affect potential output through other channels as well, such as lower capital accumulation, lower labor force participation, slow productivity growth, and so forth. Our research would suggest that to the extent that these mechanisms are operative, a monetary policy that seeks to track measured natural rates—of unemployment, interest rates, and so forth—might be insufficiently accommodative to engineer a full and quick recovery after a large recession. Such policies fall short because in a world with hysteresis, “natural” rates are endogenous. Policy should set these rates, not track them.

Also on a personal level, it’s nice to see that the phrases “potential output,” “other channels,” “lower labor force particiaption,” and “slow productivity growth” all link back to posts on this very blog. Maybe someone is listening.

 

More me being listened to: Here is a short interview I did with KCBS radio in the Bay area, on what’s wrong with economics. And here is a nice writeup by Cory Doctorow at BoingBoing of “Disgorge the Cash,” my Roosevelt paper on shareholder payouts and investment.

 

Still disgorging. Speaking of that: There were two new working papers out from the NBER last week on corporate finance, governance and investment. I’ve only glanced at them (end of semester crunch) but they both look like important steps forward for the larger disgorge the cash/short-termism argument. Here are the abstracts:

Lee, Shin and Stultz – Why Does Capital No Longer Flow More to the Industries with the Best Growth Opportunities?

With functionally efficient capital markets, we expect capital to flow more to the industries with the best growth opportunities. As a result, these industries should invest more and see their assets grow more relative to industries with the worst growth opportunities. We find that industries that receive more funds have a higher industry Tobin’s q until the mid-1990s, but not since then. Since industries with a higher funding rate grow more, there is a negative correlation not only between an industry’s funding rate and industry q but also between capital expenditures and industry q since the mid-1990s. We show that capital no longer flows more to the industries with the best growth opportunities because, since the middle of the 1990s, firms in high q industries increasingly repurchase shares rather than raise more funding from the capital markets.

And:

Gutierrez and Philippon – Investment-less Growth: An Empirical Investigation

We analyze private fixed investment in the U.S. over the past 30 years. We show that investment is weak relative to measures of profitability and valuation… We use industry-level and firm-level data to test whether under-investment relative to Q is driven by (i) financial frictions, (ii) measurement error (due to the rise of intangibles, globalization, etc), (iii) decreased competition (due to technology or regulation), or (iv) tightened governance and/or increased short-termism. We do not find support for theories based on risk premia, financial constraints, or safe asset scarcity, and only weak support for regulatory constraints. Globalization and intangibles explain some of the trends at the industry level, but their explanatory power is quantitatively limited. On the other hand, we find fairly strong support for the competition and short-termism/governance hypotheses. Industries with less entry and more concentration invest less, even after controlling for current market conditions. Within each industry-year, the investment gap is driven by firms that are owned by quasi-indexers and located in industries with less entry/more concentration. These firms spend a disproportionate amount of free cash flows buying back their shares.

I’m especially glad to see Philippon taking this question up. His Has Finance Become Less Efficient is kind of a classic, and in general he somehow seems to manages to be both a big-time mainstream finance guy and closely attuned to observable reality.  A full post on the two NBER papers soon, hopefully, once I’ve had time to read them properly.

 

 

“Sets” how, exactly? Here’s a super helpful piece  from the Bank of France on the changing mechanisms through which central banks — the Fed in particular — conduct monetary policy. It’s the first one in this collection — “Exiting low interest rates in a situation of excess liquidity: the experience of the Fed.” Textbooks tell us blandly that “the central bank sets the interest rate.” This ignores the fact that there are many interest rates in the economy, not all of which move with the central bank’s policy rate. It also ignores the concrete tools the central bank uses to set the policy rate, which are not trivial or transparent, and which periodically have to adapt to changes in the financial system. Post-2008 we’ve seen another of these adaptations. The BoF piece is one of the clearest guides I’ve seen to the new dispensation; I found it especially clarifying on the role of reverse repos. You could probably use it with advanced undergraduates.

Zoltan Pozsar’s discussion of the same issues is also very good — it adds more context but is a bit harder to follow than the BdF piece.

 

When he’s right, he’s right. I have my disagreements with Brad DeLong (doesn’t everyone?), but a lot of his recent stuff has been very good. Here are a couple of his recent posts that I’ve particularly liked. First, on “structural reform”:

The worst possible “structural reform” program is one that moves a worker from a low productivity job into unemployment, where they then lose their weak tie social network that allows them to get new jobs. … “Structural reforms” are extremely dangerous unless you have a high-pressure economy to pull resources out of low productivity into high productivity sectors.

The view in the high councils of Europe is that, when there is a high-pressure economy, politicians will not press for “structural reform”: there is no obvious need, and so why rock the boat? Politicians kick every can they can down the road, and you can only try “structural reform” when unemployment is high–and thus when it is likely to be ineffective if not destructive.

This gets both the substance and the politics right, I think. Although one might add that structural reform also often means reducing wages and worker power in high productivity sectors as well.

Second, criticizing Yellen’s opposition to more expansionary policy,which she says is no longer needed to get the economy back to full employment.

If the Federal Reserve wants to have the ammunition to fight the next recession when it happens, it needs the short-term safe nominal interest rate to be 5% or more when the recession hits. I believe that is very unlikely to happen without substantial fiscal expansion. … In the world that Janet Yellen sees, “fiscal policy is not needed to provide stimulus to get us back to full employment.” But fiscal stimulus is needed to create a situation in which full employment can be maintained…. if we do not shift to a more expansionary fiscal policy–and the higher neutral rate of interest that it brings–now, what do we envision will happen when the next recession arrives?

This is the central point of my WCEG working paper — that output is jointly determined by the interest rate and the fiscal balance, so the “natural rate” depends on the current stance of fiscal policy.  Plus the argument that, in a world where the zero lower bound is a potential constraint — or more broadly, where the expansionary effects of monetary policy are limited — what is sometimes called “crowding out” is a feature, not a bug. Totally right, but there’s one more step I wish DeLong would take. He writes a lot, and it’s quite possible I’ve missed it, but has he ever followed this argument to its next logical step and concluded that the fiscal surpluses of the 1990s were, in retrospect, a bad idea?

 

Farmer on government debt. Also on government budgets, here are some sensible observations on the UK’s, from Roger Farmer. First, the British public deficit is not especially high by historical standards; second, past reductions in debt-GDP ratios were achieved by growth raising the denominator, not surpluses reducing the numerator; and third, there is nothing particularly desirable about balanced budgets or lower debt ratios in principle. Anyone reading this blog has probably heard these arguments a thousand times, but it’s nice to get them from someone other than the usual suspects.

 

Deviation and trend. I was struck by this slide from the BIS. The content is familiar;  what’s interesting is that they take the deviation of GDP from the pre-criss trend as straightforward evidence of the costs of the crisis, and not a demographic-technological inevitability.

 

Cap and dividend. In Jacobin, James Boyce and Mark Paul make the case for carbon permits. I used to take the conventional view on carbon pricing — that taxes and permits were equivalent in principle, and that taxes were likely to work better in practice. But Boyce’s work on this has convinced me that there’s a strong case for preferring dividends. A critical part of his argument is that the permits don’t have to be tradable — short-term, non transferrable permits avoid a lot of the problems with “cap and trade” schemes.

 

 

Why teach the worst? In a post at Developing Economics, New School grad student Ingrid Harvold Kvangraven forthrightly makes the case for teaching “the worst of mainstream economics” to non-economists. As it happens, I don’t agree with her arguments here. I don’t think there’s a hard tradeoff between teaching heterodox material we think is true, and teaching orthodox material students will need in future classes or work. I think that with some effort, it is possible to teach material that is both genuinely useful and meaningful, and that will serve students well in future economics class. And except for students getting a PhD in economics themselves — and maybe not even them — I don’t think “learning to critique mainstream theories” is a very pressing need. But I like the post anyway. The important thing is that all of us — especially on the heterodox side — need to think more of teaching not as an unfortunate distraction, but as a core part of our work as economists. She takes teaching seriously, that’s the important thing.

