Could Trump Have a Point about Rate Hikes?

(Cross-posted from The Next New Deal at The Roosevelt Institute.)

At its December meeting, the Federal Reserve raised its benchmark interest rate a quarter point. The move, while widely expected, represented a clear rebuke to President Trump, who has repeatedly urged the Fed to keep rates low. He took to Twitter after the move to attack Fed head Jerome Powell as a golfer who has no touch (“he can’t putt”)—strong words in the president’s social circle.

Trump’s critics on the left may be tempted to cheer the Fed’s decision as a welcome triumph of the separation of powers. But opposing him on the grounds that the labor market is already great may end up weakening the case for a progressive agenda. We need to consider the possibility that, in this one case, the president is right.

By raising rates, the Fed is signaling that it thinks that the economy is now operating at potential, or full employment. Conventional economic theory says that when the economy is below potential, more spending will bring unemployed and underemployed people to work, and more fully utilize structures and equipment, but once potential is reached, additional spending will just lead to higher prices. So when output is below potential, anything that raises spending—whether it is tax cuts, increased federal spending, a more favorable trade balance, or lower interest rates—is macroeconomically useful. But once the economy is at potential, and there are no more unemployed people or underused buildings and machines, the same policies will lead only to more inflation.

By this standard, the case for the most recent rate increase was plausible, though not a slam dunk. By the official measures produced by the Bureau of Economic Analysis (BEA), 2018 was the first year since 2007 that GDP reached potential, and at 3.7 percent, the headline unemployment rate is quite low by historical standards. So textbook logic suggests that if demand growth does not slow, inflation is likely to rise.

The past decade, however, has given us reason to doubt the textbook models. As I argued in the Roosevelt report What Recovery?, it is far from clear that the BEA’s measure does a good job capturing the productive potential of the economy. Similarly, the headline unemployment rate may no longer be a good measure of the economically relevant category of people available for work; many people move directly between being out of the laborforce and being employed. The behavior of inflation has defied any mechanical linkage with GDP growth, wages, or unemployment. And even if one accepts that output is nearing potential, a higher interest rate may not be necessary to slow it. (This is related to the idea of r*, the “neutral” rate of interest, which neither raises nor lowers demand—something that many people, including Powell himself, have suggested we don’t actually know.) Given these uncertainties, many people—across the political spectrum—have argued that it’s foolish for the central bank to try to make policy based on guesses of where inflation is heading. Instead, they should wait to raise rates until it is clear that inflation is above target.

More broadly, the question of whether the economy is at full employment implies a judgement on whether this is the best we can do, economically. Are the millions of people who have dropped out of the laborforce over the past decade really unable or unwilling to engage in paid work? Is the decline of American manufacturing the inevitable result of a lack of competitiveness? Are the millions of people working at low-wage, dead-end jobs incapable of doing anything more rewarding? The decision to raise rates implicitly assumes that the answers are yes. People who think that the economy could work better for ordinary people should hesitate to agree.

We live in a country filled with energetic, talented, creative people, many of whom are forced to spend their days doing tedious busywork. Personally, I find it offensive to claim that a job at McDonald’s or in a nail salon or Amazon warehouse is the fullest use of anyone’s potential. When John Maynard Keynes said “we will build our New Jerusalem out of the labour which in our former vain folly we were keeping unused and unhappy in enforced idleness,” he didn’t only mean literal idleness, but wasted labor more broadly. In a society in which aggregate expenditure was constantly pushing against supply constraints, millions of people today who spend their working hours in menial, unproductive activities would instead be developing their capacities as engineers, artists, electricians, doctors, and scientists.

Progressives concerned about the distribution of income should also pause before cheering an interest rate hike. The textbook model assumes that wage changes are passed more or less one for one to prices (that’s why the Fed pays so much attention to unemployment). But we know that this is not true. Slow wage growth may simply mean a lower share of income going to workers, rather than lower inflation, and high wages may lead to an increase in labor share rather than to higher inflation. Indeed, as a matter of math, the labor share of income cannot rise unless wages rise faster than the sum of productivity growth and inflation. For most of the past decade—and much of the decade before—wages have risen more slowly than this. As a result, labor compensation has fallen to 58 percent of value added in the corporate sector (where it is most reliably measured), down from 60 percent a decade ago and 66 percent in 2000. The only way that this shift from labor to capital can be reversed is if we see an extended period of “excessive” wage growth. This recent hike suggests that the Fed will not tolerate that.

