Showing posts with label Inflation. Show all posts
Showing posts with label Inflation. Show all posts

Thursday, May 23, 2013

The Fed and Shadow Banking

The WSJ has a fascinating Op-Ed by Andy Kessler, "The Fed Squeezes the Shadow-Banking System" Andy thinks that Quantiative Easing has the opposite, contractionary effect.

QE is just a huge open market operation. The Fed buys Treasury securities and issues bank reserves instead. Why does this do anything? Why isn't this like trading some red M&Ms for some green M&Ms and expecting it to affect your weight?  (M&M of course stands for "Modigliani Miller" if you didn't get the joke.)

The usual thinking is that bank reserves are "special." They are connected to GDP in a way that Treasuries are not.  In the conventional monetary view, MV = PY.  Bank reserves, through a multiplier, control M. The bank or credit channel view says that bank reserves control lending and lending affects PY. The red M&Ms, though superficially identical, have more calories.

In Andy's view (my interpretation), that is turned around now. Now, Treasuries supply more "liquidity" needs than bank reserves, and (more importantly) the supply of treasuries is more connected to nominal GDP than is the supply of bank reserves.

Part of this inversion of roles is supply. In place of the usual $50 billion, we have $3 trillion or so bank reserves. Bank reserves can only be used by banks, so they don't do much good for the rest of us. Now, they just sit as bank assets in place of mortgages or treasuries and don't make a difference to anything. More treasuries, according to Andy, we can do something with.

More deeply, constraints only go one way. Normally, the banking system is up against a constraint. Reserves pay less interest than other assets, so banks use as little as possible. Now, they are awash in liquidity. You can't push on a string, as the saying goes. Much "constraint" economics forgets that once the constraint is off, the relationship doesn't hold any more.

Andy describes the repo market and the sense in which Treasuries are "special" in providing low-haircut collateral. Lots of academic research is now viewing Treasuries as special or liquidity-providing in the shadow banking system.

So, this is at least a gorgeous possibility: In a frictionless world, open-market operations, buying one kind of government debt (Treasuries) and issuing another (reserves)  have zero effect on anything, by the M&M theorem. Monetary economics thinks the M&M theorem is violated, because one kind of government debt (M) is connected to nominal GDP and the other is not.

But financial systems change. When the textbooks were written, banks mattered a lot, so bank reserves, leveraged to loans and checking accounts, were the "special" asset. In today's market, and given today's glut of reserves, Treasuries, leveraged to mortgage backed securities and money market funds through the repo market and "shadow banking system,"  might be the "special" asset connected to nominal GDP. In that case, the effects of open market operations might have the opposite sign. As Andy says,
... the Federal Reserve's policy—to stimulate lending and the economy by buying Treasurys..—is creating a shortage of safe collateral, the very thing needed to create credit in the shadow banking system for the private economy. The quantitative easing policy appears self-defeating, perversely keeping economic growth slower and jobs scarcer.
I'm not totally convinced, though this story and the alleged enormous demand for Treasuries is being bandied around as established fact. I'm also not convinced that this is all a good idea. Maybe the Fed should starve the shadow banking system.

You repo a security so that you can borrow against it. For example, you might buy a mortgage-backed security, then leave (repo, really) that security as collateral for a loan, which you used to buy the security in the first place. But what sense does it make to repo-finance a Treasury? You can't borrow at lower interest rate to make money on a Treasury! You could, possibly, if it's a long term Treasury and you're borrowing short, betting that interest rates don't rise. But I would think an interest rate swap or future would be a cheaper way to make that bet, and anyway betting on the slope of Treasury yield curve doesn't add up to the necessary GDP-linked lending that Andy has in mind.

In short, if you have money to buy a Treasury, why do you need to borrow? For any of this to get off the ground, you have to have some other, not totally rational,  reason for buying the Treasury, and then you want to borrow against the Treasury  so you can buy the risky asset that you really wanted all along. Who is that? Why is this such a necessary part of our financial system? Can't we fix things so they just buy the MBS with their initial cash?

Andy points out that repos are re-hypothecated. You use your Treasury as collateral against a loan, then the guy you gave it to uses it again as collateral to get the money to give to you. So one Treasury is used as collateral against two or three loans. Hmm. As the money multiplier creates run-prone structures, so using the same thing as collateral two or three times is a lot of what makes banks "too big to fail." If we all go down, who has the collateral?

A system awash in all kinds of liquidity, following the Freidman optimal quantity of money, seems a lot safer to me. I'd rather we expand the "bank reserve" concept -- fixed-value, floating-rate, electronically-transferable Treasury debt, and lots of it, washing the shadow banking system in liquidity and putting the run-prone structures out of business. Of course, open market operations would then have no effect in my world either, as I have removed the liquidity constraint in the shadow banking system just as Mr. Bernanke has removed it in the conventional banking system. But violations of M&M always mean the system can be made better.

If you want to comment and explain shadow banking, please use little words that the rest of us can understand.

Saturday, May 18, 2013

The Role of Monetary Policy, Revisited

I am giving a talk Thursday May 30, titled  "The Role of Monetary Policy, Revisited."  The event is at Booth's Gleacher Center in downtown Chicago, reception 4:30 and talk 5:15. It's part of a series of talks sponsored by the Becker-Friedman Institute.

The talk is based on  an essay I'm working on, and will be presenting at a few central banks this summer. Once per generation we re-think what central banks do, can't do, should do, and shouldn't do. Milton Friedman's famous 1968 address marked the last big transition. I think, we are in a similar moment. I will look at the big picture in the same spirit. I'm aiming at a serious talk, grounded in academic research, but accessible.

