Richmond Fed Interview

The Richmond Fed published a long interview with me in their Econ Focus, shorter pdf (print) version here and longer web version here. Some of the questions:

• Does the 2010 Dodd-Frank regulatory reform act meaningfully address runs on shadow banking?
• So what do you think is the most promising way to meaningfully end “too big to fail”?
• Do you think there’s any reason to believe recessions following financial crises should necessarily be longer and more severe, as Carmen Reinhart and Kenneth Rogoff have famously suggested?
• Many people have asked whether the finance industry has gotten too big. How should we think about that?
• What are your thoughts on quantitative easing (QE) — the Fed’s massive purchases of Treasuries and other assets to push down long-term interest rates — both on its effectiveness and on the fear that it’s going to lead to hyperinflation?
• Both fiscal and monetary policies have been on extreme courses recently. What are your thoughts on how they might affect each other as they move back to normal levels?
• Switching gears to finance specifically, what do you think are some of the big unanswered questions for research?
• You wrote an op-ed on an “alternative maximum tax.” What’s the idea there?
• Can transfers really help the bottom half of the income distribution?
• Which economists have influenced you the most?

You’ll have to click to the interview for answers!

Thanks to Aaron Steelman, Lisa Kenney and especially  Renee Haltom, who helped a lot with the editing. I’m a lot less coherent in person!

Williamson on the economics blogosphere

Steve Williamson has an insightful set of posts, Minneapolis Redux, and Journalists Looking for a Fight. They are tangentially on the Minneapolis Fed affair, but really about the coverage of the affair and deeply thoughtful about how the economics blogosphere is evolving.

Reporters at the Minneapolis Star-Tribune, the Financial Times, the Wall Street Journal, and other outlets were fair, I think. They talked to the people involved, and covered the story the way good reporters should. What went on in the economics blogosphere I think is revealing of what this medium can and cannot do. In many cases, bloggers dived into the story and did what they do best. They made stuff up, or repeated things that have become “blog truths” - basically fiction that, when repeated often enough, somehow becomes truthy. 

So, this runs from the outrageous to the comical, covering all points in between….

His own posts here set a high standard for looking up, checking, and linking to the things he’s talking about. Hopefully the market test will induce us all to better blogging.

What if we got the sign wrong on monetary policy?

I’ve been following with interest the rumblings of economists playing with an amazing idea – what if we have the sign wrong on monetary policy? Could it be that raising the interest rate raises inflation, and not the other way around?

Most recently, Steve Williamson plays with this idea towards the end of a recent provocative blog post.   Most of Steve’s post is about the Phillips curve, but he concludes

If the Fed actually wants to increase the inflation rate over the medium term, the short-term nominal interest rate has to go up.

So, here’s the policy advice for our friends on the FOMC…If there’s any tendency for inflation to change over time, it’s in a negative direction, as long as the Fed keeps the interest rate on reserves at 0.25%. Forget about forward guidance…So, as long as the interest rate on reserves stays at 0.25%…you’re losing by falling short of the 2% inflation target, which apparently you think is important. And you’ll keep losing. So, what you should do is Volcker in reverse.. For good measure, do one short, large QE intervention. Then, either simultaneously or shortly after, increase the policy rate. Under current conditions, the overnight nominal rate does not have to go up much to get 2% inflation over the medium term.

Conventional wisdom says no, of course: raising interest rates lowers inflation in the short run and and only raises inflation in a very long run if at all.

The data don’t scream such a negative relation. Both the secular trend and the business cycle pattern show a decent positive association of interest rates with inflation, culminating in our current period of inflation slowly drifting down despite the Fed’s $3 trillion dollars worth of QE.

To be sure, I left the grand Volcker stabilization out of the picture here, where a sharp spike in interest rates preceded the sudden end of inflation. And to be sure, there is a standard story to explain negative causation with positive correlation. But there are other stories too – the US embarked on a joint fiscal-monetary stabilization in 1982, then under the shadow of an implicit inflation target gradually lowered inflation and interest rates. Other countries that adopted explicit inflation targets have similar-looking data.  And every time George Washington got sicker, his doctors drained more blood.

So much for data, how about theory? Why do we think that higher interest rates produce lower inflation? We are now, in fact, in a new environment, and old theories may not apply any more.

The first standard story was money. In the past, when the Fed wanted to raise rates, it sold bonds, cutting down on the $50 billion of non-interest-paying reserves. The standard story was, with less “money” in the economy and somewhat sticky prices, nominal interest rates would rise temporarily.  The less money would eventually mean less inflation, and then and only then would nominal rates decline. In this  view, running the Fed was a tricky job, like driving 68 Volkswagen bus in a crosswind, since the steering was connected to the wheels in the wrong direction in the short run.

However, we are likely to stay with huge excess reserves and interest on reserves. When the Fed wants to raise interest rates now, it will simply pay more on reserves and bingo, interest rates rise. We will remain as awash in interest-paying reserves as before. So this 1960s monetary mechanism just won’t apply. Is it possible that in the interest-on-reserves world, raising interest rates translates right away into larger inflation?

More recent economic thinking has (rightly, I think) left the money vs. bonds distinction in the dust. The “Paleo-Keyneisian” (credit to Paul Krugman for inventing this nice word) models in policy circles state that the Fed raises rates, this lowers “demand,” and through the Phillips curve, lower demand means less inflation. No money in sight here, but yes a negative effect. The first half of Steve’s blog post tearing apart the Phillips curve at least should question one’s utter confidence in that mechanism.

