TEKNOIOT: Economists
Showing posts with label Economists. Show all posts
Showing posts with label Economists. Show all posts

7 Sept 2020

1 Sept 2020

Lessons of the ELB - Barokong

I gave a short presentation on monetary policy at the Nobel Symposium run by the Swedish House of Finance. It was an amazing conference, and I'll post a blog review as soon as they get the slides up of the other talks. Offered 15 minutes to summarize what I know about the zero bound, as well as to comment on presentations by Mike Woodford and Stephanie Schmitt-Grohé, here is what I had to say. There is a pdf version here and slides here. Novelty disclaimer: Obviously, this involves a lot of recycling and digesting older material. But simplifying and digesting is a lot of what we do.

Update: video of the presentation here. Or hopefully the following embed works:

Lessons of the long quiet ELB

(effective lower bound)

We just observed a dramatic monetary experiment. In the US, the short-term interest rate rate was stuck at zero for 8 years. Reserves rose from 10 billion to 3,000 billion. Yet inflation behaved in this recession and expansion almost exactly as it did in the previous one. The 10 year bond rate continued its gentle downward trend unperturbed by QE or much of anything else.

Europe's bound is ongoing with the same result.

Source: Stephanie Schmitt-Grohé
Japan had essentially zero interest rates for 23 years. And..

Source: Stephanie Schmitt-Grohé

Inflation stayed quiet and slightly negative the whole time. 23 years of the Friedman rule?

Our governments set off what should have been two monetary atomic bombs. Almost nothing happened. This experiment has deep lessons for monetary economics.

Stability Lessons

We learned that inflation can be stable and quiet--the opposite of volatile--in a long-lasting period of immobile interest rates, and with immense reserves that pay market interest.

The simplest theoretical interpretation is that inflation is stable under passive policy or even an interest rate peg. Alternative stories--it's really unstable but we had 23 years of bad luck--are really strained.

Stability is the central concept in my remarks today, and I emphasize it with the cute picture. If inflation is unstable, a central bank is like a seal balancing a ball on its nose. If inflation is stable, the bank is like Professor Calculus swinging his pendulum. Watching inflation and interest rates in normal times you cannot tell the seal from the Professor. Asking the professor might not help. Tintin fans will remember that the Professor, perhaps like the Fed, thought he was following the pendulum, not the other way around.

But if you hold still the seal's nose, or the professor's hand, you find out which is the case.

We just ran that experiment. The result: Inflation is stable. Many hallowed doctrines fall by the wayside.

Quantity lessons

The optimal quantity of money
We learn that arbitrary quantities of interest-paying reserves do not threaten inflation or deflation. We can live the Friedman-optimal quantity of money. There is no need to control the quantity of reserves. There is no reason for government debt to be artificially illiquid by maturity or denomination. Governments could offer reserve-like debt to all of us, essentially money market accounts. Too bad for contrary hallowed doctrines.

Interest rate lessons

The lessons for interest rate policy are even deeper.

\begin{align} x_t &= E_t x_{t+1} - \sigma(i_t - E_t\pi_{t+1} + v^r_t) \label{IS}\\ \pi_t &= E_t\pi_{t+1} + \kappa x_t \label{NK}\\ i_t &= \max\left[ i^\ast + \phi(\pi_t-\pi^\ast),0\right] \label{TR} \end{align} \begin{equation} (E_{t+1}-E_t) \pi_{t+1} = (E_{t+1}-E_t) \sum_{j=0}^\infty m_{t,t+j} s_{t+j}/b_t .\label{FTPL} \end{equation}

A common structure unites all the views I will discuss: An IS relation linking the output gap to real interest rates; a Phillips curve; a policy rule by which interest rates may react to inflation and output; and the government debt valuation equation, which states that an unexpected inflation or deflation, which changes the value of government bonds, must correspond to a change in the present value of surpluses

The equations are not at issue. All models contain these equations, including the last one. The issues are, How we solve, use, and interpret these equations? What is nature of expectations--adaptive, rational, or in between? How do we handle multiple equilibria? And what is the nature of fiscal/monetary coordination? Preview: that last one is the key to solving all the puzzles.

Adaptive Expectations / Old-Keynesian

The adaptive expectations view, from Friedman 1968 to much of the policy world today, makes a clear prediction: Inflation is unstable, so a deflation spiral breaks out at the lower bound. I simulate such a model in the graph. There is a negative natural rate shock; once the interest rate hits the bound, deflation spirals away.

The deflation spiral did not happen. This theory is wrong.

Rational Expectations / New-Keynesian I

The New Keynesian tradition uses rational expectations. Now the model is stable. That is a a big feather in the new-Keynesian cap.

But the new-Keynesian model only ties down expected inflation. Unexpected inflation can be anything. There are multiple stable equilibria, as indicated by the graph from Stephanie's famous JPE paper. This view predicts that the bound--or any passive policy--should feature sunspot volatility.

For example, Clarida Galí and Gertler famously claimed that passive policy in the 70s led to inflation volatility, and active policy in the 1980s quieted inflation. A generation of researchers worried that Japan's zero bound, and then our own, must result in a resurgence of volatility.

It did not happen. Inflation is also quiet, and thus apparently determinate, at the bound. This theory is wrong--or at least incomplete.

New-Keynesian II Selection by future active policy

Another branch of new-Keynesian thinking selects among the multiple equilibria during the bound by expectations of future active policy.

To illustrate, this graph presents inflation in the simple new Keynesian model. There is a natural rate shock from time 0 to 5, provoking a zero bound during that period. There are multiple stable inflation equilibria.

The lower red equilibrium is a common choice, featuring a deep deflation and recession. To choose it, authors assume that after the bound ends, the central bank returns to active policy, threatening to explode the economy for any but its desired inflation target, zero here. Working back, we choose that one equilibrium during the bound.

Forward guidance

In this view small changes in expectations about future inflation work backwards to large changes at earlier times. Therefore, if the central bank promised inflation somewhat above target at the end of the bound, that promise would work its way back to large stimulus during the bound. Forward guidance offers strong stimulus.

One of Mike's main points today is that a price level target can help to enforce such a commitment. Stephanie's policy of raising rates to raise inflation at the end of the bound can similarly work its way back in time and stimulate during the the bound, perhaps avoiding the bound all together.

Forward guidance puzzles

This selection by future active policy, however, has huge problems. First, promises further in the future have larger effects today! I asked my wife if she would cook dinner if I promised to clean up 5 years from now. It didn't work.

Second, as we make prices less sticky, dynamics happen faster. So, though price stickiness is the only friction, making prices less sticky makes deflation and depression worse. The frictionless limit is negative infinity, though the frictionless limit point is small inflation and no recession. These problems are intrinsic to stability, and thus very robust: stable forward is unstable backward.

New Keynesian Solutions

The new-Keynesian literature is ripping itself apart to fix these paradoxes. Mike, Xavier Gabaix, and others abandon rational expectations. Alas even that step does not fix the problem.

Mike offers a k-step induction. It is complex. I spent over a month trying to reproduce a basic example of his method, and I failed. You have to be a lot smarter or more patient than me to use it. Moreover, it only reduces the magnitude of the backward explosion, not its fundamental nature.

