MOOC

I will be running a MOOC (massively online) class this fall. Follow the link for information. The class will roughly parallel my PhD asset pricing class. We'll run through most of the "Asset Pricing" textbook. The videos are all shot, now I'm putting together quizzes... which accounts for some of my recent blog silence.

So, if you're interested in the theory of academic asset pricing, or you've wanted to work through the book, here's your chance. It's designed for PhD students, aspiring PhD students, advanced MBAs, financial engineers, people who are working in industry who might like to study PhD level finance but don't have the time, and so on. It's not easy, we start with a stochastic calculus review!  But I'm emphasizing the intuition, what the models mean, why we use them, and so on, over the mathematics.

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)

Crunch time

David Greenalw, Jim Hamilton, Peter Hooper and Rick Mishkin have a nice op-ed in the Wall Street Journal summarizing their recent paper, Crunch Time: Fiscal Crises and the Role of Monetary Policy, (The link goes to from Jim's website there is also an executive summary.)

David, Jim, Peter and Rick are after the same question in my last WSJ oped and Blog post: Suppose the Fed wants to raise interest rates with a huge debt outstanding. With, say, $18 trillion outstanding, raising interest rates to 5% means raising the deficit by $900 billion a year. That's real fiscal resources. In a present value sense, monetary tightening costs someone $900 billion a year of taxes.  There is no chance that current tax revenues can go up that much, or current spending can go down that much. So, raising interest rates to 5% with a lot of debt outstanding means we will borrow it, the debt will grow $900 billion a year faster, and the larger taxes /lower spending will come someday in the far off future.

Or maybe not. David,  Jim, Peter and Rick delve in to the "tipping point" I alluded to.

Countries with high debt loads are vulnerable to an adverse feedback loop in which doubts by lenders about fiscal sustainability lead to higher government bond rates, which in turn make debt problems more severe.

Southern Europe was basically on a similar death spiral until the ECB stepped in and said it would print euros to buy up any debt as needed. The big contribution of the paper: facts.

Using statistical methods, case studies and a wealth of recent data on fiscal crises, we have found that countries with gross debt above 80% of GDP and persistent current-account deficits—as is currently the case in the United States—face sharply increasing risk of escalating interest payments on their debt. This means even higher budget deficits and debt levels and could lead to a fiscal crunch—a point where government bond rates shoot up and a funding crisis ensues.

The vitally important point: it's nonlinear. Evidence from times and countries with lower debts does not apply.

When the Fed raised real rates in the late 1970s, Federal debt was “only” 32% of GDP. Interest payments did swell, from 1.5% to 3% of GDP, accounting for more than half of the Reagan deficits. And long-term real interest rates were high for a decade, usually interpreted as the market's worry that we would go back to inflation, which is the same thing as saying that the government might not have the stomach to pay off all this debt. But strong growth and tax reform led the US to large primary surpluses, and we paid off that extra debt.

We go in to this one with over 100% debt to GDP ratio, and much weaker growth prospects. The experience of how "easy" tightening was in the early 1980s should not lull us in to a sense of security.

They made a small, but I think crucial omission:

With sufficient political will, the U.S. government can avoid fiscal dominance and achieve long-run budget sustainability by gradually reining in spending on entitlement programs such as Medicare, Medicaid and Social Security, while increasing tax revenue by broadening the base.

Quiz question: What's missing here?

Growth. Tax revenue = tax rate x income. You can broaden the base as much as you want, without economic growth the long-term US budget is a disaster. And the current alarming projections assume that we will, someday, return to strong growth. All the reining in, soaking the rich, and base broadening in the world will not save us without growth. We prescribe "structural reform" for Greece. Why not for the US? 

Note to graduate students. The theory here is actually less well worked out than you think. Suppose the Fed follows a Taylor rule, hoping to control inflation by raising interest rates when inflation breaks out. But suppose there is a Laffer limit on taxes, total tax revenue is less than T. In this paper and my own speculations there is a conjecture that inflation can get out of control, and a sense of multiple run-prone equilibria, and a sense that current debt/GDP is an important state variable. It needs better working out.

The banker's new clothes -- review

I wrote a review of Anat Admati and Martin Hellwig's nice new book, "The banker's new clothes" for the March 2 2103 Wall Street Journal.

Bottom line: Banks should issue a lot more equity, a lot less debt, especially short term debt, and a heck of a lot less nonsense.

I admire Anat and Martin. The rest of us read the gobbledygook in the newspapers, chuckle at the faculty lunch -- "Ha ha, xyz is CEO of a huge bank and has never heard of Modigliani-Miller! Ha Ha -- pdq is a senior regulator, and doesn't know the difference between capital and reserves!" -- and then we go about our business. Anat and Martin have admirably taken the bull by the horns. They write opeds, they go to interminable banking policy conferences, they fight it out with bigwig bankers, regulators, and their consultant economists, and endure their scorn. This nice book summarizes their arguments very clearly (without the foaming at the mouth ranting and raving that I would have had a hard time avoiding in their place!)

(Links: This review at the Wall Street Journal (html), in a pdf from my webpage. Admati and Hellwig have a book website with lots of extra material and response to critics.)

Enough preamble. The review: 

Four and a half years ago, the large commercial banks nearly failed, inaugurating our great recession. They were saved by the Troubled Asset Relief Program, Federal Reserve lending and other government support. If you think all that was bad, imagine the ATMs going dark. What has been done to avoid a repetition of these events? Sadly, and despite all the noise you hear about bank regulation, not much.

The central problem, at the core of Anat Admati and Martin Hellwig's "The Bankers' New Clothes," is capital.

In order to make $100 of loans, a typical bank borrows $97—from depositors, from money-market funds, from other banks, or from bondholders—and sells $3 of stock, its "capital." So if only 4% of the bank's loans fail, the shareholders are wiped out, and the bank cannot pay its debts. Worse, if there is a rumor that some loans are in trouble, creditors may "run," each trying to get his money out first, and force a needless bankruptcy. Think of Jimmy Stewart in "It's a Wonderful Life."

When banks are on the brink, all sorts of other pathologies emerge. Bankers and their regulators may try to keep zombie loans on the books, hoping things will turn around. Or bankers may bet the farm on very risky loans that either save the bank or impose larger losses on creditors and the government. Ms. Admati and Mr. Hellwig explain all this nicely in their first few chapters.

The solution seems pretty obvious, no? Banks should fund their investments by selling a heck of a lot more stock and borrowing a heck of a lot less, especially in the form of run-prone short-term debt, as most other companies do.

Far more value was lost in the 2000 tech bust, for instance, than in the subprime mortgages that sparked the 2008 crisis, but the tech bust did not cause a financial crisis. Why? Tech companies were funded by stocks, not short-term debt. Worried shareholders can drive down the price of a stock, but they have no right to demand that the company redeem shares at yesterday's price, so they can't drive the company to bankruptcy in a run. Depositors and other short-term creditors have a fixed-value, first-come-first-serve promise from a bank—they can run.

More capital and less debt would stabilize the financial system in many ways. If a bank wants to rebuild its ratio of capital to assets from 1% to 2% by selling assets, it has to sell half of its assets. Doing so can spark a fire sale, especially if all the other banks are doing the same thing. If the same bank wants to rebuild capital from 49% to 50% of assets, it only has to sell 2% of its assets. That bank will also have a far easier time issuing more stock, rather than selling assets, which is a better way to build equity in the first place.

The U.S. government has instead addressed the risks of banking crises by guaranteeing bank debt. Guaranteeing debts creates perverse incentives, so our government tries to regulate the banks from taking excessive risks: "OK, cousin Louie, I'll cosign the loan for your Las Vegas trip, but no poker this time, and be in bed by 10."