 

 

Apple in the balance of payments. From Brad Setser, here’s a very nice example of critical reading of the national accounts. Perhaps even more than in other areas of accounts, the classification of different payments in the balance of payments is more or less arbitrary, contested, and frequently changed. It’s also shaped more directly by private interests — capital flight, tax avoidance and so on often involve moving cross-border payments from one part of the BoP to another. So we need to be even more scrupulously attentive with BoP statistics than with others to how concrete social reality gets reflected in the official numbers. The particular reality Setser is interested in is Apple’s research and development spending in the US, which ought to show up in the BoP as US service exports. But hardly any of it does, because — as he shows — Apple arranges for almost all its IP income to show up in low-tax Ireland instead. To me, the fundamental lesson here is about the relation between statistical map and economic territory. But as Setser notes, there’s also a more immediate policy implication:

Trade theory says that if the winners from globalization compensate the losers from globalization, everyone is better off. But I am not quite sure how that is supposed to happen if the winners are in some significant part able to structure their affairs so that a large share of their income is globally (almost) untaxed.

 

Lost in Fiscal Space

Arjun and Jayadev and I have a working paper up at the Washington Center for Equitable Growth on the conflict between conventional macroeconomic policy and Lerner-style functional finance. Here’s the accompanying blogpost, cross-posted from the WCEG blog.

 

One pole of current debates about U.S. fiscal policy is occupied by the “functional finance” position—the view usually traced back to the late economist Abba Lerner—that a government’s budget balance can be set at whatever level is needed to stabilize aggregate demand, without worrying about the level of government debt. At the other pole is the conventional view that a government’s budget balance must be set to keep debt on a sustainable trajectory while leaving the management of aggregate demand to the central bank. Both sides tend to assume that these different policy views come from fundamentally different ideas about how the economy works.

A new working paper, “Lost in Fiscal Space,” coauthored by myself and Arjun Jayadev, suggests that, on the contrary, the functional finance and the conventional approaches can be understood in terms of the same analytic framework. The claim that fiscal policy can be used to stabilize the economy without ever worrying about debt sustainability sounds radical. But we argue that it follows directly from the standard macroeconomic models that are taught to undergraduates and used by policymakers.

Here’s the idea. There are two instruments: first, the interest rate set by the central bank; and second, the fiscal balance—the budget surplus or deficit. And there are two targets: the level of aggregate demand consistent with acceptable levels of inflation and unemployment; and a stable debt-to-GDP ratio. Each instrument affects both targets—output depends on both the interest rate set by monetary authorities and on the fiscal balance (as well as a host of other factors) while the change in the debt depends on both new borrowing and the interest paid on existing debt. Conventional policy and functional finance represent two different choices about which instrument to assign to which target. The former says the interest rate instrument should focus on demand and the fiscal-balance instrument should focus on the debt-ratio target, the latter has them the other way around.

Does it matter? Not necessarily. There is always one unique combination of interest rate and budget balance that delivers both stable debt and price stability. If policy is carried out perfectly then that’s where you will end up, regardless of which instrument is assigned to which target. In this sense, the functional finance position is less radical than either its supporters or its opponents believe.

In reality, of course, policies are not followed perfectly. One common source of problems is when decisions about each instrument are made looking only at the effects on its assigned target, ignoring the effects on the other one. A government, for example, may adopt fiscal austerity to bring down the debt ratio, ignoring the effects this will have on aggregate demand. Or a central bank may raise the interest rate to curb inflation, ignoring the effects this will have on the sustainability of the public debt. (The rise in the U.S. debt-to-GDP ratio in the 1980s owes more to Federal Reserve chairman Paul Volcker’s interest rate hikes than to President Reagan’s budget deficits.) One natural approach, then, is to assign each target to the instrument that affects it more powerfully, so that these cross-effects are minimized.

So far this is just common sense; but when you apply it more systematically, as we do in our working paper, it has some surprising implications. In particular, it means that the metaphor of “fiscal space” is backward. When government debt is large, it makes more sense, not less, to use active fiscal policy to stabilize demand—and leave the management of the public debt ratio to the central bank. The reason is simple: The larger the debt-to-GDP ratio, the more that changes in the ratio depend on the difference in between the interest rate and the growth rate of GDP, and the less those changes depend on current spending and revenue (a point that has been forcefully made by Council of Economic Advisers Chair Jason Furman). This is what we see historically: When the public debt is very large, as in the United States during and immediately after the Second World War, the central bank focused on stabilizing the public debt rather than on stabilizing demand, which means responsibility for aggregate demand fell to the budget authorities.

We hope this paper will help clarify what’s at stake in current debates about U.S. fiscal policy. The question is not whether it’s economically feasible to use fiscal policy as our primary instrument to manage aggregate demand. Any central bank that is able to achieve its price stability and full employment mandates is equally able to keep the debt-to-GDP ratio constant while the budget authorities manage demand. The latter task may even be easier, especially when debt is already high. The real question is who we, as a democratic society, trust to make decisions about the direction of the economy as a whole.

UPDATE: Nick Rowe has an interesting response here. (And an older one here, with a great comments thread following it.)

Links for October 14

Now we are making progress. This piece by CEA chair Jason Furman on “the new view” of fiscal policy seems like a big step forward for mainstream policy debate. He goes further than anyone comparably prominent in rejecting the conventional macro-policy wisdom of the past 30 years. From where I’m sitting, the piece advances beyond the left edge of the current mainstream discussion in at least three ways.

First, it abandons the idea of zero interest rates as a special state of exception and accepts the idea of fiscal policy as a routine tool of macroeconomic stabilization. Reading stuff like this, or like SF Fed President John Williams saying that fiscal policy should be “a first responder to recessions,” one suspects that the post-1980s consensus that stabilization should be left to the central banks may be gone for good. Second, it directly takes on the idea that elected governments are inherently biased toward stimulus and have to be institutionally restrained from overexpansionary policy. This idea — back up with some arguments about  the“time-inconsistency” of policy that don’t really make sense — has remained a commonplace no matter how much real-world policy seems to lean the other way. It’s striking, for instance, to see someone like Simon Wren-Lewis rail against “the austerity con” in his public writing, and yet in his academic work take it as an unquestioned premise that elected governments suffer from “deficit bias.” So it’s good to see Furman challenge this assumption head-on.

The third step forward is the recognition that the long-run evolution of the debt ratio depends on GDP growth and interest rates as well as on the fiscal balance. Some on the left will criticize his assumption that the debt ratio is something policy should be worried about at all — here the new view has not yet broken decisively with the old view; I might have some criticisms of him on this point myself. But it’s very important to point out, as he does, that “changes in the debt ratio depend on two factors: the difference between the interest rate and the growth rate… and the primary balance… The larger the debt is, the more changes in r – g dwarf the primary balance in the determination of debt dynamics.” (Emphasis added.) The implication here is that the “fiscal space” metaphor is backward — if the debt ratio is a target for policy, then a higher current ratio means you should focus more on growth, and that responsibility for the “sustainability” of the debt rests more with the monetary authority than the fiscal authority. Admittedly Furman doesn’t follow this logic as far as Arjun and I do in our paper, but it’s significant progress to foreground the fact the debt ratio has both a numerator and a denominator.