If we go back to adaptive expectations, as Xavier and others do--after a similar hundred pages of difficult equations--then we're back to stable backward but explosive forward. Stable backward solves the forward guidance puzzle--but the lack of a spiral just told us inflation is stable forward. Also, you have to modify the model to the point that eigenvalues change from less to greater than one. It takes a discrete amount of irrationality to do that.

Fiscal theory of monetary policy

So let me unveil the answer. I call it the Fiscal Theory of Monetary Policy. The model is unchanged, but we solve it differently. We remove the assumption that surpluses ``passively'' accommodate any price level. Now, we pick equilibria by unexpected inflation, at the left side of the graph.

For example, an unexpected deflation can only happen if the government will raise taxes or cut spending to pay a windfall to bondholders. (Or, if discount rates raise the present value of surpluses, which is important empirically.) For example, if there is no fiscal news, we pick the equilibrium with the big red square at zero.

This is not some wild new theory. It is just a wealth effect of government bonds. We're replaying Pigou vs. Keynes, with much better equations.

The result is a model that is simple, stable, and solves all the puzzles.

Instantly, we know why the downward deflation jump did not happen. The great recession was not accompanied by a deflationary fiscal tightening!

Tying down the left end of the graph, promises further in the future have less effect today and there is a smooth frictionless limit. Tying down the left end of the graph stops backward explosions. You don't have to pick a particular value. The limits are cured if you just bound the size of fiscal surprises, and thus keep the jump on the left hand side from growing.

We can maintain rational expectations. This is not a religious commandment. Some irrational expectations are a fine ingredient for matching data and real-world policy; introducing some lags in the Phillips curve for example. But Mike's and others' effort to repair zero bound puzzles by irrational expectations is not such an epicycle. It asserts that the basic properties of monetary policy depend on people never catching on. It implies that all of economics and all of finance must abandon rational expectations even as rough approximations. Just to solve some murky paradoxes of new Keynesian models at the lower bound? For example, Andrei Shleifer, earlier today, argued for irrational expectations. But even he build on the efficient market rational expectation model, suggesting deviations from it. He did not require irrational expectations to begin to talk about asset pricing, or require that all of economics must adopt his form of irrational expectations.

I did not think the day would come that I would be defending the basic new-Keynesian program -- construct a model of monetary policy that plays by Lucas rules, or at least is a generalization of a model that does so -- and that Mike Woodford would be trying to tear it down. Yet here we are. Promote the fiscal equation from the footnotes and you can save the rest.

Neo-Fisherism

Neo-Fisherism is an unavoidable consequence of stability. If inflation is stable at a peg, then raising the interest rate and keeping it there must lead to higher inflation.

Conventional wisdom goes the other way. But it is still possible that higher interest rates temporarily lower inflation, accounting for that belief.

The standard new-Keyensian model, as illustrated in Harald and Marty's slides seems to achieve a temporary negative sign. However it only does so by marrying a fiscal contraction ("passively,'' but still there) to the monetary policy shock. It also requires an AR(1) policy disturbance -- beyond the AR(1) there is no connection between the permanence of the shock and the rise or decline of inflation.

Can we produce a negative sign from a pure monetary policy shock -- a rise in interest rates that does not coincide with fiscal tightening?

FTMP, long-term debt  and a negative short run response

The fiscal theory of monetary policy can deliver that temporary negative effect with long term debt. The graph presents the price level, in a completely frictionless economy consisting only of a Fisher equation and the valuation equation. When nominal interest rates rise, the market value of debt on the left declines. (First line below graph.) If surpluses on the right do not change, the price level on the left must also decline. Then, the Fisherian positive effect kicks in.

FTMP, long-term debt, sticky prices and a realistic response

If you add sticky prices, then a rise in interest rates results in a smoothed out disinflation. This is a perfectly reasonable--but long-run Fisherian--response function.

Neofisherism?

In sum, the long-run Fisherian result is an inescapable consequence of stability.

The fiscal theory can give a temporary negative sign, but only if the interest rate rise is unexpected, credibly persistent, and there is long-term debt. Those considerations amplify Stephanie's call for gradual and pre-announced interest rate rises to raise inflation.

The contrast between the US, that followed Stephanie's advice and is now seeing a rise in inflation, with Japan and Europe, is suggestive.

The negative sign in the standard new-Keynesian model comes by assuming a fiscal contraction coincident with the monetary policy shock.

Beware! These arguments do not mean that high inflation countries like Brazil, Turkey, and Venezuela can simply lower rates to lower inflation. Everything here flows from fiscal foundations, and absent fiscal foundations and commitment to permanently lower rates, inflation is inevitable.

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I promised that the ELB was an experiment that would deliver deep implications for monetary policy. Think of the hallowed doctrines that have been overturned in the last 15 minutes.

  • "The New-Keynesian Liquidity Trap'' December 2017 Journal of Monetary Economics92, 47-63.
  • "Michelson-Morley, Fisher, and Occam: The Radical Implications of Stable Inflation at the Zero Bound" Macroeconomics Annual 2017.
  • "Stepping on a Rake: the Fiscal Theory of Monetary Policy'' January 2018.  European Economic Review 101, 354-375.

What I've said today, and the graphs, are in these references. They go on to show you how the fiscal theory of monetary policy provides a simple unified framework for interest rate policy, quantitative easing, and forward guidance, that works even in frictionless models, though price stickiness is useful to produce realistically slow dynamics.

19 Aug 2020

Lottery Winners Don't Get Healthier - Barokong

Alex Tabarrok at Marginal Revolution had a great post last week, Lottery Winners Don't get Healthier (also enjoy the url.)

Wealthier people are healthier and live longer. Why? One popular explanation is summarized in the documentary Unnatural Causes: Is Inequality Making us Sick?

The lives of a CEO, a lab supervisor, a janitor, and an unemployed mother illustrate how class shapes opportunities for good health. Those on the top have the most access to power, resources and opportunity – and thus the best health. Those on the bottom are faced with more stressors – unpaid bills, jobs that don’t pay enough, unsafe living conditions, exposure to environmental hazards, lack of control over work and schedule, worries over children – and the fewest resources available to help them cope.
The net effect is a health-wealth gradient, in which every descending rung of the socioeconomic ladder corresponds to worse health.
If this were true, then increasing the wealth of a poor person would increase their health. That does not appear to be the case. In important new research David Cesarini, Erik Lindqvist, Robert Ostling and Bjorn Wallace look at the health of lottery winners in Sweden (75% of winnings within the range of approximately $20,000 to $800,000) and, importantly, on their children. Most effects on adults are reliably close to zero and in no case can wealth explain a large share of the wealth-health gradient:

In adults, we find no evidence that wealth impacts mortality or health care utilization.... Our estimates allow us to rule out effects on 10-year mortality one sixth as large as the crosssectional wealth-mortality gradient.
The authors also look at the health effects on the children of lottery winners. There is more uncertainty in the health estimates on children but most estimates cluster around zero and developmental effects on things like IQ can be rejected (“In all eight subsamples, we can rule out wealth effects on GPA smaller than 0.01 standard deviations”). (My emphasis above)

Alex does not emphasize the most important point, I think, of this study.  The natural inference is,The same things that make you wealthy make you healthy. The correlation between health and wealth across the population reflect two outcomes of the same underlying causes.