Blog followers, students, colleagues, friends, and even glider pilots are most welcome. Please rsvp so they know how many people to plan for.

The event announcement invitation and rsvp links are here on the BFI webpage

There is also an event announcement and rsvp link on the Booth Alumni events webpage here.




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Becker Friedman Institute
The Becker Friedman Institute for Research in Economics of the University of Chicago cordially invites you to
The Role of Monetary Policy Revisited
A talk by John H. Cochrane, AQR Capital Management Distinguished Service Professor of Finance at the University of Chicago Booth School of Business
Thursday, May 30, 2013
4:30 p.m. Reception
5:15 p.m. Talk and Q&A
Executive Dining Room, Sixth Floor
University of Chicago Gleacher Center
450 North Cityfront Plaza Drive
Chicago, Illinois (map and directions)
Please join us as University of Chicago Booth School of Business Professor John Cochrane reexamines Milton Friedman's 1968 presidential address to the American Economic Association. In this famous speech on the role of monetary policy, Friedman argued, "There is always a temporary trade-off between inflation and unemployment; there is no permanent trade-off."
Starting from this perspective, Cochrane will reevaluate the role of monetary policy 45 years later. Is it effective? Can it fill all the roles people expect of it? How should monetary policy be conducted going forward?
RSVP
Please respond online by
May 23.
Please extend this invitation to others who might find the program of particular interest.
Complimentary valet parking will be available at the Gleacher Center entrance.
QUESTIONS
If you have questions or require advance assistance, please contact Maria Bardo-Colon at 773.834.1898 or bfi@uchicago.edu.
John H. Cochrane
The AQR Capital Management distinguished service professor of finance at the University of Chicago Booth School of Business, Cochrane's scholarly work focuses on finance, monetary economics, macroeconomics, health insurance, time-series econometrics, and other topics. He is the author of
Asset Pricing, a coauthor of The Squam Lake Report, a research associate of the National Bureau of Economic Research, a senior fellow of the Hoover Institution at Stanford University, and an adjunct scholar of the CATO Institute. He blogs as The Grumpy Economist. Cochrane earned a bachelor's degree in physics at Massachusetts Institute of Technology and PhD in economics at the University of California, Berkeley. He was a member of the University of Chicago Department of Economics before joining Chicago Booth.

Friday, May 17, 2013

More Interest-Rate Graphs

For a talk I gave a week or so ago, I made some more interest-rate graphs. This extends the last post on the subject. It also might be useful if you're teaching forward rates and expectations hypothesis. 

The question: Are interest rates going up or down, especially long term rates?  Investors obviously care, they want to know whether they should put money in long term bonds vs. short term bonds.  As one who worries about debt and inflation, I'm also sensitive to the criticism that market rates are very low, forecasting apparently low rates for a long time. Yes, markets never see bad times coming, and markets 3 years ago got it way wrong thinking rates would be much higher than they are today (see last post) but still, markets don't seem to worry.

But rather than talk, let's look at the numbers. I start with the forward curve. The forward rate is the "market expectation" of interest rates, in that it is the rate you can contract today to borrow in the future. If you know better than the forward rate, you can make a lot of money.


Here, I unite the recent history of interest rates together with forecasts made from today's forward curve. The one year rate (red) is just today's forward curve. I find the longer rates as the average of the forward curves on those dates. Today's forward curve is the market forceast of the future forward curve too, so to find the forecast 5 year bond yield in 2020, I take the average of today's forward rates for 2020, 2021,..2024.

I found it rather surprising just how much, and how fast, markets still think interest rates will rise. (Or, perhaps, how large the risk premium is. If you know enough to ask about Q measure or P measure, you know enough to answer your own question.)


How can the forecast rise faster than the actual long term yields? Well, remember that long yields are the average of expected future short rates, and if short rates are below today's 10 year rate for 5 years, then they must be above today's 10 year rate for another 5 years. So, it's a misconception to read from today's 2% 10 year rate that markets expect interest rates to be 2% in the future. Markets expect a rise to 4% within 10 years. 

The forward curve has the nice property that if interest rates follow this forecast, then returns on bonds of all maturities are always exactly the same. The higher yields of long-term bonds exactly compensate for the price declines when interest rates rise. I graphed returns on bonds of different maturities here to make that point.

So, Mr. Bond speculator, if you believe the forecast in the first graph, it makes absolutely no difference whether you buy long or short. Otherwise, decide whether you think rates will rise faster or slower than the forward curve.

Now, let's think about other scenarios. One possibility is Japan. Interest rates get stuck at zero for a decade. This would come with sclerotic growth, low inflation, and a massive increase in debt, as it has in Japan. Eventually that debt is unsustainable, but as Japan shows, it can go on quite a long time. What might that look like?


Here is a "Japan scenario." I set the one year rate to zero forever. I only changed the level of the market forecast, however, not the slope. Thus, to form the expected forward curve in 2020, I shifted today's forward curve downwards so that the 2020 rate is zero, but other rates rise above that just as they do now.

This scenario is another boon to long term bond holders. They already got two big presents. Notice the two upward camel-humps in long term rates -- those were foreasts of rate risks that didn't work out, and people who bought long term bonds made money.

In a Japan scenario that happens again. Holders of long-term government bonds rejoice at their 2% yields.  They get quite nice returns, shown left, as rates fail to rise as expected and the price of their bonds rises. Until the debt bomb explodes.


