Taylor on monetary policy

John Taylor has a lovely little blog post, encapsulating so much in a few sentences. An excerpt with comments (emphasis mine)

…there is a crucial issue which explains much of the enormous difference of opinion between critics and supporters of the Fed’s current policy. Critics such as me and Allan Meltzer … argue that monetary policy should focus on a clear strategy for the instruments of policy. A goal for inflation or other measures of macro performance is not enough if it is simply part of a whatever-it-takes approach to the instruments. Such an approach results in highly discretionary and unpredictable changes in policy instruments with unintended adverse consequences, as we have been seeing in recent years.

Supporters such as Adam Posen… are just fine with the Fed using, even year after year, a whatever-it-takes approach to the instruments of policy as long as there is an overall goal. With such a goal in mind, so their argument goes, the central bank can and should always intervene in any market, by any amount, over any time frame, with any instrument or program (old or new), and with little concern for unintended consequences in the long run or collateral damage in the short run (say on certain groups of people or markets) as long as it furthers that goal.

Critics are very concerned about those unintended consequences and collateral damage; they are also concerned about an independent government agency wielding such a great deal of power as it carries out a year-after-year whatever-it-takes approach. Supporters are much less concerned.

I have always had this problem with nominal GDP targets, inflation targets, and so forth. Ok, the Fed adopts your target. Now what? If nominal GDP doesn’t do what the Fed wants it to do, what should the Fed do about it? Talk more? (Monetary policy is starting to look more and more like foreign policy here).

Taylor points out a deeper danger. The Fed’s “mandate,” the list of its “goals,” keeps expanding. Beyond just inflation and unemployment, now the Fed is in charge of “financial stability,” managing “systemic risks,” the health of specific markets (mortgages, exports), the health of specific institutions (too big to fail banks), the diagnosis and pricking of bubbles (when not the deliberate stoking of such bubbles), management of the details of every part of financial system (how swaps get traded, for example) and surely coming soon a federal anti-crabgrass mandate.  The list of things the Fed can do in pursuit of these goals is getting bigger and bigger too, while the power of its conventional instruments (setting short rates, quantiative easing) is diminishing.  If the Fed doesn’t think banks are lending enough, and to the right people, in pursuit of one of its many goals, what stops them from using their regulatory power to just go tell the banks who they should lend to?

We have told the Fed to attain unattainable goals, and given it great power to do “whatever it takes” in their pursuit.  The Fed seems to go along. It’s fun to be given so much power, in the short run at least.  But in a democracy, the price of great independence must be limited power, and the Fed will soon have to choose. Congress already limited some of the Fed’s powers after some “whatever it takes” of the financial crisis.

Taylor, of course, would like the Fed limited to the instrument of short-term rates, and to follow the Taylor “rule” for setting them. But the principle is larger than that instance.

Alternative Maximum Tax

This is an Op-Ed for the Wall Street Journal, original here on April 15 2013

Source: Wall Street Jouirnal

They keep coming back, like the villains of a good zombie movie, chanting “more taxes, more taxes.” Long ago, Congress passed the alternative minimum tax, or AMT—a simple flat rate to ensure that in an insanely complex tax code, no one escapes paying something. Now we need an alternative maximum tax as a simple, rough-and-ready way to limit the tax zombies’ economic damage. Call it the AMaxT.

With Monday’s deadline for filing tax returns looming, let’s start a national conversation: How much is the most anyone should have to pay? When do taxes indisputably start to harm the economy and produce less revenue—when government takes 50% of people’s income? 60%? 70%?

I like half, but the principle matters more than the number. Once the country settles on a number, each of us gets to add up everything we pay to government at every level: federal income taxes, yes, but also payroll (Social Security, Medicare, etc.) taxes, state, city and county taxes, estate taxes, property taxes, sales taxes, payroll taxes and unemployment insurance for nannies, household workers, or other employees, excise taxes, real-estate transfer taxes, and so on and on, right down to your vehicle stickers and those annoying extra taxes on your airline tickets.

On April 15, once this total hits the alternative maximum tax, you’ve done your bit and federal income taxes can take no more. You compute federal income taxes as usual, but then you get to reduce the “tax due” that the total is less than the alternative maximum.


The zombies howl that the top federal tax bracket is still “only” 40%. Surely “the rich” can contribute a bit more? They forget that the economic damage of taxes comes from the total tax bite, not just the federal income tax.