Ms. Admati and Mr. Hellwig show how this approach has failed, repeatedly, over the course of many years—in the 1984 Continental Illinois rescue; in the Latin American debt crisis and savings-and-loan crisis in the 1980s; in the Asian-currency crisis and the collapse of Long-Term Capital Management in the 1990s; and in the recent financial crisis. Each time, our government bailed out more and more creditors in a wider array of institutions. Each time, our government wrote reams of new rules that banks quickly got around.

Now pretty much all of the big banks' debt is guaranteed, explicitly or implicitly through the widely held expectation that a big bank's creditors will be bailed out. But our regulators promise that next time, trust them, they really will spot trouble ahead and do something to stop it—even though our massive bank-regulation machinery failed to notice that subprime mortgages might be a bit risky in 2006 and even though, as Ms. Admati and Mr. Hellwig note, Europe's regulators still consider Greek government bonds to be risk-free assets.

Most basically, Ms. Admati and Mr. Hellwig point out that current regulation is focused on a bank's assets: the loans, securities and other investments that bring money in (and sometimes don't). They want us to focus instead on the bank's liabilities: the ways banks get money and the promises banks make to depositors and investors. Bank assets are not particularly risky or illiquid. Apple's profits from selling iPhones or a mutual fund's portfolio of stocks are far riskier than any bank's portfolio of loans and mortgage-backed securities, or even their much-disparaged trading books. Bank liabilities—too much debt and too much short-term debt—are the central problem that causes financial crises.

What about those "tough" new capital regulations that you keep reading about? They are not nearly as tough as you think. At best, the new Basel III international bank regulation agreement calls for a 7% ratio of capital to assets by a leisurely 2019 deadline. But that is the ratio of capital to "risk-weighted" assets. Risk-weighting is a complex system in which some assets count less against capital requirements than others. A dollar of mortgage assets might count as 50 cents, but it might count as 10 cents or less if it is a complex mortgage-backed security, and zero if it is government debt. When Ms. Admati and Mr. Hellwig unravel those "risk weights," we're still talking about 2% to 3% actual capital.

Foreseeing the usual risk-weighting games, Basel III requires a backstop 3% ratio of equity to all assets. "If this number looks outrageously low," Ms. Admati and Mr. Hellwig write, "it is because the number is outrageously low." Indeed.

This simple truth has been met by howls of protest and layers of obfuscation and derision by bankers, their consultants and many of their regulators. "Oh, you just don't understand the complexities of banking" is the basic attitude. "Go away and let the experts fix this." Well, Ms. Admati and Mr. Hellwig, top-notch academic financial economists, do understand the complexities of banking, and they helpfully slice through the bankers' self-serving nonsense. Demolishing these fallacies is the central point of "The Bankers' New Clothes."

No, they write, it was not always thus. In the 19th century, banks funded themselves with 40% to 50% capital. Depositors wouldn't lend to banks unless the banks had a lot of skin in the game. Without a government debt guarantee—and, early on, without limited liability—shareholders wanted less risk as well.

"Capital" is not "reserves," and requiring more capital does not reduce funds available for lending. Capital is a source of money, not a use of money. When, as Ms. Admati and Mr. Hellwig gleefully note, the British Bankers' Association complained in 2010 about regulations that would require banks to "hold"—the wrong verb—"an extra $600 billion of capital that might otherwise have been deployed as loans to businesses or households," it made an argument both "nonsensical and false," contradicting basic facts of a bank balance sheet. Requiring more capital does not require banks to raise one cent more money in order to make a loan. For every extra dollar of stock the bank must issue, it need borrow one dollar less.

Capital is not an inherently more expensive source of funds than debt. Banks have to promise stockholders high returns only because bank stock is risky. If banks issued much more stock, the authors patiently explain, banks' stock would be much less risky and their cost of capital lower. "Stocks" with bond-like risk need pay only bond-like returns. Investors who desire higher risk and returns can do their own leveraging—without government guarantees, thank you very much—to buy such stocks.

Nothing inherent in banking requires banks to borrow money rather than issue equity. Banks could also raise capital by retaining earnings and forgoing dividends, just as Microsoft MSFT +0.54% did for years. Every dividend drains capital from banks and removes a layer of protection between us taxpayers and the next bailout. Ms. Admati and Mr. Hellwig are at their best in decrying U.S. regulators' decision to let banks pay dividends in 2007-08—amounting to half the TARP bailouts—and to let big banks begin paying out dividends again in 2011.

Why do banks and protective regulators howl so loudly at these simple suggestions? As Ms. Admati and Mr. Hellwig detail in their chapter "Sweet Subsidies," it's because bank debt is highly subsidized, and leverage increases the value of the subsidies to management and shareholders. To borrow without the government guarantees and expected bailouts, a bank with 3% capital would have to offer very high interest rates—rates that would make equity look cheap. Equity is expensive to banks only because it dilutes the subsidies they get from the government. That's exactly why increasing bank equity would be cheap for taxpayers and the economy, to say nothing of removing the costs of occasional crises.

And, in an all-too-short chapter on "The Politics of Banking," they show us how politicians and regulators like the cozy cronyism of the current system. Banks are, of course, "where the money is," and governments around the world use regulation to direct funds to politically favored businesses, to preferred industries, to homeowners and to the government itself. Politicians want to subsidize and protect their piggy bank. Regulators commonly become sympathetic to the interests of the industry they regulate, which advances their careers in government or back in industry. Last week's news coverage of Treasury Secretary Jack Lew's interesting career is only the most recent reminder.

Part of me wishes that Ms. Admati and Mr. Hellwig had been more specific in their criticisms: naming more names and quoting more nonsense, writing a gripping exposé dripping with their justified outrage. But their restraint is wise: Too much exposé would detract from the clarity of their ideas. So readers will have to recognize the arguments and add their own outrage.

Ms. Admati and Mr. Hellwig do not offer a detailed regulatory plan. They don't even advocate a precise number for bank capital, beyond a parenthetical suggestion that banks could get to 20% or 30% quickly by cutting dividend payments. (I would go further: Their ideas justify 50% or even 100%: When you swipe your ATM card, you could just sell $50 of bank stock.)

But this apparent omission, too, is a strength. A long, detailed regulatory proposal would simply distract us from the clear, central argument of "The Bankers' New Clothes": More capital and less debt, especially short-term debt, equals fewer crises, and common contrary arguments are nonsense. More capital would be far more effective at preventing crises than the tens of thousands of pages of Dodd-Frank regulations and its army of regulators, burrowed deep in the financial system, on a hopeless quest to keep highly leveraged and subsidized too-big-to-fail banks from taking too much risk. Once the rest of us accept this central idea, the details fill in naturally.

 How much capital should banks issue? Enough so that it doesn't matter! Enough so that we never, ever hear again the cry that "banks need to be recapitalized" (at taxpayer expense)!


(Update in response to a lot of comments. C'mon, this is a review of a book about banks. It's not my place here to expand the discussion to GSEs' CRA, the run on repo and broker dealers, money market funds etc. On the ATM card that sells bank stock: That card can also sell a share of your S&P500 index. And if you want stable value accounts, money market funds that hold only short term treasuries can provide all the fixed-value assets we could possibly want.)

More new-Keynesian paradoxes

Last week I saw Johannes Wieland's paper "Are negative supply shocks expansionary at the zero lower bound?"  A side benefit of the job market season is that we see interesting new papers like this one, and it contributed to my project of trying to better understand new-Keynesian models.

