A Bridge Too Far?

There is much current angst on the difficult problem of how to escape a liquidity trap. Paul Krugman points out that in Japan, the ratio of debt to GDP is growing, leaving little room for a further tame fiscal expansion. He favors something more aggressive.

Tony Yates argues instead for a helicopter drop. Print money and give it to Japanese citizens. The benefit of that approach is that it does not leave the government with an increase in interest bearing debt. Simon Wren Lewis looks more closely at the technical aspects of this idea.

What are the differences between aggressive fiscal expansion financed by debt creation; and printing money and giving it to citizens? There are two.

First, an aggressive fiscal expansion, as envisaged by Keynesians, would be spent on infrastructure. A money financed transfer would be spent by citizens.

Second, an aggressive fiscal expansion, as envisaged by Keynesians, would be financed by issuing long term bonds. A money financed transfer would be financed by printing money.

While infrastructure expenditure is sorely needed, at least in the U.S., I see no reason to give up on sound cost benefit analysis to decide which projects are worth pursuing and which are not. That’s why I favor giving checks to citizens over building a bridge to nowhere.

Once we decide how the fiscal expansion is to be distributed, we face the second question: how should it be financed? Print money? Or issue long term debt. Standard Economic models tells us that it doesn’t matter. At the zero lower bound, money and three month T-bills are perfect substitutes. And financing expenditure by three month T-bills has the same effect as financing it by thirty-year bonds because the composition of the government’s liabilities is supposed to be irrelevant. That of course, is nonsense. The composition of government liabilities matters. And it matters a lot.

Why does the composition of debt matter? Because the asset markets are incomplete. Our children and our grandchildren cannot participate in asset markets that open before they are born. And none of us can sell our human capital or buy the human capital of others. Once you realize that the composition of the governments portfolio matters, it is a short step to recognize that it is all that matters.

Why be wary of building bridges that are financed with 30 year bonds? Because the yield on these bonds is low; but it is not yet zero. A big increase in public sector borrowing, at the long end of the yield curve, will drive up rates and crowd out some private investment. A big increase in public sector borrowing at the short end of the yield curve will not crowd out private sector investment because rates at the short end of the yield curve are currently zero.

That observation suggests a third alternative to building bridges or to a helicopter drop. Buy back long term government debt and refinance it by printing money. That strategy would, one hopes, lower yields at the long end of the yield curve and stimulate private companies to invest in new capital projects.

I prefer private sector investment over government sector investment. But there are also good arguments for more public infrastructure projects. Build a bridge if it is needed; but make sure that it goes somewhere first. More importantly; finance the project by printing money: not by issuing thirty year bonds.

Give me a One Armed Economist

I'm glad to see that Olivier Blanchard and Yanis Varoufakis have come out in favor of my plan for People's QE.

The following passage is from How the Economy Works, (HTEW) page 151.

Economists are famous for hedging their bets. A typical response to the question of how to run fiscal policy might be: “On the one hand we should raise taxes but on the other we should balance the budget”. President Harry Truman who instituted the Council of Economic Advisors famously quipped; “give me a one-armed economist.”

Here's what I said about fiscal stimulus in HTEW. 

A large fiscal stimulus may or may not be an important component of a recovery plan. My own view is that there is a better alternative to fiscal policy that I explain in [How the Economy Works, Chaper 11]. But if a fiscal policy is used it should take the form of a transfer payment to every domestic resident; not an increase in government expenditure.

Well ok, I didn't call it peoples QE. "Peoples QE", was coined by a speech writer for Jeremy Corbyn, the new leader of the Labour Party in the UK and its one of the less crazy parts of the Corbyn platform.  Why do I believe that? Because I also believe something that may seem contradictory. Its time to get interest rates into positive territory. SOON. Quoting again from an impeccable source (HTEW page 152).

Here are my views on monetary policy. Short term interest rates should be increased as soon as feasible, because a positive interest rate is needed if a national central bank is effectively to control inflation. In future, central banks should use the interest rate for this purpose and not to prevent recessions.

Why do I favor a fiscal transfer, rather than currently popular bandwagon of infrastructure expenditure? Two reasons.

• Because the work of Christina and David Romer suggests that tax multipliers (and by implication, transfer multipliers) are big. 