Paleo-Keynesian models aren’t really economics though. What do new-Keynesian (DSGE)  models say? Interestingly, new-Keynesian models can quite easily produce a positive effect of interest rates on inflation. Here are two examples (The models I use here are discussed in more depth in “Determinacy and Identification with Taylor Rules” and “The New-Keynesian Liquidity Trap”)

Lets’ start with the absolutely simplest New-Keynesian model, a Fisher equation and a Taylor rule,
\[ i_t = E_t \pi_{t+1} \] \[ i_t = \phi_{\pi} \pi_t + v_t \]
The standard solution ( \(\phi_{\pi} \gt 1 \) and choosing the nonexplosive equilibrium) is
\[ \pi_t = -E_t \sum_{j=0}^{\infty} \phi^{-(j+1)} v_{t+j}. \]
So, suppose \(v_t\)=0 for \(t \lt T\) and imagine an unexpected permanent tightening to \(v_t=v \) for \(t \ge T\). Interest rates and inflation are zero (deviations from trend) until T, and then

\[ \pi_t =i_t = -\frac{1}{\phi_{\pi}-1} v \]
Both inflation and the interest rate jump down together. Wait, you say, I thought this was a tightening, why are interest rates going down? It is a tightening – v is positive. The Fed deviates from its Taylor rule, so interest rates are higher than they would be for this inflation rate. But an observer sees interest rates and inflation move together, both going down. Conversely, if the Fed were to “loosen” by deviating from its Taylor rule in a lower direction, then we would see inflation and interest rates move immediately and positively together. I’m not sure news papers would call this “tighter interest rates!”

A better way to think of this experiment is, what if the Fed adopted a higher inflation target? Rewrite the Taylor rule as
\[ i_t = \phi_{\pi} \left(\pi_t -\pi^*_t \right) \]
You see this is the same, with \(v_t = -\phi_{\pi}\pi^*_t \). So, if the Fed suddenly (and credibly!) raises its inflation target from \(\pi^*_t=0\) to \(\pi^*_t=\pi^* \gt 0 \) at \(t=T\), inflation and interest rates jump from zero to
\[ \pi_t =i_t = \frac{\phi_{\pi}}{\phi_{\pi}-1}\pi^*. \]
The higher inflation target gives instantly higher inflation – and must come with a sudden rise in the Fed’s interest rate target!

Blog readers will know I’m not much of a fan of the standard New-Keynesian equilibrium selection devices. But since this “model” is only an Fisher equation, obviously it’s going to be even easier to see a positive connection between interest rates and inflation in other equilibria of this model. For example, take \(\phi_{\pi}=0\) (as we must at the zero bound anyway) and choose the equilibrium that has zero fiscal effects, i.e. no unexpected inflation at time T.
\[ i_t = E_t \pi_{t+1} \] \[ i_t = v_t \] Now, a sudden unexpected rise from \(i_t=0\) to \(i_t=v\) for \(t \ge T\) gives us \(\pi_T\)=0 (no unexpected inflation) but then \(\pi_t=v\) for \(t=T+1,T+2,….\). In words, the Fed raises rates at \(T\), there is a one-period pause and then inflation rises to match the higher interest rate after this one-period pause. 

“But what about price-stickiness?” I hear you protesting, and rightly. The whole story about a temporary effect in the wrong direction hinges on price stickiness and Phillips curves. I happen to have a paper and program handy with explicit solutions so let’s look. The model is the standard continuous time New-Keynesian model, 
\[ \frac{dx_{t}}{dt} =i_{t}-\pi _{t} \] \[ \frac{d\pi _{t}}{dt} =\rho \pi _{t}-\kappa x_{t}. \]
Now, suppose the Fed raises the interest rate from zero to a constant i starting at time T. This is a simple matrix differential equation with solution
 \begin{equation*} \left[ \begin{array}{c} \kappa x_{t} \ \pi _{t} \end{array} \right] =\left[ \begin{array}{c} \rho \ 1 \end{array} \right] i+\left[ \begin{array}{c} \lambda ^{p} \ 1 \end{array} \right] e^{\lambda ^{m}\left( t-T\right) }z_{T} \end{equation*}
where
\begin{eqnarray*} \lambda ^{p} &=&\frac{1}{2}\left( \rho +\sqrt{\rho ^{2}+4\kappa }\right) \geq 0 \ \lambda ^{m} &=&\frac{1}{2}\left( \rho -\sqrt{\rho ^{2}+4\kappa }\right) \leq 0. \end{eqnarray*}
There are multiple solutions, as usual, indexed by \(z_T\), equivalently by what inflation does at time T. The inflation target or Taylor rule selects these, but rather than get in to that, let’s just look at the possibilities:

Here I graphed an interest rate rise from 0 to 5% (blue dash)  and the possible equilibrium values for inflation (red). (I used \(\kappa=1\, \ \rho=1\) ).

As you can see, it’s perfectly possible, despite the price-stickiness of the new-Keynesian Phillips curve, to see the super-neutral result, inflation rises instantly. The equilibrium I liked in “New-Keynesian Liquidity Trap” with no instantaneous response produces a gradual rise in inflation. The only way to get a big decline in inflation is to imagine that by a second “equilibrium selection policy” the Fed insists on a quick jump down in inflation.

Obviously this is not the last word. But, it’s interesting how easy it is to get positive inflation out of an interest rate rise in this simple new-Keynesian model with price stickiness.

So, to sum up, the world is different. Lessons learned in the past do not necessarily apply to the interest on ample excess reserves world to which we are (I hope!) headed. The mechanisms that prescribe a negative response of inflation to interest rate increases are a lot more tenuous than you might have thought. Given the downward drift in inflation, it’s an idea that’s worth playing with.

I don’t “believe” it yet (I hate that word – there are models and evidence, not “beliefs” – but this is the web, and it’s easy for the fire-breathing bloggers of the left to jump on this sort of playfulness and write “my God, that moron Cochrane ‘believes’ monetary policy signs are wrong” – so one has to clarify this sort of thing.) We need to explore the question in a much wider variety of models. But it is certainly a fascinating question. What is the connection between interest rates and inflation in the interest-on reserves world? If one wants to raise inflation, is Steve right that raising rates does the trick?