Marginal taxes are a purer measure of economic damage. If you earn one more dollar, how much do you get to keep? Marginal rates are higher than average rates in a progressive system: If the government takes 100% of income above $100,000, then somebody earning $150,000 pays a 33% average tax rate but has no incentive to work at all after he reaches $100,000. Ideally, we would limit marginal rates, but this is not practical in a simple backstop like the AMaxT.

American governments also like to hide taxing and spending by passing mandates and regulations, forcing people and businesses to spend on their behalf. Ideally, we would limit this economic damage as well, but this is also not practical in an alternative maximum tax.

However, both considerations mean that the true economic damage will be higher than the AMaxT rate, so we should leave some headroom in setting that rate.

Every cent of corporate taxes comes out of some person’s pocket, in higher prices, lower wages, or lower returns to investors. For example, even the tax zombies don’t dream that we stick it to the big oil companies by charging gas taxes. To limit this damage, every single cent of tax that government assesses, at all levels, should be assigned to somebody and count against that person’s alternative maximum tax. It is easiest to assign all corporate taxes to shareholders. When corporations send you the annual 1099 dividend form, they also report all taxes paid by your shares, which count against your AMaxT. Some taxes could similarly be assigned to workers and reported on W2 forms.

Yes, there are details to work out. People get big tax bills in some years, such as when they pay estate taxes. Incomes fluctuate. Smart tax lawyers could game the system.

This isn’t hard to fix. For example, we could use an average of several years’ income or, better yet, scale the AMaxT limit to consumption rather than income.

Liberals might object to a maximum tax, since it leaves out all the benefits that we get from government. In setting the maximum level of taxation, shouldn’t we consider the nice roads, free schooling, police, national defense, thoughtful regulation, and other benefits and services?

This is a valid consideration if one argues about what’s “fair.” But I propose the AMaxT entirely to limit the economic damage of taxation, a goal you must consider even if you think it’s “fair” to take every cent of a rich person’s income.

To limit economic damage, benefits are irrelevant. Suppose that the government levies a 100% income tax, but it is so good at providing services that each of us gets back twice the value of what we put in. Good deal? Yes. Functioning economy? No. Each person gets services whether they do or don’t pay taxes. But with a 100% income tax, nobody works, nobody pays any taxes, and nobody actually gets any services.

How many people are really being taxed at outrageous rates? I don’t know. The U.S. tax system is so complex, with so many layers of taxing authority, that nobody really knows. Still, an alternative maximum tax is a win-win bet.

If there really are few people who pay an extraordinarily high percentage of their income, then liberals shouldn’t object. They won’t lose any revenue and will enjoy snickering “I told you so.” If it turns out that there are lots of people being so taxed, then we will sharply reduce the unintended, multiplicative effect of taxation, and we will measure that fact. A canary in the coal mine is as valuable chirping as choking.

The disincentive effects of heavy taxation settle in gradually. For the first year or two, all people can do is hire smarter lawyers and work a little less hard. It takes years for businesses to retrench, close, never get started or fail to expand; for people and companies to move abroad; for students to give up investing in an expensive M.B.A., medical school or engineering degree; for people to stay put rather than follow lucrative opportunities, or to retire early. All this shows up slowly and gradually drags down an economy and its tax revenues.

So the AMaxT is most important for the backstop promise it makes to young people and entrepreneurs. Yes, start a company, go to school, work hard, invest, hire people. We guarantee you that no matter what happens, no matter how loud the zombies chant, no matter what clever “revenue enhancers” they come up with, you will get to keep some reasonable fraction of what you earn. Go for it.

( One more point that got cut for length: With an alternative maximum tax, people might abandon complex tax dodges in favor of simply taking the alternative maximum.)

Updates: Several people have pointed out that this system advantages states with high income taxes. Good point. Since state and federal income taxes are both due April 15, let’s amend the proposal to let you cut back proportionally on both federal and state income taxes. Oh, and credits against next year too.

A colleague writes: Perhaps you know this, (I didn’t) but the corporate system you describe is close to the franking credits used in Australia, New Zealand, Malta and maybe other countries. In essence, rather than declare the dividends they receive on their income taxes, shareholders report the corporation’s before-tax earnings that supported the dividends (the grossed-up dividend) and include the taxes the corporation paid as a credit against their taxes. For your purposes, this system already assigns the corporate taxes to the shareholders. (If your tax rate is 0, you actually get a check back from the government for the amount of taxes the corporation paid on your behalf.)

