The Slack Wire

No More ZLB

Can we please stop talking about the zero lower bound?

Krugman today insists that we do, in fact, face a problem of inadequate demand. And he’s right! But he glosses this as an “excess supply of savings even at a zero interest rate,” which isn’t right at all.

Let’s be clear: There is not “an” interest rate, certainly not a zero one. There are various interest rates, and the ones that are relevant to saving and investment remain high. The BAA corporate bond rate (the red line in the figure below) is currently at 5.7 percent — pretty much exactly where it was in the first half of 2005. And given that inflation is substantially lower than it was five years ago, that particular real interest rate is not only not zero, it’s gone up.


The real question is, can reducing the federal funds rate reduce the economically important interest rates? Now, obviously the answer is No if the fed funds rate (the blue line in the graph) is as low as it can go; in this sense the ZLB is real. But the answer can also be No when the fed funds rate is well above zero, if there’s no reliable link between the overnight Treasury rate and the rates businesses borrow at; and that seems to have been the case since sometime in the ’90s. As the figure shows, the Fed’s recent rate reductions didn’t reduce bond rates at all, even before the Fed Funds rate hit zero; and all the hikes earlier in the decade didn’t raise bond rates either. You’d see a similar picture if you looked at any other economically relevant interest rate. In general, as my friend Hasan Comert shows in his just-defended dissertation, the Fed lost control of the important interest rates some time ago. So the best thing you can say for the zero lower bound, is that arriving there has dramatized a truth that should have been evident for some time already.

As usual, Keynes got it right: “The acuteness and the peculiarity of our contemporary problem arises out of the possibility that the average rate of interest which will allow a reasonable average level of employment is one so unacceptable to wealth-owners that it cannot be readily established merely by manipulating the quantity of money. … The most stable, and the least easily shifted, element in our contemporary economy has been hitherto, and may prove to be in future, the minimum rate of interest acceptable to the generality of wealth-owners.” The failure of interest rates to move to a level compatible with full employment is not a technical problem, but a structural one.

The Lucas Critique: A Critique

Old-fashioned economic models (multiplier-accelerator models of the business cycle, for example) operate in historical time: outcomes in one period determine decisions in the next period. That is, agents are backward-looking. The Lucas critique is that this assumes that people cannot predict what will happen in the future. The analyst on the other hand can derive later outcomes from earlier ones (or we would not be able to tell a causal story), so why can’t the agents in the model?
Lucas says this is an unacceptable contradiction, and resolves it by attributing to the agents the model used by the analyst. (Interestingly some Post Keynesians (e.g. Shackle) seem to see the same contradiction but they resolve it the other way, and take the inability to predict the future attributed to the agents in the model as a fundamental feature of the universe, so applicable to the analyst too.) But is the idea of predictable but unpredicted outcomes such an unacceptable contradiction?

One reason to say no is that the idea that agents must know as much as analyst rests on a sociological foundation – that institutions are such as to foster knowledge of the best estimate of future outcomes. This need not be the case. For example, consider the owners of an asset that has recently appreciated in value, where there is some doubt about whether the appreciation is transitory or permanent, or whether further appreciation should be expected. Those asset-owners who have a convincing story of why further appreciation is likely will be most successful at selling at a higher price, and so will increase their weight in the market. And to have a convincing story you should yourself be convinced by it – this is true both logically and psychologically. Similarly with various arm’s-length relationships that must be periodically renewed – the most accurate promises are not necessarily the most likely to bring success. Or on the other side, classes and organizations to maintain their coherence need their members to hold certain beliefs. This could take the deep form of ideology of various kinds, or the simple form of the practical requirements of organizational decision-making implying a limited set of inputs. The other reason comes if you carry the Lucas critique through to its logical conclusion. Those who accept rational expectations also use the method of comparative statics, where transitions from one equilibrium to another is the result of “shocks”. One set of technologies, tastes, endowments, policies, etc. yields equilibrium A. Then a shock changes those parameters, and now there’s equilibrium B. Joan Robinson objected to this procedure on grounds that it ignored dynamics of transition from A to B, but there is another problem. Evidently B is a possible future of A. The analyst knows this. So why don’t the inhabitants of A? Unless the shock is literally divine intervention, presumably its probability can be affected by the their actions, so doesn’t the analysis of A have to take that into account? Or, even if the shock is indeed an act of God, it’s possibility must be known – since it is known to the analyst – and so it must affect decisions made in A. But in that case the effects of the shock can be hedged and nothing happens as a result of the shock; there is no longer two equilibria, just one. So we either have agents with perfect knowledge of everything and no knowledge of shocks, which must literally be divine interventions; or we can have only a single equilibrium which nothing can change; or we can become nihilists like Shackle; or we can reject the Lucas critique and accept that there are regularities in economic behavior that are not anticipated by the actors involved.