We can speculate what those causes are.  (I haven't read the paper, maybe the authors do.) A natural hypothesis is a whole set of circumstances and lifestyle choices have both health and wealth effects. These causes can be either "right" or "left" as far as the evidence before us: "Right:" Thrift, hard work, self discipline and clean living lead to health and wealth. "Left:" good parents, good neighborhood, the right social connections lead to health and wealth.

Either way, simply transferring money will not transfer the things that produce money, and produce health.

Perhaps the documentary was right after all: "class shapes opportunities for good health."  But "class" is about more than a bank account.

Also, Alex can be misread as a bit too critical: "If this were true." It is true that health and wealth are correlated. It is not true that more wealth causes better health.  The problem is  not just "resources available to help them cope."

Why a blog post? This story is a gorgeous example of the one central thing you learn when doing empirical economics: Correlation is not causation. Always look for the reverse possibility, or that the two things correlated are both outcomes of something else, and changing A will not affect B.   We seldom get an example that is so beautifully clear.

Update:  Melissa Kearney writes,

"Bill Evans and Craig Garthwaite have an important study [AER] showing that expansions of EITC benefits led to improvements in self-reported health status among affected mothers.
Their paper provides a nice counterpoint to the Swedish lottery study, one that is arguably more relevant to the policy question of whether more income would causally improve the health of low-income individuals in the U.S.

Thanks Melissa for pointing it out. This is interesting, but I'd rather not get in to a dissection of studies here -- just who takes advantage of EITC benefits, how instruments and differences do and don't answer these problems. The main point of my post is not to answer once and for all the question -- how much does showers of money improve people's heath -- but to point out with this forceful example for non-economists the possibility that widely reported correlations - rich people are healthier -- don't automatically mean that money showers raise health.

Syverson on the productivity slowdown - Barokong

Chad Syverson has an interesting new paper on the sources of the productivity slowdown.

Background to wake you up: Long-term US growth is slowing down. This is a (the!) big important issue in economics (one previous post).  And productivity -- how much each person can produce per hour -- is the only source of long-term growth. We are not vastly better off than our grandparents because we negotiated better wages for hacking at coal with pickaxes.

Why is productivity slowing down? Perhaps we've run out of ideas (Gordon). Perhaps a savings glut and the  zero bound drive secular stagnation lack of demand (Summers). Perhaps the out of control regulatory leviathan is killing growth with a thousand cuts (Cochrane).

Or maybe productivity  isn't declining at all, we're just measuring new products badly (Varian; Silicon Valley). Google maps is free! If so, we are living with undiagnosed but healthy deflation, and real GDP growth is actually doing well.

Chad:

First, the productivity slowdown has occurred in dozens of countries, and its size is unrelated to measures of the countries’ consumption or production intensities of information and communication technologies ... Second, estimates... of the surplus created by internet-linked digital technologies fall far short of the $2.7 trillion or more of “missing output” resulting from the productivity growth slowdown...Third, if measurement problems were to account for even a modest share of this missing output, the properly measured output and productivity growth rates of industries that produce and service ICTs [internet] would have to have been multiples of their measured growth in the data. Fourth, while measured gross domestic income has been on average higher than measured gross domestic product since 2004—perhaps indicating workers are being paid to make products that are given away for free or at highly discounted prices—this trend actually began before the productivity slowdown and moreover reflects unusually high capital income rather than labor income (i.e., profits are unusually high). In combination, these complementary facets of evidence suggest that the reasonable prima facie case for the mismeasurement hypothesis faces real hurdles when confronted with the data.

An interesting read throughout.

[Except for that last sentence, a near parody of academic caution!]

17 Aug 2020

NYT on zoning - Barokong

Conor Dougherty in The New York Times has a good article on zoning laws,

a growing body of economic literature suggests that anti-growth sentiment... is a major factor in creating a stagnant and less equal American economy.
...Unlike past decades, when people of different socioeconomic backgrounds tended to move to similar areas, today, less-skilled workers often go where jobs are scarcer but housing is cheap, instead of heading to places with the most promising job opportunities  according to research by Daniel Shoag, a professor of public policy at Harvard, and Peter Ganong, also of Harvard.
One reason they’re not migrating to places with better job prospects is that rich cities like San Francisco and Seattle have gotten so expensive that working-class people cannot afford to move there. Even if they could, there would not be much point, since whatever they gained in pay would be swallowed up by rent.
Stop and rejoice. This is, after all, the New York Times, not the Cato Review. One might expect high housing prices to get blamed on developers, greed, or something, and the solution to be government-constructed housing, "affordable" housing mandates, rent controls, low-income housing subsidies (which protect incumbent low-income people, not those who want to move in to get better jobs) and even more restrictions.

No. The Times, the Obama Administration, California Governor Gerry Brown, have figured out that zoning laws are to blame, and they're making social stratification and inequality worse.

In response, a group of politicians, including Gov. Jerry Brown of California and President Obama, are joining with developers in trying to get cities to streamline many of the local zoning laws that, they say, make homes more expensive and hold too many newcomers at bay.
.. laws aimed at things like “maintaining neighborhood character” or limiting how many unrelated people can live together in the same house contribute to racial segregation and deeper class disparities. They also exacerbate inequality by restricting the housing supply in places where demand is greatest.
“You don’t want rules made entirely for people that have something, at the expense of people who don’t,” said Jason Furman, chairman of the White House Council of Economic Advisers.
This could be a lovely moment in which a bipartisan consensus can get together and fix a real problem.

The article focuses on Boulder Colorado, where

.. the university churns out smart people, the smart people attract employers, and the amenities make everyone want to stay. Twitter is expanding its offices downtown. A few miles away, a big hole full of construction equipment marks a new Google campus that will allow the company to expand its Boulder work force to 1,500 from 400.
Actually, The reason Google and Twitter are in Boulder is that things are much, much worse in Palo Alto! A fate Boulder may soon share:

“We don’t need one more job in Boulder,” Mr. Pomerance said. “We don’t need to grow anymore. Go somewhere else where they need you.”

16 Aug 2020

How to step on a rake - Barokong

How to step on a rake is a little note on how to solve Chris Sims' stepping on a rake paper.

This is mostly of interest if you want to know how to solve continuous time new-Keneysian (sticky price) models. Chris' model is very interesting, combining fiscal theory, an interest rate rule, habits, long term debt, and it produces a temporary decline in inflation after a rise in nominal interest rates.

Federalization of Labor - Barokong

We are getting a good hint that a centerpiece of economic policy in the Hillary Clinton administration will be an increase in Federal control over labor markets.

The news here is that serious economists are advocating these policies, not just to transfer income from one to another, reduce inequality, help specific groups, or enhance some sense of social justice, at the expense of dynamism and growth, but that more Federal control of the labor market will increase wages, productivity and economic growth for everyone!

Alan Blinder's cogent Aug 2 Wall Street Journal opinion piece gives a good sense of the language and logic,

... Hillary Clinton has presented an extensive list of policies that would raise wages, starting with a higher minimum wage. ...