By the way, none of this is an endorsement of the idea that more inflation is a good thing. If interest rates stay low, and we trend to zero inflation or even slight deflation, why wouldn’t we just welcome the Friedman rule – inflation  policy has attained perfection, on to other things? Technically, welfare calculations come after understanding policy in these models, and “believing” that all our seemingly endless doldrums can all be fixed with a little monetary magic like taxing reserves is another proposition that needs a lot more support.  More likely, if you don’t like the long-term economy, go fix “supply” and growth where the problems are.  Nobody’s Phillips curve gives a big output gap with steady inflation.

History: I last thought about this question here, in response to a John Taylor Op-Ed also suggesting that raising rates might be stimulative. This sign is an old question. The last time it came up was around the stabilization of 1980-1982. A school suggested money was “superneutral.” They were wrong, I think, in the short run, at the time. I wrote my thesis showing there is a short run effect of money on interest rates, in the expected direction, which tells you a bit about how long monetary controversies go on. But both interest rates and unemployment did come down much faster than the Paleo-Keynesians of the time thought possible.  It’s definitely time to rethink it.

There is lots more good stuff in Steve’s post. Like causality and Japan:

.. There used to be a worry (maybe still is) of “turning into Japan.” I think what people meant when they said that, is that low inflation, or deflation, was a causal factor in Japan’s poor average economic performance over the last 20 years. In fact, I think that “turning into Japan” means getting into a state where the central bank sees poor real economic performance as something it can cure with low nominal interest rates. Low nominal interest rates ultimately produce low inflation, and as long as economic stagnation persists (for reasons that have nothing to do with monetary policy), the central bank persists in keeping nominal interest rates low, and inflation continues to be low. Thus, we associate stagnation with low inflation, or deflation.

and the value of forward guidance without commitment

You’ve [Fed] pretty much blown that, by moving from “extended period” language, to calendar dates, to thresholds, and then effectively back to extended periods. That’s cheap talk, and everyone sees it that way

And the whole Phillips curve thing is good stuff too.  But we’re here to talk about the possible negative sign.

(Thanks to Frank Diebold for showing me how to get MathJax to work in blogger. )

Hansen Nobel Spanish Translation

Spanish translation of my blog post on Lars Hansen’s Nobel Prize

El premio Nobel de Lars Hansen (traducción al español de Pedro Cervera)

Lars ha realizado tal cantidad de investigación pionera y profunda, que ni siquiera puedo comenzar a enumerar la lista completa sin comentar que sólo entiendo una parte de ella.

Escribí capítulos enteros de mi libro de texto “Valoración de activos” basándome tan sólo en uno de los documentos de Hansen. Lars escribe para el futuro y normalmente tardamos diez años o más en entender lo que ha hecho y su verdadera importancia….

(para el resto, haga clic aquí (pdf))

A limited central bank

Philadelphia Fed president Charles Plosser gave a noteworthy speech, “A limited central bank.” It’s especially noteworthy in the context of Janet Yellen’s nomination, discussion between Congress and Fed about how the Fed should be run, the Fed’s focus on unemployment, and the current state of the hawks vs. doves debate.

We find out what he thinks of micromanaging the taper based on monthly employment reports:

The active pursuit of employment objectives has been and continues to be problematic for the Fed. Most economists are dubious of the ability of monetary policy to predictably and precisely control employment in the short run, and there is a strong consensus that, in the long run, monetary policy cannot determine employment….

When I talk to Fed types about this, the usual answer is a version of “well, yes, we don’t really have that much effect on employment, but employment is in the toilet, we have to do what we can, no?”

Charlie has a good answer to that, along the way blasting his colleagues who want the Fed to continue to fiddle with long term bond markets, mortgage rates, credit spreads, credit “availability” and perceived bubbles:

When establishing the longer-term goals and objectives for any organization, and particularly one that serves the public, it is important that the goals be achievable. Assigning unachievable goals to organizations is a recipe for failure. …

…We have assigned an ever-expanding role for monetary policy, and we expect our central bank to solve all manner of economic woes for which it is ill-suited to address. We need to better align the expectations of monetary policy with what it is actually capable of achieving.

…Even though the [Fed’s] 2012 statement of objectives acknowledged that it is inappropriate to set a fixed goal for employment and that maximum employment is influenced by many factors, the FOMC’s recent policy statements have increasingly given the impression that it wants to achieve an employment goal as quickly as possible.

What should the Fed do?

I have concluded that it would be appropriate to redefine the Fed’s monetary policy goals to focus solely, or at least primarily, on price stability.

The speech is very thoughtful about independence. In a democracy, an agency can only be independent if it has limited powers. An agency that writes checks to voters, allocates credit to favored businesses and industries, cannot be politically independent.

The current deal for independence is written in part in the Federal Reserve act which sets up the current “dual mandate,” but

The act doesn’t talk about managing short-term credit allocation across sectors; it doesn’t mention inflating housing prices or other asset prices. It also doesn’t mention reducing short-term fluctuations in employment.

You’re getting a sense of what genies Charlie would like to put back in their bottles. It’s a bit remarkable for a Fed president to essentially say that Fed policy is not only unwise, but stretching the Fed’s legal authority.  Yet independence is a good thing:

Even with a narrow mandate to focus on price stability, the institution must be well designed if it is to be successful. To meet even this narrow mandate, the central bank must have a fair amount of independence from the political process so that it can set policy for the long run without the pressure to print money as a substitute for tough fiscal choices

Such independence in a democracy also necessitates that the central bank remain accountable. Its activities also need to be constrained in a manner that limits its discretionary authority. 

… in exchange for such independence, the central bank should be constrained from conducting fiscal policy… [yet] the Fed has ventured into the realm of fiscal policy by its purchase programs of assets that target specific industries and individual firms.

What would Charlie do to draw some lines in the sand? One, by reinstating traditional limits on what assets the Fed can buy:

One way to circumscribe the range of activities a central bank can undertake is to limit the assets it can buy and hold. My preference would be to limit Fed purchases to Treasury securities and return the Fed’s balance sheet to an all-Treasury portfolio. This would limit the ability of the Fed to engage in credit policies that target specific industries.