If you’re doubting whether there’s anything really new here, just compare this piece with what his CEA chair predecessor Christina Romer was saying a decade ago — you couldn’t ask for a clearer statement of what Furman now rejects as “the old view.” It’s also, incidentally, a sign of how far policy discussions — both new view and old view — are from academic macro. DSGE models and their associated analytic apparatus don’t have even a walk-on part here. I think left critics of economics are too quick to assume that there is a tight link — a link at all, really — between orthodox theory and orthodox policy.

 

Why do stock exchanges exist? I really enjoyed this John Cochrane post on volume and information in financial markets. The puzzle, as he says, is why there is so much trading — indeed, why there is any trading at all. Life cycle and risk preference motivations could support, at best, a minute fraction of the trading we see; but information trading — the overwhelming bulk of actual trading — has winners and losers. As Cochrane puts it:

all trading — any deviation of portfolios from the value-weighted market index — is zero sum. Informed traders do not make money from us passive investors, they make money from other traders. It is not a puzzle that informed traders trade and make money. The deep puzzle is why the uninformed trade, when they could do better by indexing. …

Stock exchanges exist to support information trading. The theory of finance predicts that stock exchanges, the central institution it studies, the central source of our data, should not exist. The tiny amounts of trading you can generate for life cycle or other reasons could all easily be handled at a bank. All of the smart students I sent to Wall Street for 20 years went to participate in something that my theory said should not exist.

At first glance this might seem like one of those “puzzles” beloved of economists, where you describe some real-world phenomena in terms of a toy model of someone maximizing something, and then treat the fact that it doesn’t work very well as a surprising fact about the world rather than an unsurprising fact about your description. But in this case, the puzzle seems real; the relevant assumptions apply in financial markets in a way they don’t elsewhere.

I like that Cochrane makes no claim to have a solution to the puzzle — the choice to accept ignorance rather than grab onto the first plausible answer is, arguably, the starting point for scientific thought and certainly something economists could use more of. (One doesn’t have to accept the suggestion that if we have no idea what social needs, if any, are met by financial markets, or if there is too much trading or too little, that that’s an argument against regulation.) And I like the attention to what actual traders do (and say they do), which is quite different from what’s in the models.

 

Yes, we know it’s not a “real” Nobel. So the Nobel went to Hart and Holmstrom. Useful introductions to their work are here and here. Their work is on contract theory: Why do people make complex ongoing agreements with each other, instead of just buying the things they want? This might seem like one of those pseudo-puzzles — as Sanjay Reddy notes on Twitter, the question only makes sense if you take economists’ ideal world as your starting point. There’s a whole genre of this stuff: Take some phenomenon we are familiar with from everyday life, or that has been described by other social scientists, and show that it can also exist in a world of exchange between rational monads. Even at its best, this can come across like a guy who learns to, I don’t know, play Stairway to Heaven with a set of spoons. Yes, getting the notes out takes real skill, and it doesn’t sound bad, but it’s not clear why you would play it that way if you weren’t for some reason already committed to the gimmick. Or in this case, it’s not clear what we learn from translating a description of actual employment contracts into the language of intertemporal optimization; the process requires as an input all the relevant facts about the phenomenon it claims to explain. What’s the point, unless you are for some already committed to ignoring any facts about the world not expressed in the formalism of economics? This work — I admit I don’t know it well — also makes me uncomfortable with the way it seems to veer opportunistically between descriptive and prescriptive. Is this about how actual contracts really are optimal given information constraints and so on, or is it about how optimal contracts should be written? Anyway, here’s a more positive assessment from Mark Thoma.

 

Still far from full employment. Heres’ a helpful report from the Center for Economics and Policy Research on the state of the labor market. They look at a bunch of alternatives to the conventional unemployment rate and find that all of them show a weaker labor market than in 2006-2007. Hopefully the Clinton administration and/or some Democrats in the Senate will  put some sharp questions to FOMC appointees over the next few years about whether they think the Fed as fulfilled its employmnet mandate, and on what basis. They’ll find some useful ammunition here.

 

Saving, investment and the natural rate. Here’s a new paper from Lance Taylor taking another swipe at the pinata of the “natural rate”. Taylor points out that if the “natural” interest rate simply means the interest rate at which aggregate demand equals potential output (even setting aside questions about how we measure potential), the concept doesn’t make much sense. If we look at the various flows of spending on goods and services by sector and purpose, we can certainly identify flows that are more or less responsive to interest rates; but there is no reason to think that interest rate changes are the main driver of changes in spending, or that “the” interest rate that balances spending and potential at a given moment is particularly stable or represents any kind of fundamental parameters of the economy. Even less can we think of the “natural” rate as balancing saving and investment, because, among other reasons, “saving” is dwarfed by the financial flows between and within sectors. Taylor also takes Keynes to task (rightly, in my view) for setting us on the wrong track with assumption that households save and “entrepreneurs” invest, when in fact most of the saving in the national accounts takes place within the corporate sector.

 

On other blogs, other wonders:

At Vox, another reminder that the rise in wealth relative to income that Piketty documents is mainly about the rising value of existing assets, not the savings-and-accumulation process he talks about in his formal models.

Also at Vox: How much did Germany benefit from debt forgiveness after World War II? (A lot.) EDIT: Also here.

Is there really a “global pivot” toward more expansionary fiscal policy? The IMF and Morgan Stanley both say no.

Another one for the short-termism file: Here’s an empirical paper suggesting that when banks become publicly traded, their management starts responding to short-run movements in their stock, taking on more risk as a result.

Matias Vernengo has a new paper on Raul Prebisch’s thought on business cycles and growth. Prebisch would be near the top of my list of twentieth century economists who deserve more attention than they get.

I was just at Verso for the release party for Peter Frase’s new book Four Futures, based on his widely-read Jacobin piece. I don’t really agree with Peter’s views on this — I don’t see the full replacement of human labor by machines as the logical endpoint of either the historical development of capitalism or a socialist political project — but he makes a strong case. If the robot future is something you’re thinking about, you should definitely buy the book.

 

EDIT: Two I meant to include, and forgot:

David Glasner has a follow-up post on the inconsistency of rational expectations with the “shocks” and comparative statics they usually share models with. It’s probably not worth beating this particular dead horse too much more, but one more inconsistency. As I can testify first-hand, at most macroeconomic journals, “lacks microfoundations” is sufficient reason to reject a paper. But this requirement is suspended as soon as you call something a “shock,” even though technology, the markup, etc. are forms of behavior just as much as economic quantities or prices are. (This is also one of Paul Romer’s points.)

And speaking of people named Romer, David and and Christina Romer have a new working paper on US monetary policy in the 1950s. It’s a helpful paper — it’s always worthwhile to reframe abstract, universal questions as concrete historical ones — but also very orthodox in its conclusions. The Fed did a good job in the 1950s, in their view, because it focused single-mindedly on price stability, and was willing to raise rates in response to low unemployment even before inflation started rising. This is a good example of the disconnect between the academic mainstream and the policy mainstream that I mentioned above. It’s perfectly possible to defend orthodoxy macroeconomic policy without any commitment to, or use of, orthodox macroeconomic theory.

 

EDIT: Edited to remove embarrassing confusion of Romers.

Links for May 25, 2016

Deliberately. The IMF has released its new Debt Sustainability Analysis for Greece. Frances Coppola has the details, and they are something. Per the IMF,

Demographic projections suggest that working age population will decline by about 10 percentage points by 2060. At the same time, Greece will continue to struggle with high unemployment rates for decades to come. Its current unemployment rate is around 25 percent, the highest in the OECD, and after seven years of recession, its structural component is estimated at around 20 percent. Consequently, it will take significant time for unemployment to come down. Staff expects it to reach 18 percent by 2022, 12 percent by 2040, and 6 percent only by 2060.