The alternative is to deliberately foster what is sometimes called a “high-pressure” economy. Allowing the unemployment rate to remain low enough for sustained rapid wage growth won’t just help restore the ground that workers have lost over the past decade. It could also boost laborforce participation, as discouraged workers return to the labor market. And it could boost productivity, as scarce workers and strong demand encourage businesses to undertake labor-saving investment. An increasing number of economists think that these kinds of effects, called hysteresis, mean that weak demand conditions can reduce the economy’s productive potential—and strong demand can increase it.

We are already seeing some signs of this. The fall in the laborforce participation over the past decade was, according to most studies, was much larger than can be explained by aging and other demographic factors. Now, as the labor market gets stronger, people who dropped out of the laborforce are reentering it. Some businesses in low-unemployment areas are now paying for English lessons so they can hire non-English speaking immigrants, who are normally among the last to be employed. After years of stagnation, wages are beginning to rise fast enough to produce a modest rise in the hare of output going to workers—the predictable result of a strong labor market. A recent study by the Federal Reserve Bank of Atlanta confirmed that a high-pressure economy, with unemployment well below normal levels, can boost earnings and strengthen attachment to the laborforce. The effects are long-lasting and strongest for those at the back of the hiring queue, such as Black Americans and those with less-formal education. Labor productivity has yet to pick up, but business investment is now quite strong, so it is likely that productivity may soon start rising as well. None of these gains will be realized if the Fed acts too quickly to rein in a boom.

Critics of the president who argue that the economy is already at full employment risk replaying the 2016 election, where the Democrats were perceived—fairly or not—as defenders of the status quo, while Trump spoke to and for those left behind by the recovery. And they risk throwing away one of the best arguments for a progressive program in 2021 and beyond. The next Democratic president will enter office with an ambitious agenda. Whether the top priority is Medicare for All, a Green New Deal, universal childcare, or free higher education, realizing this agenda will require a substantial increase in government spending. Making the case for this will be much easier if there is broad agreement that the economy still suffers from a demand shortfall that public spending can fill.

 

EDIT: The one thing I did not mention here and should have is that the principle of central bank indpedence is also not something that anyone on the left should be defending. Like the various countermajoritarian features of the US political system, it will be wielded more aggressively against any kind of progressive program. And as Mike Konczal and I have argued, both financial crises and extended periods of weak demand have forced central banks to broaden their mandate, making it much harder to mark off “monetary policy” proper from economic policy in general.

New Piece on MMT

Arjun Jayadev and I have a new piece up at the Institute for New Economic Thinking, trying to clarify the relationship between Modern Monetary Theory (MMT) and textbook macroeconomics. (There is also a pdf version here, which I think is a bit more readable.) I will have a blogpost summarizing the argument later today or tomorrow, but in the meantime here is the abstract:

An increasingly visible school of heterodox macroeconomics, Modern Monetary Theory (MMT), makes the case for functional finance—the view that governments should set their fiscal position at whatever level is consistent with price stability and full employment, regardless of current debt or deficits. Functional finance is widely understood, by both supporters and opponents, as a departure from orthodox macroeconomics. We argue that this perception is mistaken: While MMT’s policy proposals are unorthodox, the analysis underlying them is largely orthodox. A central bank able to control domestic interest rates is a sufficient condition to allow a government to freely pursue countercyclical fiscal policy with no danger of a runaway increase in the debt ratio. The difference between MMT and orthodox policy can be thought of as a different assignment of the two instruments of fiscal position and interest rate to the two targets of price stability and debt stability. As such, the debate between them hinges not on any fundamental difference of analysis, but rather on different practical judgements—in particular what kinds of errors are most likely from policymakers.

Read the rest here or here.

Macroeconomic Lessons from the Past Decade

Below the fold is a draft of a chapter I’m contributing to an edited volume on aggregate demand and employment. My chapter is supposed to cover macroeconomic policy and employment in the US, with other chapters covering other countries and regions. 