Rules are important,

A third way to constrain central bank actions is to direct the monetary authority to conduct policy in a systematic, rule-like manner. It is often difficult for policymakers to choose a systematic rule-like approach that would tie their hands and thus limit their discretionary authority.  

And for more reasons than usual: if the bank is following a rule, it’s much less open to political criticism and able to preserve its independence:

Systematic policy can also help preserve a central bank’s independence. When the public has a better understanding of policymakers’ intentions, it is able to hold the central bank more accountable for its actions. And the rule-like behavior helps to keep policy focused on the central bank’s objectives, limiting discretionary actions that may wander toward other agendas and goals

…assigning multiple objectives for the central bank opens the door to highly discretionary policies, which can be justified by shifting the focus or rationale for action from goal to goal.

Charlie agrees: you can’t have effective forward guidance without precommitment, and you can’t have precommitment and discretion. Here is the slam at how taper talk roiled bond markets

My sense is that the recent difficulty the Fed has faced in trying to offer clear and transparent guidance on its current and future policy path stems from the fact that policymakers still desire to maintain discretion in setting monetary policy. Effective forward guidance, however, requires commitment to behave in a particular way in the future. But discretion is the antithesis of commitment and undermines the effectiveness of forward guidance. Given this tension, few should be surprised that the Fed has struggled with its communications.

In some sense, arguing about the dual mandate is the last war. The Fed is now the Gargantuan Financial Regulator, and the “mandate” includes “financial stability,” and detailed discretionary direction of credit flows. Charlie:

Some have even called for an expansion of the monetary policy mandate to include an explicit goal for financial stability. I think this would be a mistake.

The Fed plays an important role as the lender of last resort…. the role of lender of last resort is not to prop up insolvent institutions. However, in some cases during the crisis, the Fed played a role in the resolution of particular insolvent firms that were deemed systemically important financial firms. .. by taking these actions, the Fed has created expectations — perhaps unrealistic ones — about what the Fed can and should do to combat financial instability.

In fact, the bigger the fire house, the more the chance of fires:

I can think of three ways in which central bank policies can increase the risks of financial instability. First, by rescuing firms or creating the expectation that creditors will be rescued, policymakers either implicitly or explicitly create moral hazard and excessive risking-taking by financial firms. For this moral hazard to exist, it doesn’t matter if the taxpayer or the private sector provides the funds. What matters is that creditors are protected, in part, if not entirely.

Second, by running credit policies, such as buying huge volumes of mortgage-backed securities that distort market signals or the allocation of capital, policymakers can sow the seeds of financial instability because of the distortions that they create, which in time must be corrected.

I would add, if you prop up prices in bad times, you kill the incentive for people to keep some cash around to buy in the next “fire sale.”

And third, by taking a highly discretionary approach to monetary policy, policymakers increase the risks of financial instability by making monetary policy uncertain. Such uncertainty can lead markets to make unwise investment decisions — witness the complaints of those who took positions expecting the Fed to follow through with the taper decision in September of this year.

“You can keep your bonds if you like them?”

The whole speech is good, I hope my excerpts get you to go to the real thing.

New vs. Old Keynesian Stimulus

While fiddling with a recent paper, “The New-Keynesian Liquidity Trap” (blog post), a simple insight dawned on me on the utter and fundamental difference between New-Keynesian and Old-Keynesian models of stimulus.

Old-Keynesian. The “Keynesian cross” is the most basic mechanism. (If you are worried that I’m making this up, see Greg Mankiw’s Macroeconomics, p. 308 eighth edition, “Fiscal policy and the multiplier: Government Purchases.”)

Consumption follows a “consumption function.” If people get more income Y, they consume more C

C = a + m Y.

Output Y is determined by consumption C investment I and government spending G

Y = C+ I + G.

Put the two together and equilibrium output is

Y = a + mY + I + G
Y = (a + I + G)/(1-m).

So, if the marginal propensity to consume m=0.6, then each dollar of government spending G generates not just one dollar of output Y (first equation), but $2.5 dollars of additional output.

This model captures a satisfying story. More government spending, even if on completely useless projects, “puts money in people’s pockets.” Those people in turn go out and spend, providing more income for others, who go out and spend, and so on. We pull ourselves up by our bootstraps. Saving is the enemy, as it lowers the marginal propensity to consume and reduces this multiplier.

New-Keynesian. The heart of the New-Keynesian model is a completely different view of consumption. In its simplest version

Here consumption C, relative to trend, equals the sum of all future real interest rates i less inflation π i.e. all future real interest rates. The parameter σ measures how resistant people are to consuming less today and more tomorrow when offered a higher interest rate.

(This is just the integrated version of the standard first order condition, in discrete time

People in this model think about the future when deciding how much to consume and allocate consumption today vs. tomorrow looking at the real interest rate. I’ve simplified a lot, leaving out trends, the level and variation of the “natural rate” and so on.)

In this model too, totally wasted government spending can raise consumption and hence output, but by a radically different mechanism.  Government spending raises inflation π . (How is not important here, that’s in the Phillips curve.) Holding nominal interest rates i fixed, either at the zero bound or with Fed cooperation, more inflation π means lower real interest rates. It induces consumers to spend their money today rather than in the future, before that money loses value.

Now, lowering consumption growth is normally a bad thing. But new-Keynesian modelers assume that the economy reverts to trend, so lowering growth rates is good, and raises the level of consumption today with no ill effects tomorrow. (More in a previous post here)

Comparing stories

This new-Keynesian model is an utterly and completely different mechanism and story. The heart of the New-Keynesian model is Milton Friedman’s permanent income theory of consumption, against which old-Keynesians fought so long and hard! Actually, it’s more radical than Friedman: The marginal propensity to consume is exactly and precisely zero in the new-Keynesian model.  There is no income at all on the right hand side. Why? By holding expected future consumption constant, i.e. by assuming the economy reverts to trend and no more, there is no such thing as a permanent increase in consumption.