Though starting academic papers with blog quotations is usually a bad idea, Johannes starts with a great and very appropriate one,

As some of us keep trying to point out, the United States is in a liquidity trap: [...] This puts us in a world of topsy-turvy, in which many of the usual rules of economics cease to hold. Thrift leads to lower investment; wage cuts reduce employment; even higher productivity can be a bad thing. And the broken windows fallacy ceases to be a fallacy: something that forces firms to replace capital, even if that something seemingly makes them poorer, can stimulate spending and raise employment.” -Paul Krugman

I endorse this quote, because it is an accurate and pithy description of the properties of many careful new-Keynesian analyses in the academic literature.

 Johannes explains

Does destroying productive capacity raise output when the zero lower bound (ZLB) binds? [ZLB: When interest rates are zero, the Fed can't lower them any more in response to shocks -JC] While this question may seem absurd, in fact it is a common prediction of many macroeconomic models: In these models, temporary negative supply shocks raise inflation expectations and lower expected real interest rates at the ZLB, which stimulates consumption and output. While some prominent economists have subscribed to this view and its policy implications (e.g., Eggertsson and Woodford [2003], Eggertsson and Krugman [2011], Eggertsson [2012]), there is wide disagreement over such a radical and unintuitive proposition.

Indeed there is.

These are just the beginning of the strange predictions new-Keynesian models (or modelers) make.

"Fiscal stimulus" is the prediction that even completely wasted government spending is good for the economy. Paul Krugman recommended, with refreshing clarity, that the US government fake an alien invasion so we could spend trillions of dollars building useless defenses. (I'm not exactly sure why he does not call for real defense spending. After all, if building aircraft carriers saved the economy in 1941, and defenses against imaginary aliens would save the economy in 2013, it's not clear why real aircraft carriers have the opposite effect. But I'm still working on the nuances of new-Keynesianism, so I'll let him explain the difference. I'm not a big fan of huge defense spending anyway.)

Furthermore, all the new-Keynesian models are "Ricardian." They predict the same stimulus whether spending is financed by borrowing or by lump-sum taxes  today. Good, we don't need to argue about "Ricardian equivalence," but to believe their predictions for spending borrowed money, you have to believe that taxing you and me a trillion dollars and spending it on a trillion dollars of alien defenses will raise overall output by 2, 3, or 4 (you can get really big multipliers in these models) trillion dollars.

Actually, stimulus financed by temporary payroll taxes can be even better than from borrowing money. These are a negative supply shock, which causes inflation and lowers the real interest rate. Sand in the gears is good. Stimulus financed by temporary consumption taxes is worse, because that encourages saving. Promises of higher future consumption taxes, anathema in the standard view of the world, are good, as they get people to consume today.

Super-weirdly, many new-Keyensian paradox predictions get worse as the central friction, price stickiness, gets better.

Johannes again on the new-Keynesian paradoxes:

First, according to the “Paradox of Thrift,” a rise in the desire to save is self-defeating at the ZLB, because it reduces output so much that aggregate savings fall (Keynes [1936], Krugman [1998], Eggertsson and Woodford [2003], and Christiano [2004]). Second, according to the “Paradox of Flexibility,” output volatility may rise at the ZLB when prices and wages are more flexible (e.g., Werning [2011], Eggertsson and Krugman [2011]).

My empirical results concern primarily the “Paradox of Toil” (Eggertsson [2010]), whereby a temporary increase in desired labor supply at the ZLB reduces the equilibrium employment level in standard models. .... Following this logic, payroll tax cuts are contractionary at the ZLB because they lower expected inflation (Eggertsson [2011]), and allowing collusion among firms is expansionary because it raises expected inflation (Eggertsson [2012]).

A pause in praise of economic models: They tie ideas together. You can't pick and choose. If you like stimulus with borrowed money, but suspect that tax-financed stimulus might not work so well, you can't just waive your hands and refer to new-Keynesian models to defend you. These models predict the two policies have the same effect. If you like your stimulus, but think that maybe hurricanes wiping out a bunch of the capital stock isn't great, sorry, you can't refer to new-Keynesian models to defend you. If you don't buy one of Krugman's assertions, you don't buy any of them. (At a minimum, you have to build a new variant of model -- you can't refer to existing new-Keynesian models to defend you.) To taste fish, you have to swallow the whole whale, hook, line, and sinker.

So, back to Johannes. He notes that the models predict quite different behavior away from the bound than at the bound, so conventional estimates don't really tell us that much about whether these predictions are true. But we have enough experience with economies at the lower bound now, that we can begin to test some of these astonishing predictions.

(Minor suggestion for PhD students. The key requirement for these predictions is that the Fed does not change the nominal interest rate in response to shocks. There have actually been other periods of time when central banks have fixed nominal interest rates, for example between 1945 and 1952 in the US. More generally, the general new-Keynesian view is that interest rates did not respond enough to shocks before 1980. So in fact, versions of the paradoxes should be visible in data away from the zero bound.)

Johannes looks at the earthquake in Japan, and oil price shocks. Surprise, surprise, earthquakes are bad for output. More subtly, the new-Keynesian prediction flows through inflation: "Supply shocks" should raise expected inflation, which lowers real interest rates, and lower real interest rates should raise consumption and output. (As I explained last week, new-Keynesian models anchor expected consumption in the far off future. Then real interest rates determine the growth rate of consumption, and higher growth means a lower level today. In the models consumption=output. See Johannes' equation 2 page 7.) Johannes finds that the supply shocks led to higher expected inflation, and hence a lower real rate. But the lower real rate just didn't have the predicted effect on output. In fact, he finds that oil shocks have worse negative effects on employment at the zero bound than in normal times!

Like all provocative empirical work, I'm sure this one will be picked over. The Booth Macroeconomics workshop did its usual good job of exploring nooks and crannies. But let us also pause in praise of serious empirical work. Rather than blurt "this is ridicuous!" let us go see if indeed earthquakes, hurricanes, labor market restrictions, oligopolization and other normally adverse "supply" shocks actually help the economy. The sun might just come up in the West at the zero bound.

Where to go from here? If I had this great introduction, and results that rather decisively reject a central night-is-day new-Keynesian proposition, clearly linked to all the others, I would obviously have been tempted to write it up as "this model is wrong," and dig deep into which key assumptions of the model drive its basic mistakes. Johannes takes another tack, and adds credit constraints to the model. Whether this is a successful repair or a clever epicycle I will leave for another time -- and frankly I haven't studied it closely enough to opine yet.  How many of the paradoxes it overturns is another good question. It seems to overturn quite a few. But the paradoxes are also the sexy policy implications.  It may save new-Keynesian models from their prediction that hurricanes are good, by destroying the new-Keynesian multiplier.

Sargent and interest-rate options

By now, you've probably seen Tom Sargent's great Ally Bank TV spot.


But, were I to needle Tom just a bit, I might ask, "Tom, the Ally Bank CD allows you the option of raising your CD rate once over its two-year life. Can you explain when to optimally exercise that option?''  Or (second beer), "Tom, to what portfolio optimization question is the answer, combine a two-year CD with an American option to raise the rate once?  You must have some great robust-control result here about parameter uncertainty in dynamic interest-rate models."

Unraveling the Mysteries of Money

Harald Uhlig and I did a fun interview run by Gideon Magnus (Chicago PhD) at Morningstar. We talk about the foundations of money, fiscal theory, monetary policy, European debt problems, etc. Gideon framed it well, and Harald is really sharp. Somebody combed my hair. A cleaned up version of the interview appeared in the Morningstar Advisor Magazine (html) (A prettier pdf)



A link in case the video doesn't work or doesn't embed well (if you see "server application unavailable" the link usually still works), or if you want the original source.