• Because I trust markets to decide how to allocate a fiscal stimulus more than I trust the government.

So: Raising interest rates is necessary to eventually raise inflation. I'm with the "neo-Fisherians" here. But an interest rate hike must be offset by some other expansionary policy to prevent the normalization of rates from creating a new recession. Here's what I said about that in HTEW.

But if a central bank raises the domestic interest rate without independently managing confidence, the result will be a drop in the value of the national stock market and a further deterioration in the real economy. To prevent this from happening, central banks need a second instrument.

So: Janet, Mark, Mario: yes: raise rates. Please. But give us QE too.

Beliefs are Fundamental: Whatever your Religion

A couple of weeks ago, I had the pleasure of attending a very interesting conference at the Federal Reserve Bank of Saint Louis. The topic

of the conference was the relationship between income inequality and monetary policy, but the papers, more broadly, were all trying to cope with the intellectual problem of rebuilding monetary economics to incorporate the lessons of the Great Recession.

I discussed a fascinating paper, presented by Jim Bullard, joint with Costas Azariadis, Aarti Singh and Jacek Suda (ABSS). ABSS Built a 241 period overlapping generations model in which the people who inhabit the model are permitted to trade one period nominal bonds: but nothing else. They focused on one particular equilibrium of their model and they showed that, conditional on this equilibrium, a central bank can help the economy to function efficiently. Here is a link to the paper and here is a link to my discussion.

In this blog post I am going to give a synopsis of some general points that I made in my discussion, with a slight change of notation to make it blog friendly. 

Gather round and I will tell you a story. It is a story of how classical economists from the dark side bamboozled the Keynesian children of the light into accepting their dark version of the truth.

I don’t see how to discuss this issue without a little notation. So bear with me, and you will be rewarded. I promise.

For the past thirty years, most monetary models were built around a three equation New Keynesian monetary model.

Eqn 1. R – (PF-P) – (YF-Y) = Rstar + Dshock

Eqn 2. R = beta1*(PF-P) + beta2*(Y-Ybar) 

Eqn 3. H(PF-P,Y-Ybar) = Sshock

Here, P is this year’s price index, PF is next year’s price index (the F is for future) Y is GDP this year, YF is GDP next year and R is the money interest rate. Rstar is Wicksell's natural rate of interest and Ybar is potential GDP. 

Dshock and Sshock are random variables that represent demand and supply shocks. All variables are written as natural logarithms so PF-P is the inflation rate and YF-Y is the growth rate of real GDP. The star means multiplication and beta1 and beta 2 are numbers that describe policy.

Equation 1 (sometimes called the Fisher equation) is derived, in New Keynesian models, from the choices made by a representative person with superhuman powers of perception who chooses to optimally allocate resources between the present and the future. It says, in words, that the price of future goods, relative to current goods, is proportional to the ratio of consumption this year to next.

Equation 2 reflects central bank policy and it is sometimes called a Taylor Rule after John Taylor who showed that an equation like this does a pretty good job of describing how the Fed actually behaved in the period preceding the Great Recession.

Equation 3 specifies how the real and the monetary economy interact, and, in the New-Keynesian model, it takes the form,

Eqn 3A. P-PL = PF-P + k(Y-Ybar) + Sshock

where k is a number and PL is last year’s price index. This is called the New Keynesian Phillips curve and it plays the same role in New Keynesian economics that the Nicene creed plays in Christianity.

Almost all of the papers at the conference last week accepted equation 2 and most of them accepted some version of equation 3. 

The focus of pretty much every paper at the St. Louis Fed conference was on how to replace Equation 1. That is an interesting development, which reflects the fact that monetary economists have woken up to the fact that there is a problem with the representative agent assumption.

That is a start. And it is a good start. But, as I argued, in my discussion of ABSS, the problem with monetary economics is deeper than replacing the representative agent assumption: although that is certainly a big part of the problem. The problem is with the rational expectations assumption.

The New Keynesian monetary model is a child of the rational expectations revolution. In the dark days, before Robert Lucas wrote his game changing paper, Expectations and the Neutrality of Money, economists had a more nuanced approach to super-human powers of perception. Here is the monetary model we worked with back then.