The old-Keynesian model is driven completely by an income effect with no substitution effect. Consumers don’t think about today vs. the future at all. The new-Keynesian model based on the intertemporal substitution effect with no income effect at all.

Models and stories

Now, why is Grumpy grumpy?

Many Keynesian commentators have been arguing for much more stimulus.  They like to write the nice story, how we put money in people’s pockets, and then they go and spend, and that puts more money in other people’s pockets, and so on.

But, alas, the old-Keynesian model of that story is wrong. It’s just not economics. A 40 year quest for “microfoundations” came up with nothing. How many Nobel prizes have they given for demolishing the old-Keynesian model? At least Friedman, Lucas, Prescott, Kydland, Sargent and Sims. Since about 1980, if you send a paper with this model to any half respectable journal, they will reject it instantly.

But people love the story. Policy makers love the story.  Most of Washington loves the story. Most of Washington policy analysis uses Keynesian models or Keynesian thinking. This is really curious. Our whole policy establishment uses a model that cannot be published in a peer-reviewed journal. Imagine if the climate scientists were telling us to spend a trillion dollars on carbon dioxide mitigation – but they had not been able to publish any of their models in peer-reviewed journals for 35 years.

What to do? Part of the fashion is to say that all of academic economics is nuts and just abandoned the eternal verities of Keynes 35 years ago, even if nobody ever really did get the foundations right. But they know that such anti-intellectualism is not totally convincing, so it’s also fashionable to use new-Keynesian models as holy water. Something like “well, I didn’t read all the equations, but Woodford’s book sprinkles all the right Lucas-Sargent-Prescott holy water on it and makes this all respectable again.” Cognitive dissonance allows one to make these contradictory arguments simultaneously.

Except new-Keynesian economics does no such thing, as I think this example makes clear. If you want to use new-Keynesian models to defend stimulus, do it forthrightly: “The government should spend money, even if on totally wasted projects, because that will cause inflation, inflation will lower real interest rates, lower real interest rates will induce people to consume today rather than tomorrow, we believe tomorrow’s consumption will revert to trend anyway, so this step will increase demand. We disclaim any income-based "multiplier,” sorry, our new models have no such effect, and we’ll stand up in public and tell any politician who uses this argument that it’s wrong.“

That, at least, would be honest. If not particularly effective!

You may disagree with all of this, but that reinforces another important lesson. In macroeconomics, the step of crafting a story from the equations, figuring out what our little quantitative parables mean for policy, and understanding and explaining the mechanisms, is really hard, even when the equations are very simple. And it’s important. Nobody trusts black boxes. The Chicago-Minnesota equilibrium school never really got people to understand what was in the black box and trust the answers. The DSGE new Keynesian black box has some very unexpected stories in it, and is very very far from providing justification for old-Keynesian intuition.

Miron and Rigol go after a classic

Jeff Miron and Natalia Rigol have a provocative working paper, “Bank Failures and Output During the Great Depression.” They take on one of Ben Bernanke’s most famous papers.

Bernanke concluded that the great depression was severe not because of a lack of money– medium of exchange – but because of the credit effects of so many bank failures.

You may say, “duh,” but it’s not so easy. If bank A fails, what stops you from going and getting a loan from bank B? Well, if your ability to get a loan is wrapped up in the knowledge that employees of bank A have about you. And if, as a result of some sort of friction, Bank B doesn’t hire those people for their knowledge. And if, as a result of another friction, someone can’t come buy the assets of Bank A, including people and knowledge, and continue to operate the bank. In the great depression, restrictions on branches and interstate banking did that. The process is, fortunately, much swifter now that the assets of a small local bank can be swiftly bought up by other banks even out of state.

Bernanke’s paper was - and is – enormously influential. It was part of a movement to put credit rather than money at the heart of monetary economics and understanding of Fed policy.

But, as Jeff and Natalia point out, what if the banks fell because output was going down, not the other way around? How strong was Bernanke’s actual evidence?

Source: Jeff Miron and Natalia Rigol

The graph, from the paper, makes the basic point. We can argue about the “bank holiday” but you see that even the other failures came rather late in the game. It’s not at all obvious that bank failures cause output declines and not the other way around.

And of course, “the economy will tank if banks go under” is the mantra that produced the bailouts. Jeff and Natalia’s closing words:

To the extent U.S. experience during the Great Depression – and especially the view that bank  failures played a significant, independent role during that period – formed the intellectual foundation for  Treasury and Fed actions, however, our results suggest a hint of caution. If the Great Depression does not constitute evidence for Too-Big-to-Fail, then what historical episodes do provide that evidence? We leave  that question for another day

There are lots of important unsettled issues, justifying Jeff and Natlia’s cautious tone in the paper.  How about regional evidence – didn’t  towns whose banks failed suffer more than others, and had lower loan volumes? (I vaguely remember seeing that.  I don’t pretend to be an expert on empirical great depression work. If someone has the cross-sectional evidence, add a comment.)

Still, given how the “credit channel” view underlies most of Fed thinking, even though inequalities by definition don’t always bind, and how deeply the “we can’t let banks fail or there won’t be any new lending” view underlies so much crisis policy, I salute a careful reexamination of even classic “facts.”

Update:

On the cross-sectional point, Hanno Lustig found Hal Cole and Lee Ohanian’s “Reexamining the contributions of money and banking shocks to the U.S. great depression” and suggests this graph as a summary. Not even in the cross section. Thanks Hanno!

Source Hal Cole and Lee Ohanian

The New-Keynesian Liquidity Trap

I just finished a draft of an academic article, “The New-Keynesian Liquidity Trap"  that might be of interest to blog readers, especially those of you who follow the stimulus wars. 