Frances adds:

For Greece’s young people currently out of work, that is all of their working life. A whole generation will have been consigned to the scrapheap. …

The truth is that seven years of recession has wrecked the Greek economy. It is no longer capable of generating enough jobs to employ its population. The IMF estimates that even in good times, 20 percent of adults would remain unemployed. To generate the jobs that are needed there will have to be large numbers of new businesses, perhaps even whole new industries. Developing such extensive new productive capacity takes time and requires substantial investment – and Greece is not the most attractive of investment prospects. Absent something akin to a Marshall Plan, it will take many, many years to repair the damage deliberately inflicted on Greece by European authorities and the IMF in order to bail out the European banking system.

For some reason, that reminds me of this. Good times.

Also, here’s the Economist, back in 2006:

The core countries of Europe are not ready to make the economic reforms they so desperately need—and that will change, alas, only after a diabolic economic crisis. … The sad truth is that voters are not yet ready to swallow the nasty medicine of change. Reform is always painful. And there are too many cosseted insiders—those with secure jobs, those in the public sector—who see little to gain and much to lose. … One reason for believing that reform can happen … is that other European countries have shown the way. Britain faced economic and social meltdown in 1979; there followed a decade of Thatcherite reform. … The real problem, not just for Italy and France but also for Germany, is that, so far, life has continued to be too good for too many people.

I bet they’re pretty pleased right now.

 

 

Polanyism. At Dissent, Mike Konczal and Patrick Iber have a very nice introduction to Karl Polanyi. One thing I like about this piece is that they present Polanyi as a sort of theoretical back-formation for the Sanders campaign.

The vast majority of Sanders’s supporters … are, probably without knowing it, secret followers of Karl Polanyi. …

One of the divides within the Democratic primary between Bernie Sanders and Hillary Clinton has been between a social-democratic and a “progressive” but market-friendly vision of addressing social problems. Take, for example, health care. Sanders proposes a single-payer system in which the government pays and health care directly, and he frames it explicitly in the language of rights: “healthcare is a human right and should be guaranteed to all Americans regardless of wealth or income.” … Sanders offers a straightforward defense of decommodification—the idea that some things do not belong in the marketplace—that is at odds with the kind of politics that the leadership of the Democratic Party has offered … Polanyi’s particular definition of socialism sounds like one Sanders would share.

 

Obamacare and the insurers. On the subject of health care and decommodification, I liked James Kwak’s piece on Obamacare.

The dirty not-so-secret of Obamacare … is that sometimes the things we don’t like about market outcomes aren’t market failures—they are exactly what markets are supposed to do. …  at the end of the day, Obamacare is based on the idea that competition is good, but tries to prevent insurers from competing on all significant dimensions except the one that the government is better at anyway. We shouldn’t be surprised when insurance policies get worse and health care costs continue to rise.

It’s too bad so many intra-Democratic policy debates are conducted in terms of the radical-incremental binary, it’s not really meaningful. You can do more or less of anything. Would be better to focus on this non-market vs market question.

In this context, I wish there’d been some discussion in the campaign of New York’s new universal pre-kindergarten, which is a great example incremental decommodification in practice. Admittedly I’m a bit biased — I live in New York, and my son will be starting pre-K next year. Still: Here’s an example of a social need being addressed not through vouchers, or tax credits, or with means tests, but through a universal public services, provided — not entirely, but mainly and increasingly — by public employees. Why isn’t this a model?

 

The prehistory of the economics profession. I really liked this long piece by Marshall Steinbaum and Bernard Weisberger on the early history of the American Economics Association. The takeaway is that the AEA’s early history was surprisingly radical, both intellectually and in its self-conception as part of larger political project. (Another good discussion of this is in Michael Perelman’s Railroading Economics.) This is history more people should know, and Steinbaum and Weisberger tell it well. I also agree with their conclusion:

That [the economics profession] abandoned “advocacy” under the banner of “objectivity” only raises the question of what that distinction really means in practice. Perhaps actual objectivity does not require that the scholar noisily disclaim advocacy. It may, in fact, require the opposite.

The more I struggle with this stuff, the more I think this is right. A field or discipline needs its internal standards to distinguish valid or well-supported claims from invalid or poorly supported ones. But evaluation of relevance, importance, correspondence to the relevant features of reality can never be made on the basis of internal criteria. They require the standpoint of some outside commitment, some engagement with the concrete reality you are studying distinct from your formal representations of it. Of course that engagement doesn’t have to be political. Hyman Minsky’s work for the Mark Twain Bank in Missouri, for example, played an equivalent role; and as Perry Mehrling observes in his wonderful essay on Minsky, “It is significant that the fullest statement of his business cycle theory was published by the Joint Economic Committee of the U.S. Congress.” But it has to be something. In economics, I think, even more than in other fields, the best scholarship is not going to come from people who are only scholars.

 

Negative rates, so what. Here’s a sensible look at the modest real-world impact of negative rates from Brian Romanchuk. It’s always interesting to see how these things look from the point of view of market participants. The importance of a negative policy rate has nothing to do with the terms on which present consumption trades off against future consumption, it’s about one component of the return on some assets relative to others.

 

I’m number 55. Someone made a list of the top 100 economics blogs, and put me on it. That was nice.

Links for April 12

Maybe I should aspire to do a links post like this once a week. Today is Tuesday; is Tuesday a good day? Or would it be better to break a post like this into half a dozen short ones, and put them up one at a time?

Anyway, some links and thoughts:

 

Public debt in the 21st century. Here is a very nice piece by DeLong, arguing that over the next 50 years, rich countries should see a higher level of public expenditure, and a higher level of public debt, and that even much higher debt ratios don’t have any important economic costs. There’s no shortage of people making this general case, but this is one of the better versions I’ve seen.

The point that the “sustainability” of a given deficit depends on the relation between interest rates and growth rates has of course been made plenty of times, by people like Jamie Galbraith and Scott Fullwiler. But there’s another important point in the DeLong piece, which is that technological developments — the prevalence of increasing returns, the importance of information and other non-rival goods, and in general the development of what Marx called the “cooperative form of the labour process” — makes the commodity form  less and less suitable for organizing productive activity. DeLong sees this as an argument for a secular shift toward government as opposed to markets as our central “societal coordinating mechanism” (and he says “Smithian market” rather than commodity form). But fundamentally this is the same argument that Marx makes for the ultimate supercession of capitalism in the penultimate chapter of Capital.

 

Short-termism at the BIS. Via Enno Schroeder, here’s a speech by Hyun Song Shin of the BIS, on the importance of bank capital. The most interesting thing for my purposes is how he describes the short-termism problem for banks:

Let me now come back to the question as to why banks have been so reluctant to plough back their profits into their own funds. … we may ask whether there are possible tensions between the private interests of some bank stakeholders versus the wider public interest of maintaining a soundly functioning banking system… shareholders may feel they can unlock some value from their shareholding by paying themselves a cash dividend, even at the expense of eroding the bank’s lending base.

As many of the shareholders are asset managers who place great weight on short-term relative performance in competition against their peers, the temptation to raid the bank’s seed corn may become too strong to resist. … These private motives are reasonable and readily understandable, but if the outcome is to erode capital that serves as the bank’s foundation for lending for the real economy, then a gap may open up between the private interests of some bank stakeholders and the broader public interest.