The chapter is mostly based on material I’ve pulished elsewhere, mainly my Roosevelt papers “What Recovery?” and “A New Direction for the Federal Reserve.” My goal was something that summarized the arguments there for an audience of (presumably) heterodox macroeconomists, and that could also be used in the classroom.

There is still time to revise this, so comments/criticisms are very welcome.

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Continue reading Macroeconomic Lessons from the Past Decade

The King’s Two Bodies

This looks like a good book:

Private outposts in the state and public outposts in finance, central banks have historically moved back and forth between very different institutional forms: private, public and various combinations of the two. Far from constituting a rational-functionalist formation, they have performed widely diverse and often barely related functions—from the administration of state debt to the issuing of currency and the supervision of private banks—cobbled together more or less ad hoc according to political expediency… Central banks, Vogl argues, constitute a fourth power, overshadowing legislature, executive and judiciary, and integrating financial-market mechanisms into the practice of government.

Central banks’ claim to autonomous authority is based on their assumed, and asserted, technical competence. As they and their aficionados in the media and in economics departments are fond of telling us, central bankers know things about the economy that normal people, inevitably overwhelmed by such complexity, cannot even begin to fathom. … Central bankers themselves have always been aware … that what they sell to the public as a quasi-natural science is in fact nothing more than intuitive empathy, an ability acquired by long having moved in the right circles to sense how capital will feel, good or bad, about what a government is planning to do in relation to financial markets. (Economic theory is best understood as an ontological reification of capitalist sensitivities represented as natural laws of a construct called ‘the economy’.) At critical moments, such as when the Bank of England went off the gold standard in 1931 …, central banking relies on the trained intuition of great men and their capacity to make others believe that they know what they’re doing, even when they don’t. At a university event in London almost a decade after the 2008 crash, Alan Greenspan was remembered by an enthusiastic admirer as having had ‘a complete model of the American economy in his body’.

The Class Struggle on Wall Street: A Footnote

Remember back at the beginning of February when the stock markets were all crashing? Feels like ages ago now, I know. Anyway, Seth Ackerman and I had an interesting conversation about it over at Jacobin.

My rather boring view is that short-term movements in stock markets can’t be explained by any kind of objective factors, because in the short run prices are dominated by conventional expectations — investors’ beliefs about investors’ beliefs… [1] But over longer periods, the value of shares is going to depend on the fraction of output claimed as profits and that, in general, is going to move inversely with the share claimed as wages. So if working people are getting raises — and they are, at least more than they were in 2010-2014 — then shareholders are right to worry about their own claim on the product.

One thing I say in the interview that a couple people have been surprised at, is that

there has been an upturn in business investment. In the corporate sector, at least, business investment, after being very weak for a number of years, is now near the high end of its historical range as a fraction of output.

Really, near the high end? Isn’t investment supposed to be weak?

As with a lot of things, whether investment is weak or strong depends on exactly what you measure. The figure below shows investment as a share of total output for the economy as a whole and for the nonfinancial corporate sector since 1960. The dotted lines show the 10th and 90th percentiles.

Gross capital formation as a percent of output

 

As you can see, while invesment for the economy as a whole is near the low end of its historic range, nonfinancial corporate investment is indeed near the high end.

What explains the difference? First, investment by households collapsed during the recession and has not significantly recovered since.  This includes purchases of new houses but also improvements of owner-occupied houses, and brokers’ fees and other transactions costs of home sales (that last item accounts for as much as a quarter of residential investment historically; many people don’t realize it’s counted at all). Second, the investment rate of noncorporate businesses is about half what it was in the 1970s and 80s. This second factor is exacerbated by the increased weight of noncorporate businesses relative to corproate businesses over the past 20 years. I’m not sure what concrete developments are being described by these last two changes, but mechanically, they explain a big part of the divergence in the figure above. Finally, the secular increase in the share of output produced by the public sector obviously implies a decline in the share of private investment in GDP.