The video starts a little abruptly, as it left out Gideon's thoughtful introduction (it's in the Magazine) and framing question:

Gideon Magnus: I want to discuss the value of money and the idea that money is valued similarly to any other asset. Are there really assets backing money? If so, what are they? John, please explain.

Woodford at Jackson Hole

Mike Woodford's Jackson Hole paper is making a big buzz, and for good reasons. Readers of this blog may be surprised to learn that I agree with about 99% of it. (Right up to the "and hence this is what we should do" part, basically!)

Any student of economics should read this paper. Mike lays out in clear if not always concise prose, and remarkably few equations, the central ideas of modern monetary economics, on all sides, along with important evidence.

Mike's central question is this: how can the Fed "stimulate," now that interest rates are effectively zero, and given that (as Mike reviews), "quantiative easing" seems extremely weak if not completely powerless? He comes up with two answers: (Hint: starting with the conclusions on p. 82 is a good way to read this paper!)

First, the Fed can make promises to keep interest rates low in the future, past the time when normally the Fed would start to raise rates. He hopes that such promises would lower long-term interest rates, through the usual expectations hypothesis mechanism that long rates are expected future short rates. He is sympathetic to "nominal GDP targeting" as a way to commit to those promises.

Second, drop money from helicopters, i.e. "coordinated monetary-fiscal policy." Basically, the Treasury borrows money, writes checks to voters ("helicpoters"), and the Fed buys the debt. I certainly agree the latter policy can create inflation (I wrote as much in "Understanding Policy"), though both Mike and I  emphasize that policy needs some expectations and commitments asterisks too.

Why monetary stimulus?

One reason I disagree so little with the analysis of this paper is because of the part that Mike left out (rightly, it's already 98 pages): Mike didn't explain why he thinks more monetary "stimulus" is a good thing right now.

Treasury rates are at 50 year lows. The 10 year Treasury rate is 1.5%. At 2% inflation, that's a negative 0.5% real rate. Yes, the economy is in the toilet, but surely too-high Treasury interest rates are not the crucial economic problem right now.

So the case for "stimulus" must be that some other, unstated lack of "demand" is the problem, and that all "demand" is the same so that monetary "stimulus" will cure that problem. I disagree on that one.

Mike's enthusiasm for deliberate inflation is even more puzzling to me.  Mike uses the word "stimulus," never differentiating between real and nominal stimulus. Surely, we don't want to cook up some inflation just for its own sake -- we want to cook up some inflation because we think it will goose output. But why? Why especially will increasing expected inflation help? Because that is the aim of all the policies under discussion here -- promising to keep rates low even once inflation rises, adopting "nominal GDP targets," helicopter drops, or similar policies such as raising the inflation target.

I don't put much faith in Phillips curves to start with  -- the idea that deliberate inflation raises output. I put less faith in the idea floating around Jackson hole that a little inflation will set us permanently back on the trend line, not just be a little sugar rush and then back to sclerosis.

But it's a rare Phillips curve in which raising expected inflation is a good thing.  It just gives you more inflation, with if anything less output and employment.

So, in my view, the problem isn't overly tight monetary policy. The economy's problems lie elsewhere. Monetary policy is basically impotent. And it's hard to see that deliberate monetary "stimulus" via expected inflation will help the real economy. We should be telling the Fed to stop pretending to be so all important. You've done what you can. Thanks. You'll do best now by sitting on your hands and letting others cure the real problems.  But that kind of advice doesn't get you (me!) invited to Jackson Hole! The Fed wants to "do more."

So, let's leave alone the question whether a bit of deliberate inflation is a good thing -- I think not, but that's where we disagree -- and analyze Mike's proposals for  how the Fed can create some inflation. Here I mostly agree, with a few asterisks.

Open mouth operations 

So, interest rates are stuck at zero. Can the Fed do anything about it? Many economists have advocated promising that rates will stay at zero further in the future. I've been a bit sceptical of this advice, for example in" Understanding Policy"

I read this move as sign of desperation. Teddy Roosevelt said to speak softly but carry a big stick. These steps are speaking loudly because you have no stick. What will the Fed do if it announces a higher target but inflation does not change? [Announce a larger one still?] We are here in the first place because the Fed is out of actions it can take. Talking is the ‘‘WIN’’ (Whip Inflation Now) strategy that failed in the 1970s. 

More generally, I'm skeptical of the idea that wise governance consists of "managing expectations" by government official's promises.

Mike starts with a review of the literature that studies whether announcements -- "open mouth operations" have had effects in the past. Here's a good example.

These are "Intraday OIS rates in Canada on April 21, 2009. The dotted vertical line indicates the time of release of the Bank of Canada’s announcement of its “conditional commitment” to maintain its policy rate target at 25 basis points through the end of the second quarter of 2010."

On many occasions Fed announcements, coupled with no actions, do move markets. Monika Piazzesi and I once looked at high-frequency data and came to the same conclusion.

But these what do we make of this fact? They certainly do not mean that the Fed can talk down rates at its pleasure. Mike briefly acknowledges one possibility: Markets do not interpret these announcements as changes in policy, or "intentions" but instead simply inform the markets of the Fed's deteriorating economic forecasts.   If the Fed gets news, or forms an opinion, that the economy will be weak, then future interest rates will be lower even if the bank follows the same old Taylor rule.  We can see this reaction even if the central bank has no influence at all over market interest rates (as in Gene Fama's latest) but has a decent forecasting shop. A coming recession means that interest rates will fall no matter what the Fed does about it, so long term rates fall now. Mike has a long section on open mouth operations that don't work, or go the wrong way, and pages of advice for central bankers on how to move markets the way they want.

Mike makes an excellent point though. Overnight rates last overnight. If the Fed has any influence at all on long-term rates, it is entirely through expectations. Talk may not matter, but expectations are everything.

Promises, Promises

Assuming that the Fed does have total control over short term rates, the answer to my Teddy Roosevelt quip is this: Yes, the Fed is powerless to do anything now. But the time will come that the economy recovers or inflation breaks out, and the Fed will want to raise rates. Those 1.5% 10 year rates reflect expectations over some paths in which short rates rise. If the Fed can credibly promise not to raise short rates, even in circumstances in which it would normally be expected to do so, then by expectations hypothesis logic today's 1.5% ten-year rate will decline, as will the implied 10 year real rate (we're assuming the Fed can hold short rates at zero in the future despite the outbreak of significant inflation.)

The deep, intractable problem with this idea is commitment. This occupies the bulk of Mike's analysis, but I don't think he, or others advocating these policies, successfully solves it.

Every day I promise that tomorrow I'm not going to have dessert. Every tomorrow I change my mind. Because I can. Tomorrow, if inflation breaks out, the Fed will want to raise rates sharply.

How can the Fed promise today to do something it will very much regret tomorrow, and get people to believe that promise?  More deeply, how does the Fed commit to allowing "just a bit" of inflation in the future, and not starting down the path of the 1970s again?

Here (p. 42, 44) Mike comes out in favor of a nominal GDP targets. In his view, they're not as good as the optimal policies he and Gauti Eggertsson have calculated, but clarity and communication are important, and Mike can see that nobody but he and Gauti understands the optimal policy.

Nothing communicates like a graph. Here's Mike's, which will help me to explain the view:

The graph is nominal GDP and the trend through 2007 extrapolated. (Nominal GDP is price times quantity, so goes up with either inflation or larger real output.)

Now, let's be clear what a nominal GDP target is and is and is not. Many people (and a few persistent commenters on this blog!) urge nominal GDP targeting by looking at a graph like this and saying "see, if the Fed had kept nominal GDP on trend, we wouldn't have had  such a huge recession. Sure, part of it might have been more inflation, but surely part of a steady nominal GDP would have been less recession." This is NOT what Mike is talking about.