Obviously, this is very similar to the argument I’ve been making for the corporate sector in general. I especially like the focus on asset managers — this is an aspect of the short-termism story that hasn’t gotten enough attention so far. People talk about principal-agent problems here in terms of management as agents and shareholders as principals; but only a trivial fraction of shares are directly controlled by the ultimate owners, so there are plenty of principal-agent problems in the financial sector itself. When asset managers’ performance is evaluated every year or two — not to mention the performance of the individual employees — the effective investment horizon is going to be short, and the discount rate correspondingly high, regardless of the preferences of the ultimate owners.

I also like his diplomatic rejection of a loanable-funds framework as a useful way of thinking about bank lending, and his suggestion that the monetary-policy and supervisory functions of a central bank are not really distinct in practice. (I touched on this idea here.) The obligatory editorializing against negative rates not so much, but I guess it comes with the territory.

 

Market failure and government failure in the euro crisis. This piece by Peter Bofinger gets at some of the contradictions in mainstream debates around the euro crisis, and in particular in the idea that financial markets can or should “discipline” national governments. My favorite bit is this quote from the German Council of Economic Experts:

Since flows of capital as well as goods and services are market outcomes, we would not implicate the ‘intra-Eurozone capital flows that emerged in the decade before the crisis’ as the ‘real culprits’ …Hence, it is the government failures and the failures in regulation … that should take centre-stage in the Crisis narrative.

Well ok then!

 

Visualizing the yield curve. This is a very nice visualization of the yield curve for Treasury bonds since 1999. Two key Keynesian points come through clearly: First, that the short-term rate set by policy has quite limited purchase on the longer term market rates. This is especially striking in the 2000s as the 20- and 30-year rates barely budget from 5% even as the short end swings wildly. But second, that if policy rates are held low enough long enough, they can eventually pull down market rates. The key Keynes texts are here and here; I have some thoughts here, developed further here.

 

Trade myths. Jim Tankersley has a useful rundown in the Washington Post on myths about trade and tariffs. I’m basically on board with it: You don’t have to buy into the idolatry of “free trade” to think that the economic benefits of tariffs for the US today would be minimal, especially compared with the costs they would impose elsewhere. But I wish he had not bought into another myth, that China is “manipulating” its exchange rate. Pegged exchange rates are in general accepted by orthodoxy; for much of modern history they were the norm. And even where exchange rates are not officially pegged or targeted, they are still influenced by all kinds of macroeconomic policy choices. It’s not controversial, for instance, to say that low interest rates in the US tend to reduce the value of the dollar, and thereby boost US net exports. Why isn’t that a form of currency manipulation? (To be fair, people occasionally suggest that it is.) I heard Joe Stiglitz put it well, at an event a year or two ago: There is no such thing as a free-market exchange rate, it’s just a question of whether our central bank sets it, or theirs does. And in any case, the Bank of China’s purchase of dollars has to be considered alongside China’s capital controls, which — given the demand of wealthy Chinese for dollar assets — tend to raise the value of the renminbi. On net, the effect of Chinese government interventions has probably been to keep the renminbi “artificially” high, not low. (As I’ve been saying for years.)

 

The politics of the minimum wage. Here is a nice piece by Stephanie Luce on the significance of New York’s decision to raise the minimum wage to $15. Also in Jacobin, here’s Ted Fertik on why our horrible governor signed onto this and the arguably even more radical paid family leave bill.

It would be a great project for some journalist — I don’t think it’s been done — to explore how, concretely, this was won — the way the target was decided, what the strategy was, who was mobilized, and how. In mainstream press accounts these kinds of reforms seem to spring fully formed from the desks of executives and legislators, midwifed by some suitably credentialed experts. But when you dig beneath the surface there’s almost always been years of grassroots organizing before something like this bears fruit. The groups that do that work tend to avoid the press, I think for good reasons; but at some point it’s important to share with a wider public how the sausage got made. My impression in this case is that the key organizing work was done by Make the Road, but I’d love to see the story told properly. I haven’t yet read my friend Mark Engler’s new book, This Is an Uprising, but I think it has some good analysis of other similar campaigns.

At Jacobin: The Fed Doesn’t Work for You

I have a new piece up at Jacobin on December’s rate hike. In my experience, the editing at Jacobin is excellent. But for better or worse, they don’t go for footnotes. So I’m reposting this here with the original notes. And also for comments, which Jacobin (perhaps wisely) doesn’t allow.

I conveyed some of the same views on “What’d You Miss?” on Bloomberg TV a couple weeks ago. (I come on around 13:30.)

 

To the surprise of no one, the Federal Reserve recently raised the federal funds rate — the interest rate under its direct control — from 0–0.25 percent to 0.25–0.5 percent, ending seven years of a federal funds rate of zero.

But while widely anticipated, the decision still clashes with the Fed’s supposed mandate to maintain full employment and price stability. Inflation remains well shy of the Fed’s 2 percent benchmark (its interpretation of its legal mandate to promote “price stability”) — 1.4 percent in 2015, according to the Fed’s preferred personal consumption expenditure measure, and a mere 0.4 percent using the consumer price index — and shows no sign of rising.

US GDP remains roughly 10 percent below the pre-2008 trend, so it’s hard to argue that the economy is approaching any kind of supply constraints. Set aside the fundamental incoherence of the notion of “price stability” (let alone of a single metric to measure it) — according to the Fed’s professed rulebook, the case for a rate increase is no stronger today than a year or two ago. Even the business press, for the most part, fails to see the logic for raising rates now.

Yet from another perspective, the decision to raise the federal funds rate makes perfect sense. The consensus view considers the main job of central banks to be maintaining price stability by adjusting the short-term interest rate. (Lower interest rates are supposed to raise private spending when inflation falls short of the central bank’s target, and higher interest rates are supposed to restrain spending when inflation rises above the target.) But this has never been the whole story.

More importantly, the central bank helps paper over the gap between ideals and reality — the distance between the ideological vision of the economy as a system of market exchanges of real goods, and the concrete reality of production in pursuit of money profits.

Central banks are thus, in contemporary societies, one of the main sites at which capitalism’s “Polanyi problem” is managed: a society that truly subjected itself to the logic of market exchange would tear itself to pieces. But the conscious planning that confines market outcomes within tolerable bounds has to be hidden from view because if the role of planning was acknowledged, it would undermine the idea of markets as natural and spontaneous and demonstrate the possibility of conscious planning toward other ends.

The Fed is a central planner that dare not speak its name. [1]

One particular problem for central bank planners is managing the pace of growth for the system as a whole. Fast growth doesn’t just lead to rising prices — left to their own devices, individual capitalists are liable to bid up the price of labor and drain the reserve army of the unemployed during boom times. [2] Making concessions to workers when demand is strong is rational for individual business owners, but undermines their position as a class.

Solving this coordination problem is one of modern central bankers’ central duties. They pay close attention to what is somewhat misleadingly called the labor market, and use low unemployment as a signal to raise interest rates.

So in this respect it isn’t surprising to see the Fed raising rates, given that unemployment rates have now fallen below 5 percent for the first time since the financial crisis.

Indeed, inflation targeting has always been coupled with a strong commitment to restraining the claims of workers. Paul Volcker is now widely admired as the hero who slew the inflation dragon, but as Fed chair in the 1980s, he considered rolling back the power of organized labor — in terms of both working conditions and wages — to be his number one problem. [3] Volcker described Reagan’s breaking of the air-traffic controllers union as “the single most important action of the administration in helping the anti-inflation fight.”

As one of Volcker’s colleagues argued, the fundamental goal of high rates was that

labor begins to get the point that if they get too much in wages they won’t have a business to work for. I think that really is beginning to happen now and that’s why I’m more optimistic. . . . When Pan Am workers are willing to take 10 percent wage cuts because the airlines are in trouble, I think those are signs that we’re at the point where something can really start to happen.