Fragment of an Argument

David Colender, in Beyond Microfoundations: Post Walrasian Macroeconomics, explains that Post Walrasian macro is based on the idea that complexity of macro economy and limits to individual rationality mean that there will not be a unique equilibrium. Institutions and non-price coordinating mechanisms are needed to constrain the available degrees of freedom, to produce stability. But “while many past critics of Walrasian economics have based their criticism on the excessive mathematical nature of Walrasian models, I want to be clear that this is not the Post Walrasian criticism; if anything, the post Walrasian criticism is that the mathematics used in Walrasian models is too simple. … The reason Marshall stuck with partial equilibrium was not that he did not understand the interrelationships among markets…. Instead Marshall felt that general equilibrium issues should be dealt with informally until the math appropriate for them was developed. That has only recently happened.” I heard something very similar from Duncan Foley last week: Heterodox macro needs to be more mathematically sophisticated than the mainstream, with nonlinear regressions and models using statistical mechanics drawn from physics.

Sorry, I’m not buying it. Colender and Foley are right that it’s not possible to construct a consistent, tractable, intuitive model of the economy using linear equations. But the solution is not to construct intractable, non-intuitive models using more complex math. It’s to abandon the search for a general model and focus instead on locally stable aggregate relationships that allow us to tell causally meaningful stories about particular developments. We don’t need a theory of institutions in the abstract, but historically grounded accounts of specific institutions.

Is There Really a European Sovereign Debt Crisis?

The past few months have seen a flurry of articles warning that the next stage of the financial crisis will be a flight from sovereign debt, specifically in the European periphery. Even people who don’t believe in confidence fairies when it comes to the US or the UK accept the conventional wisdom that financing the deficit of the PIIGS countries (Portugal, Ireland, Italy, Greece and Spain) is a problem — that there is simply no way to convince the public to hold the amount of debt these countries will have to issue in the absence of austerity. For these countries, it’s sadly conceded, in the absence of the option of devaluation the hard exigencies of the bond market leaves them no choice but slash spending and force down wages. But is it true? Here are the relevant debts and deficits, in billions of euros (not percent of GDP, for reasons that will be clear in a moment.)
General Government Debt and Net Borrowing

2010 2009 2008
Greece Net debt 259 230 199
Net borrowing 19 32 18
Ireland Net debt 86 58 41
Net borrowing 28 23 13
Italy Net debt 1542 1473 1395
Net borrowing 80 80 42
Portugal Net debt 135 121 105
Net borrowing 12 16 5
Spain Net debt 1051 1054 1088
Net borrowing 97 118 44
PIIGS Net debt 3073 2936 2828
Net borrowing 236 269 122

Source: IMF, World Economic Outlook (General government here includes all levels of government; “net” means that intra-government borrowing is excluded.) As we can see, deficits approximately doubled in the PIIGS countries between 2008 and 2009, and stabilized in 2010. But how big are these deficits? Are they, for example, big compared with the balance sheet of the European Central Bank?
ECB Assets (billions of euros)

4th week of October of…
2010 2009 2008 2007 2006 2005
Euro-area bank loans 547 701 831 451 444 389
Euro-area securities 471 361 153 133 121 133
Total assets 1878 1786 1958 1249 1119 999