Mike recognizes, as I do, that the Fed can do nothing more to raise nominal GDP today. Rates are at zero. The Fed has did what it could. The trend line was not achievable.

The point of a nominal GDP target to Mike is this: When and if inflation breaks out (which raises nominal GDP) or (let's hope) real GDP starts growing again, the Fed, following the usual Taylor rule linking interest rates to GDP growth or inflation, would normally raise rates. If the Fed instead changes to a nominal GDP target, then the Fed will not raise rates, until the cumulative inflation or real growth brings us back to the dashed line. Then, and only then, will the Fed raise rates.

And, it will (supposedly) use all its hard-won anti-inflationary toughness to keep nominal GDP (inflation at that point) from growing faster than the trend line. In fact, it will become super-tough. In the past, with an inflation target, the Fed swallowed inflation shocks. With a nominal GDP target, the future Fed will supposedly commit to a slow deflation after a 1% surprise inflation shock, to bring the level of nominal GDP back, just as now it is committing to a substantial inflation to bring up the nominal GDP level.

In sum, this nominal GDP target discussion is not about what the Fed does now, or what it should have done in 2008. It is not about whether over the long run a nominal GDP target is better or worse than a Taylor rule (roughly, its first difference), which is a good topic for another day. It is a proposal to manage expectations about what the Fed will do in the future, and its hope is to lower long-term rates now.

Sounds good? Not so fast. Odysseus had himself tied to the mast so he could not change his mind. The Fed is changing rules now, in response to extreme conditions. What stops the Fed from "changing rules" again, the minute inflation does break out? True precommitment means setting things up so you can't change your mind, or at least so there are substantial costs to changing your mind. When Woodford 2016 comes back to Jackson Hole saying, "to fight this galloping inflation we need to change to the Gold standard rule" what stops that?

"Rules" without costs are no better than promises. I don't just promise each day not to have dessert. I change each day to the "no dessert" rule. Each night, I change back to the "no dessert, starting tomorrow" rule.

Furthermore, people might be less worried about the tough anti-inflation Fed than the new we-want inflation Fed. The second promise of the nominal GDP target is to contain expectations that once inflation breaks out it explodes. One inflation breaks out, and the Fed isn't responding, will people really say "oh, that's the new nominal GDP target Fed, they'll get really tough once we get to the 2007 nominal GDP trend?" Or will people think "oh-oh, we've got the 1970s Fed on our hands again"!

Suppose it's 2016, inflation has brought nominal GDP to trend, but real growth is still stagnant, unemployment is still high, the eurozone mess is worse, and candidate Hilary Clinton's poll numbers are tanking. Will Mike--and maybe more importantly, Christina Romer, Paul Krugman, Brad Delong, and the rest of the dovish punditry  recently converted to nominal GDP targeting -- really stand up and say, "we're on the nominal GDP target. We have to keep our promises. Raise rates and open the bar early."? More importantly still, do people now believe that will happen?

(There is also a larger question here, why do we that people will believe fine-tuned promises from the Fed about some brand new, never-tried rule, about how it will behave 5 years from now. To the public, how are the Fed's promises different from annual rosy scenario budget forecasts out of every Administration? How many average Jay-Walking voters even know who Ben Bernanke is or what nominal GDP is?)

I think the lesson of all precommitment economics is, that if you want people actually to believe the commitment, it must have substantial costs to change. Making the target a legal restriction might do. But the Fed adamantly doesn't want any restrictions on its power.

If you cannot limit your power ex post, you cannot commit to anything ex ante. If you cannot commit ex ante to do things you will not want to do ex post, your promises are empty. Even if they are "rules" not "actions."

Mike beautifully sums up what we're looking for on p. 82,

Central bankers confronting the problem of the interest-rate lower bound have tended to be especially attracted to proposals that offer the prospect of additional monetary stimulus while (i) not requiring the central bank to commit itself with regard to future policy decisions...

That criterion dooms a nominal GDP target or any other promise that is not "forward-looking" or "discretionary."  

Especially the Fed. Institutions work from historical perspective, and the Fed regards itself as fresh from the great success of "unconventional" policy experimentation in the great crash of 2008. What, tie ourselves to some rule that might keep us from saving the world again with our innovative discretionary policy? Not a chance.

(And even a legal restriction, writing nominal GDP targets into the law, is no guarantee. The ECB has a legal restriction against buying sovereign debt. Ha Ha Ha.)

The Fed was an alcoholic in the 1970s. It went on a 12 step program, reformed in the 1980s, and not it's a teetotaler on inflation. It wants to promise to go back to being a social drinker -- just three drinks until my nominal alcohol target is fulfilled for the night. And it doesn't want to let its spouse pour the drinks.

Quantitative easing

Mike moves on to quantitative easing. Here, the Fed buys short term treasuries, long term treasuries or other securities, issuing money in the process. Does this "stimulate?"

Mike starts (p. 49) by masterfully destroying the theoretical idea that QE should work. Yes, monetarists think the quantity of "money" matters, even at zero interest rates. They believe that because they think velocity is stable. The historical experience behind that conclusion does not have long periods of zero rates. When interest rates hit zero,

the demand for reserves should become infinitely elastic, so that variations in the precise quantity of excess reserves (as opposed to other short-term, essentially riskless assets) that banks must hold will have no consequences for equilibrium determination. ...once that lower bound is reached, further expansion of the supply of reserves should not have any consequences for aggregate expenditure or the general level of prices (or for that matter, for broad monetary aggregates).

Mike goes on to skewer long term bond purchaes -- they are the same as ineffective QE plus a rearrangement of the maturity structure of debt, which at least should not involve the Treasury doing the opposite.

Starting on p. 60, he points out that no asset market purchases should have any effect. If the Fed buys mortgages or long term bonds, yes, the private sector seems to hold less risk. But the Fed is ultimately holding risk that is guaranteed by the Treasury and hence by your taxes -- The  Modigliani-Miller theorem of Fed impotence. The starting place should be that purchases have no effects.

Of course there are frictions, liquidity effects, and so on. But with this theorem, all monetary theory must be about really understanding the frictions. (I did say this is a great review of monetary theory! Students, pay attention to these sections) For example, the monetarist position that only the issuance of money matters, but what assets the Fed buys do not matter, comes from recognizing one and only one friction, the necessity of money for making transactions. Mike reviews all the currently hypothesized frictions underlying asset purchases. Go read.

Though Mike goes for frictions a lot more than I do, we end up at the same place: a logical conundrum. If the Fed can affect, say long-term treasuries because that market is segmented, cut off from, say, mortgage markets, practically ipso facto changing long term treasuries won't spill over into markets you care about such as mortgages

Second, the existence of market segmentation makes it possible for central-bank purchases to affect the price of an asset, but at the same time limits the generality of the effects of a change in that particular asset price on the rest of the economy. In order for the policy to be judged effective, it is necessary that influencing that particular asset price can be expected to achieve an important aim. In the case of the CPFF, this presumably was the case — only the financing costs of a particular narrow class of borrowers were affected, rather than financial conditions more generally, but the program achieved a specific goal that motivated its creation. One cannot, however, point to such a program as evidence that purchasing any kind of assets eases financial conditions generally. Instead, to the extent that market segmentation is relied upon as the basis for a policy’s effectiveness, one should expect the effects to be relatively local, and the composition of the asset purchases needs to be tailored to the desired effect.