OK, what if things go the other way? What would an unexpectedly large rise in interest rates look like? 
For example Feburary 1994 looked a lot like today, and then rates all of a sudden jumped up when the Fed started tightening.  

To generate a 1994 style scenario from today's yields, I did the opposite of the Japan scenario. I took today's forward curve and added 1%, 2%, 3% and 4% to the one-year rate forecast. As with the Japan scenario, I shifted the whole forward curve up on those dates. We'll play with forward steepness in a moment.

Here are cumulative returns from the 1994 scenario. Long term bonds take a beating, of course. Returns all gradually rise, as interest rates rise. (These are returns to strategies that keep a constant maturity, i.e. buy a 10 year bond, sell it next year as a 9 year bond, buy a new 10 year bond, etc)

These have been fun, but I've only changed the level of the forward curve forecast, not the slope. Implicitly, I've gone along with the idea that the Fed controls everything about interest rates. If you worry, as I do, you worry that long rates can go up all on their own. Japan's 10 year rate has been doing this lately. When markets lose faith, long rates rise. Central bankers see "confidence" or "speculators"  or "bubbles" or "conundrums." What does that look like?


To generate a "steepening" scenario, I imagined that markets one year from now decide that interest rates in 2017 will spike up 5 percentage points. This may be a "fear" not an "expectation," i.e. a rise in risk premium.

Then, the 5 and 10 year rates rise immediately, even though the Fed (red line) didn't do anything to the one-year rate. The bond market vigilantes stage a strike on long term debt.



Here are the consequences for cumulative returns of my steepening scenario. The long term bonds are hit much more than the shorter term bonds. This really is a bloodbath for 10 year and higher investors, leaving those under 5 years much less hurt.

So what will happen? I don't know, I don't make forecasts. But I do think it's useful to generate some vaguely coherent scenarios. The forward curve is not a rock solid this is what will happen forecast. The forward curve adds up all of these possiblities, with probabilities assigned to each, plus risk premium. There is a lot of uncertainty, and good portfolio formation starts with risk management not chasing alpha.


Sunday, April 14, 2013

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 

2:00–2:45pmRegistration
2:45–3:00pmOpening remarks: Christine Lagarde
3:00–4:30pmSESSION I: Monetary Policy 
Chair
Janet Yellen

Discussants

Lorenzo Bini-Smaghi
Mervyn King
Mike Woodford
4:30–5:00pmCoffee break
5:00–6:30pmSESSION II: Macroprudential Policies 
Chair
Andy Haldane

Discussants

Claudio Borio
Stanley Fischer
Choongsoo Kim

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

8:15–9:00amRegistration/Continental Breakfast
9:00–10:30amSESSION III: Financial Regulation
Chair
Sheila Bair

Discussants

Jeremy Stein
Jean Tirole
John Vickers
10:30–11:00amCoffee Break
11:00–12:30pmSESSION IV: Fiscal Policy
Chair
Janice Eberly

Discussants

Anders Borg
Roberto Perotti
Nouriel Roubini
2:00–3:30pmSESSION V: Exchange Rate Arrangements 
Chair
Agustín Carstens

Discussants

Jay Shambaugh
Martin Wolf
Gang Yi
3:30–4:00pm***Coffee Break***
4:00–5:30pmSESSION VI: Capital Account Management
Chair
Duvvuri Subbarao

Discussants

Philipp Hildebrand
Márcio Holland de Brito
Hélène Rey
5:30–6:30pmPANEL DISCUSSION 
George Akerlof
Olivier Blanchard
David Romer
Joseph Stiglitz
6:30–8:30pm***Cocktail Reception ***
(Venue: HQ2 Second Floor)

Debt and growth in 10 minutes



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

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

Wednesday, April 10, 2013

Interest rate graphs

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



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


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

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

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


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


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

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

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

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

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

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

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

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

Thursday, March 21, 2013

Fun debt graphs

I was having a bit of fun making graphs for a talk. Are we all fine and debt is no longer a problem? I went back for a closer look at the CBO's long term budget outlook and The budget and economic outlook 2013 to 2023. All numbers from these sources.




 Above, I plot the CBO's long term outlook, in the alternative fiscal scenario (i.e. the one that is even faintly plausible).  As you can see, though they think the deficit gets better for a bit, then the entitlements disaster is still with us.

Of course, this will not happen, the only question is what adjusts.  If bond markets get a whiff that we actually will try these paths, we have a crisis on our hands.

So what can adjust? Revenue is historically about 20% of GDP no matter what tax rates are.  Doubling Federal revenue, while of course states, cities and counties keep taxing us, seems like an unlikely prospect. I'm all for cutting spending, but really, cutting spending in half, and by more than 20 percentage points of GDP? Well, it's in the Ryan budget, but it's a lot. So, what else can we do?

Answer: Growth. Tax revenue equals tax rate times income, and income equals todays income times growth. Greater growth makes all the difference.

To illustrate this point, I made a simple calculation. Suppose growth is 1% and then 2% greater than the CBO projects. What effect does that have? To keep it very simple, I assume that spending stays the same, and revenue stays the same fraction of GDP. Thus, I just divide spending/GDP by a 1% and then 2% growth rate (e^(0.01 t)) and we have the new spending as a fraction of the larger GDP.

This is pretty amazing, no? If we just had two percentage points GDP growth greater than the CBO's forecast (which is a bit above 2% in the out years) the whole budget would be solved without fixing anything.