I think that for the issues Seth and I were talking about, the corporate sector is the most relevant. It’s only there that we can more or less directly observe quantities corresponding to our concepts of “the economy.” In the public (and nonprofit) sector we can’t observe output, in the noncorproate sector we can’t observe profits and wages (they’re mixed up in proprietors income), and in the household sector we can’t observe either. And financial sector has its own issues.

Anyway, you should read the interview, it’s much more interesting than this digression. I just thought it was worth explaining that one line, which otherwise might provoke doubts.

 

[1] While this is a truism, it’s worth thinking through under what conditions this kind of random walk behavior applies. The asset needs to be and liquid and long-lived relative to the relevant investment horizon, and price changes over the investment horizon have to be much larger than income or holding costs. An asset that is normally held to maturity is never going to have these sort of price dynamics.

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.

Links for July 17, 2017

The action is on the asset side. Arjun Jayadev, Amanda Page-Hoongrajok and I have a new version of our state-local balance sheets paper up at Washington Center for Equitable Growth. It’s moderately improved from the version posted here a few months ago. I’ll have a blogpost up in the next day or two laying out the arguments in more detail. In the meantime, here’s the abstract:

This paper … makes two related arguments about the historical evolution of state-local debt ratios over the past 60 years. First, there is no consistent relationship between state and local budget deficits and changes in state and local government debt ratios. In particular, the 1980s saw a shift in state and local budgets toward surplus but nonetheless saw rising debt ratios. This rise in debt is fully explained by a faster pace of asset accumulation as a result of increased pressure to prefund future expenses… Second, budget imbalances at the state level are almost entirely accommodated on the asset side – both in the aggregate and cross-sectionally, larger state-local deficits are mainly associated with reduced net asset accumulation rather than with greater credit-market borrowing. …

 

What recovery? One of the central questions of U.S. macroeconomic policy right now is whether the slow growth of output and employment over the past decade are the result of supply-side factors like demographics and an exhaustion of new technologies, or whether — despite low measured unemployment — we are still well short of potential output. Later this month, I’ll have a paper out from the Roosevelt Institute making the case for the latter — that there is still substantial space for more expansionary policy. Some of my argument is anticipated by this post from Simon Wren-Lewis, which briefly lays out several ways in which a demand shortfall can have lasting effects on the economy’s productive capacity — discouraged workers leaving the labor force; reduced investment by business; and slower technical progress, because a slack economy is less favorable for innovation. He concludes: “There is no absence of ideas about how a great recession and a slow recovery could have lasting effects. If there is a problem, it is more that this simple conceptualization” — textbook model in which demand has only short-run effects — “has too great a grip on the way many people think.”

Along the same lines, here is a nice post from Adam Ozimek on the “mystery” of low wage growth. The mystery is that despite low unemployment, annual wage growth (as measured by the Employment Costs Index) has remained relatively low – 2 to 2.5 percent, rather than the 3 to 3.5 percent we’d expect based on historical patterns. (Ozimek doesn’t mention it, but total compensation growth — including benefits — is even lower, less than one percent for the year ending March 2017.) But, he points out, this historical relationship is based on measured unemployment; if we use the employment-population ratio instead, then recent wage gains are exactly where you’d expect historically. So the behavior of wages is another piece of evidence that the official unemployment rate is underestimating the degree of labor market slack, and that the fall in the employment-population ratio reflects — at least in part — weak demand rather than the inevitable result of worse demographics (or better video games).

 

The bondholders’ view of the world.  Matthew Klein has a very enjoyable post at FT Alphaville taking apart the claim (from three prominent academics) that “The French Revolution began with the bankruptcy of the ancient regime.” This is, of course, supposed to illustrate the broader dangers of allowing sovereigns to stiff bondholders. But in fact, as Klein points out, the old regime did not default on in its loans — Louis XVI went to great lengths to avoid bankruptcy, precisely because he was afraid of the reaction of creditors. Further: It was the monarchy’s efforts to avoid default — highly unpopular taxes and spending cuts, then the calling of the Estates General to legitimate them — that set in motion the events that led to the Revolution. So the actual history — in which a government was overthrown after choosing austerity over bankruptcy — has been reversed 180 degrees to fit the prevailing myth of our times: that good and bad political outcomes all depend on the grace of the bond markets. As Klein says, this might seem like a small mistake, but it is deeply revealing about how ideology operates: “ Whoever introduced it must have been working off what he thought was common knowledge that didn’t need to be checked. There is no citation.”