On the issue, how many people are there who pay more than half. Total, on budget, federal state and local spending is about 42% of GDP. Tax expenditures bring that up to 46%. Off budget, mandates, etc. bring us easily over 50%. The average person is already paying something like his income in taxes, either now or later (when the debt comes due). Europe’s numbers only look bigger because they collect it all in one place.

Allen Sanderson has a nice related Op-Ed adding up some state and local taxes in Illinois

What the IMF consideres macro

Via Greg Mankiw’s blog, I learned about the IMF conference on “Rethinking Macro Policy.” See the announcement and program here. I reproduce the program below.

I find this most striking as a reflection on what the IMF considers “macro.” Yes, they have the whole spectrum, indeed, all the way from  Geroge Akerlof and Joe Stiglitz on the far left end of traditional Keynesian economics, to… Olivier Blanchard and David Romer on the pretty-far left end of somewhat new-Keynesian economics?


Don’t get me wrong, these are all very smart people, in the whole program and the final panel. Akerlof was one of my thesis advisers, and a lot of what I learned from him sticks with me today. But really, this is the entire spectrum of macro? Has anyone heard of, oh, Lucas, Sargent, Sims, Prescott and all their many descendants?  Especially if the project is to “rethink,” would not some slight broadening of a spectrum have made sense?

It is a sharp lesson in the range of ideas that the IMF will bring to anything they do.

Program

IMF Headquarters 2
Conference Hall 1
Tuesday, April 16, 2013 

2:00–2:45pm	Registration
2:45–3:00pm	Opening remarks: Christine Lagarde
3:00–4:30pm	SESSION I: Monetary Policy  Chair Janet Yellen Discussants Lorenzo Bini-Smaghi Mervyn King Mike Woodford
4:30–5:00pm	Coffee break
5:00–6:30pm	SESSION II: Macroprudential Policies  Chair Andy Haldane Discussants Claudio Borio Stanley Fischer Choongsoo Kim

IMF Headquarters 2
Conference Hall 1
Wednesday, April 17, 2013

8:15–9:00am	Registration/Continental Breakfast
9:00–10:30am	SESSION III: Financial Regulation Chair Sheila Bair Discussants Jeremy Stein Jean Tirole John Vickers
10:30–11:00am	Coffee Break
11:00–12:30pm	SESSION IV: Fiscal Policy Chair Janice Eberly Discussants Anders Borg Roberto Perotti Nouriel Roubini
2:00–3:30pm	SESSION V: Exchange Rate Arrangements  Chair Agustín Carstens Discussants Jay Shambaugh Martin Wolf Gang Yi
3:30–4:00pm	***Coffee Break***
4:00–5:30pm	SESSION VI: Capital Account Management Chair Duvvuri Subbarao Discussants Philipp Hildebrand Márcio Holland de Brito Hélène Rey
5:30–6:30pm	PANEL DISCUSSION  George Akerlof Olivier Blanchard David Romer Joseph Stiglitz
6:30–8:30pm	***Cocktail Reception *** (Venue: HQ2 Second Floor)

Debt and growth in 10 minutes

This is a short video from last year. I only just found out it exists. It still seems pretty topical, and (for once) condensed because Lars Hansen really forced me to obey the 10 minute time limit!

There is a better link here from the BFI page here that covers the whole event, but I couldn’t figure out how to embed those.

Energy Idiocy

What is it about energy that send all sides of the political spectrum into spasms of babbling idiocy? Here are two items heard on my jog yesterday, courtesy of NPR, one from the right, one from the left, with the NPR interviewers mindlessly accepting idiocy in the middle.

Start with NPR’s coverage of Gina McCarthy’s Senate confirmation hearings. The issue is the EPAs efforts to close down coal-fired power plants to reduce carbon emissions

ELIZABETH SHOGREN, BYLINE: For four years, Gina McCarthy has been heading up the EPA’s office in charge of air quality. She’s crafted rules that are cleaning up exhausts from old coal-fired power plants. Some of those plants are opting to shut down instead of installing expensive pollution controls. Republican Senator John Barrasso from Wyoming says those rules have cost jobs.