This thought sent me back to look at the CBO's economic assumptions,

Uh-oh. The CBO thinks we are going to quickly enter a period of 4% growth, go back to trend, and then start growing smartly. Tax revenue = tax rate x income, that's a lot of revenue.  The CBO, the Fed, and everyone else (me too for a few years) has been forecasting this bounce back growth just around the corner for a while now. What if it doesn't happen, and 1.5% growth without catching up to trend is the new normal?

To keep it simple, I redid the above chart now just assuming 1% and 2% less growth than the CBO.

Is that Greece, or Cyprus?

So, the real budget news that could matter has little to do with tax rates or spending. What matters most of all is whether we break out of this sclerotic growth trap.

I found this graph pretty chilling as well: 


Really, what chance do you think there is that defense, nondefense discretionary and other mandatory spending will decrease form 4% of GDP to 2.5-3% of GDP in 10 years?

The net interest line is interesting. That's a huge rise. Why? Here are the other economic assumptions

You see the strong GDP growth, 4% for several years, in the top left panel. Inflation, bottom left, apparently has nothing to do with deficits, the Phillips Curve is alive and well.

But, the CBO is projecting interest rates to rise sharply in 2016, back to a low-normal 4% 3 month and 5% 5 year rate. This causes the $850 billion a year in interest costs highlighted in the previous graph, about the same numbers I was bandying about in "Monetary Policy with Large Debts" when worrying whether the Fed could actually do that to deficits.

From the deficit view, a Japanese lost decade of low interest rates would keep this from happening (or postpone it). Of course any financial event leading to higher interest rates would increase these interest payments a lot. 

Friday, March 8, 2013

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.

Sunday, March 3, 2013

Monetary policy with large debts

This is a Wall Street Journal Op-Ed, March 4 2013. They titled it "Treasury needs a better long game," but the most important question is whether the Fed can keep any independence, if 5% interest rates will cause $900 billion interest costs. There is a pdf version of the oped on my webpage. 


Sooner or later, the Federal Reserve will want to raise interest rates. Maybe next year. Maybe when unemployment declines below 6.5%. Maybe when inflation creeps up to 3%. But it will happen.

Can the Fed tighten without shedding much of the record $3 trillion of Treasury bonds and mortgage-backed securities on its balance sheet, and soaking up $2 trillion of excess reserves? Yes. The Fed can easily raise short-term interest rates by changing the rate it pays banks on reserves and the discount rate at which it lends.

But this comforting thought leaves out a vital consideration: Monetary policy depends on fiscal policy in an era of large debts and deficits. Suppose that the Fed raises interest rates to 5% over the next few years. This is a reversion to normal, not a big tightening. Yet with $18 trillion of debt outstanding, the federal government will have to pay $900 billion more in annual interest.

Will Congress and the public really agree to spend $900 billion a year for monetary tightening? Or will Congress simply command the Fed to keep down interest payments, as it did after World War II, reasoning that "Fed independence" isn't worth that huge sum of money?


This additional expenditure would double the deficit, which tempts a tipping point. Bond markets can accept fairly big temporary deficits without charging higher interest rates—buyers understand that bigger deficits for a few years can be made up by slightly larger tax revenues or spending cuts over decades to follow. But once markets sense that deficits may be unsustainable, and that bond buyers may face default, restructuring or inflation, they will demand still-higher interest rates. Higher rates mean higher deficits—leading to a fiscal death spiral.

Many economists think the tipping point starts when total government debt (federal, state and local) exceeds 90% of GDP. We are past that value, with large state and local debts, continuing sclerotic growth and a looming entitlements crisis to boot. This, not the "balance sheet" or other monetary or institutional constraints, will be the Fed's quandary—can the monetary authority really dare to risk a fiscal crisis?

The obvious answer is to fix the long-run deficit problem, with the reform of runaway spending, entitlement programs and a pro-growth tax policy. So far that is not happening.

Still, the Fed and the Treasury can buy a lot of time by lengthening the maturity of U.S. debt. Suppose all U.S. debt were converted to 30-year bonds. Then, if interest rates rose, Treasury would pay no more on its outstanding debt for 30 years. And if the country couldn't solve its fiscal problems by that time, it would deserve a Greek crisis.

Maturity structure of US debt.
Alas, the maturity structure of U.S. debt is quite short. I estimate that our government rolls over 40% of its debt every year, and 65% within three years. (I account for Federal Reserve holdings, coupon payments and use market values.) Thus the fiscal impact of higher interest rates will come quickly.

Mr. and Mrs. Smith shopping for a mortgage understand this trade-off. Mr. Smith: "Let's get the adjustable rate, we only have to pay 1%." Mrs. Smith: "No, honey, that is just the teaser rate. If we get the 30-year fixed at 3%, then we won't get kicked out of the house if rates go up."

Amazingly, nobody in the federal government is thinking about this trade-off. Instead, each agency thinks only for itself.

The Fed is still buying long-term bonds in an effort to temporarily drive down long-term interest rates by a few basis points. It has concluded it can survive the loss in mark-to-market value of its bond portfolio that higher interest rates will imply, when they come, by suspending its customary interest-rebate payments to the Treasury. If the Treasury was counting on that roughly $80 billion per year, that is Treasury's problem. If higher rates cost the Treasury $900 billion a year, that is Congress's problem.

The Treasury's Bureau of Public Debt controls the maturity of federal debt issues. It has been gently borrowing longer in response to low long-term rates, but not enough to substantially alter the government's interest-rate risk. The bureau also views its job narrowly—which is to finance whatever deficits Congress determines, not to take actions that mitigate future deficits. Congress and the administration are busy with other matters.