Volcker’s successors at the Fed approached the inflation problem similarly. Alan Greenspan saw the fight against rising prices as, at its essence, a project of promoting weakness and insecurity among workers; he famously claimed that “traumatized workers” were the reason strong growth with low inflation was possible in the 1990s, unlike in previous decades.

Testifying before Congress in 1997, Greenspan attributed the “extraordinary’” and “exceptional” performance of the nineties economy to “a heightened sense of job insecurity” among workers “and, as a consequence, subdued wages.”

As Greenspan’s colleague at the Fed in the 1990s, Janet Yellen took the same view. In a 1996 Federal Open Market Committee meeting, she said her biggest worry was that “firms eventually will be forced to bid up wages to retain workers.” But, she continued, she was not too concerned at the moment because

while the labor market is tight, job insecurity also seems alive and well. Real wage aspirations appear modest, and the bargaining power of workers is surprisingly low . . . senior workers and particularly those who have earned wage premia in the past, whether it is due to the power of their unions or the generous compensation policies of their employers, seem to be struggling to defend their jobs . . . auto workers are focused on securing their own benefits during their lifetimes but appear reconciled to accepting two-tier wage structures . . .

And when a few high-profile union victories, like the Teamsters’ successful 1997 strike at UPS, seemed to indicate organized labor might be reviving, Greenspan made no effort to hide his displeasure:

I suspect we will find that the [UPS] strike has done a good deal of damage in the past couple of weeks. The settlement may go a long way toward undermining the wage flexibility that we started to get in labor markets with the air traffic controllers’ strike back in the early 1980s. Even before this strike, it appeared that the secular decline in real wages was over.

The Fed’s commitment to keeping unemployment high enough to limit wage gains is hardly a secret — it’s right there in the transcripts of FOMC meetings, and familiar to anyone who has read left critics of the Fed like William Greider and Doug Henwood. The bluntness with which Fed officials take sides in the class war is still striking, though.

Of course, Fed officials deny they’re taking sides. They justify policies that keep workers too weak, disorganized, and traumatized to demand higher wages by focusing on the purported dangers of low unemployment. Lower unemployment, they say, leads to higher money wages, and higher money wages are passed on as higher prices, ultimately leaving workers’ real pay unchanged while eroding their savings.

So while it might look like naked class warfare to deliberately raise unemployment to keep wage demands “subdued”, the Fed assures us that it’s really in the best interests of everyone, including workers.

Keeping Wages in Check

The low-unemployment-equals-high-prices story has always been problematic. But for years its naysayers were silenced by the supposed empirical fact of the Phillips curve, which links low unemployment to higher inflation.

The shaky empirical basis of the Phillips curve was the source of major macroeconomic debates in the 1970s, when monetarists claimed that any departure from unemployment’s “natural” rate would lead inflation to rise, or fall, without limit. This “vertical Phillips curve” was used to deny the possibility of any tradeoff between unemployment and inflation — a tradeoff that, in the postwar era, was supposed to be managed by a technocratic state balancing the interests of wage earners against the interest of money owners.

In the monetarist view, there were no conflicting interests to balance, since there was just one possible rate of unemployment compatible with a stable price system (the “Non Accelerating Inflation Rate of Unemployment”). This is still the view one finds in most textbooks today.

In retrospect, the 1970s debates are usually taken as a decisive blow against the “bastard Keynesian” orthodoxy of the 1960s and 1970s. They were also an important factor in the victory of monetarism and rational expectations in the economics profession, and in the defeat of fiscal policy in the policy realm.

But today there’s a different breakdown in the relationship between unemployment and inflation that threatens to dislodge orthodoxy once again. Rather than a vertical curve, we now seem to face a “horizontal” Phillips curve in which changes in unemployment have no consequences for inflation one way or another.

Despite breathless claims about the end of work, there hasn’t been any change in the link between output and employment; and low unemployment is still associated with faster wage growth. But the link between wage growth and inflation has all but disappeared.

Annual wage growth for nonsupervisory workers (X) and CPI inflation (Y), 1965–1995.
Annual wage growth for nonsupervisory workers (X) and CPI inflation (Y), 1965–1995.

 

Annual wage growth for nonsupervisory workers (X) and CPI inflation (Y), 1995–2015.
Annual wage growth for nonsupervisory workers (X) and CPI inflation (Y), 1995–2015.

This gap in the output-unemployment-wages-inflation causal chain creates a significant problem for central bank ideology.

When Volcker eagerly waited for news on the latest Teamsters negotiations, it was ostensibly because of the future implications for inflation. Now, if there is no longer any visible link between wage growth and inflation, then central bankers might stop worrying so much about labor market outcomes. Put differently, if the Fed’s goal was truly price stability, then the degree to which workers are traumatized would no longer matter so much.

But that’s not the only possibility. Central bankers might want to maintain their focus on unemployment and wages as immediate targets of policy for other reasons. In that case they’d need to change their story.

The current tightening suggests that this is exactly what’s happening. Targeting “wage inflation” seems to be becoming a policy goal in itself, regardless of whether it spurs price increases.

recent piece by Justin Wolfers in the New York Times is a nice example of where conventional wisdom is heading: “It is only when nominal wage growth exceeds the sum of inflation (about 2 percent) and productivity growth (about 1.5 percent) that the Fed needs to be concerned. . .”

This sounds like technical jargon, but if taken seriously it suggests a fundamental shift in the objectives of monetary policy.

By definition, the change in the wage share of output is equal to the rise in money wages minus the sum of the inflation rate and the increase in labor productivity. To say “nominal wage growth is greater than the sum of inflation and productivity growth” is just a roundabout way of saying “the wage share is rising.” So in plain English, Wolfers is saying that the Fed should raise rates if and only if the share of GDP going to workers threatens to increase.

Think for a moment about this logic. In the textbook story, wage growth is a problem insofar as it’s associated with rising inflation. But in the new version, wage growth is more likely to be a problem when inflation stays low.

Wolfers is the farthest thing from a conservative ideologue. His declaration that the Fed needs to guard against a rise in the wage share is simply an expression of conventional elite wisdom that comes straight from the Fed. A recent post by several economists at the New York Fed uses an identical definition of “overheating” as wage growth in excess of productivity growth plus inflation.

Focusing on wage growth itself, rather than the unemployment-inflation nexus, represents a subtle but far-reaching shift in the aim of policy. According to official rhetoric, an inflation-targeting central bank should only be interested in the part of wage changes that co-varies with inflation. Otherwise changes in the wage share presumably reflect social or technological factors rather than demand conditions that are not the responsibility of the central bank.

To be fair, linking demand conditions to changes in the distribution between profits and wages, rather than to inflation, is a more realistic than the old orthodoxy that greater bargaining power for workers cannot increase their share of the product. [4]

But it sits awkwardly with the central bank story that higher unemployment is necessary to keep down prices. And it undermines the broader commitment in orthodox economics to a sharp distinction — both theoretically and policy-wise — between a monetary, demand-determined short run and a technology and “real”-resources-determined long run, with distributional questions firmly located in the latter.

There’s a funny disconnect in these conversations. A rising wage share supposedly indicates an overheating economy — a macroeconomic problem that requires a central bank response. But a falling wage share is the result of deep structural forces — unrelated to aggregate demand and certainly not something with which the central bank should be concerned. An increasing wage share is viewed by elites as a sign that policy is too loose, but no one ever blames a declining wage share on policy that is too tight. Instead we’re told it’s the result of technological change, Chinese competition, etc.

Logically, central bankers shouldn’t be able to have it both ways. In practice they can and do.

The European Central Bank (ECB) — not surprisingly, given its more overtly political role — has gone further down this road than the Fed. Their standard for macroeconomic balance appears to be shifting from the NAIRU (Non-Accelerating Inflation Rate of Unemployment) to the NAWRU (Non-Accelerating Wage Rate of Unemployment).