Source: ECB, Weekly Financial Statements In passing, it’s interesting how different the balance sheet of the ECB looks from the Fed’s especially before the crisis. While the asset side of the Fed’s balance sheet, at least until three years ago, consists almost entirely of treasury bills, the ECB has more lending to banks, much more foreign exchange reserves, much more gold (about 10 percent of its pre-crisis assets!) and relatively little in the way of securities. For present purposes, though, two points stand out. First, the ECB increased its security holdings by E320 billion over the past two years, or E160 billion a year. This is equal to two-thirds of the total annual borrowing of the PIIGS countries. So in principle the ECB would only have to increase its current rate of securities purchases by 50 percent to meet the entire borrowing needs of the five threatened countries. Second, looking now at stocks rather than flows, the ECB increased its balance sheet about about 1 trillion euros between 2005 and 2008. Another similar increase would allow the ECB to purchase one-third of the entire outstanding debt of the PIIGS countries. Interestingly, this is very similar to the increase in the Fed’s balance sheet over the same period. More to the point, it’s well within the range that has been suggested as an appropriate size for a second round of quantitative easing (QE2). Now, I’m not suggesting that the ECB should actually finance all new borrowing by ECB countries facing crises, or try to monetize a substantial portion of their existing debt. For one thing, there’s no need to; presumably even modest additional purchases would be enough to convince private actors to hold the debt at a reasonable price, if the ECB made it clear it stood ready to do more. I’m just saying that the frequently-heard argument that the governments of Southern Europe are “too big to save” isn’t obviously true. It seems more likely that any European QE2 — quantitative easing in its current use, remember, just means big central bank purchases of long-dated government debt — that had appreciable macroeconomic effects would be more than enough to solve the sovereign debt problem as well. Of course people (or their equivalents in the world of respectable business opinion) get very upset when you suggest that a government debt problem can be solved by just monetizing it. Oh, they say, but that’s inflationary. Maybe; but in the current context that’s an argument for it, rather than against it. And given that the 2005-2008 expansion of the ECB balance sheet didn’t produce any noticeable upward pressure on prices, it;s hard to see why another comparable one would. OK, they say, but what about the incentives? Why should governments ever show fiscal discipline if they know the ECB will just bail them out when they get in trouble? And there’s the heart of the matter, I think. It’s not that Greece, Spain, and the rest need tough austerity because they can’t be bailed out; rather, they won’t be bailed out in order to force them to implement austerity. The metaphor you sometimes see for the European sovereign debt situation is of mountain climbers roped together above a cliff. If one falls, it goes, the others can hold him up. But if they don’t act quickly and more fall, then the ones still holding on may be pulled down themselves if they don’t cut their companions loose. Maybe a more apt analogy would be that the climbers up top have a powerful winch, securely bolted to the rock; they could pull up the danglers just by turning a crank. But they wonder, wouldn’t it be better to leave them hanging, to teach them a lesson?

EDIT: The counterargument is that, while there is no technical problem with the ECB guaranteeing the financing of budget gaps in peripheral Europe, this would exacerbate the anti-democratic character of Euorpean institutions by giving the ECB a quasi-fiscal role. This is a trickier question.

Substitution and Allometry

Brad DeLong channels Milton Friedman:

Supply and demand curves are never horizontal. They are never vertical. If somebody says that quantities change without changing prices, or that prices change without changing quantities, hold tightly onto your wallet–there is something funny going on.

Yes, this is how economists think, or at least think they think. And there’s more than a bit of truth in it. Certainly in the case at hand, DeLong-cum-Friedman is right, and Myron Scholes is wrong: It’s neither plausible nor properly thinking like an economist to suppose that if unconventional monetary policy can substantially reduce the quantity of risky financial assets held by the public, the price of such assets — the relevant interest rates — will remain unchanged.

That’s right. But it’s not the only way to be right.

Consider the marginal propensity to consume, that workhorse of practical macroeconomic analysis. It’s impossible to talk about the effects of changes in government spending or other demand-side shifts without it. What it says is that, in the short run at least there is a regular relationship between the level of income and the proportion of income spent on current consumption, both across households and over time. Now, of course, you can explain this relationship with a story about relative prices driving substitution between consumption now and consumption later, if you want. But this story is just tacked on, you don’t need it to observe the empirical relationship and make predictions accordingly. And more restrictive versions of the substitution story, like the permanent income hypothesis, while they do add some positive content, tend not to survive confrontations with the data. The essential point is that whatever one thinks are the underlying social or psychological processes driving consumption decisions (it’s unlikely they can be usefully described as maximizing anything) we reliably observe that when income rises, less of it goes to consumption; when it falls, more of it does.