Mrs. Clinton also advocates widespread profit-sharing as a way to put more money into workers’ pockets. She would promote that goal both by using the presidential bully pulpit and by providing tax incentives for businesses that share profits. Since the scholarly evidence suggests that profit-sharing raises productivity, such tax breaks will partly pay for themselves.

Increased vocational training and apprenticeships for the non-college-bound are also major Clinton policies....The U.S. can increase its productivity and reduce inequality by ensuring that the right people get vocational training and apprenticeships.

And then there is what may be the surest way to raise wages over the long run: providing pre-K education for all American children.... Labor market intervention is getting wrapped up in "stimulus," as reported in an excellent Bloomberg column by Brendan Greeleyhere,

"It’s really simple," she said at a rally in June in Ohio. "Higher wages leads to more demand, which leads to more jobs, which leads to higher wages." ...

When Clinton uses the word "demand" on the stump, she’s blowing a dog whistle. (Economists have them, too.) Increase demand, she’s saying, and you get growth....  Bob Gordon signs on reluctantly,

"I think it’s a very marginal way of promoting economic growth," says Robert Gordon, economist at Northwestern University who specializes in the subject. Like Summers, he prefers a massive investment in infrastructure. But he does agree that a shift in business income away from profits and toward salaries would create growth. Workers are more likely to buy things from their paychecks than businesses are to invest out of their profits.
Alan Krueger ["former chairman of the Council of Economic Advisers and an informal adviser to the Clinton campaign," and candidate for vice-president of the American Economic Association] agrees wholeheartedly:

... "I think the time could be right for a more virtuous growth model," he said, "which is driven by stronger wage growth...more consumption, more demand, creating more jobs."
Novel rationalizations for decades-old policies are always suspect. And the usual passive or verb-less sentences hiding the heavy hand of Federal government always invites skepticism.

But let's take it seriously. How much sense do these analyses make?

Without rehashing the whole minimum-wage fight, it is worth asking, if the Federal Government forces businesses to raise some people's wages, but others become unemployed as a result, whether that really count as raising wages overall?

The words "presidential bully pulipit" has poor overtones in the current age. The bully pulpit means the DOJ, EEOC, IRS, NLRB, EPA and who knows even the fish and wildlife service may come calling if you don't do what the president wants. Schoolyard bully, not Teddy Roosevelt's jolly-good pulpit.

"The scholarly evidence indicates that profit-sharing raises productivity.." That's a new twist on the abominable "studies show" argument by reference to vague authority.  But even "scholarly evidence" has to make some sense.

It does make sense that firms which study the question and choose profit-sharing plans can thereby raise productivity, either by giving their employees better incentives or by attracting different and more productive employees. They would not do it otherwise.

But this classic subject-free sentence is about Federal Regulations to force profit-sharing that "puts money into workers' pockets" on all firms. It does not follow that such a mandate will have the same effect. This is the classic, "rich guys drive BMWs, so if we force BMW to give cars away we'll all get rich."

To belabor the obvious, that some firms choose it because they see it will work does not mean that the Federal Government forcing it on all firms will work.  That profit sharing which increases workers' incentives can work does not mean that reducing profits and paying lump sums to workers will work. That profit sharing accompanied by greater selection of productive workers works does not mean that forced profit sharing will work for everyone -- someone employs the less productive, I hope.

If it's about incentives, then there should be a widespread Federal initiative to promote piece-work, commissions rather than salaries, independent contractors rather than employees... Hmm, we're headed the other way.

As economists, we are supposed to start with a problem. What is the market failure that stops companies form putting in productivity enhancing profit sharing programs? Or are they just too dumb and need the benevolent hand of the "bully pulpit" to educate them?

"Increased vocational training and apprenticeships for the non-college-bound," are more Orwellian subject-less sentences. Who is going to do this increasing and how? What is the market failure? Do we need to have triple digit numbers of Federal Job-training programs?

"Providing pre-k education" is another subject-free sentence. I presume he does not mean reducing regulations and union requirements so more pre-k schools can start up! That might actually be effective. But perhaps it is technically correct: a large Federal subsidy for pre-k education, funneled through the public school systems and teacher's unions will raise someone's wages. The "scholarly evidence" is not that it will be the kids.

The idea that forcing companies to pay out greater wages is the key to "stimulus," and that demand-side "stimulus" is the key to long-run growth is...er... even more novel economics.

In classic Keynesian stimulus, there is something about the government borrowing money and spending it, or giving it to consumers to spend, that causes people to forget that the borrowed money must be paid back someday. Not here -- this is directly the claim that taking from Peter and giving to Paul is the key to prosperity. And not just temporary stimulus, but long run growth.

One of many fallacies at work here is the notion that companies face a choice between "paper" investment and "real" investment; that by piling up cash reserves they are somehow diverting resources that could be "real demand" into "paper investments." But every paper asset is a paper liability, so this possible truth about an individual company makes no sense for an economy as a whole.

And let's follow the logic.  If this works for stimulus and growth, force companies to give away cash to consumers. Consumers are, well, people who like to consume. Force them to give cash away to thieves. They consume quickly.  If this is a bad idea.. well then maybe the whole "stimulus" thin is a bit of bunk as well.

Gordon at least has the decency to belittle the idea. And on "a shift in business income [another subjectless sentence -- this shift is forced by the Federal Government!] away from profits and toward salaries would create growth"  because "Workers are more likely to buy things from their paychecks than businesses are to invest out of their profits," one can hope that a statement which violates basic accounting is a misquotation.

Krueger has less defense: "a more virtuous growth model,...which is driven by stronger wage growth...more consumption, more demand, creating more jobs" is a direct quote. It may be "virtuous" to feel this way, but the classic criticism of Democratic economic policy is doing things that make you feel good but don't work.

Well maybe, maybe not. Economics is a work in progress. But it is certainly brand-new, made-up-on-the spot economics, designed to buttress policies decided on for other reasons.

A last grumpy comment. The WSJ titled Blinder's oped, "Only one candidate can make wages grow again."  Actually I agree with the sentence   Like most media they forgot there are more than two candidates!

15 Aug 2020

A Look in the Mirror - Barokong

Tyler Cowen and Alex Tabarrok have written a splendid article, "A Skeptical View of the National Science Foundation’s Role in Economic Research" in the summer Journal of Economic Perspectives. Many of their points apply to research support in general.

The article starts with classic Chicago-style microeconomics: What are the opportunity costs -- money may be helpful here, but what else could you do with it? What are the unexpected offsetting forces -- if the government subsidizes more, who subsidizes less? What is the whole picture -- how much public and private subsidy is there to economics research without the NSF? Too many good economists just say "economic research is a public good, the government should subsidize it."

They go on to ask deeper questions, "Are NSF Grants the Best Method of Government Support for Economic Science?" The NSF largely supports mainstream research by established economists at high-prestige universities. Are there better "public goods," undersupported by other means, for it to support?

Yes. Among others, replication and data. There are few current rewards for replication, and much economics research is not replicable. We live in the age of big data, but it's expensive and hard to access. The NSF has done commendable work here -- and other government agencies including the Census, Bureau of Labor Statistics, Federal Reserve, etc. provide huge public goods by collecting and disseminating good data. Without data we would not exist.  That strikes me as the single most underfunded public good in the economics sphere.