If the goal all along has been lower wage growth, then this is not surprising: when the link between wages and inflation weakens, the response is not to find other tools for controlling inflation, but other arguments for controlling wages.

Indeed finding fresh arguments for keeping wages in check may be the real content of much of the “competitiveness” discourse. Replacing price stability with elevating competitiveness as the paramount policy goal creates a convenient justification for pushing down wages even when inflation is already extremely low.

It’s interesting in this context to look back at the ransom note the ECB sent to the Spanish government during the 2011 sovereign debt crisis. (Similar letters were sent to the governments of other crisis-hit countries.) One of the top demands the ECB made as a condition of stabilizing the market for government debt was the abolition of cost-of-living (COLA) clauses in employment contracts — even if adopted voluntarily by private employers.

Needless to say this is far beyond the mandate of a central bank as normally understood. [5] But the most interesting thing is the rationale for ending COLA clauses. The ECB declared that cost-of-living clauses are “a structural obstacle to the adjustment of labour costs” and “contribute to hampering competitiveness.”

This is worth unpacking. For a central bank concerned with price stability, the obvious problem with indexing wages to prices (as COLA clauses do) is that it can lead to inflationary spirals, a situation in which wages and prices rise together and real wages remain the same.

But this kind of textbook concern is not the ECB’s focus; instead, the emphasis on labor costs shows an abiding interest in tamping down real wages. In the old central bank story, wage indexing was supposedly bad because it didn’t affect (i.e., raise) real wages and only led to higher inflation. In the new dispensation, wage indexing is bad precisely because it does affect real wages. The ECB’s language only makes sense if the goal is to allow inflation to erode real wages.

The Republic of the Central Banker

Does the official story matter? Perhaps not.

The period before the 2008 crisis was characterized by a series of fulsome tributes to the wisdom of central banking maestros, whose smug and uncritical tone must be causing some embarrassment in hindsight.

Liberals in particular seemed happy to declare themselves citizens of the republic of the central bankers. Cristina Romer — soon to head President Obama’s Council of Economic Advisers — described the defeat of postwar Keynesian macroeconomics as a “glorious counterrevolution” and explained that

better policy, particularly on the part of the Federal Reserve, is directly responsible for the low inflation and the virtual disappearance of the business cycle . . . The story of stabilization policy of the last quarter century is one of amazing success. We have seen the triumph of sensible ideas and have reaped the rewards in terms of macroeconomic performance. The costly wrong turn in ideas and macropolicy of the 1960s and 1970s has been righted and the future of stabilization looks bright.

The date on which the “disappearance of the business cycle” was announced? September 2007, two months before the start of the deepest recession in fifty years.

Romer’s predecessor on Clinton’s Council of Economic Advisers (and later Fed vice-chair) Alan Blinder was so impressed by the philosopher-kings at the central bank that he proposed extending the same model to a range of decisions currently made by elected legislatures.

We have drawn the line in the wrong place, leaving too many policy decisions in the realm of politics and too few in the realm of technocracy. . . . [T]he argument for the Fed’s independence applies just as forcefully to many other areas of government policy. Many policy decisions require complex technical judgments and have consequences that stretch into the distant future. . . . Yet in such cases, elected politicians make the key decisions. Why should monetary policy be different? . . . The justification for central bank independence is valid. Perhaps the model should be extended . . . The tax system would surely be simpler, fairer, and more efficient if . . . left to an independent technical body like the Federal Reserve rather than to congressional committees.

The misguided consensus a decade ago about central banks’ ability to preserve growth may be just as wrong about central banks’ ability to derail it today. (Or at least, to do so with the conventional tools of monetary policy, as opposed to the more aggressive iatrogenic techniques of the ECB.)

The business press may obsess over every movement of the Fed’s steering wheel, but we should allow ourselves some doubts that the steering wheel is even connected to the wheels.

The last time the Fed tightened was ten years ago; between June 2004 and July 2006, the federal funds rate rose from 1 percent to 5 percent. Yet longer-term interest rates — which matter much more for economic activity — did not rise at all. The Baa corporate bond rate and thirty-year mortgage, for instance, were both lower in late 2006 than they had been before the Fed started tightening.

And among heterodox macroeconomists, there is a strong argumentthat conventional monetary policy no longer plays an important role in the financial markets where longer-term interest rates are set. Which means it has at best limited sway over the level of private spending. And the largest impacts of the rate increase may not be in the US at all, but in the “emerging markets” that may be faced with a reversal of capital flows back toward the United States.

Yet whatever the concrete effects of the Fed’s decision to tighten, it still offers some useful insight into the minds of our rulers.

We sometimes assume that the capitalist class wants growth at any cost, and that the capitalist state acts to promote it. But while individual capitalists are driven by competition to accumulate endlessly, that pressure doesn’t apply to the class as a whole.

A regime of sustained zero growth, by conventional measures, might be difficult to manage. But in the absence of acute threats to social stability or external competition (as from the USSR during the postwar “Golden Age”), slow growth may well be preferable to fast growth, which after all empowers workers and destabilizes existing hierarchies. In China, 10 percent annual growth may be essential to the social contract, but slow growth does not — yet — seem to threaten the legitimacy of the state in Europe, North America, or Japan.

As Sam Gindin and Leo Panitch persuasively argue, even periodic crises are useful in maintaining the rule of money. They serve as reminders that the confidence of capital owners cannot be taken for granted. As Kalecki famously noted, the threat of a crisis when “business confidence” is shaken is a “powerful controlling device” for capitalists vis-à-vis the state. Too much success controlling crises is dangerous — it makes this threat less threatening.

So perhaps the most important thing about the Fed’s recent rate hike is that it’s a reminder that price stability and inflation management are always a pretext, or at best just one reason among others, for the managers of the capitalist state to control rapid growth and the potential gains for workers that follow. As the shifting justifications for restraining wage growth suggest, the republic of the central banker has always been run in the interests of money owners.

Some critics of the rate hike see it as a ploy to raise the profits of banks. In my opinion, this theory isn’t convincing. A better conspiracy theory is that it’s part of the larger project of keeping us all insecure and dependent on the goodwill of the owning class.

 

[1] The role of central banks in disguising the moment of conscious planning under capitalism and preserving the ideological fiction of spontaneous order is clearly visible in the way monetary policy is discussed by economists. From the concrete to the abstract. First, the “independent” status of central banks is supposed to place them outside the collective deliberation of democratic politics. Second, there is a constant attraction to the idea of a monetary policy “rule” that could be adopted once and for all, removing any element of deliberate choice even from the central bankers themselves. (Milton Friedman is only the best-known exponent of this idea, which is a central theme of discussion of central banks from the 18th century down to the present.) Third, in modern models, the “reaction function” of the central bank is typically taken as one of the basic equations of the model — the central bank’s reaction to a deviation of inflation from its chosen path has the same status as, say, the reaction of households to a change in prices. As Peter Dorman points out, there’s something very odd about putting policy inside the model this way. But it has the clear ideological advantage of treating the central bank as if it were simply part of the natural order of optimization by individual agents.

[2] The best analysis of the crisis of the 1970s in these terms remains Capitalism Since 1945, by Armstrong, Glyn and Harrison.