In biology, a regular relationship between the size of an organism and the proportions of its body is called an allometry. A classic example is the skeleton of mammals, which becomes much more robust and massive relative to the size of the body as the body size increases. Economists are fond of importing concepts from harder sciences, so why not this one? After all, consumption is just one of a number of areas where we rely on stable relations between changes in aggregates and relative changes in their components. There’s fixed-coefficient production functions (strictly, an isometry rather than allometry, but we can use the term more broadly than biologists do); the stylized fact, important to (inter alia) classical Marxists, that capital-output ratios rise as output grows; or composition effects in trade, which seem to play such a major role in explaining the collapse in trade volumes during the Great Recession.

This is a way of thinking about economic shifts that doesn’t require the price-quantity links that Friedman-DeLong think are the mark of honest economics, even if you can come up with some price-signal based microfoundation for any observed allometry. It’s more the spirit of the old institutionalists, or traditional development or industrial-organization economics, which tend to take a natural historian’s view of the economy. Of course, not every change in proportion can be explained in terms of regular responses to a change in the aggregate they’re part of. Plenty of times, we should still think in terms of prices and substitution; the hard question is exactly when. But it would be an easier question to answer, if we were clearer about the alternatives.

Does the Level of the Dollar Matter?

Mike Konczal has kindly reposted my back-of-the-envelope estimate of how much a dollar devaluation would boost US demand. (Spoiler: Not much.)

I am far from an expert on international trade and exchange rates. (Or on anything else.) Maybe some real economist will see the post and explain why it’s all wrong. But until then, I’m going to continue asking why Krugman and others who claim that exchange rates are an important cause of unemployment in this country, never provide any quantitative analysis to back that opinion up.

More abstractly, one might ask: Is the time it takes for demand to respond to changes in relative prices, minus the time it takes for exchange rate changes to move relative prices, greater than the time it takes for exchange rates changes to move relative costs (or to be reversed)? Just because freshwater economists say No for a bad reason (because relative costs adjust instantly) doesn’t mean the answer isn’t actually No for a good reason.

Abject Patience

Aldous Huxley says, “The abject patience of the oppressed is perhaps the most inexplicable, as it is also the most important, fact in all history.”

I thought of that today when I came across this story, which really must be read to be believed. And if you read the fantastic work that Mike Konczal and a few other left bloggers are doing on the foreclosure crisis, it’s clear that what happened here is shocking and horrifying but not especially unusual. All over the country, people’s homes are quite simply being stolen from them by banks and other creatures from the financial sector.

But the most disturbing part isn’t the mortgage servicers evicting people from their homes with no clear title or other legal basis. It is the homeowners themselves. The “good” ones most of all.

Tina Kimmel was told by Citi, her lender, that she qualified for a trial loan modification under HAMP. Then after seven months of paying the lower amount as instructed, she was told without explanation she did not qualify and would be considered in default if she didn’t make all the back payments with interest and penalties. She paid them. Then Citi said they wouldn’t accept her money, she was being foreclosed. She kept paying. Without informing her they sold her mortgage to Carrington Mortgage Services, which told her that all they knew was she was in foreclosure and it was up to her, not Citi, to give them documentation on anything else regarding her loan. She gave it. And that while they were deciding whether to evict her, she’d have to keep paying. She paid. Next thing she heard was a sheriff’s notice on her door, announcing the house would be auctioned in three weeks. At the last minute, she paid the $13,000 — borrowed from family and friends — that Carrington was demanding for her nonexistent missed payments, and was allowed to keep her house.

She did everything the banks told her to. She’s proud of that. Shouldn’t she be ashamed?

I don’t know that much about mortgages or mortgage fraud. But one thing I do know is that the Citis and the Carringtons will keep stealing houses as long as the victims think it’s their duty to do whatever it takes to satisfy them, and to peacefully move out if they fail.