Ironically, the Fed's buying and the Treasury bureau's selling have neatly offset, leaving very little change in the maturity structure of debt in private hands.

What to do? First, the Treasury and Fed need a new "accord" to decide who is in charge of interest-rate risk, most likely the Treasury, and then grant it clear legal authority to manage that risk. The Fed should then swap its portfolio of long-term bonds for a portfolio of short-term Treasuries and forswear meddling in the maturity structure again.

Second, the Treasury should seize its once-in-a lifetime opportunity to go long. Thirty-year interest rates are at 2.8%, a 60-year low. Many corporations and homeowners are borrowing long to lock in low funding costs. So should the Treasury.

You may complain that if the Treasury borrows long, then long-term rates will rise. If so, it is better that everyone knows that now. It means that markets aren't really willing to buy long-term government debt, that the 2.8% yield is only a fiction of the Fed's current buying, and that it won't last long anyway. Better fix the fiscal hole, fast.

[WSJ cut: Moreover, if buying and selling a lot of bonds is a problem, the Treasury should engage in an aggressive swap program. In a swap, the Treasury pays a counterparty a fixed rate (say, 2.8%) and receives floating rates, with no bond changing hands. The First Bank of Podunk uses swaps to manage interest rate risk, when it doesn’t want to buy and sell assets. So can the Treasury.

You may complain about counterparty risk. But swaps are collateralized, so each counterparty does not lose if the other one defaults. And if the thousands of pages of Dodd-Frank regulation, and the army of stress testers can’t ensure that too-big-to-fail banks properly manage simple interest rate risk, then we really should have a law-book bonfire. ]

You also may argue that 2.8% long term-debt is more expensive than 0.16% one-year debt. There are two fallacies here. First, the 2.8% long-term yield reflects an expectation that short rates will rise in the future, so the expected cost over 30 years, as well as the true annual cost, are much closer to the same. Second, to the extent that long-term bonds really do pay more interest over their life span, this is the premium for insurance. Sure, running a restaurant is cheaper if you don't pay fire insurance. Until there is a fire.

A much longer maturity structure for government debt will buy a lot of insurance at a very low premium. It will buy the Fed control over monetary policy and preserve its independence. If Fed officials realized the risks, they would be screaming for longer maturities now.

But we don't have long to act. All forecasts say long-term rates will rise soon. As the car dealer says, this is a great deal, but only for today.



Notes: See this earlier blog post or pdf essay for more. I hope to sell WSJ on the second part, keeping the balance sheet big and Treasury floating-rate debt, sometime soon.

If you think I'm pessimistic or making up numbers, here are the CBO's baseline budget projections 


By 2023, the CBO thinks interest payments on the debt will be $857 billion, essentially the entire deficit!  The CBO assumes (see p. 67 here) that interest rates start rising in 2016 and in 2018 stop at 4% one year and 5.2% ten year rates. What if the Fed really wants to tighten?

Moreover, the cheery forecast of return to a balanced primary budget relies on an assumption of spectacular growth (p. 68) -- 3 years of 4% growth bringing us back to "potential" (see p.36) -- in-your-dreams tax revenues, and the rosy-scenario "baseline" expenditure cuts. What if the primary deficit is also $900 billion dollars?     
 

Sunday, February 3, 2013

Three views of consumption and the slow economy

I'm still digesting New-Keynesian models. As part of that effort, today I offer some thoughts on how economists come to such different views of the current situation and desirable policies. It's a nice story, in the end. Real economists, unlike much of the commentary and blogging world, come to different conclusions by using much the same model, but making different assumptions and simplifications, each of which we can look at and evaluate, and hopefully come to some consensus.


The economy is not doing well. The black line in the graph shows log consumption. (The units are percent increase in consumption since 2002.) After trending up steadily at close to 3% per year through the previous decade, consumption -- along with output and everything else -- took a dive, totaling 10% loss relative to the red trendline. And consumption has been stuck there ever since.

So, the big questions: why, and what might be done about it?

All current macroeconomic theories start with the same basic story: when interest rates are higher, people consume less today, save, and then consume more in the future. Higher real interest rates mean higher consumption growth. In equations,

(c represents log consumption, i is the interest rate, pi is inflation, rho and gamma are parameters. Rho is a "discount rate" capturing how much people prefer the present to the future, and gamma captures how strongly people react to interest rate changes. I simplified, leaving out uncertainty.)

We build on this insight in different ways. 

I. New Keynesians 

Integrating forward, today's consumption reflects all expected future interest rates, and where we think consumption will be in the far-off future

This is the central equation of the new-Keynesian model and world-view. (For example, this is Johannes Wieland's equation 2, see my last post. I have taken out growth or trend, so these represent deviations from a steady growth path.)

The green line in the graph presents the New-Keynesian diagnosis of the current situation. New-Keynesians assume consumption will return to trend, so the last term in the equation is zero. In the graph, they anchor future consumption at the green dot. Then, a too-high interest rate means too-high consumption growth, which drives the level of today's consumption down.  (For example,  Ivan Werning's figure 3, discussed in an earlier post here.)

Why is the interest rate too high? The "zero lower bound" is to blame. The Fed cannot lower nominal interest rates (i) below zero. So if the inflation and discount rate terms (pi and rho) require a strongly negative nominal rate, the real rate will be stuck at a big positive number.

From this one equation and graph, you can make sense of lots and lots of new-Keynesian analysis and policy advice.