[3] The linked post by Peter Frase does an excellent job puncturing the bipartisan mythmaking around the Volcker and bringing out the centrality of his anti-labor politics. But it contains one important error. Frase describes the late-1970s crisis to which Volcker was responding as “capital refusing to invest, and labor refusing to take no for an answer.” The latter might be true but the former certainly is not: The late 1970s saw the greatest boom in business investment in modern US history; 1981 had the highest investment-GDP ratio since the records begin in 1929. High demand and negative real interest rates — which made machines and buildings more attractive than wealth in financial form — outweighed low profits, and investment boomed. (An oil boom in the southwest and generous tax subsidies also helped.) The problem Volcker was solving was not,as Frase imagines, that the process of accumulation was threatened by the refusal of unhappy money owners to participate. It was, in some ways, an even more threatening one — that real accumulation was proceeding fine despite the unhappiness of money owners. In the often-brilliant Buying Time, Wolfgang Streeck  makes a similar mistake.

[4] More precisely, it’s a return to what Anwar Shaikh calls the classical Phillips curve found in the Marxist literature, for instance in the form of Goodwin cycles. (The Shaikh article is very helpful in systematically thinking through alternative relationships between nominal wages, the wage share and inflation.)

[5] It’s worth noting that in these cases the ECB got what it wanted, or enough of it, and did aggressively intervene to stabilize government debt markets and the banking systems in almost all the crisis countries. As a result, the governments of Spain, Italy and Portugal now borrow more cheaply than ever in history. As I periodically point out, the direct cause of the crisis in Greece was the refusal of the ECB to extend it the same treatment. A common liberal criticism of the euro system is that it is too rigid, that it automatically applies a single policy to all its members even when their current needs might be different. But the reality is the opposite. The system, in the form of the ECB, has enormous discretion, and the crisis in Greece was the result of the ECB’s choice to apply a different set of policies there than elsewhere.

How Strong Is Business Investment, Really?

DeLong rises to defend Ben Bernanke, against claims that unconventional monetary policy in recent years has discouraged businesses from investing. Business investment is doing just fine, he says:

As I see it, the Fed’s open-market operations have produced more spending–hence higher capacity utilization–and lower interest rates–has more advantageous costs of finance–and we are supposed to believe that its policies “have hurt business investment”?!?! … As I have said before and say again, weakness in overall investment is 100% due to weakness in housing investment. Is there an argument here that QE has reduced housing investment? No. Is nonresidential fixed investment below where one would expect it to be given that the overall recovery has been disappointing and capacity utilization is not high?

As evidence, DeLong points to the fact that nonresidential investment as a share of GDP is back where it was at the last two business cycle peaks.

As it happens, I agree with DeLong that it’s hard to make a convincing case that unconventional monetary policy is holding back business investment. Arguments about the awfulness of low interest rates seem more political or ideological, based on the real or imagined interests of interest-receivers than any identifiable economic analysis. But there’s a danger of overselling the opposite case.

It is certainly true that, as a share of potential GDP, nonresidential investment is not low by historical standards. But is this the right measure to be looking at? I think not, for a couple of reasons, one relatively minor and one major. The minor reason is that the recent redefinition of investment by the BEA to include various IP spending makes historical comparisons problematic. If we define investment as the BEA did until 2013, and as businesses still do under GAAP accounting standards, the investment share of GDP remains quite low compared to previous expansions. The major reason is that it’s misleading to evaluate investment relative to (actual or potential GDP), since weak investment will itself lead to slower GDP growth. [1]

On the first point: In 2013, the BEA redefined investment to include a variety of IP-related spending, including the commercial development of movies, books, music, etc. as well as research and development. We can debate whether, conceptually, Sony making Steve Jobs is the same kind of thing as Steve Jobs and his crew making the iPhone. But it’s important to realize that the apparent strength of investment spending in recent expansions is more about the former kind of activity than the latter.  [2] More relevant for present purposes, since this kind of spending was not counted as investment — or even broken out separately, in many cases — prior to 2013, the older data are contemporary imputations. We should be skeptical of comparing today’s investment-cum-IP-and-R&D to the levels of 10 or 20 years ago, since 10 or 20 years ago it wasn’t even being measured. This means that historical comparisons are considerably more treacherous than usual. And if you count just traditional (GAAP) investment, or even traditional investment plus R&D, then investment has not, in fact, returned to its 2007 share of GDP, and remains well below long-run average levels. [3]

investment

More importantly, using potential GDP as the yardstick is misleading because potential GDP is calculated simply as a trend of actual GDP, with a heavier weight on more recent observations. By construction, it is impossible for actual GDP to remain below potential for an extended period. So the fact that the current recovery is weak by historical standards automatically pulls down potential GDP, and makes the relative performance of investment look good.

We usually think that investment spending the single most important factor in business-cycle fluctuations. If weak investment growth results in a lower overall level of economic activity, investment as a share of GDP will look higher. Conversely, an investment boom that leads to rapid growth of the economy may not show up as an especially high investment share of GDP. So to get a clear sense of the performance of business investment, its better to look at the real growth of investment spending over a full business cycle, measured in inflation-adjusted dollars, not in percent of GDP. And when we do this, we see that the investment performance of the most recent cycle is the weakest on record — even using the BEA’s newer, more generous definition of investment.

investmentcycles_broad
Real investment growth, BEA definition

The figure above shows the cumulative change in real investment spending since the previous business-cycle peak, using the current (broad) BEA definition. The next figure shows the same thing, but for the older, narrower GAAP definition. Data for both figures is taken from the aggregates published by the BEA, so it includes closely held corporations as well as publicly-traded ones. As the figures show, the most recent cycle is a clear outlier, both for the depth and duration of the fall in investment during the downturn itself, and even more for the slowness of the subsequent recovery.

investmentcycles_narrow
Real investment growth, plant and equipment only

Even using the BEA’s more generous definition, it took over 5 years for inflation-adjusted investment spending to recover its previous peak. (By the narrower GAAP definition, it took six years.) Five years after the average postwar business cycle peak, BEA investment spending had already risen 20 percent in real terms. As of the second quarter of 2015 — seven-and-a-half years after the most recent peak, and six years into the recovery — broad investment spending was up only 10 percent from its previous peak. (GAAP investment spending was up just 8.5 percent.) In the four previous postwar recoveries that lasted this long, real investment spending was up 63, 24, 56, and 21 percent respectively. So the current cycle has had less than half the investment growth of the weakest previous cycle. And it’s worth noting that the next two weakest investment performances of the ten postwar cycles came in the 1980s and the 2000s. In recent years, only the tech-boom period of the 1990s has matched the consistent investment growth of the 1950s, 1960s and 1970s.

So I don’t think it’s time to hang the “Mission Accomplished” banner up on Maiden Lane quite yet.

As DeLong says, it’s not surprising that business investment is weak given how far output is below trend. But the whole point of monetary policy is to stabilize output. For monetary policy to work, it needs to able to reliably offset lower than normal spending in other areas with stronger than normal investment spending. If after six years of extraordinarily stimulative monetary policy (and extraordinarily high corporate profits), business investment is just “where one would expect given that the overall recovery has been disappointing,” that’s a sign of failure, not success.

 

[1] Another minor issue, which I can’t discuss now, is DeLong’s choice to compare “real” (inflation-adjusted) spending to “real” GDP, rather than the more usual ratio of nominal values. Since the price index for investment goods consistent rises more slowly than the index for GDP as a whole, this makes current investment spending look higher relative to past investment spending.

[2] This IP spending is not generally counted as investment in the GAAP accounting rules followed by private businesses. As I’ve mentioned before, it’s problematic that national accounts diverge from private accounts this way. It seems to be part of a troubling trend of national accounts being colonized by economic theory.

[3] R&D spending is at least reported in financial statements, though I’m not sure how consistently. But with the other new types of IP investment — which account for the majority of it — the BEA has invented a category that doesn’t exist in business accounts at all. So the historical numbers must involve more than usual amount degree of guesswork.