Why the ECB Should Take More Risks

Mrs. Merkel and Mr. Schäuble are worried. The ECB is planning to buy the sovereign debt of its member states and Mr. Schäuble doesn't trust his southern European partners. He thinks that Portuguese, Spanish and Italian debt is risky and he knows that Greek debt is.

Bankers are supposed to be boring. And central bankers are supposed to be boring in spades. What would happen if the Fed were to bet the farm, buying shares in an internet start-up that subsequently goes bust? The public purse would be on the hook for the loss. At least, that’s the theory. That theory is wrong.

The central banking business plan is a money-spinner beyond a venture capitalist’s wildest dream. Buy an asset, any asset, and pay for it by issuing little pieces of colored paper. Collect the interest payments and dividends from the assets and use them to pay for your house, your car and a holiday in Spain. If you happen to be the central bank of a sovereign state, pay the interest and dividends to the treasury to help reduce the tax bill of your citizens.

Does it matter which assets you buy? Conventional wisdom says yes. A central bank should buy safe assets, typically promises issued by its own national government that will never fall in value. The Fed buys T-bills on the private market. The Treasury pays the interest and principal to the Fed, and the Fed turns around and pays them straight back to the Treasury. The point of all of this is to keep enough of the little pieces of colored paper passing from one person to another to “oil the wheels of trade”.

What if the Federal Open Market Committee were to put all of the Fed’s assets into the stock market the day before a stock market crash? If the Fed were privately owned, it would be put into receivership. After the crash, it has liabilities of $2,500b. These are the circulating pieces of colored paper. But its asset portfolio has been decimated by the market crash and the market value of those shares has fallen from $2,500b to $1,000b. What a calamity! Surely the taxpayer must rush in and recapitalize the Bank by pumping in another $1,500b. Not so.

Central banks, like the rich, "are different from you and me". Their debts are all in the form of those little pieces of colored paper. And the magic of central banking is that you and I will carry on passing those pieces of paper from one to another without ever trying to cash them in for something else. There was a time when the UK government printed the promise to “pay the bearer on demand, the sum of one pound” on its notes; at the time, a pound note was redeemable in gold. That time is long gone. All you will get at the Bank of England now, if you try to redeem your ten pound note, is two fives.

What does all of this have to do with the ECB? Mrs. Merkel and Mr. Schäuble should sleep easily in their beds. The interest payments on ECB assets are returned to national governments in proportion to a formula that weights each country by its relative size. As Paul DeGrauwe pointed out recently in a VoxEU post, as long as the ECB sticks to this formula when it buys sovereign debt, the only people to suffer from an Italian default will be private holders of Italian bonds. The net worth of the ECB may take a temporary hit, but that shouldn't bother European taxpayers, least of all the Germans.

Extraordinary times require extraordinary measures. There was a time when central banks were privately owned. The Swiss National Bank still is. But the Bank of England, the Federal Reserve and the European Central Bank are supra-national institutions that play by different rules. We should not be concerned if sovereign states are permanently in debt. This has been the case with the UK and the US treasuries for as long as the US and the UK have existed as sovereign nations. What is true for a national treasury, is also true for a central bank.

Secular stagnation: a neo-paleo-Keynesian perspective

I first posted this piece back in January but it got deleted by from my blog by mistake. Since secular stagnation is back in the blogosphere with a vengeance: its time to repost it.

In a recent piece on his blog, David Beckworth has taken another swing at the secular stagnation hypothesis. Secular stagnation is a term coined by Alvin Hansen in a 1938 article in which he claimed that public expenditure might be required to maintain full employment.

Here is Alvin, as quoted by David...

"The business cycle was par excellence the problem of the nineteenth century. But the main problem of our times, and particularly in the United States, is the problem of full employment. ... This is the essence of secular stagnation— sick recoveries which die in their infancy and depressions which feed on themselves and leave a hard and seemingly immovable core of unemployment."

Hansen is writing in 1938, before Keynesian economics had been forever altered by Samuelson's bastardization of Keynes' key idea: that high involuntary unemployment is an equilibrium that can persist for decades. 

The secular stagnation hypothesis was resuscitated by Larry Summers.  In Larry's view

... it is increasingly clear that the trend in growth can be adversely affected over the longer term by what happens in the business cycle.