New-Keynesian models produce some stunning predictions of what happens in a "liquidity trap” when interest rates are stuck at zero.  They predict a deep recession. They predict that promises work: “forward guidance,” and commitments to keep interest rates low for long periods, with no current action, stimulate the current level of consumption.  Fully-expected future inflation is a good thing. Growth is bad. Deliberate destruction of output, capital, and productivity raise GDP. Throw away the bulldozers, let them use shovels. Or, better, spoons. Hurricanes are good. Government spending, even if financed by current taxation, and even if completely wasted, of the digging ditches and filling them up type, can have huge output multipliers.

Even more puzzling, new-Keynesian models predict that all of this gets worse as prices become more flexible.  Thus, although price stickiness is the central friction keeping the economy from achieving its optimal output, policies that reduce price stickiness would make matters worse.

In short, every law of economics seems to change sign at the zero bound. If gravity itself changed sign and we all started floating away, it would be no less surprising.

And of course, if you read the New York Times, people like me who have any doubts about all this are morons, evil, corrupt, and paid off by some vast right-wing conspiracy to transfer wealth from the poor to the secret conspiracy of hedge fund billionaires.

So I spent some time looking at all this.

It’s true, the models do make these predictions. However, there is a crucial step along the way, where they choose one particular equilibrium. There is another equilibirum choice, where all of normal economics works again: no huge recession, no huge deflation, and policies work just as they ought to.

I took a setup from Ivan Werning’s really nice 2012 paper: There is a negative “natural rate” from time 0 to time T, and the interest rate is stuck at zero. After that, the natural rate becomes positive again, and everyone expects the actual interest rate to follow. I solved the standard new-Keynesian model in this circumstance – forward-looking “IS” and Phillips curves.

This is Werning’s “standard” equilibrium choice, which shows all the new-Keynesian predictions. The liquidity trap lasts until T=5, shown as the vertical line in the middle of the graph.

The thick red line is inflation. As you see, there is huge deflation during the liquidity trap, though deflation is steadily decreasing.

The dashed blue line is output (deviation from  "potential".) As you see, there is a huge output gap, though strong expected output growth as it comes back to “trend” at the end of the trap. This is why growth is bad – in these models you always come back to trend, so if you can lower growth, that raises today’s level.

The thin red dashed lines marching toward the vertical axis show what happens as you reduce price stickiness. (I only showed inflation, output does the same thing.) As you reduce price stickiness, it all gets worse – output at any given date falls dramatically. For price stickiness epsilon away from a frictionless market, output falls to zero and inflation to negative infinity.

I verify in the paper that all the claimed policy magic works in this equilibrium.  Even a small amount of “forward guidance” can dramatically raise output, wasted-spending multipliers can be as large as you like, and those policies get more effective as price stickiness gets smaller.

However, for the same interest rate path, there are lots and lots of equilibria.

This graph shows a different equilibrium. I call it the “local-to-frictionless” equilibrium. Again, the thick  red line is inflation. Now, during the liquidity trap, there is steady, mild inflation. The inflation pretty much matches the negative natural rate, so the zero interest rate during the trap (from t=0 to t=T=5) produces a the real interest rate near the natural rate.

As the trap ends, inflation slowly declines and then takes a “glide path” to zero – i.e. zero deviation from trend, or back to the Fed’s long-run target.

In this equilibrium, there is a small increase in potential output, shown in the dashed blue output line. The new-Keynesian Phillips curve says that when inflation today is higher than inflation tomorrow, output is above potential.

As we turn down price stickiness, the thin red lines show that inflation smoothly approaches the totally frictionless case, positive inflation from 0 to T and zero inflation immediately thereafter. I didn’t have room to show it, but  output smoothly approaches a flat line as well.

The paper shows that all the magical policies are absent in this equilibrium: The multiplier is always negative, announcements about the far off future do no good, and deliberately making prices sticker doesn’t help.

These are not different models. These are not different policies or different expected policies. Interest rates follow exactly the same path in each case, zero from t until T=5, and following the natural rate thereafter. These are different equilibrium choices of the same model. Each choice is completely valid by the rules of new-Keynesian models. I don’t here challenge any of the assumptions, any of the model ingredients, any of the rules of the game for computation. Which outcome you choose is completely arbitrary.

The difference between the calamitous equilibrium and the mild local-to-frictionless equilibirum, in this model, is just expectational mulitple equilibria (with an implicit Ricardian regime.) If people expect the inflation glide path, we get the benign equilibrium. If they expect inflation to be zero the minute the trap ends, we get the disaster.

The paper goes on to compute all the magical policies, consider Taylor rules, and every other objection I can think of. So far.

What do I make of all this? Well obviously, maybe one isn’t so dumb, evil, or corrupt for having doubts about changing the sign of all economic principles when interest rates hit zero.

Let me just quote from the conclusion

At a minimum, this analysis shows that equilibrium selection, rather than just interest rate policy, is vitally important for understanding these models’ predictions for a liquidity trap and the effectiveness of stimulative policies. In usual interpretations of new-Keynesian model results, authors feel that interest rate policy is central, and equilibrium-selection policy by the Fed, or equilibrium-selection criteria, are details relegated to technical footnotes (as in Werning 2012), game-theoretic foundations, or philosophical debates, which can all safely be ignored in applied research. These results deny that interpretation.

….there really are multiple equilibria and choosing one vs. another is simply an arbitrary choice. Since there is an equilibrium with no depression and deflation, and no magical policy predictions, one cannot say that the new-Keynesian model makes a definite prediction of depression and policy impact.

I have not advocated a specific alternative equilibrium selection criterion. Obviously, the local-to-frictionless equilibrium has some points to commend it: It is bounded in both directions, it produces normal policy predictions, it has a smooth limit as price stickiness is reduced, and it does not presume an enormous fiscal support for deflation. But this is not yet economic proof that it is the “right” equilibrium choice.