I'm less a fan of their proposal to support "far out" research, naming "post-Keynesians, econo-physicists, or the Austrians." While they cite popular authors  and a "gadfly'" sensational claims for the end of macroeconomics in 2009, in fact Macroeconomics is not all that much changed since the crisis and recession, and none of these claims -- nor the wackier approaches -- have in fact borne any fruit.  Yes, it's easy to support mediocre incremental research, but government agency that must appear impartial can too quickly end up subsidizing crank research, of which there is plenty in economics (see my inbox!)

They ask a great question. If the government wants to subsidize economic research, why hand out grants, rather than hire people directly?

I think there are good answers here. Another big subsidy to economics research which they do not mention are the legions of government employees already doing it. The Federal Reserve, Treasury, OFR, CEA, SEC, CFTC, HHS, EPA and hundreds of other agencies employ thousands of PhD economists who spend considerable if not full time on "research," and are expected to write academic journal articles. Make up your own mind about the value of this effort. The success of the research university I think points to an important externality between doing research, teaching it, and evaluating it through service to the profession. Also, research coming out of government agencies always seems to find just how wonderful those agencies' policies are. However, replication and data production, or other more easily guided research seems a good fit.

Also not mentioned is the danger that government subsidized research ends up being politicized, or at least ends up calling for more government.

One of the main methods of NSF support is "summer support." Universities pay academics on a 9 month basis. If you get an NSF grant it pays for 2 months of "summer support."  This is, of course, a fiction. In fact, most universities chop up the "9 month" salary into 12 pieces anyway. And most academics are not about to go work elsewhere in the summer -- it's the only time to really focus on research, and as Alex and Tyler point out the rewards to publishing are huge.  By and large the NSF does not (or did not when I last looked in to it) buy off teaching or other duties, the one thing that might free up some marginal research time. Alex and Tyler mention low labor supply elasticities as a reason to be cautious about the effectiveness of support. They don't mention this system, practically guaranteed to be a pure transfer rather than induce more research.

On the other hand, NSF grants are typically awarded based on a working paper. They already are a "prize" as Tyler and Alex recommend. So perhaps the lump-sum nature of the reward is not such a bad idea, and ends up subsidizing good research rather than more effort.

I stopped applying for NSF grants some time ago. Sometime in the mid-1990s, I was driving through Indiana, and I saw a guy hooking a shiny new boat up to his pickup truck. It occurred to me, my NSF check for that summer was worth about 5 boats. I didn't think I could get out of the car and say with a straight face that he and four neighbors should forego their boats so I could work on unit roots for the summer. I'm not pure either; I still benefit from many government subsidies, not least of which the tax-deductibility of charitable contributions.

A world without cash - Barokong

Max Raskin and David Yermack have a nice WSJ OpEd last week, "Preparing for a world without cash." The oped summarizes their relatedpaper.

What would a government-backed digital currency look like? A country’s central bank would need to become a deposit-taking institution and hold accounts on behalf of citizens and businesses. All of their debits would be tracked on the central bank’s blockchain, a digital ledger resistant to tampering. The central bank would pay interest electronically by adjusting the balances of depositor accounts.
I'm a big fan of the idea of abundant interest-bearing electronic money, and that the Fed or Treasury should provide abundant amounts of it. (Some links below.) Two big reasons: First, we then get to live Milton Friedman's optimal quantity of money. If money pays interest, you can hold as much as you'd like. It's like running a car with all the oil it needs. Second, it is a key to financial stability. If all "money" is backed by the Treasury or Fed, financial crises and runs end. As Max and David say,

Depositors would no longer have to rely on commercial banks to hold their checking accounts, and the government could get out of the risky deposit-insurance business. Commercial banks that wished to keep making loans would raise long-term capital in the debt and equity markets, ending the mismatch between demand deposits and long-term loans that can cause liquidity problems.
However, there are different ways to accomplish this larger goal. Do we all need to have accounts directly at the Fed, and is a blockchain the best way for the Fed to handle transfers?

The point of the blockchain, as I understand it, is to demonstrate the validity of each "dollar" by keeping a complete encrypted record of its creation and each person who held it along the way.

Its archival blockchain links together all previous transfers of a given unit of currency as a method of authentication. The blockchain is known as a “shared ledger” or “distributed ledger,” because it is available to all members of the network, any one of whom can see all previous transactions into or out of other digital wallets
That, and a limited supply to control its value, was the basic idea of bitcoin. But when we are clearing transactions by transferring rights to accounts at the Fed, the validity of the "dollar" is not in question. It's at the Fed. And, the big advantage relative to bitcoin as I see it, the value of the dollar comes from monetary policy and ultimately the government's demand for "dollars" to be paid in taxes, not from a fixed supply as was the case with gold.

The blockchain also appears to clear transactions more quickly and offer some security advantages. The latter are very attractive -- in my personal life I've recently had the questionable pleasure of spending days enjoying 19th century finance of multi-day clearing times, obtaining notarized signatures and medallion guarantees, and sending pieces of paper around. But not yet ironclad -- The same week of the WSJ has a string of articles on the security ofBitcoin following a recent hack.

The biggest stumbling block in my mind is "all members of the network, any one of whom can see all previous transactions into or out of other digital wallets." Per Max and David, this has pluses and minuses:

Tax collection would become much simpler, and tax evasion and money laundering could become prohibitively difficult.
Yet the centralization of banking under this system would also create a Leviathan with the power to monitor and control the personal finances of every citizen in the country. This is one of the chief reasons why many are loath to give up on hard currency. With digital money, the government could view any financial transaction and obtain a flow of information about personal spending that could be used against an individual in a whole host of scenarios.
This really is a big change in how "money" works. Traditional cash has a lovely property, that it has no memory. Its physical properties determine its value in a way independent of its history. It is incredibly efficient, in a Hayek information sense. The economy does not need the memory of every transaction. Blockchains turn this around.

The anonymity of cash makes it enduringly popular -- cash holdings are up, not down in the digital age. The same week of WSJ reading had articles delving into the continuing popularity of cash, and themechanics of handling it, the ongoing fury over theplaneload of cashdelivered by the Obama administration to Iran. It's not hard to figure out why both Iranians and Administration needed to send old-fahshioned bills on an unmarked plane, not a wire transfer.

Indeed creating this Leviathan is a danger, to the economy, and to our political freedom. Our government likes to pass aspirational laws that we don't really mean to enforce. Get rid of cash, and allow the government to see every transaction and enforce every law regarding payment of anything, and 11 million immigrants suddenly can't work at all and become penniless. Rigorous enforcement of all transactions would not only stop your kids lemonade stand and babysitting business, it would wipe out most of the employment opportunities for lower-income America. Many businesses would come to a halt.

The natural response is, well, maybe we shouldn't pass laws we don't really mean to enforce. Good luck with that.

More deeply,  "flow of information about personal spending that could be used against an individual in a whole host of scenarios" is truly frightening. I don't think there is a political candidate in the whole country who could not be embarrassed with one purchase at some point in their lives. Consider the brouhaha now over "disclosure" of political contributions -- there is a real fear that disclosure is a way of setting up hit lists for the administration to go after its political enemies. Multiply that by a thousand. Dissenters could easily be silenced if the government can monitor or block every transaction.