SENATOR JOHN BARRASSO: Since you’ve taken office, 10 percent of coal-fired generated power in the United States has been taken offline. Do you see the EPA having any responsibility for the thousands of folks who are out of work for these plant closures?

GINA MCCARTHY: Senator, I take my job seriously when I’m developing standards for protecting public health to take a look at the economic consequences of those and do my best to provide flexibility in the rules.

SHOGREN: Senator Barrasso continues his barrage, naming coal miners he’s met who are out of work for the first time in their lives.

BARRASSO: How many more times, if confirmed, will this EPA director pull the regulatory lever and allow another mining family to fall through the EPA’s trapdoor to joblessness, to poverty and to poor health?

So, quick question: What is the ideal number of jobs in the electricity production industry? Answer: zero.

Really. If you want “jobs,” the right answer is to shut down all the coal-fired plants, and let all those workers move to installing very inefficient windmills. No, better, hook them all up to stationary bicycles, producing 50 watts each; and then hire a bunch more people to grow food for them on locally-sourced sustainable organic farms. And, as Milton Friedman famously quipped, have them plow the fields with spoons so more people still can have jobs. (Coal mining itself has lost almost all of its “jobs” due to mechanization. Perhaps the senator would like to reverse that.)

Ms. McCarthy could easily have answered: “No, Senator. Industries will still need electricity, and that demand will move to renewables. Look at all the green jobs we will create.”  Having started down the coal miner job route, the senator would surely not have had the wit to point out that the real “jobs” cost is in downstream industries that have to pay more for electricity.

Now from the left. The cost-benefit calculation prize of the year goes to NPRs next story, covering a scientific paper that predicts that climate change will cause more clear-air turbulence for flights near the jet stream over the North Atlantic.

BLOCK: Your study finds that by 2050, we might see the frequency of turbulence on flights across the Atlantic doubling and also getting stronger. This has to do with the jet stream. Can you explain why?

WILLIAMS: Well, climate change is accelerating the jet stream, making the wind speeds faster. And this is making the atmosphere more susceptible to the particular instability that causes clear air turbulence to break out. … The conditions seem to be smooth and all of a sudden, you can hit turbulence unexpectedly …

BLOCK: Well, do you figure that airlines will have to reconfigure their flight patterns, will have to change how they fly, where they fly?

WILLIAMS: Well, a pilot taking off from perhaps New York in the middle of this century to come across the Atlantic to somewhere in Europe will be looking at twice as much airspace containing turbulence. Now, they’re going to face a choice that they could just grit their teeth and decide to fly right through those extra patches of turbulence or if the turbulence is particularly strong, they might instead decide to try to fly around it or above it or below it.

All of this, of course, means that journey times could lengthen if flight paths have to become more wiggly and less of a straight line. This is an increase in journey times, maybe more delays at airports and also, perhaps more importantly, an increase in fuel consumption. And I should mention that fuel is the number one cost to airlines. So any increase in fuel consumption will, of course, imply increased costs to the airlines.

And ultimately, of course, it could be passengers who see the ticket prices going up to pay for that.

BLOCK: Well, the irony there, too, I suppose would be that if you’re increasing fuel consumption, you’re also increasing the contribution to global warming which will be causing the turbulence in the first place, right?

WILLIAMS: Right. There’s a sort of feedback there and it’s a bit like poetic justice that maybe the atmosphere is somehow seeking its revenge on planes for causing this problem in the first place.

So much low-hanging fruit here. There have been a lot of attempts to add up the economic costs of global warming. Just how big is this effect? Should Gina McCarthy have answered Senator Barrasso with, “Yes, some miners will lose their jobs. But think how much cheaper airline tickets to Paris will be in 2050 because pilots won’t have to fly longer routes to avoid clear-air turbulence?”

Savor the irony. One of the highest items on the global warming agenda is to deliberately raise ticket prices by carbon taxes.

“Feedback.” About 2% of carbon emissions are from all aircraft. So how much do carbon emissions rise from slightly longer jet routes? Are we out of the fifth decimal point?