We might consider which equilibrium choice is more consistent with the data. The US economy 2009-2013 features steady but slow growth, a level of output stuck about 6-7% below the previous trendline and the CBO’s assessment of “potential,” a stagnant employment-population ratio, and steady positive 2-2.5% inflation.

The local-to-frictionless equilibrium as shown in my second Figure can produce this stagnant outcome, but only if one thinks that current output is about equal to potential, i.e. that the problem is “supply” rather than “demand,” and that the CBO and other calculations of “potential” or non-inflationary output and employment are optimistic, as they were in the 1970s, and do not reflect new structural impediments to output.

The standard equilibrium choice as shown in my first Figure cannot produce stagnation. It counterfactually predicts deflation, and it counterfactually predicts strong growth. One would have imagine a steady stream of unexpected negative shocks – that each year, the expected duration of the negative natural rate increases unexpectedly by one more year – to rescue the model. But five tails in a row is pretty unlikely.

The problem in generating stagnation is central to the new-Keynesian model. The “IS” curve and the assumption that we return to trend means that we can only have a low level of output and consumption if we expect strong growth. The Phillips curve says that to have a large output gap, we must have inflation today much below expected inflation tomorrow and thus growing inflation (or declining deflation). Thus if we are to return to a low-inflation steady state, we must experience sharp deflation today.  If one wants a model with stagnation resulting from perpetual lack of “demand,” this model isn’t it. Static old-Keynesian models produce slumps, but dynamic intertemporal new-Keynesian models do not.
….
I close with a few kinds words for the new-Keynesian model. This paper is really an argument to save the core of the new-Keynesian model – proper, forward-looking intertemporal behavior in its IS and price-setting equations – rather than to attack it. Inaccurate predictions for data (deflation, depression, strong growth), crazy-sounding policy predictions, a paradoxical limit as price stickiness declines, and explosive off-equilibrium expectations, are not essential results of the model’s core ingredients.  A model with the core ingredients can give a very conventional view of the world, if one only picks the local-to-frictionless equilibrium. That model will build neatly on a stochastic growth model, represented here in part by the forward-looking “IS” equation and changes in “potential.” Its price stickiness will modify dynamics in small but sensible ways and allow a description of the effects of monetary policy. This was the initial vision for new-Keynesian models, and it remains true.

Really, the fault is not in the core of the new-Keynesian model. The fault is in its application, which failed to take seriously the fundamental problem of nominal indeterminacy…. Interest rate targets, even those that vary with output and inflation, or money supply control with interest-elastic demand, simply do not determine the price level or inflation.  In a model with price stickiness, nominal indeterminacy spills over in to real indeterminacy.

In that context, this paper shows there is an equilibrium choice that leads to sensible results. Alas, those sensible results are non-intoxicating. In that equilibrium, our present (2013) economic troubles cannot be chalked up to one big simple story, a “negative natural rate” (whatever that means) facing a lower bound on short term nominal rates; and our economic troubles cannot be solved by promises, or a sign reversal of all the dismal parts of our dismal science. Technical regress, wasted government spending, and deliberate capital destruction do not work. Growth is good, not bad. That outcome is bad news for those who found magical policies an intoxicating possibility, but good news for a realistic and sober macroeconomics.
    

If all this just whets your appetite, I hope you will read the paper. Similarly, if you’re brimming with objections, take a look at my attempts to anticipate most objections – what about the Taylor rule, etc. – in the paper.

(This follows an earlier paper in the JPE (online appendix) looking deeply at multiple equilibria in new-Keynesian models. In that paper, I questioned whether ruling out multiple explosive equilibria made sense. In this paper, I accept that part of the rules of the game, and think about the mulitple non-explosive equilibria.)

Sargent online

Tom Sargent and John Stachurski go online with a fascinating web based course in quantitative economic modeling.

Two thoughts.  The education world is going online, but we’re all in version 1.0 at best. Tom and John’s website is an interestingly different paradigm than the online courses such as the Coursera platform that I’m using for an online asset pricing course.  I’ll be curious to see which elements of which paradigm survive. Or perhaps the Toms’ webiste will become the “textbook” for Coursera type courses, which can then add videos, forums, a structured environment for plowing through the material, and  the carrot of certification at the end.

The website is just gorgeous. Producing economic (and scientific) articles for viewing online has so far been a headache. Our journals produce beautiful pdf representations of.. printed pages. They might as well show 3-d images of a papyrus scroll. Math and tables in html as presented on most journal websites is just pathetically ugly. As I looked through this website, I’m enthused that 1) I need to learn python and 2) I need to learn to write my papers and textbooks in this gorgeous format.

Macro-prudential policy

Source: Wall Street Journal

Not a fan. A Wall Street Journal Op-Ed. Link to WSJ. Link to pdf on my website. Director’s cut follows:

Interest rates make the headlines, but the Federal Reserve’s most important role is going to be the gargantuan systemic financial regulator. The really big question is whether and how the Fed will pursue a “macroprudential” policy. This is the emerging notion that central banks should intensively monitor the whole financial system and actively intervene in a broad range of markets toward a wide range of goals including financial and economic stability.

For example, the Fed is urged to spot developing “bubbles,” “speculative excesses” and “overheated” markets, and then stop them—as Fed Governor Sarah Bloom Raskin explained in a speech last month, by “restraining financial institutions from excessively extending credit.” How? “Some of the significant regulatory tools for addressing asset bubbles—both those in widespread use and those on the frontier of regulatory thought—are capital regulation, liquidity regulation, regulation of margins and haircuts in securities funding transactions, and restrictions on credit underwriting.”

This is not traditional regulation—stable, predictable rules that financial institutions live by to reduce the chance and severity of financial crises. It is active, discretionary micromanagement of the whole financial system. A firm’s managers may follow all the rules but still be told how to conduct their business, whenever the Fed thinks the firm’s customers are contributing to booms or busts the Fed disapproves of.

Macroprudential policy explicitly mixes the Fed’s macroeconomic and financial stability roles. Interest-rate policy will be used to manipulate a broad array of asset prices, and financial regulation will be used to stimulate or cool the economy.