Klein’s piece is also, in passing, a nice response to that silly Jacob Levy post which argues that democracy and popular sovereignty are myths and that modern states have always been ruled by the bondholders. Levy offers zero evidence for this claim; his post is of interest only as a signpost for where elite discourse may be heading.

 

Don’t blame Germany. Here is a very useful paper from Enno Schroeder and Oliver Piceck estimating the effects of an increase in German demand on other European economies. They use an input-output model to estimate the effect of an increase in spending in Germany on output and employment in each of the other 10 largest euro-area countries. One of the things I really like about this is that it does not depend on either econometrics or on any kind of optimization; rather, it is simply based on the observable data of the distribution of consumption spending and of intermediate inputs by various industries over different industries and countries, along with the fraction of household income consumed in various countries. This lets them answer the question: If spending in Germany increased by a certain amount and the composition of spending otherwise remained unchanged, what would the effect be on total spending in various European countries? Yes, they ignore possible price changes; but I don’t think it’s any less reasonable than the conventional approach, which goes to the opposite extreme and assumes prices are everything. And even if you want to add a price story, this approach gives you a useful baseline to build on.

Methodology aside, their results are interesting and a bit surprising: They find that the spillovers from Germany to other European countries are surprisingly small.

Our main finding suggests that if Germany’s final demand were to exogenously increase by one percent of GDP, then France, Italy, Spain, and Portugal’s GDP would grow by around a 0.1 percent, their unemployment rates would be reduced by a bit over 0.1 points, and their trade balances would improve by approximately 0.04 points. The spillover effects on Greece are significantly smaller.

Given how much larger Germany is than most of these countries, and how tightly integrated European economies are understood to be, these are surprisingly small numbers. It seems that a large proportion of German demand still falls on domestic goods, while imports come largely from the euro area — particularly, in the case of intermediate goods, from the former Warsaw Pact countries. As a result, even

if a German demand boom were to materialize, France, Greece, Italy, Spain, and Portugal would not benefit much in terms of growth and external adjustment. The real beneficiaries would be small neighbors (e.g. Austria and Luxembourg) and emerging economies in Eastern Europe that are well integrated into German supply chains (e.g. Czech Republic and Poland).

Of course, this doesn’t mean that more expansionary policy in Germany isn’t desirable for other reasons. (For one thing, German workers badly need raises.) But for the balance of payments problems in Southern Europe, other solutions are needed.

 

Today’s conventional is yesterday’s unconventional, and vice versa. Here is a useful NBER paper from Mark Carlson and Burcu Duygan-Bump on the conduct of monetary policy in the 1920s. As they point out, much of today’s “unconventional” policy apparatus was standard at that point, including large purchases of a range of securities — quantitative easing avant le lettre. As I’ve written on this blog before (here and here and here) discussion of monetary policy is made needlessly confusing by economists’ habit of treating the policy instrument as having a direct, immediate link to macroeconomic outcomes, which can be derived from first principles. Whereas anyone who reads even a little history of central banking finds that the ultimate goal of control over the pace of credit expansion has been pursued by a wide range of instruments and intermediate targets in different settings.

Also on the mechanics of monetary policy, I liked these two posts from the New York Fed’s Liberty Street Economics blog. They do something which should be standard but isn’t — walk through step by step the balance sheet changes associated with various central bank policy shifts. In my experience, teaching monetary policy in terms of balance sheet changes is much more straightforward than with the supply-and-demand diagrams that are the basic analytic tool in most textbooks. The curves at best are metaphors; the balance sheets tell you what actually happens.

Posts in Three Lines

I haven’t been blogging much lately. I’ve been doing real work, some of which will be appearing soon. But if I were blogging, here are some of the posts I might write.