The ability to transact with anonymity and privacy has been a central freedom for hundreds of years. It's largely gone already. Losing it entirely and giving the government huge power to enforce any law it passes is not necessarily a good thing.

Mike and David opine

creating and respecting privacy firewalls and rethinking legal-tender laws could mitigate the dangers of monopoly and stifled competition in currency markets.
[Subject-free sentences (creating?) are always a sign of trouble!] The dangers are not of monopoly and competition, the dangers are in the vast loss of privacy that the government, and its leakers and hackers knowing all our transactions implies.

(Here I'm out on a limb on my blockchain knowledge, but I gather that one does have to wipe the slate clean occasionally. Otherwise, the blockchain gets ridiculously long. Imagine each dollar, a hundred years from now, attached to a list of everyone who has ever held it! That wiping out process could do a lot for privacy.)

So, back to basics. It is not at all clear to me in their analysis why the Fed has to manage all the accounts. The Fed, Treasury, and the government in general are very good at defining the units of a currency, and providing an easy standard of value -- cash, coins, liquid government debt, reserves.  That is their natural monopoly. I don't see that the government has a similar natural advantage in providing low-cost transactions services, especially on monitoring fraud in the use of those services. The Fed got hacked by employees of the central bank of Bangladesh.

So I leave with two big questions -- and these are questions, and this is an invitation to more thought.

Is a blockchain really better than accounts at the Fed, and instructions to flip a switch to send money from my account to your account? What is the best way to get low transactions costs and fraud prevention, given that we don't need authentication of the dollar itself and a supply limitation?

Is it really better for the Fed to handle all transactions directly, rather than for the Fed to provide clearing accounts, and "banks" (narrow!) to provide transactions services between people, using reserves as now for netting and clearing? The latter setup allows competition and innovation in transactions services, and a better hope for an information firewall retaining some privacy and anonymity in transactions.

(Note for readers new to the blog: I've written about some of these issues inA new structure for US Federal Debt, Toward a run-free financial system, A blueprint for effective financial reform and previous blog posts, such as here.)

Summers on growth and stimulus - Barokong

Larry Summers has an important, and 95% excellent, Financial Times column. Larry is especially worth listening to. I can't imagine that if not a main Hilary Clinton adviser he will surely be an eminence grise on its economic policies. He's saying loud and clear what they are, so far, not: Focus on growth.

The title "the progressive case" for growth, is interesting enough. Perhaps Larry now uses the word "progressive" to describe himself. More importantly, Larry's audience here is the Clinton campaign and the Democratic party. He's saying loud and clear: you're not paying enough attention to growth, and growth ought to be at the center of the party, and the new Administration's, economic plans.

...many people, in their eagerness to focus on fairness, neglect the single most important determinant of almost every aspect of economic performance: the rate of growth of total income,
Hooray. Not only is this vitally important and factually correct, a growth oriented policy, if sold without the usual demonization, could well attract bipartisan support. That sentence could come from Paul Ryan's a better way

Alas, Larry blows that spirit right off the bat with a sentence that take a gold medal for convoluted calumny and bombastic bulverism:

Because those who champion strategies that centre on business tax-cutting and deregulation and favour the wealthy have placed the most emphasis on growth over the past 35 years, the objective of increasing growth has been discredited in the minds of too many progressives.
Translated into something approximating English: because people whose only and base motive was "favoring the wealthy" happened to advocate growth to sell their (as later described) useless tax-cutting and deregulation strategies, the goal of growth has become tarnished in the minds of good progressives.

This is below Larry -- in person I have always known him to recognize that conservatives and free-marketers have exactly the same dispassionate goal, advocate growth primarily to help the less well off, and tax-cutting and deregulation as time-proven policies that improve growth.  But, again, his audience is to the left, so perhaps one can excuse some I-hear-you agreeing with common demonizations.

But then he gets to well written and praiseworthy work, so good I must quote it in entirety:

It can hardly be an accident that the decades of maximum growth, the 1960s and 1990s, also saw the most rapid job growth and most rapid increase in middle-class living standards.

Growth provides the wherewithal for increased federal revenue and so encourages the protection of vital social insurance programmes such as Social Security and Medicare....

Tight labour markets are the best social programme, as they force employers to hire and mentor inexperienced people in order to be adequately staffed. Some years ago, I estimated that for each 1 per cent point increase in adult male employment, the employment of young black men rose 7 per cent. More recent research confirms economic growth has an outsized benefit for younger people and minorities.

Rising growth has other benefits, as well. It strengthens the power of the American example in the world. It obviates the need for desperation monetary policies that risk future financial stability. Greater growth also has historically operated to reduce crime, encourage environmental protection and contributes to public optimism about the country that our children will inherit.

The reality is that if American growth continues to have a 2 per cent ceiling, it is doubtful that we will achieve any of our major national objectives.

If, on the other hand, we can boost growth to 3 per cent, interest rates will normalise, middle-class wages will rise faster than inflation, debt burdens will tend to melt away and the power of the American example will be greatly enhanced.

...the vast majority of job creation and income growth comes from the private sector. If the next president is lucky enough to oversee the creation of 10m jobs from 2017-20, more than 8m of them will surely come from businesses hiring in response to profit opportunities.
All true, excellent, well-stated, and bipartisan (at least for the pre-Trump era). Jeb Bush's 4%, Paul Ryan's opportunity society agree totally. Heck, even Gary Johnson might find little to quibble with here. If growth could be the mantra for the Hilary Clinton administration, and if Larry can persuade his fellow "progressives," great things could follow.

And now to the remaining 5%:

There is no case for reducing already low corporate taxes or removing regulations unless it can be shown that these have costs in excess of benefits.

What is needed is more demand for the product of business. This is the core of the case for policy approaches to raising public investment, increasing workers’ purchasing power and promoting competitiveness. No case? Really? The higher taxes, steadily more convoluted tax code, vast expansion of regulation (Dodd-Frank, Obamacare are just the start) that coincided with our epic slow growth, have nothing at all to do with that sorry experience?   There is absolutely nothing wrong with the microeconomics of the American economy and its vast administrative, judicial and regulatory state, we just need a bit more "demand?"

Leave aside the last 30 years of growth theory, which is silent on "demand," we can do nothing better than move around 1970s era IS and LM curves, and revive ideas from the 1930s?

Read the second paragraph carefully. "More demand" is the ""core of the case for policy approaches to raising public investment, increasing workers’ purchasing power and promoting competitiveness."

That "more demand" is the "core of the case" for (The Federal Government to borrow a lot of money and spend it on things labeled as) "public investment" admits up front that the actual value of such investment is at best secondary. Public investment in a great Ice Wall of Westeros on the southern border, or for high-speed trains from Tonopah to Winemucca, do just as well in boosting "demand."

What is needed is a serious negotiation: Fund needed infrastructure investment, but put in serious cost-benefit analysis,  buy it at reasonable prices, and so forth. That negotiation should start by abandoning the whole idea that we're doing it to provide "jobs" and "demand." If you're not wiling to do that, at least be honest and state that Mr. Trump's wall provides the same "demand."

Then explain to us how Japan has been at this for 20 years, producing no great shakes of growth.