Well, if it makes no theoretical sense, maybe it works anyway? Mike's graph here

is better art than the graphs I made in a QE oped here. QE is supposed to lower interest rates. You have to tie yourself in knots to get this graph to say that interest rates are lower in the grey periods when the Fed is buying lots of stuff.

The Fed and its defenders do: they point to the declines in rates just before QE episodes as evidence for QE's power, then point to the rise in rates as verifying that the economy got better.  Mike explodes this view deliciously (p.71). The view that only the announcement-day decline measures the effects of QE relies on efficient markets. And if markets are efficient, then QE doesn't work, because it relies on segmented markets.

Mike concludes with an interesting observation: the only way that it makes sense for QE to have any effect is not directly, but because it signals to markets just how desperate the Fed thinks the situation is, and therefore communicates that interest rates will be zero for a long time.

But that makes no sense (p.84 of the conclusion is quietly devastating on this widespread view.) QE has the same commitment problem. The only hope for it to work is for people to think the money will stay out there once interest rates rise above zero. But the Fed has loudly told us how easy it will be to soak up all this money the minute it needs to do it, which is reassuring for inflation. But the point was to stoke inflation!

Helicopter drops

So, in conclusion (p. 82 -- hey, at least the blog post is shorter than the paper!) Suppose the Fed wants some inflation, what should it do? The only thing that can create some inflation, if the Fed wants to do that is helicopter drops, which are really fiscal policy: (p. 87):

the most obvious recipe for success is one that requires coordination between the monetary and fiscal authorities. The most obvious source of a boost to current aggregate demand that would not depend solely on expectational channels is fiscal stimulus—whether through an increase in government purchases, tax incentives for current expenditure such as an investment tax credit, or subsidies for lending like the FLS.. At the same time, commitment to a nominal GDP target path by the central bank would increase the bang for the buck from fiscal stimulus, by assuring people that premature interest-rate increases in response to rising economic activity and prices would not crowd out other types of spending than those directly affected by fiscal policy. And the existence of the central bank’s declared nominal GDP target path should also limit the degree of alarm that might arise about risks of unbridled inflation when special fiscal stimulus measures are introduced.

The Treasury borrows and, with Congress, spends the money. The Fed buys the debt and issues money. That's how we do helicopters today.

Even helicopter drops aren't easy however.  If people think that the government will raise taxes tomorrow to pay back the debt, and the Fed will unwind the purchase, even helicopter drops don't cause inflation. There really is no escape from "expectations." Helicopters -- or boondoggle stimulus projects -- are thus a communication mechanism for the government to say, "no, we are not raising taxes to soak up this debt. We really are leaving the money outstanding so it will inflate. You'd better spend it fast." And that's just what Mike wants, more "spending." (See "Understanding Policy" for more).

But Mike is being inconsistent here. He told us how impossible it is to commit to a nominal GDP target. And he told us how irrelevant the maturity structure of goverment debt is. Not raising taxes is really a fiscal commitment not a monetary one. Why is Mike back to a costlessly chageable promise to target nominal GDP? I think he recognizes that the commitment not to undo the helicopter drop is crucial to his proposal, and so he has to rescue that somehow.

So, in the end, I find Mike and I in strong agreement on mechanics. IF the Fed wants to inflate, a helicopter drop is the only way to do it. Even that is about expectations. And it's essentially fiscal policy. And, of course, we have now arrived at a point that completely contradicts the intial search: A policy of announcements, open mouth operations, that the Fed can follow alone.

The question, which Mike does not address, is this: Why in the world would such a deliberate inflation -- which in this case is a deliberately-induced flight from US government debt, exactly what Europe is so desperately trying to avoid -- be a good idea right now?

The rest of p.82 is chilling really. It is a lovely statement of the Fed's problem:

Central bankers confronting the problem of the interest-rate lower bound have tended to be especially attracted to proposals that offer the prospect of additional monetary stimulus while (i) not requiring the central bank to commit itself with regard to future policy decisions, and (ii) purporting to alter general financial conditions in a way that should affect all parts of the economy relatively uniformly, so that the central bank can avoid involving itself in decisions about the allocation of credit. Unfortunately, the belief that methods exist that can be effective while satisfying these two desiderata seems to depend to a great extent on wishful thinking 

We saw how (i) dooms open mouth operations, and conversely dooms the chance the Fed can affect the economy by announcing any new rules and targets.

Yet the Fed wants to be powerful. That leaves (ii). "Allocation of credit" means lending to particular favored markets and institutions.  The Fed understands the huge danger of going here. Lending to cronies is how central banks operate in all the basket cases of the world. But, if the Fed is unwilling to say "Inflation 2%. Banks steady. Interest rates zero. We've done our job," and wants to stay powerful, direct lending (which is really fiscal policy) or direct intervention in the policies of the TBTF banks under its control is going to be increasingly attractive.

Gordon on Growth

Bob Gordon is making a big splash with a new paper, Is US Growth Over?

Gordon's paper is about the biggest and most important economic question of all: Long-run growth. It's easy to forget that per-capita income, the overall standard of living, only started to increase steadily in about 1750. The Roman empire lasted centuries, but the average person at the end of it did not live better than at the beginning.

Gordon's Figure 1, reproduced here shows how growth picked up in the mid 1700s, reached 2.5% per year -- which made us dramatically better off than our great-grandparents -- and now seems to be tailing off.

As Bob reminds us with colorful vignettes of 18th and 19th century living, nothing, but nothing, is more important to economic well being than long-run growth.

And modern growth economics is pretty clear on where the goose is that lays this golden egg: Innovation. New ideas, embodied in new products, processes and businesses. For example, see Bob Lucas' "Ideas and Growth" which starts

What is it about modern capitalist economies that allows them, in contrast to all earlier societies, to generate sustained growth in productivity and living standards? It is widely agreed that the productivity growth of the industrialized economies is mainly an ongoing intellectual achievement, a sustained flow of new ideas

Growth theory neatly divides economics into "growth effects," which is really how fast new ideas are born and implemented, versus "level effects." Many economic distortions screw up the level, making an area or a country less well off than its neighbors. But so long as the frontier keeps growing, even level effects only retard a country a few decades.

Here's a picture. The red line represents 2% growth (real, per capita), starting at $100,000 income. By 2100 your great grandchildren are earning $738,000. The blue line shows a "level effect." Suppose some set of harebraned policies is so awful that it reduces the level of GDP by 20% -- but does not interfere with the growth mechanism. It's pretty bad. But the blue line is really just shifted to the right, lagging a decade or so behind but still participating in the eventual miracle.

By contrast, the black line says, what if there is a policy or change in the environment that has no effect on the level of GDP, but lowers the long-run growth rate to 1%. 2%, 1%, what's the difference? Cumulate that over a century, and your great grandchildren make $300,000, not $738,000.

OK, so, to Bob's first thesis: Long-run growth is slowing down. The big ideas of the first two industrial revolutions, roughly the harnessing of energy, urbanization, clean water, have been used as far as they can. The computer revolution, to Bob, seems to running out of its ability to raise productivity. 20-somethings updating their facebook profiles instead of paying attention class are not the jet-packs and rocket ships we thought we were going to have by 2001.

I think Bob has the right question here. And his warning is well-taken. Just because growth has been steady does not mean it's assured. The "trend" does not come for free. Each improvement in productivity takes hard work, and disruptive new companies putting established incumbents out to pasture.

But I think  -- or at least I hope -- he has the wrong answer (and he freely admits this is speculative).

My pet theory is that the real defining innovation of growth was Gutenberg. Science gives us real knowledge, at last, by controlled experimentation. But controlled experimentation is extraordinarily expensive.  A farmer can't afford to test which crops grow best, a country doctor can't do clinical trials. For society to gain knowledge by scientific method, we need communication. One doctor's clinical trials inform another doctor's practice a thousand miles away. Gutenberg made that possible.