One can’t help wondering how many houses would have to end up mysteriously burned a few days after an eviction, to make the banks find loan modifications suddenly quite attractive. But instead we get Tina Kimmel, stakhanovite bill-payer.

A Bit More on China

Mike Konczal points me to this interesting piece by Walker Frost in The American Scene, on the Chinese currency peg. I asked earlier how much Chinese appreciation would boost US demand (more on that below). But there’s a prior question, which is whether an end to Chinese currency intervention would lead to appreciation at all. As Frost points out, the dollar purchases by the central bank coexist with restrictions on private investment abroad and strong incentives for FDI by foreign firms. These policies increase net capital inflows and therefore tend to raise the value of the Chinese currency; the Chinese central bank then pushes it back down with its dollar purchases. It’s far from clear which of these effects is stronger, and therefore, whether an across-the-board liberalization would lead the Chinese currency to rise against the dollar, or to fall. In short, we should see Chinese currency interventions not as part of an export-led growth strategy that requires a current-account surplus, but as part of an investment-led growth strategy that would otherwise tend to produce a current-account deficit. [1]

This is a point Anwar Shaikh has also made, when I’ve discussed this stuff with him. Don’t talk about undervaluation, he says, that implies some known free-market equilibrium exchange rate, and there isn’t one; talk about stabilization instead.

Another interesting discussion of the Chinese currency peg is in this Deutsche Bank report, which tends to confirm my skepticism about the effect of currency adjustment on US-China trade flows. They note that “RMB appreciation tends to … reduce nominal wages in the export sector,” confirming my sense that exchange rate changes don’t reliably move relative costs. And they use an estimate of -0.6 for exchange rate elasticity of Chinese exports. I don’t want to put too much weight on this number — I’m not sure how it’s derived — and they don’t give any estiamtes for US-China flows specifically; but given the well-established empirical fact that exchange-rate elasticity is unsually low for US imports, we have to conclude that the number for Chinese exports to the US is substantially lower. So if you believe the Deutsche Bank number for Chinese exports as a whole, my estimate of -0.17 for Chinese exports to the US is probably in the right ballpark. Which, again, means that even a very large Chinese appreciation would have only a trivial impact on US aggregate demand.

[1] The same goes for tariffs and other trade restrictions imposed by Latin American countries as part of import-substitution industrialization.

… and How About a Higher Yuan?

Another day, another Paul Krugman post blaming China for US unemployment. And maybe he’s right. But it would be nice to see some numbers.

On the same lines as my earlier post about the effect of dollar devaluation on aggregate demand, we can make a rough estimate of trade elasticities to calculate the effect of a Chinese revaluation.

Unfortunately, there aren’t many recent estimates of bilateral trade elasticities between the US and China. But common sense can get us quite a ways here. In recent years, US imports from China have run around 2 percent of GDP, and US exports to China a bit under 0.5 percent. So even if we assume that (1) a change in the nominal exchange rate is reflected one for one in the real exchange rate, i.e. that it doesn’t affect Chinese prices or wages at all; (2) a change in the real exchange rate is passed one for one into prices of Chinese imports in the US; (3) Chinese goods compete only with American-made goods, and not with those of other exporters; and (4) the price elasticity of US imports from China is a very high 4.0; then a 20 percent appreciation of the Chinese currency still boosts US demand by less than 1 percent of GDP.

And of course, those are all wildly optimistic assumptions. My own simple error-correction model, using 1993-2010 data on US imports from China and the relative CPI-deflated bilateral exchange rate, gives an import elasticity of just 0.17. [1] If the real figure is in that range, then a Chinese appreciation of 20 percent will reduce our imports from China by just 0.03 percent of GDP — and of course much of even that tiny demand shift will be to goods from other low-wage exporters.

I don’t claim my estimate is correct. But is it too much to ask that Krugman tell us what estimates he is using, that have convinced him that the best way to help US workers is to foment a trade war with China?

[1] This is a real exchange-rate elasticity, not a price elasticity, so it accounts for incomplete passthrough and offsetting movements in Chinese real wages. It assumes, however, that changes in the nominal exchange rate don’t affect inflation in either country; to that extent, it’s more likely an overestimate than an underestimate