"policy-approaches to... increasing worker's purchasing power" is another classic hidden-subject clause. I presume it means [The Federal Government, by legislation, regulation, or threat, will force companies to pay workers more, and then control employment to make sure those companies don't just fire workers or select better ones in order to ] increase [some] worker's purchasing power." Gary Johson's program also increases worker's purchasing power, and I don't think that's what Larry has in mind. I'm also curious where in modern economics forced transfers increase employment and long-run growth.

But in context, this is a small complaint. If Larry can persuade Mrs. Clinton and the "progressives" in the Democratic Party to focus on growth, to state goals for growth, and to hold themselves accountable for growth, then we can have an honest and very productive conversation about what's stopping growth and what steps can further it.

14 Aug 2020

Interview, talk, and slides - Barokong

I did an interview with Cloud Yip at Econreporter, Part I and Part II, on various things macro, money, and fiscal theory of the price level. It's part of an interestingseries on macroeconomics. Being a transcript of an interview, it's not as clean as a written essay, but not as incoherent as I usually am when talking.

On the same topics, I will be giving a talk at the European Financial Association, on Friday, titled  "Michelson-Morley, Occam and Fisher: The radical implications of stable inflation at the zero bound,"slides here. (Yes, it's an evolution of earlier talks, and hopefully it will be a paper in the fall.)

And, also on the same topic, you might find useful a set of slides for a 1.5 hour MBA class covering all of monetary economics from Friedman to Sargent-Wallace to Taylor to Woodford to FTPL.  That too should get written down at some point.

The talk incorporates something I just figured out last week, namely how Sims' "stepping on a rake" model produces a temporary decline in inflation after an interest rate rise. Details here. The key is simple fiscal theory of the price level, long-term debt, and a Treasury that stubbornly keeps real surpluses in place even when the Fed devalues long-term debt via inflation.

Here is really simple example.

Contrast a perpetuity with one period debt, and a frictionless model. Frictionless means constant real rates and inflation moves one for one with interest rates

$$ \frac{1}{1+i_t} = \beta E_t \frac{P_t}{P_{t+1}} $$

The fiscal theory equation, real value of government debt = present value of surpluses,  says

$$\frac{Q_t B_{t-1}}{P_t} = E_t \sum \beta^j s_{t+j}$$

where Q is the bond price, B is the number of bonds outstanding, and s are real primary surpluses. For one period debt Q=1 always. (If you don't see equations above or picture below, come back to the original here.)

Now, suppose the Fed raises interest rates, unexpectedly,  from \(i\) to \(i^\ast\), and (really important) there is no change to fiscal policy \(s\). Inflation \(P_{t+1}/P_t\) must jump immediately up following the Fisher relation. But the price level \(P_t\)might jump too.

With one period debt, that can't happen -- B is predetermined, the right side doesn't change, so \(P_t\) can't change. We just ramp up to more inflation.

But with long-term debt, any change in the bond price Q must be reflected in a jump in the price level P. In the example, the price of the perpetuity falls to

$$ Q_t = \sum_{j=1}^\infty \frac{1}{(1+i^\ast)^j} = \frac{1+i\ast}{i^\ast}$$

so if we were expecting P under the original interest rate i, we now have

$$\frac{P_t}{P} = \frac{1+i^\ast}{1+i} \frac{i}{i^\ast}$$

If the interest rate rises permanently from 5% to 6%, a 20% rise, the price level jumps down 20%. The sticky price version smooths this out and gives us a temporary disinflation, but then a long run Fisher rise in inflation.

Do we believe it? It relies crucially on the Treasury pigheadedly raising unchanged surpluses when the Fed inflates away coupons the Treasury must pay on its debt, so all the Fed can do is rearrange the price level over time.

But it tells us this is the important question -- the dynamics of inflation following an interest rate rise depend crucially on how we think fiscal policy adjusts. That's a vastly different focus than most of monetary economics. That we're looking under the wrong couch is big news by itself.

Even if the short-run sign is negative, that is not necessarily an invitation to activist monetary policy which exploits the negative correlation. Sims model, and this one, is Fisherian in the long run -- higher interest rates eventually mean higher inflation. Like Friedman's example of adjusting the temperature in the shower, rather than fiddle with the knobs it might be better to just set it where you want it and wait.

13 Aug 2020

Asset Pricing Mooc, Resurrected - Barokong

The videos, readings, slides/whiteboards and notes are all now here on my webpage.  If you just want the lecture videos, they are all on Youtube, Part 1 here and Part 2 here.

These materials are also hosted in a somewhat prettier manner on the University of Chicago's Canvas platform. You may or may not have  access to that. It may become open to the public at some point.

I'm working on the quizzes, problems, and exams, and also on finding a new host so you can have problems graded and get a certificate. For now, however, I hope these materials are useful as self-study, and as assignments for in-person classes. I found that sending students to watch the videos and then having a more discussion oriented class worked well.

What happened? Coursera moved to a new platform. The new platform is not backward-compatible, did not support several features I used from the old platform, and some of the new platform features don't work as advertised either. Neither the excellent team at U of C, nor Coursera's staff, could move the class to the new platform. And Coursera would not keep the old platform open. So, months of work are consigned to the dustbin of software "upgrades," at least for now.

Obviously, if you are thinking of doing an online course, I do not recommend that you work with Coursera. And make sure to write strong language about keeping your course working in the contract.

Update: The latest version of the class is here

12 Aug 2020

Glaeser and Summers on Infrastructure - Barokong

Ed Glaeser has a superb essay on infrastructure at City Journal, titled "If you Build It.." I have a few excerpts, but do go and enjoy the whole thing. Larry Summers also has a new blog post on infrastructure, with some fascinating bits if you read carefully. I wrote about some of these issues in the WSJ and recent post, but not with Ed's clarity and erudition, nor Larry's imprimatur.

Glaeser starts with a clear summary paragraph:

While infrastructure investment is often needed when cities or regions are already expanding, too often it goes to declining areas that don’t require it and winds up having little long-term economic benefit. As for fighting recessions, which require rapid response, it’s dauntingly hard in today’s regulatory environment to get infrastructure projects under way quickly and wisely. Centralized federal tax funding of these projects makes inefficiencies and waste even likelier, as Washington, driven by political calculations, gives the green light to bridges to nowhere, ill-considered high-speed rail projects, and other boondoggles. America needs an infrastructure renaissance, but we won’t get it by the federal government simply writing big checks. A far better model would be for infrastructure to be managed by independent but focused local public and private entities and funded primarily by user fees, not federal tax dollars
Ed documents well my own doubts that infrastructure spending will do much for the economy as a whole, especially in the short run. Buy the infrastructure for the infrastructure, at lowest possible cost -- not for the "jobs" or on the idea this is the key to returning to growth. Annoying as they may be, there is no case that US GDP growth has been cut in half because there are too many potholes. The Hillary Clinton plan included a praiseworthy -- and  novel, considering her party's years of opposition to freeway building -- proposal to cut commuting times. But