Larry supports his position with the following graph.

Figure 1: Downward Revision of Potential GDP

Growth is the percentage annual increase in real GDP.  In terms of Figure 1, it is measured by the slope of the lines that represent estimates of potential GDP made in 2007 (the dark grey line) and in 2013, (the light grey line). Try as I may, I do not see compelling evidence of a change in the slope. 

What I do see in Figure 1, is evidence that a business cycle shock (the Great Recession) has caused a permanent downward shift in the level of GDP. And that is tragic because if Alvin Hansen is right, and I think he is, the gap between these two lines represents an annual loss of output of approximately one trillion dollars.  

Contemporary accounts of secular stagnation, beginning with Larry Summers, confound two distinct ideas. The first, and this is Hansen’s meaning, is that a market economy, in the absence of counter-cyclical fiscal and monetary policies, may experience prolonged periods of high involuntary unemployment. The second,  is that a market economy may experience a period of depressed productivity growth.

David is critical of the second of these two ideas. Here is David...

"Hansen’s article was of course spectacularly wrong as a guide to the next few decades. Instead of suffering through stagnation we entered an extended, broad-based, and massive economic boom. In hindsight we can see that his analysis, ... was unduly influenced by the depression he was living through, ... [which] was the result of specific policy mistakes rather than inexorable trends. Recent research by Alexander J. Field shows that the 1930s were actually a time of exceptionally high productivity growth. " 

David claims that postwar productivity  growth was high. That may be true. But it says nothing about secular stagnation, which is the idea that there has been a permanent long-term increase in involuntary unemployment. Back to David:

"The fact that Hansen was wrong does not prove that contemporary stagnationists are. In this case, though, history is repeating itself rather exactly. We do not pretend to know what the future path of economic growth in the United States will be. But the case for stagnation is weak—and, as in the 1930s, it is getting undue credence because of a long slump caused by policy mistakes."

Not so. David is confounding growth, the annual percentage increase in real GDP per person, with unemployment, the percentage of workers who claim to be looking for a job but are unable to find one. Growth remains a topic on which, as economists, we are spectacularly ignorant despite the fact that there is a large subset of  macroeconomists who have  studied very little else for the past thirty years. Unemployment, is a topic on which we have made considerable progress.

Were there policy mistakes?  Most certainly.  Would a more effective way of running monetary policy be to replace inflation targeting with a nominal GDP target as the market monetarists have claimed? I am skeptical.  

It is a premise of the monetarist position, that the real economy is self-stabilizing and that a rule based monetary policy is the most effective way to ensure both low inflation and maximum sustainable employment. 

Keynes claimed, in contrast, that the real economy can get stuck in a position of high unemployment and that permanent high involuntary unemployment can persist as an equilibrium phenomenon. See my earlier post on the neo-paleo-keynesian perspective. If Keynes is correct, and I believe he is, a single instrument, monetary policy, is not enough to hit two targets. Fiscal policy in one form or another, is an important second string to the policy maker's bow.

The Greek dance with debt

If you thought that the Greek debt crisis was over; think again. Tomorrow, the Greek parliament will try, for the third time, to agree on who will be the next president. If parliamentarians cannot agree (and that now seems likely) we are headed for the first potential rock in the road to recovery for 2015.  There is a real danger that the Greek debt crisis will emerge with a vengeance and, once again, throw world financial markets into turmoil.

Under the rules of the Greek constitution, if no candidate receives an absolute majority, parliament will be dissolved, and there will be a general election, most likely in early February. If that happens, all signs point to a victory by Syriza, a left of center party that proposes to renegotiate the Greek debt.

A Syriza victory would force the core Euro countries to decide either to give up on the project of European integration, or to move to the next stage of full scale fiscal union in which German taxpayers assume responsibility for Greek debt.

If the Euro breaks apart, the fallout will be global. The world economy has been hit by a falling demand for raw materials and oil is trading at less than US$60 a barrel. Some of this is caused by newly discovered proven reserves and that is a good thing. But Jim Hamilton has argued that  falling world demand is a big part of the reason for lower oil prices and that does not bode well for a truly global recovery.