Foreign central banks are at it already, and a growing consensus among international policy types has left the Fed’s relatively muted discussions behind. The sweeping agenda laid out in “Macroprudential Policy: An Organizing Framework,” a March 2011 International Monetary Fund paper, is a case in point.

“The monitoring of systemic risks by macroprudential policy should be comprehensive,” the IMF paper explains. “It should cover all potential sources of such risk no matter where they reside.” Chillingly, policy “should be able to encompass all important providers of credit, liquidity, and maturity transformation regardless of their legal form, as well as individual systemically important institutions and financial market infrastructures.”

What could possibly go wrong?

It’s easy enough to point out that central banks don’t have a great track record of diagnosing what they later considered “bubbles” and “systemic” risks. The Fed didn’t act on the tech bubble of the 1990s or the real-estate bubble of the last decade. European bank regulators didn’t notice that sovereign debts might pose a problem. Also, during the housing boom, regulators pressured banks to lend in depressed areas and to less creditworthy customers. That didn’t pan out so well.

More deeply, the hard-won lessons of monetary policy apply with even greater force to the “macroprudential” project.

First lesson: Humility. Fine-tuning a poorly understood system goes quickly awry. The science of “bubble” management is, so far, imaginary.

Consider the idea that low interest rates spark asset-price “bubbles.” Standard economics denies this connection; the level of interest rates and risk premiums are separate phenomena. Historically, risk premiums have been high in recessions, when interest rates have been low.

One needs to imagine a litany of “frictions,” induced by institutional imperfections or current regulations, to connect the two. Fed Governor Jeremy Stein gave a thoughtful speech in February about how such frictions might work, but admitting our lack of real knowledge deeper than academic cocktail-party speculation.

Based on this much understanding, is the Fed ready to manage bubbles by varying interest rates? Mr. Stein thinks so, arguing that “in an environment of significant uncertainty … standards of evidence should be calibrated accordingly,” i.e., down. The Fed, he says, “should not wait for "decisive proof of market overheating.” He wants “greater overlap in the goals of monetary policy and regulation.” The history of fine-tuning disagrees. And once the Fed understands market imperfections, perhaps it should work to remove them, not exploit them for price manipulation.

Second lesson: Follow rules. Monetary policy works a lot better when it is transparent, predictable and keeps to well-established traditions and limitations, than if the Fed shoots from the hip following the passions of the day. The economy does not react mechanically to policy but feeds on expectations and moral hazards. The Fed sneezed that bond buying might not last forever and markets swooned. As it comes to examine every market and targets every single asset price, the Fed can induce wild instability as markets guess the next anti-bubble decree.

Third lesson: Limited power is the price of political independence. Once the Fed manipulates prices and credit flows throughout the financial system, it will be whipsawed by interest groups and their representatives.

How will home builders react if the Fed decides their investments are bubbly and restricts their credit? How will bankers who followed all the rules feel when the Fed decrees their actions a “systemic” threat? How will financial entrepreneurs in the shadow banking system, peer-to-peer lending innovators, etc., feel when the Fed quashes their efforts to compete with banks?

Will not all of these people call their lobbyists, congressmen and administration contacts, and demand change? Will not people who profit from Fed interventions do the same? Willy-nilly financial dirigisme will inevitably lead to politicization, cronyism, a sclerotic, uncompetitive financial system and political oversight. Meanwhile, increasing moral hazard and a greater conflagration are sure to follow when the Fed misdiagnoses the next crisis.

The U.S. experienced a financial crisis just a few years ago. Doesn’t the country need the Fed to stop another one? Yes, but not this way. Instead, we need a robust financial system that can tolerate “bubbles” without causing “systemic” crises. Sharply limiting run-prone, short-term debt is a much easier project than defining, diagnosing and stopping “bubbles.” [For more, see this previous post] That project is a hopeless quest, dripping with the unanticipated consequences of all grandiose planning schemes.

In the current debate over who will be the next Fed chair, we should not look for a soothsayer who will clairvoyantly spot trouble brewing, and then direct the tiniest details of financial flows. Rather, we need a human who can foresee the future no better than you and I, who will build a robust financial system as a regulator with predictable and limited powers.

*****
Bonus extras. A few of many delicious paragraphs cut for space.

Do not count on the Fed to voluntarily limit its bubble-popping, crisis management, or regulator discretion. Vast new powers come at an institutionally convenient moment. It’s increasingly obvious how powerless conventional monetary policy is. Four and a half percent of the population stopped working between 2008 and 2010, and the ratio has not budged since. GDP fell seven and a half percent below “potential,” in 2009 and is still six points below. Two trillion didn’t dent the thing, and surely another two wouldn’t make a difference either. How delicious, in the name of “systemic stability,” to just step in and tell the darn banks what to do, and be important again!

Ben Bernanke on macroprudential policy:

For example, a traditional microprudential examination might find that an individual financial institution is relying heavily on short-term wholesale funding, which may or may not induce a supervisory response. The implications of that finding for the stability of the broader system, however, cannot be determined without knowing what is happening outside that particular firm. Are other, similar financial firms also highly reliant on short-term funding? If so, are the sources of short-term funding heavily concentrated? Is the market for short-term funding likely to be stable in a period of high uncertainty, or is it vulnerable to runs? If short-term funding were suddenly to become unavailable, how would the borrowing firms react–for example, would they be forced into a fire sale of assets, which itself could be destabilizing, or would they cease to provide funding or critical services for other financial actors? Finally, what implications would these developments have for the broader economy? …

As if in our lifetimes anyone will have precise answers to questions like these. In case you didn’t get the warning,

… And the remedies that might emerge from such an analysis could well be more far-reaching and more structural in nature than simply requiring a few firms to modify their funding patterns.

A big thank you to my editor at WSJ, Howard Dickman, who did more than the usual pruning of prose and asking tough questions.