Eqn 1B. R – (EPF-P) – (YF-Y) = Rstar + Dshock

Eqn 2B. R = F(EPF-P,Y-Ybar)

Eqn 3B. H(P-PL,Y-Ybar) = Sshock

This looks superficially like the New Keynesian model. But the differences are deep. First, I have replaced PF, the realization of the future price, with EPF, our current belief about what PF will be.  (I could have done the same with YF, but changing PF to EPF is sufficient to make my point.) Second, back in the dark days, we worked with a version of the Phillips curve that was purely backward looking. More on that point in a future blog.

Let me deal first, with expectations. By replacing PF with EPF I have added a new variable. The belief about what the future price will be is NOT the same as what it actually is. And because beliefs are not always correct, we need another equation. That equation, pre Lucas, was called adaptive expectations and it took the form

Eqn 4B.  EPF-P = F1(X)

where X is stuff we observe this year.

In words, expected inflation between this year and next year is some function of things we can observe this year. For example, Friedman used the following form for the function F1( )

Eqn 5B.  EPF-P = lambda*(P-PL) + (1-lambda)*(EPFL-PL)

which says that our belief of inflation is a weighted average, with weight lambda, of last period’s belief of this year's inflation rate and the inflation rate that actually happened. People don’t have superhuman powers of perception. They do, pretty much, what econometricians do.

So how were we bamboozled into accepting rational expectations? Bob Lucas argued that, just as econometricians add random shocks to their models, so should theorists. And if the theorists’ model has shocks: the people who inhabit the model should recognize that fact. According to Bob, EPF is not the same as PF because PF is a random variable.

If people inhabit a stationary environment, they will learn that every time they see X, P is equal to P(X). The rule that they use to forecast PF is irrelevant. In equilibrium, people will learn to forecast in a way that is unbiased. In equilibrium, PF will not equal EPF every time. But these two variables will be equal on average.

This was a brilliant and beautiful argument. But Bob slipped in an unwarranted assumption. He assumed that for given fundamentals, there is a unique rational expectations equilibrium. That assumption is false in every monetary general equilibrium model that anyone has ever written down. And it was false in the model that Bob used to make his point as Mike Woodford and I pointed out at the time and as I have tried to hammer home in pretty much everything I’ve ever written since then.

So how does this relate to the papers at the St Louis Fed conference? And how should it shape the way we move forward?

Let me be clear. Rational expectations is a great assumption. In the words of Abraham Lincoln: you can’t fool all of the people all of the time. But, even in a stationary environment where the world is not changing in unpredictable ways, RATIONAL EXPECTATIONS IS NOT ENOUGH TO DETERMINE BELIEFS. The forecast rule, equation 4B, is a separate independent equation that represents beliefs. 

The moral of my story is this: Beliefs are fundamental: whatever your religion.

Washington: We have a problem

John Cochrane makes the case in the WSJ that everything is back to normal. Hunky Dory, rosy tinted, don’t panic, keep-calm-and-carry-on normal. He points out that inflation is under control. We have not entered a deflationary death-spiral and unemployment is back in reasonable territory.

Here is what John learned from the Great Recession.

The [QE] experiment was huge, and the lessons are clear. The economy is stable, not subject to Keynesian “spirals” requiring constant Fed intervention. And when reserves pay the same rate as bonds, banks do not care which one they hold. So even massive bond purchases do not cause inflation. Quantitative easing is like trading a $20 bill for $10 and $5 bills. How would that make anyone spend more money?

John sees the world through the lens of a model where QE can’t matter. Doubling down on this view…

As then Fed Chairman Ben Bernanke said in January 2014: “The problem with QE is that it works in practice, but it doesn’t work in theory.” That’s a big problem. If we have no theory why something works, then maybe it doesn’t really work.

My emphasis.

I'm not sure we’re living on the same planet. In fact, I know we’re not living on the same planet. John is on planet Chicago. I'm on planet UCLA.

On my planet, QE has some pretty big effects. By increasing the size of the monetary base, the Fed averted an even bigger deflation than the one that occurred.

Here’s the evidence for that. Figure 1 shows how the Federal Reserve Board responded to the financial crisis. The solid line, measured in percent per year on the right-hand axis, measures the expected rate of inflation. The boundary of the shaded region, measured on the left-hand axis in millions of dollars, is the size of the Federal Reserve’s balance sheet.