More generally, the process of growth, of incorporating new ideas into the economy, almost always represents standing on the shoulders of giants, appropriating, slightly improving, and implementing someone else's ideas. That, for example, is why we see clusters of innovation such as Silicon Valley.

Well, if Gutenberg (and subsequent innovations that used his ideas, the newspaper, the scientific journal, and the public library) lowered the costs of communicating ideas and widened the community of people that a given idea could reach, the internet just did that tenfold. As I look at the cool stuff -- nanotechnology, genetic engineering etc. -- underway and the instant worldwide communication of ideas, I have hope we'll see that 2.5 percent again. If we let the process run.

For example, think how Bob's idea got to your desk. When I was a young economist, before the internet, he would have mailed a paper to the NBER, a month or two later the working paper would have been distributed. The internet buzz I saw that got me to go look at it would have taken a few more months to percolate to me by older information networks, then I'd have to go read it in the library. Finally, who knows how I would have gotten to you. That all happened in a week. The diffusion of ideas is on steroids.

Well, maybe my pet theory is wrong. Still, long-run growth is the issue,  it is not guaranteed but hard-won,  we didn't always have it and we could lose it, and that would be a catastrophe.  

Bob prognosticates not only that we seem to have run out of productivity-increasing ideas, but that "six headwinds" stand in the way. His headwinds are 1) Demographics: aging and reduced labor-force participation 2) Plateau in US educational attainment 3) "The most important quantitatively in holding down the growth of our future income is rising inequality." 4) Globalization and outsourcing 5) Energy and enviroment 6)  Household and government debt.

Here I think Bob is mostly confusing "level" effects with "growth" effects.  He is also mixing constraints -- run out of ideas -- with self-inflicted wounds -- dysfunctional public education, refusing to let in immigrants, refusing to use nuclear power or GM foods.  And, I don't see how he can focus on the US. Suppose we cede the frontier to, say, China, as the UK ceded the frontier to us in Bob's graph. But as long as we still use China's ideas and technology, and they grow at 2.5 percent, so do we.

The optimistic lesson of growth theory is that, no matter how badly you screw up level effects, growth will bail you out eventually. So, any "headwinds" need to be clearly linked to the possibility that economic distortions lower the rate of finding new ideas and incorporating them. The whole point of growth theory is that, in the long run, that's all that matters.

Do they? My impression of modern growth theory is that the economics of innovation production and adoption are not well understood. Do the distortions of a high-tax,  regulated, crony-capitalist, welfare state,  just screw up levels? Or do they  reduce the spread of ideas behind long-run growth? My fear is "yes."

In any case, just posing the question this way argues that the dangerous "headwinds" are entirely different from the ones that Bob highlights. The returns from innovation, starting new companies, introducing new products and processes -- and in that process making established incumbents very unhappy -- are the most likely targets.

But it's also clear that ideas are public goods, or high fixed cost zero marginal cost goods. Their production and diffusion depends a lot on non-market structures, like, say, universities. (Don't jump from that observation to "they need to be subsidized," as it it's all to easy to subsidize bad ideas too.) That's another lesson of Bob Lucas' paper, which is remarkably free of economic incentives.

Finally, a warning about statistics. Here is my last picture, blown up.

As you can see, if you're just looking at GDP trends, it's hard to tell a "level" effect from a "growth" effect for several decades.

Much discussion of our current slump presumes it's a temporary "level" shock; the blue line will go back up quickly to the red line. The "stagnation" hypothesis is that we're on the blue line -- we lost about 5% of GDP in the recession, and now we're on the growth path with a lower level. That's disastrous enough. Bob warns us that we might be on the worst of the blue and black lines. That would be a huge disaster.

All said before.  The graph reminds us is that it takes a long time to figure out which it is based on just eyeballing the GDP or productivity data. We have to think. Which Bob is prodding us to do.

The mismeasure of inequality

Kip Hagopian and Lee Ohanian have a wonderful new policy review titled "the mismeasurement of inequality."  Calmly, and with careful grounding in facts and review of research, it destroys most of the current liberal myths about the amount of inequality and its importance. The promise:

We will show that much of what has been reported about income inequality is misleading, factually incorrect, or of little or no consequence to our economic well-being. We will also show that middle-class incomes are not stagnating; in fact, middle-class incomes have risen significantly over the 29 years covered by the cbo study. Lastly, we will address assertions that the rich are not paying their “fair share” of taxes

"Address" should be "destroy", but they're being careful. Some nuggets:


Standard measures of inequality are based on pretax cash income, ignoring transfer payments from the government, goods provided directly (housing), benefits (health insurance, retirement contributions), all home-produced goods, and focus on income rather than consumption, which is often suspiciously higher than reported income.  Kip and Lee do their best. When done, the increase in inequality disappears.

Looking at consumption (though still imperfect, as it leaves out home production) yields surprising results:

In 1960–61 consumption expenditures in the lowest quartile were 112 percent of reported income, rising to 140 percent (in the lowest quintile) in 1972–73, and 198 percent (in the lowest quintile) in 2005. Thus, a family claiming $22,300 in income in 2005 would have reported about $44,000 in expenditures in that year. ... the gap between reported income and consumption is filled by various categories of government transfer payments (including Medicaid, food stamps, subsidized housing, the Earned Income Tax Credit, Temporary Assistance for Needy Families, etc.), family savings, imputed income from owner-occupied housing, barter, support from family and friends, and income from the underground economy.

The poor did not get poorer, or stagnate.

..on average America’s poor live in housing that totals 515 square feet per person, about 40 percent more per person than the living quarters of the average European household. (The average American household lives in about 845 square feet per person, or 2.3 times the average European household.)

In addition to food, clothing, and shelter, some of the most meaningful indicators of well-being are the properties and amenities that make life more comfortable or enjoyable. Based on data from the 2009 “American Housing Survey,” Rector and Sheffield report that 42 percent of poor households own a home (median price: $100,000); 80 percent have air conditioning; 98 percent have a color tv (65 percent have two or more); 99.6 percent have a refrigerator; 98 percent have a stove and oven; 75 percent have a car or truck (31 percent have two or more); 81 percent have a microwave oven; 78 percent have a dvd or vcr; 64 percent have a satellite connection; and 25 percent have a dishwasher. 

Our purpose is not to make light of the deprivations the poor suffer every day. [My emphasis. Liberals always try to say "you don't care" because you don't want to swallow the latest scheme.]  There is no doubt that the poorest Americans struggle mightily, and that too many Americans are poor. But these data are useful in understanding the difficulties in defining poverty, and for constructing effective policies aimed at helping those in need

Since "are we becoming Europe?" and "how bad is that really?" are often in the news, a fact based comparison is interesting

...the U.S. has a significantly higher standard of living than almost all of the most advanced economies. According to “The Luxembourg Wealth Study,” the data source used by the oecd for international comparisons, in 2002 (the latest year for which results were available), median disposable personal income in the U.S., adjusted to reflect purchasing power parity, was 19.3 percent higher than in Canada; 68 percent higher than in Finland; 45 percent higher than in Germany; 59 percent higher than in Italy; 31 percent higher than in Norway; 73 percent higher than in Sweden; and 31 percent higher than in the United Kingdom.

 Europe doesn't look so bad when you go visit? Answer: averages matter. Not every body lives on the Via Veneto, dear tourist.