The level of today's consumption depends on the whole string of future interest rates, not just today's interest rate. So, if people expect the interest rate in 2014 to be lower, that is every bit as effective in raising today's consumption as would be lowering today's rate. Hence, "open mouth operations," "forward guidance," and "managing expectations."  If the Fed by just talking can persuade people it will hold interest rates low for a longer periods, when they are expecting rates to rise above zero, that expectation will "stimulate" today's consumption. If promises don't help, perhaps announcing a new "rule" which if followed would lead to lower rates for longer will help to change expectations.

In this equation, more inflation lowers the real interest rate too. So, anything that boosts inflation is a good thing. Boosting inflation isn't primarily about a Phillips curve, direct "monetary stimulus," encouraging investment, and so on. It's a way to lower real interest rates inside the integral and shift consumption from the future to the present.

Once again, increasing expected future inflation would be just as effective as increasing current inflation. Hence, calls for the Fed to announce a higher inflation target, or at least announce that it will tolerate more inflation before beginning to raise rates, as it has.

Fiscal stimulus, and many of the other seemingly magical properties of new-Keynesian models (see  last post) follow from the idea that inflation is good. Fiscal stimulus raises inflation. Broken windows, hurricanes, pointless public works projects, temporarily lowering the economy's productive capacity, all raise inflation (how is in other equations of the model), which lowers interest rates.

I'm not sold on this story, as you probably guessed, for a variety of reasons.  

New Keynesian models are a bit fuzzy on just why interest rates have to be so low -- why the "natural rate" is sharply negative and why zero interest rates aren't enough. Many of the formal models assume that consumer's discount rate (rho) has declined sharply, beyond the capacity of the interest rate to follow it. If rho goes to, say -5%, with our 2% inflation, then even a zero nominal interest rate is like a 3% real interest rate. (These are deviations from trend, so one might not need actually negative discount rates to hit the zero bound. But even adding growth, it's hard to avoid the need for a negative natural rate to cause a problem of this size.)

Now, a spontaneous outbreak of thrift, to the point of valuing the future a lot more than the present, seems a bit of a strained diagnosis for the fundamental trouble of the US economy. That a bit more thrift is a great danger to the economy, rather than the long awaited return to normal after decades of debt-financed consumption, seems strained as well.

To be fair, all the papers I've read say clearly that they regard the decline in the discount rate rho as a stand-in for some more complex process involving the financial crisis. For example, a more precise version of my first equation adds a "precautionary saving" term. When people are very uncertain about the future, they save more, just as if they had become much more patient. In equations,

This story seems possible for 2008 and 2009, in the depths of the financial crisis and recession. But I'm less convinced that it describes our current moment. Just look at the graph. Our state is one of steady but sclerotic growth, not one of great consumption volatility.

New-Keynesian introductions have something more complex in mind, involving the "frictions" of the financial crisis, and lots of models in this spirit add explicit financial frictions. That too seems to me a useful line to pursue to understand the onset of the recession and the financial crisis. But that too is really not our question. The  "frictions" of the financial crisis -- capital constraints at banks and financial intermediaries,  or the run in the shadow banking system -- passed quite a while ago, and the models with frictions are by and large not being used to address the current moment. 

The question before us is not really why consumption fell so drastically in 2008 and 2009. The question is, why did consumption get stuck at so low a level starting in 2010? For this question, it's much harder for me to understand what a strongly negative discount rate means.

This question and controversy is much like those surrounding the Great Depression. The controversy there has not been about why the stock market crash and recession happened in the first place. (Though perhaps it should, as we really don't know much about that process.) The controversy is, why did the US get stuck so low for so long? Was it bad monetary policy (Friedman and Schwartz), bad microeconomic policy, war on capital, and high marginal tax rates (Cole, Ohanian, Prescott, etc.), or inadequate fiscal stimulus (Keynesians)? 

Many new-Keynesian models (such as Ivan Werning's) generate the high real interest rate by predicting strong deflation. Yes, if inflation (pi) were negative 10% in (2), then a zero interest rate would be a 10% positive real rate. But our inflation has been positive throughout. Our zero interest rate has meant a negative 1.5% to 2.5% real rate all along. Deflation simply did not happen. Moreover, the other ingredient in new-Keynesian modeling -- the Phillips curve -- says that a big output gap should be accompanied by some action on inflation, not a steady 2%.  The Phillips curve part of the model suggests that "potential" dropped, not that current output is far below that potential.

I graphed the green line to 2010, a good date for supposing the crisis is over and we entered the period of sclerotic growth rather than swift return to trend. We've had some time since 2010. Again, the new-Keynesian model generates a low consumption level by saying that we have too-strong consumption growth. But we don't have strong consumption growth. Equation (2) does not produce a steadily depressed level of consumption, with (if anything) weaker than normal growth. I guess you could argue for a constant sequence of unexpected negative shocks, so that each quarter, people are expecting the big consumption growth which just ends up not happening. But you can see how strained that argument is. It would be much more appealing to refer to a model and analysis that describes slumponomics directly.  (Update: I just found Kathryn Dominguez and Matt Shaprio on a sequence of negative shocks.)

And, you might be exploding a bit at the economic logic of it all. How can it be that all we need to do is to decide how much to consume, and the output just magically appears? Doesn't consumption have to be limited a bit by income?

Well, the new-Keynesian models are coherent on this subject. The simple models have no capital; output is produced by more or less labor each period. The logical structure of the models, is, roughly, that you first decide how much you want to consume, then you'll work hard enough to make the required income. (This isn't a behavioral assumption, it's the equilibrium outcome of sticky prices and monopolistic competition.)