The US economy has been the single flickering light in a dark sky. If the Euro collapses, the knock-on-effect will derail the US recovery and send the entire world economy back into recession.

Is a Greek default and a breakup of the Euro the most likely outcome? Probably not. But it is the first of many building storms that the global economy will need to weather in 2015. All eyes on Greece tomorrow!

Real business cycle theory and the high school Olympics

I have lost count of the number of times I have heard students and faculty repeat the idea in seminars, that “all models are wrong”. This aphorism, attributed to George Box,  is the battle cry  of the Minnesota calibrator, a breed of macroeconomist, inspired by Ed Prescott, one of the most important and influential economists of the last century.

All models are wrong... all models are wrong...

Of course all models are wrong. That is trivially true: it is the definition of a model. But the cry  has been used for three decades to poke fun at attempts to use serious econometric methods to analyze time series data. Time series methods were inconvenient to the nascent Real Business Cycle Program that Ed pioneered because the models that he favored were, and still are, overwhelmingly rejected by the facts. That is inconvenient.

Ed’s response was pure genius. If the model and the data are in conflict, the data must be wrong. Time series econometrics, according to Ed, was crushing the acorn before it had time to grow into a tree. His response was not only to reformulate the theory, but also to reformulate the way in which that theory was to be judged. In a puff of calibrator’s smoke, the history of time series econometrics was relegated to the dustbin of history to take its place alongside alchemy, the ether, and the theory of phlogiston.

How did Ed achieve this remarkable feat of prestidigitation? First, he argued that we should focus on a small subset of the properties of the data. Since the work of Ragnar Frisch, economists have recognized that economic time series can be modeled as linear difference equations, hit by random shocks. These time series move together in different ways at different frequencies.

For example, consumption, investment and GDP are all growing over time. The low frequency movement in these series is called the trend. Ed argued that the trends  in time series are a nuisance if we are interested in understanding business cycles and he proposed to remove them with a filter. Roughly speaking, he plotted a smooth curve through each individual series and subtracted the wiggles from the trend. Importantly, Ed’s approach removes a different trend from each series and the trends are discarded when evaluating the success of the theory.

After removing trends, Ed was left with the wiggles. He proposed that we should evaluate our economic theories of business cycles by how well they explain co-movements among the wiggles. When his theory failed to clear the 8ft hurdle of the Olympic high jump, he lowered the bar to 5ft and persuaded us all that leaping over this high school bar was a success.

Keynesians protested. But they did not protest loudly enough and ultimately it became common, even among serious econometricians, to filter their data with the eponymous Hodrick Prescott filter.

Ed’s argument was that business cycles are all about the co-movements that occur among employment, GDP, consumption and investment at frequencies of 4 to 8 years. These movements describe deviations of  a market economy from its natural rate of unemployment that, according to Ed, are caused by the substitution of labor effort of households between times of plenty and times of famine. A recession, according to this theory, is what Modigliani famously referred to as a ‘sudden attack of contagious laziness’.

The Keynesians disagreed. They argued that whatever causes a recession, low employment  persists because of ‘frictions’ that prevent wages and prices from adjusting to their correct levels. The Keynesian view was guided by Samuelson’s neoclassical synthesis which accepted the idea that business cycles are fluctuations around a unique classical steady state.

By accepting the neo-classical synthesis, Keynesian economists had agreed to play by real business cycle rules. They both accepted that the economy is a self-stabilizing system that, left to itself, would gravitate back to the unique natural rate of unemployment. And for this reason, the Keynesians agreed to play by Ed’s rules. They filtered the data and set the bar at the high school level.

Keynesian economics is not about the wiggles. It is about permanent long-run shifts in the equilibrium unemployment rate caused by changes in the animal spirits of participants in the asset markets. By filtering the data, we remove the possibility of evaluating a model which predicts that shifts in aggregate demand cause permanent shifts in unemployment. We have given up the game before it starts by allowing the other side to shift the goal posts.

We don't have to play by Ed's rules. We can use the methods developed by Rob Engle and Clive Granger as Giovanni Nicolò and I have done here. Once we allow aggregate demand to influence permanently the unemployment rate, the data do not look kindly on either real business cycle models or on the new-Keynesian approach. It's time to get serious about macroeconomic science and put back the Olympic bar.