The figures for gdp per capita and median income understate America’s economic performance advantage because the median age of the U.S. population (36.8 years) is about four years lower than the average median age in the European Union and almost eight years lower than in Japan. Age, as a proxy for experience, is a significant contributor to income until individual earnings peak sometime between age 50 and 55. 

A good point I hadn't thought of.

Taxes, and "fair share"?

The U.S. income tax system is, by any measure, quite progressive. In fact, according to a study released in 2008 by the oecd, the U.S. federal income tax system is the most progressive of any of the 24 countries in the “oecd-24,” which includes Canada, Japan, Australia, and all of the richest European nations: Germany, France, the United Kingdom, Italy, the Netherlands, Norway, Switzerland, Luxembourg, and Sweden. In fact, the U.S. progressivity index is 22 percent higher than the average for the 24 countries...

In addition to economic efficiency considerations, we believe that taxing any income from savings and investment is inequitable. Here’s why: Assume two people, Angelina and Brad, have exactly the same lifetime earned income, but Angelina saves ten percent of her after-tax income and Brad saves nothing. In this hypothetical, if income from savings is taxed, Angelina will pay more lifetime tax than Brad, simply because Angelina saved. We believe this is clearly inequitable.

Angelina will also get a lot fewer government benefits. She'll pay more college tuition, get less out of social security, have all her subsequent income taxed at higher marginal rates, and so on. (Investment income may not be taxed that highly iteslf, but it pushes you into a high adjusted gross income bracket and then makes your other income subject to more taxation.)

So what is a “fair share”? The U.S. tax system is more progressive than that of any other advanced economy. Higher-income workers already pay a substantially disproportionate amount of the income tax relative to their share of income. The top five percent pay 44 percent more in taxes than the bottom 95 percent, while 47 percent of tax filers pay no tax at all. The bottom 50 percent of filers pay only 2.3 percent of taxes, and the bottom quintile gets money back. Based on these facts, how does one make a case that the rich are not paying their fair share?

OK, as they admit, nobody has defined "fair," still well written.

I prefer cause and effect, positive analysis. Will redistribution through taxation make us better off, or consign us to egaliatrian misery? I want to raise the living standards of less well off Americans every bit as much as my lefty colleagues. Will redistribution help them or leave them worse off?

We are unaware of persuasive evidence that reducing income inequality will increase economic well-being for the majority of citizens; in fact, America’s superior standard of living and economic growth relative to other advanced economies is evidence to the contrary. 

For arguably the most commonly used measure of inequality and for the Census Bureau’s most comprehensive definition of income, inequality has not risen since 1993. Moreover, the rise in income inequality that occurred before that year appears to have been, at least in part, a byproduct of the remarkable success of a group of entrepreneurs who in the past few decades created countless jobs and contributed substantially to the higher living standards we all currently enjoy. ..

A final cheer:

Rather than focusing on income inequality, policymakers should address the very real impediments to achieving equality of opportunity, particularly for the youngest and least-skilled workers among us. We believe such efforts should begin with fixing our k-12 education system, which is failing to train many young Americans to be competitive in today’s global labor market. If we can solve this problem, we will enable future generations of young people to climb the economic ladder and achieve the economic success that has long made the United States the world’s leading economy

Yes. What the public education system in this country has done to the poor and less well off is a scandal (I don't like the term "middle class," as I reject the idea that we are a class-based society).

I'm not doing justice to the careful argument in the report. Go read the original

Subsidies for economists?

My colleagues Gary Becker and Jim Heckman have an interesting OpEd in the Wall Street Journal, arguing for Federal funding for economists. I respectfully disagree.

Yes, economic research is a public good. And, yes, they point to some good examples of good research that was supported by the Federal Government. That does not prove the research would not have been produced without Federal support.

We would demand a much higher standard of proof from, say, the Sugar Farmers of America, asking for continuation of their tariffs, on the grounds that saving the American Family-run sugar farm is a crucial public good that will vanish without support. Or any of the other supplicants from the federal government, all of whom make public interest arguments on behalf of their subsidies and tax brakes. 

We need a grand bargain. I give up mine, you give up yours. If economists pushing for the grand bargain are the first to say, "you give up yours, but we're an important public good," we're hardly credible.  At a minimum, we need a uniform standard of proof of just who is a public good that really would not be produced without Federal support.

The largest subsidy for economic research -- other than the tax exempt status of our employers -- is the National Science Foundation. They give grants to economists. But they don't pay for the one thing that would generate more research -- they won't buy out teaching. Instead, we operate under the fiction that the university pays us for 9 months, and the NSF can then pay "summer salary." (The NIH, which supports some of the research cited by the OpEd, will buy out teaching as they do for real scientists.) One might defend this as a prize for good past research, which is how it works out in practice. Might.

Is this producing important research that would not be done otherwise?  I've received a few NSF grants in the past. I can tell you the answer. I enjoyed the money. The institutions that took 60% "overhead" enjoyed the money. But I would have written exactly the same papers exactly as fast without it. (I don't apply for NSF grants any more. Given my views on others taking federal money, even though the institutions I work for would appreciate the overhead, it seems inconsistent to do so.)

Is there really not enough economic research being done? Research is not a good of which there is simply "more" or "less," like, say domestically-produced corn-based ethanol. It's "good" and "bad." There is a tremendous amount of it. And mostly "bad."

An economist, looking at the way economic research is funded, would say this is a system designed to produce lots and lots of not very innovative papers. 

Ask a few scientists, after a few beers, about how much faster human knowledge increased in the "war on cancer," the massive funding for HIV research, or now global warming. More federally directed research, is not necessarily better.

An economist looking at this system would also predict swift capture, and that the result of Federal support of research would be that lots of research comes to conclusions supportive of the Federal Government and its agencies. How many papers supported by the Federal Reserve are critical of the Fed? How many of the huge volume of health - policy studies even consider market-based approaches that don't have a huge role for federally sponsored health policy research? Is it just a coincidence that the kind of research that ends up being most critical of the Federal government is supported by private foundations, think tanks, and universities that don't take of federal money?

There are other mechanisms. Adam Smith did not have a Federal grant. Most of us support research by teaching, an activity that produces at least some externalties towards research. Private foundations support economic research, and would do so a great deal more if the Federal government did not. Yes, many private foundations have political goals. But they recognize that research is more credible if it's a-political, and as long as there is competition, all voices can get supported.  Having to convince a wider audience of the importance of our work might produce a lot better writing.  I want to see fewer papers and more second drafts!

And what's good for the goose is good for the gander. Many economists look down disdainfully at what our social science and humanities colleagues call research. They view it as jargon-ridden, highly politicized, intellectually shoddy waste of good trees  (or, now, bits). Well, nothing in Jim and Gary's column would not apply fairly to everything done in the academy.  Their panels of experts can write reports, hand out money, and plead public goods as well as we do.

I do agree heartily on support for data. For the moment, the Federal Government does have a unique role in creating and supplying economic data. We can't study what we can't measure. This really is a public good, reasonably well created managed, and starved for resources. But most of our data sources are decades old, and have not been adequately re-thought or expanded in that time.  Especially with the internet, there is more and more private collection and supply of data, but for the moment it cannot supplant the Federal government.

Here I think there is a middle ground where we agree. Economics is not, yet, "big science" requiring massive infrastructure to produce research. Economic data collection is "big," and best directed by researchers not government officials. Data can be sold, so it's not a pure public good. But I'm willing to go with the idea that not enough good data is produced. Much of the research Jim describes as success is really massive data collection. But much of the federal research subsidy to economists does not go to creating new, publicly useful data sets. So, I think we can agree on research support for researchers to produce new data, but we don't need support to analyze that data. Fortunately, for now, that just needs an office, a computer, and some free time