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Lessons from the 1990s. I have a new paper coming out from the Roosevelt Institute, arguing that we’re not as close to potential as people at the Fed and elsewhere seem to believe, and as I’ve been talking with people about it, it’s become clear that your priors depend a lot on how you think of the rapid growth of the 1990s. If you think it was a technological one-off, with no value as precedent — a kind of macroeconomic Bush v. Gore — then you’re likely to see today’s low unemployment as reflecting an economy working at full capacity, despite the low employment-population ratio and very weak productivity growth. But if you think the mid-90s is a possible analogue to the situation facing policymakers today, then it seems relevant that the last sustained episode of 4 percent unemployment led not to inflation but to employers actively recruiting new entrants to the laborforce among students, poor people, even prisoners.

Inflation nutters. The Fed, of course, doesn’t agree: Undeterred by the complete disappearance of the statistical relationship between unemployment and inflation, they continue to see low unemployment as a threatening sign of incipient inflation (or something) that must be nipped in the bud. Whatever other effects rate increases may have, the historical evidence suggests that one definite consequence will be rising private and public debt ratios. Economists focus disproportionately on the behavioral effects of interest rate changes and ignore their effects on the existing debt stock because “thinking like an economist” means, among other things, thinking in terms of a world in which decisions are made once and for all, in response to “fundamentals” rather than to conditions inherited from the past.

An army with only a signal corps. What are those other effects, though? Arguments for doubting central bankers’ control over macroeconomic outcomes have only gotten stronger than they were in the 2000s, when they were already strong; at the same time, when the ECB says, “let the government of Spain borrow at 2 percent,” it carries only a little less force than the God of genesis. I think we exaggerate power of central banks over real economy, but underestimate their power over financial markets (with the corollary that economists — heterodox as much as mainstream — see finance and real activity as much more tightly linked than they are).

It’s easy to be happy if you’re heterodox. This spring I was at a conference up at the University of Massachusetts, the headwaters of American heterodox economics, where I did my Phd. Seeing all my old friends reminded me what good prospects we in the heterodox world have – literally everyone I know from grad school has a good job. If you are wondering whether your prospects would be better at a nowhere-ranked heterodox economics program like UMass or a top-ranked program in some other social science, let me assure you, it’s the former by a mile — and you’ll probably have better drinking buddies as well.

The euro is not the gold standard. One of the topics I was talking about at the UMass conference was the euro which, I’ve argued, was intended to create something like a new gold standard, a hard financial constraint on governments. But that that was the intention doesn’t mean its the reality — in practice the TARGET2 system means that national central banks don’t face any binding constraint , unlike under the gold standard the central bank is “outside” the national monetary membrane. In this sense the euro is structurally more like Keynes’ proposals at Bretton Woods, it’s just not Keynes running it.

Can jobs be guaranteed? In principle I’m very sympathetic to the widespread (at least among my friends on social media) calls for a job guarantee. It makes sense as a direction of travel, implying a commitment to a much lower unemployment rate, expanded public employment, organizing work to fit people’s capabilities rather than vice versa, and increasing the power of workers vis-a-vis employers. But I have a nagging doubt: A job is contingent by its nature – without the threat of unemployment, can there even be employment as we know it?

The wit and wisdom of Haavelmo. I was talking a while back about Merijn Knibbe’s articles on the disconnect between economic theory and the national accounts with my friend Enno, and he mentioned Trygve Haavelmo’s 1944 article on The Probability Approach in Econometrics, which I’ve finally gotten around to reading. One of the big points of this brilliant article is that economic variables, and the models they enter into, are meaningful only via the concrete practices through which the variables are measured. A bigger point is that we study economics in order to “become master of the happenings of real life”: You can contribute to economics in the course of advancing a political project, or making money in financial markets, or administering a government agency (Keynes did all three), but you will not contribute if you pursue economics as an end in itself.

Coney Island. Laura and I took the boy down to Coney Island a couple days ago, a lovely day, his first roller coaster ride, rambling on the beach, a Cyclones game. One of the wonderful things about Coney Island is how little it’s changed from a century ago — I was rereading Delmore Schwartz’s In Dreams Begin Responsibilities the other day, and the title story’s description of a young immigrant couple walking the boardwalk in 1909 could easily be set today — so it’s disconcerting to think that the boy will never take his grandchildren there. It will all be under water.

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.