John, Paul and Say's Law

I've followed, with a great deal of interest, the debate between John Cochrane and Paul Krugman. I have a lot in common with both of them.

I agree with Paul that, for the most part, the IS-LM model provides the right answer to policy questions. I agree with John, that we have learned a lot since 1955, when Paul Samuelson invented the Neo-classical synthesis.

But there were a couple of ideas in the General Theory that have been buried by MIT macro. The first, and most important, is that high unemployment is an equilibrium. Repeat after me. E-Q-U-I-L-I-B-R-I-U-M. The second is that animal spirits are an independent causal factor that determines which equilibrium the private economy will select.

Let me ask a simple question that you should feel free to answer. And do please also try to guess the PK and JC answers. (To answer this question, you will need to arm yourself with a knowledge of the textbook IS-LM model. A good introduction would be Greg Mankiw's textbook or, the book I learned from, the intermediate text by Dornbusch, Fischer and Starz.)

Figure 1

Start from a world with no inflation, and no expected inflation. Suppose that the IS curve intersects the LM curve at a position where the interest rate on T-Bills is 5% and unemployment is 4.4%. This is pretty much where we were in December of 2006, as depicted in Figure 1. (Yes I know the zero expected inflation assumption is not quite right, but thats a bell and a whistle).

If you measure Real GDP (equal to real income) by dividing nominal GDP by the money wage (as I do here and as Keynes advised in the GT) you may plot the stationary value of GDP in wage units on the horizontal axis. That will be at 95% of its maximum value. (Incidentally, this is not synonymous with GDP deflated by the price level, even in a one-good economy).

Now suppose that the IS curve shifts to the left as a consequence of a crash in house prices caused by a loss of confidence that prices will continue to keep going up. Suppose that there is no corrective fiscal action and that the Fed allows the interest rate to fall by lowering interest rates as GDP collapses.  

The textbook theory says that we will slowly track down the LM curve, and as people lose their jobs, demand will fall, supply will fall, and we will end up at a new lower level equilibrium. The key word here is equilibrium. This is the prediction of the Hicks-Hansen model before it was polluted by Samuelson’s neoclassical synthesis. That's pretty much what happened between December of 2006 and September of 2008, and thats what I show in Figure 2.

Figure 2:

Now suppose that the initial drop in asset values gets much much worse as the crash in house values hits the balance sheets of financial institutions.  Initially, those institutions were baled-out by the treasury but after the collapse of Lehman Brothers, US financial institutions were left to fend for themselves. The situation, post Lehman Brothers, is depicted in Figure 3.

Figure 3:

Ok. Here’s the question.

If the Fed keeps the interest rate at zero, and IF ANIMAL SPIRITS REMAIN PESSIMISTIC: What will happen to GDP, the interest rate, inflation and real wages, once we have reached the new lower steady state (Y3 on Figure 3)? My answer is nothing. Repeat after me. N-O-T-H-I-N-G.

Long before it became fashionable, I made the distinction between old Keynesian and new Keynesian economics. Using my definition, old Keynesians would assert that there are many steady state unemployment rates. In contrast, new Keynesians view high unemployment as a disequilibrium caused by sticky prices. They agree with John that there is a unique natural rate of unemployment, determined by supply side factors, and that the private economy is gravitating towards that rate. They disagree on the speed of adjustment and in the role of government in achieving that adjustment.

It ain't so. There is no natural rate of unemployment in the sense that Friedman used that term. But by accepting some version of the Neo-classical synthesis,  both John and Paul are agreeing that Say’s Law holds in the long run. Supply creates its own demand. By accepting Samuelson’s interpretation of the GT, Paul is playing in John’s backyard. 

If we don't accept the MIT worldview: how do we reconcile Keynesian economics with Walras? My answer explained here, is that multiple equilibria arise as a result of missing factor markets. I explain WHY there can be multiple equilibria where there is no incentive for firms to change wages and prices. High unemployment, in the absence of a recovery in animal spirits, is an equilibrium in the sense in which physicists use this term. This  is not rocket science. But you do have to read my work, rather than assume you know what it says, in order to get this point.