That's why fiscal stimulus works at all. You might think that if you have to pay taxes to the goverment, which buys output to throw it away, you'll have to consume less.  (Again, stimulus in these models is Ricardian so the same whether from taxed or borrowed money, and stimulus does not depend on the government doing anything useful with the output.) But if consumption is determined first by the above equation, then you just work harder to pay taxes and make the stuff the government wants to throw away. That gives us a multiplier of one, not zero, and then inflation kicks in to raise desired consumption and give us a larger multiplier. (Roughly! Again, I'm trying to explain the core simplest idea, not to fairly describe all the complexities of the models.)

The very simple new-Keynesian model also does not have investment or capital stock. Output is produced as you need it. That's why consumption "demand" immediately means changes in output. I've always wondered why buying a car is good (consumption) but buying a forklift is bad (investment) in new-Keynesian models. You just can't ask that question in the very simplified model here -- there is no investment. Now, real quantitative new-Keynesian models do have investment and capital (with adjustment costs and other wedges). But as far as I can tell, the same basic conclusions emerge from models with capital, so the intuition must be as here, in which consumption is everything.

II Permanent income

An alternative view asks, what about the second term on the right hand side of the basic equation (2)?  What if nothing's terribly wrong with the intertemporal allocation of consumption, but the long-run productive capacity of the economy has declined?

There is certainly an abundant litany of such complaints. What if all the over regulation (Obamacare, Dodd-Frank, EPA "crucifixions," etc.), sand in the gears, disincentives of social programs, crony capitalism, policy uncertainty, high and prospectively much higher marginal tax rates, and other litany of complaints, have permanently reduced the productive capacity of the US economy, or, worse, its long run growth rate? Then we are not returning to trend. The trend has shifted down.

If so, the trouble is in the second term on the right hand side of the basic equation (2). And this basic equation has a dramatic and important lesson for us: Long-run ("supply") will depress today's consumption every bit as much as expected future interest rates ("demand") effects do. And improving the long-run "supply" effects can have a direct "stimulative" effect on consumption today.

I italicized, because I think this is an underappreciated consequence of the common world-view of all modern macroeconomics, both new-Keynesian and not, embodied in (2). The old-Keynesian view was,  take care of the short run now, because helping the long run only helps in the long run. You hear this over and over in policy circles. More stimulus now, and then talk about "structural reform" once the economy has recovered. Equation (2) denies that separation:  Improving the long run improves the present. 

I drew the blue line to reflect this view of matters. For an equation, we can turn to our old friend the permanent income model

Here W represents wealth (capital stock), r is the real rate r = i - pi, and y represents the stream of expected future income. This is an extremely oversimplified version of the standard stochastic growth model at the heart of... well, I don't know what to call us anymore. "Neoclassical?" "Anybody left who is a bit suspicous of the new-Keynesian juggernaut?"

The difference is really one of emphasis, not deep economics. (3) also derives from (1), but with a different set of auxiliary assumptions. The real interest rate is constant at r. There is capital W, and investment freely adds or subtracts from capital. Labor's product y is fixed rather than produced.

Again, this model is, like (2), extremely simplified. Yes, interest rates do vary, and it's easy enough to add that to the model.  Similarly, new-Keynesians know there is capital and investment.  We're outlining basic stories today, not constructing completely realistic, but often obscure and complex, models.

In this equation, the level of consumption shifts up and down along with expectations of permanent income. So, if you get news that the productive efficiency of the economy is permanently 10% lower, consumption drops 10%, and then goes on at the previous growth rate. As, by picking 2010 as the decision date, my graph suggests.

Like the new-Keynesians,  I won't be that specific here about just why consumption fell so drastically in the financial crisis.  The permanent income model does suggest that we look for changes in permanent income to explain the fall, rather than (only) a rise in discount rates or real interest rates, i.e. the desired intertemporal allocation of consumption.  From this perspective, consumers realized in fall 2008, that this recession was going to last forever rather than bounce back quickly, and they adjusted consumption downward accordingly. They were right. Just how they knew, when all the Government's forecasters thought we would quickly bounce back, is an interesting question.  Surely, my litany of free-marketer's complaints did not obvioulsy get suddenly worse in October 2008, just coincident with a run in the shadow banking system.  Well, maybe not so surely. Maybe consumers thought, we're in a horrible banking crisis, and our government is likely to prolong this one with ham-handed policies just like they did in the 1930s. But that's pretty speculative. And I do think (just as speculatively) there was a run in the shadow banking system, effective risk aversion spiked, and the financial crisis was more than just a signal of bad policy to come.

But all that is a topic for another day. The question is why consumption (and output) remain so low for so long after the crisis, when whatever outside-the-model chaos is over. The permanent income view suggests the problem is a poor long-term level, poor long-term prospects for the productive capacity of the economy, not too high growth, to an unchanged long-term level.

In this view, the Fed largely wasting its time with all its QEs and promises about future interest rates. The right policy answer is to forget about stimulating and fine tuning. Fix the long-run growth problem and the short run will take care of itself, much faster than you might have thought. This isn't the Fed's job. For Europe, do the "structural reforms" now and you'll start growing now in anticipation of their effect.

Moreover, in the underlying stochastic growth model, a rise in real interest rates is a good thing. Yes, we can get on the new-Keynesian green trajectory. What does that is a rise in the marginal product of capital, which raises interest rates, attracts investment, and leads to greater output. In that model, consumption is (very roughly) anchored at its position today, and increased interest rates raise future consumption, not the other way around. Of course, in the stochastic growth model, the Fed can't raise interest rates all on its own --  a higher marginal product of capital comes from greater efficiency or better technology. Still, it encapsulates the comments you read here and there that maybe the conventional sign is wrong -- maybe higher interest rates are desirable, as a sign of a good thing, not as a cause of a bad thing. There is always supply and demand in economics, and two sides to every question.