Figure 1

From January of 2007, through September of 2008, expected inflation fluctuated between two percent and three and a half percent. When Lehman Brothers declared bankruptcy in September 2008, expected inflation fell by nearly eight hundred basis points in the space of two months and by October of 2008 it reached a low of negative four and half percent.

Immediately following the Federal Reserve purchase of one point three trillion dollars of new securities, expected inflation went back up into positive territory.

The Fed’s actions did not completely prevent deflation, and the CPI inflation rate fell to negative two percent in July of 2009. But the Fed’s actions did turn around inflationary expectations and it is likely that QE prevented a much larger deflation that would have had catastrophic effects on unemployment, had it been allowed to occur.

What about the composition of the balance sheet? By intervening in the MBS market, the Fed turned around a stock market crash and held the unemployment rate at 10%. Pretty bad, but not the 25% of 1933. 

Figure 2

Figure 2 contains the same information on asset purchases as Figure 1 but instead of plotting expected inflation on this chart, the solid line is the value of the stock market. I want to use this chart to make a point about the effects on markets of the type of assets that central banks buy.

Figure 2 shows that the turn around in the stock market that occurred at the beginning of 2009 coincides closely with the Fed’s intervention in the MBS market. Further, when asset buying was suspended temporarily, in the second quarter of 2010, the stock market resumed its downward spiral, picking up again only when the Federal Reserve announced at the Jackson Hole conference in the autumn of the same year, that large-scale asset purchases would resume.

Here’s a link that explains how QE works. And here is a link that presents the evidence for a causal connection from the stock market to the real economy. John is aware of my argument that financial instability is Pareto inefficient. He either disagrees or chooses to ignore it. I'm not sure which.

So, is there a case for raising interest rates and getting ‘back to normal’. John thinks not

For interest rates, the Fed has set itself a nearly impossible task. Fed officials need to know what the correct, or “natural,” real rate of interest is. Is there a “savings glut” or another recession on its way, driving the correct real interest rate down? Or are tight markets for skilled workers and large corporate profits a sign of high “natural” rates? Setting the right price of tomatoes is hard enough, let alone divining the right real interest rate for an entire economy.

John is wrong to think that we do not have a problem when rates are at zero. And he is wrong for two reasons.

First. Even if we accept that the Fed has no business trying to influence the real economy it does have a responsibility to control inflation. And the lever that controls inflation is the money interest rate. That lever did a pretty effective job for thirty-five years. Right now, it’s set at full speed ahead with no room to maneuver.

Second. The Fed does influence the real economy; not just in the short run: But in the long run. Financial markets do not allocate capital efficiently and the Fed has an important role as lender of last resort. We left markets to themselves in the nineteenth century and that didn’t turn out too well.  Lets not forget that lesson.

So what should we do? Raise rates. And raise them soon. But raising rates is not a get out of jail free card. A higher nominal rate will drive the economy back into recession by triggering a fall in the stock market.  

Financial wealth goes up. Financial wealth goes down. And with it - so goes the real economy. Movements in financial wealth do not reflect future booms or busts. They cause them. The lesson from Figure 2, is that the Fed can, and should, stabilize asset markets by actively trading the risk composition of its portfolio.  So - yes: raise rates. But; at the same time, absorb the risk that the private sector is unwilling to bear by trading equities.

Perhaps that sounds too radical? Intervening in the asset markets in any capacity was a radical proposal when the Fed was created in 1913. If you think the last crisis was bad: Wait and see what the next one will bring.

Not too simple: Just wrong

Simon Wren-Lewis has a nice post discussing Paul Romer’s critique of macro.

In Simon's words:

"It is hard to get academic macroeconomists trained since the 1980s to address [large scale Keynesian models] , because they have been taught that these models and techniques are fatally flawed because of the Lucas critique and identification problems."

"But DSGE models as a guide for policy are also fatally flawed because they are too simple. The unique property that DSGE models have is internal consistency."

"Take a DSGE model, and alter a few equations so that they fit the data much better, and you have what could be called a structural econometric model. It is internally inconsistent, but because it fits the data better it may be a better guide for policy."

Nope! Not too simple. Just wrong!

I disagree with Simon. NK models are not too simple. They are simply wrong. There are no ‘frictions’. There is no Calvo Fairy. There are simply persistent nominal beliefs.

Period.