This is all so sad. I don’t mind liberals who don’t profess to believe in free markets getting it all wrong. But “free market” conservatives shouldn’t quickly revert to Keynesian pump priming and public works arguments.  I don’t mind conservative bible-thumpers who get science wrong. But bien-pensant “scientific” global warming nannies shouldn’t be off by, oh, let’s say 10^6 or more on cost-benefit analyses and feedback effects. Each makes their causes ludicrous. And just how incredulous should journalists be not to catch any of this?

Interest rate graphs

Where are interest rates going? Here are two fun graphs I made, for a talk I gave Tuesday at Grant’s spring conference, on this question. (Full slide deck here or from link on my webpage here)

Here is a graph of the recent history of interest rates. (These are constant maturity Treasury yields from the Fed)  You can see the pattern:


Early in a recession, interest rates fall, but long rates stay above short rates. These are great times for holders of long-term bonds. They get higher yields, but prices also rise as rates fall, so they make money both ways. But you also see the see-saws. Interpretation: long-term bond holders are getting a premium for holding interest rate risk at a time that nobody wants to hold risks.

Then there is the flat part at the bottom of the recession. Now long-term bond holders get the yield, but interest rates don’t change. Still, they’re making money.

Then comes the interest rate rise, when long-term bond holders lose money. Obviously, you want to get out before interest rates start rising. But it’s not easy. Nobody knows for sure how long recessions will last. (That seems to be the lesson of  more serious work too.) Look at all the fits and starts, all the zig zags in long interest rates. You don’t want to be caught napping like in 1994. But if you, like me, thought last year or the year before looked like 1994, you got out too early. Welcome to risk and return. Notice in 2003 that long rates started rising long before the Fed did anything.


As I look at the fundamentals, current rates look pretty low. Will inflation really average less than 3% for the next 30 years, so you just break even on 30 year bonds?  But the criticism, “if we’re in such trouble, why don’t markets see it coming?” is still troublesome. So let’s look at the actual market forecast

The solid blue line and red line are today’s yield curve and forward curve. (This is the Gürkaynak, Sack, and Wright data). The blue forward curve is the market expectation of where interest rates will go in the future. You can lock in these rates today, so if you really know something different is going to happen, you can make a fortune. (This is why I’m not persuaded by arguments that the Fed is driving down rates below market expectations.) We can interpret this blue forward curve by the “consensus forecast.” The economy slowly recovers, interest rates slowly rise back to normal levels (4%) consistent with 2% inflation and 2% real rates. The fall back to 3% rates at the long end of the curve seems a bit low, but that’s the market forecast and always a good place to start prognosticating.

If the path of future interest rates follows the blue forward curve, there is no bloodbath in long term bonds: you earn this rate of return on bonds of all maturity at every date going forward. (Proving this is a good finance class problem.)

How good are market forecasts though? This may be the market’s best guess, but a lot of the future is simply unknowable.  The thin blue and red lines show the forward curve and yield curve in April 2010. You can see that at the time, the consensus market forecast was for interest rates to rise starting sooner, and to rise more quickly. We all expected the recession to end quickly, as recessions usually do.

In 2010, the market forecast that today’s interest rate would be 3.5%, not zero. I graphed that forecast and realization by the leftmost vertical arrow. Furthermore, the entire forward curve forecasts the entire forward curve. So, second point from the left, in 2010 the market forecast that today’s one-year forward rate would be about 4.2%, not the tenth of a percent or so that we see. If the forward rate forecast is correct, today’s forward rate curve should lie exactly on the 2010 forward curve. (Proving that is another nice problem set question for finance classes.)

So, from the perspective of 2010, we have seen quite a large, surprise, downward shift of the “market expectations” in the forward curve.  It has been a great few years for holders of long term bonds.

However, beware: What goes down can come up again. To those who say “interest rates are low, the market doesn’t see trouble coming, why worry?” I think the graph shows the magnitude of interest rate risk. And risk goes in both directions.

So, I’m still doom and gloomy. But the danger we face is unpredictable. Large debts mean that the government is out of ammunition, didn’t pay the insurance bill, the fire extinguishers are empty, we are prone to a run or a sovereign debt “bubble” bursting (I hate that word, but I think it conveys the spirit), choose your anecdote. We could have a Japanese decade. It could be February 1994, when spreads and recent history looked a lot like today’s. Or we could be on the edge of Greece, whose interest rates were pretty low once upon a time as well. The market forecast interpolates between these options.

The first principle of portfolio maximization is risk management, not prognostication. There remains a lot of risk.