Which view is right? To my eyes, consumption seems stuck on a lower trend line, not growing sharply. Real interest rates are already negative -- we do not have deflation -- and I find it hard to believe that the discount rate and marginal product of capital are negative 5% or worse. The very large discount rate shock needed for the new-Keynesian story is pretty nebulous. The shocks to long-run productivity are staring us in the face.

I wish, of course, for more serious structural investigation to separate the two stories. I haven't seen a serious attempt to look at the structure of the US economy and measure a sharp negative "natural rate." (I welcome pointers from commenters.) I would welcome a quantitative assessment of how much the level of GDP is depressed from my litany of free-market complaints. With trillions of dollars of GDP, and potentially trillions of wasted stimulus at stake, you'd think we could do better.  

I want to emphasize, this is not a fight between models. This is the same model, with different emphasis, and different simplifications. There is nothing in the new-Keynesian modeling paradigm that forbids one to ask the question, what if the long-run productivity of the economy has sunk and high real rates are not the problem? The models were developed to talk about other things, to talk about historical "cycles" defined as deviations from "trend." Nothing but old habits prohibits one from asking the opposite questions.

III. Old Keynesians

A traditional view of consumption has been conspicuously absent so far, the textbook old-Keynesian consumption function

Consumption depends on today's income through the "marginal propensity to consume" mpc.

Modern new-Keynesian models are utterly different from this traditional view. Lots of people, especially in policy, commentary, and blogging circles, like to wave their hands over the equations of new Keynesian models and claim they provide formal cover for traditional old-Keynesian intuition, with all the optimization, budget constraints, and market clearing conditions that the old-Keynesian analysis never really got right taken care of. A quick look at our equations and the underlying logic shows that this is absolutely not the case.

Consider how lowering interest rates is supposed to help. In the old Keynesian model, investment I = I(r) responds to lower interest rates, output and income Y = C + I + G, so rising investment raises income, which raises consumption in (4), which raises income some more, and so on. By contrast, the simple new-Keynesian model needs no investment, and interest rates simply rearrange consumption demand over time.

Similarly, consider how raising government spending is supposed to help. In the old Keynesian model,  raising G in Y = C + I + G raises Y, which raises consumption C by (4), which raises Y some more, and so on. In the new-Keynesian model, the big multiplier comes because raising government spending raises inflation, which lowers interest rates, and once again brings consumption forward in time.

Old-Keynesians spent two generations fighting against the intertemporal view of consumption embodied in my first two equations, and now at the heart of the new-Keynesian model, in favor of the last equation. They said consumers were "liquidity constrained," or "rule of thumb," their expectations (if they had any) "adaptive," either too stupid to look forward in time or unable to do so.

I must confess a little sympathy to some of these views. A long long time ago I wrote a paper on "near-rationality" criticizing excessive zeal in the application of equation (1). Really, if the Fed today raises interest rates to 12% (annual rate) for a month, would everybody's consumption fall one percent today, so that it could rise one percentage point over the next month? Or is the relation between consumption and interest rates one of those looser relations that yes, applies roughly, for large sustained changes, and over long time periods, but not necessarily instantly?

In any case, a look at (1) and its application in (2) tells us that Friedman won more than he could possibly have imagined. Intertemporal optimization is now not the heretical pariah suggesting a low marginal propensity to consume and low multiplier, but it is the heart of the model. The Lucas-Sargent-Prescott revolution pervades new-Keynesian models as much as their more classical counterparts. Consumers are forward-looking. Expectations matter. No self-respecting mid 1970s Keynesian would have said that Fed pronouncements about what interest rates were going to be in 2016 -- or how the future unemployment rate would condtion that choice -- would have the slightest effect at all on today's consumption. Consumers are myopic, he would say. Expectations are adaptive.
 
But as a result, the new-Keynesian model really has nothing to do with the old-Keynesian intuition.

IV. Bottom line

Enough history of thought, though. The relevant choice today is between the first two alternatives. Are we in a situation where the long run is just fine, but the zero bound is forcing us to have too high interest rates, so consumption growth is too high and the level is depressed? Or are we in a situation that consumers doubt the long-run productive capacity of the economy, and are consuming little today because they expect to consume little tomorrow and little 10 years from now?

The answer matters: whether the economy can be stimulated merely by more solemn promises from the Fed about future interest rates and inflation, by broken-window interventions that reduce supply today to engender some inflation, or whether the economy must be stimulated today by ignoring short-run stimulus, fixing the long run, and counting on the permanent income model to increase consumption, and the present value model (q theory) to increase investment today.

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P.S. It's 2013. Why is displaying math in html so hard?! The people who developed the internet are all nerd engineers who took calculus! I'm back to  pasting in png files to show equations. I tried mathjax, but it only seems to work on traditional screens, not in mobile, rss, etc. Suggestions welcome.

P.P.S. Martin Boulanger and Absalon below asked if maybe consumption wasn't growing unsustainably before the crash. Here's a longer view of the first graph, with my 2000-2007 trend line.
Or, even go back to 1945.
A big boom in the 2000's does not stick out from the consumption data. If anything, it was a little weaker than usual.

Also, yes, this is total consumption. Nondurable and services does not look much different. I started to break out the components but the post was getting too long.