What about the economic value of the shorter commuting times that new infrastructure can bring? ... it’s hard to see how substantially reducing time lost to traffic congestion will turbocharge the economy. Imagine that America gets its act together and cuts traffic time sufficiently to save $80 billion—a pretty miraculous improvement. That would still represent less than one-half of 1 percent of America’s $18 trillion GDP....Transportation infrastructure isn’t a solution for America’s lackluster growth rates
The idea of public works to boost the economy goes back, I think, to the Romans, but I'm glad to read just how fresh an idea it is in America:

The idea of using infrastructure building as a weapon against unemployment first entered American politics after the economic panic of 1893. Before that recession hit, in 1891, businessman and Ohio politician Jacob Coxey drafted his “Good Roads Bill.” Coxey wanted the government to spend at least $20 million per month building roads across America, paying workers “at least 80 percent above the going hourly rate.” This building campaign, he argued, would be financed by the printing press—Coxey was a pro-inflation Greenback Party member—and would hike government spending by 75 percent.
Fiscal expansion financed by helicopter drops remains the cutting edge of Keynesian policy macroeconomics. Keynes once said that "Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist." It sees instead that practical policy Keynesian economists who believe themselves a vanguard of intellectual influence are usually the slaves of some defunct politician! It's a more general problem when economics comes to the service of policies decided for other reasons.

On the stimulus aspect of infrastructure, I have long been suspicious. The Keynesian argument for stimulus works for wasted spending just as well as infrastructure. That you have to wrap it in something nice to get it past the rubes who will not believe that wasted spending is a good thing suggests faith in the idea is not as strong as it should be. Anyway, Ed takes this on with precision

... one should be wary of drawing infrastructure-related lessons from the 1930s for the twenty-first century. .. While a sensible anti-unemployment policy targets resources at areas that have high unemployment rates, many of those areas are today in long-term decline, and the last thing they need is new roads and bridges...
...The relatively simple technology of infrastructure construction of the 1930s meant that the unskilled unemployed could easily be put to work building roads. Among the iconic images of the Great Depression are scores of men wielding shovels and picks. That isn’t how roads and bridges are built anymore, though. Big infrastructure requires fancy equipment and skilled engineers, who aren’t likely to be unemployed. The most at-risk Americans, if they’re working at all, usually toil in fast-food restaurants, where the average worker makes $22,000 a year. They’re typically not trained to labor on complex civil-construction projects. Subsidizing Big Mac consumption would be a more effective way to provide jobs for the temporarily unemployed than subsidizing airport renovation.
My emphasis because it's such a great quote. It also holds for the permanently unemployed, low-skilled or not construction union members.

The building process was also much quicker in the past, meaning that projects proposed during the Depression could be started and even finished during the Depression, making them more likely to fight temporary joblessness. Robert Moses built the Triborough Bridge complex, the construction of which got under way on Black Friday in October 1929, in just four years. Such speed is hard to imagine today. Boston’s Big Dig, to take one famous example, took 25 years from initial planning to its final completion in 2007.
It took 6 years to build the transcontinental railroad in the 1860s. By hand.

Why have transportation projects become so much slower? Yes, they’re usually more technologically complicated, but much of the time, politics is also to blame. ... To erect the Triborough, Moses could just demolish the buildings that he needed to get out of the way—neighborhood complaints be damned. Such tactics are no longer politically acceptable, so the Big Dig and other large-scale undertakings needed painstakingly to avoid inconveniencing anybody, dramatically raising costs and delays. New Deal projects also didn’t face environmental-impact reviews, which can add years to a project timeline. Detroit’s Gordie Howe International Bridge’s review process took “four years of consultations, public hearings, traffic analyses, and environmental studies,” to take a recent example. The project should be finished around 2020—15 years after that review process began.
Ed closes with an important point. Just why are roads and bridges, today, financed by Federal tax money? Groceries are funded by the money of people who buy them. In the past, roads and bridges were public goods -- it was not practical to charge users. Now, electronics make real-time, congestion-contingent tolling practical on city streets.

Many tasks of government have nothing in common with private enterprise. Neither our military nor our courts should be in the business of extracting revenues from, respectively, foreign powers or litigants. Aid to the poor and to the elderly is meant to be money-losing. But infrastructure is different and has much more in common with ordinary businesses. After all, infrastructure provides valuable services, the use of which by one individual typically crowds out the use by someone else. E-ZPass technology has made it simple to charge for transportation. Why not, then, establish a business model for transportation infrastructure?
Back from Free-Market Nirvana, Larry Summers' latest blog post has a predictably strong argument for infrastructure investment along the lines of the Hilary Clinton plan, multiplied by about a factor of 10. But he has some wise and important words of caution as well:

How can we be sure investment is carried out efficiently? There is legitimate scepticism about this, and there is no silver bullet for this problem. ... progressive advocates of more investment should compromise with conservative sceptics and, in the context of increased spending, accept regulatory streamlining, as well as requirements that projects undergo cost-benefit analysis. Minimising cost should be the objective of infrastructure procurement.
This is a very important statement. Me, in the WSJ,

In return for more spending, Mrs. Clinton could have offered serious structural reforms: repeal of Davis-Bacon, time limits on environmental reviews, serious cost-benefit analysis, and so forth. Such a package would have been irresistible
It's nice to agree. But minimizing cost is a breathaking proposition in American politics. A good acid test for infrastructure fans: Suppose a Chinese company offers to build your high speed train at half the cost. Do you say yes? If no, you're not really serious about infrastructure. Larry just said yes.

Larry also takes on the private sector issue,

What about the private sector? ...Policy frameworks that streamline regulatory decision-making and reduce uncertainty could spur investment in these sectors. There is a case for experimenting with mobilising private capital for use on infrastructure that has been a public-sector preserve, such as airports and roads. But, the reality that government borrowing costs are much lower than the returns demanded by private-sector infrastructure investors should lead to caution. It would be unfortunate if, in an effort to avoid deficits, large subsidies were given to private financial operators. Only when private-sector performance in building and operating infrastructure is likely to be better than what the public sector can do is there a compelling argument for privatisation.
Anytime someone uses a passive locution so convoluted as "experimenting with mobilising private capital," I suggest you react as you would to "Ladies and Gentlemen, a band of pickpockets has been discovered working the room." Precisely for the reasons laid out in Larry's last sentence: "Public-Private partnerships" usually mean public protection, private profits, and a piñata for politicians.

9 Aug 2020

Volume and Information - Barokong

This is a little essay on the puzzle of volume, disguised as comments on a paper by Fernando Alvarez and Andy Atkeson, presented at theBecker-Friedman Institute Conference in Honor of Robert E. Lucas Jr. (The rest of the conference is really interesting too, but I likely will not have time to blog a summary.)

Like many others, I have been very influenced by Bob, and I owe him a lot personally as well. Bob pretty much handed me the basic idea for a "Random walk in GNP" on a silver platter. Bob'sreview of a report to the OECD, which he might rather forget, inspired the Grumpy Economist many years later. Bob is a straight-arrow icon for how academics should conduct themselves.

On Volume:  (alsopdf here)

Volume and Information. Comments on “Random Risk Aversion and Liquidity: a Model of Asset Pricing and Trade Volumes” by Fernando Alvarez and Andy Atkeson

John H. Cochrane

October 7 2016

This is a great economics paper in the Bob Lucas tradition: Preferences, technology, equilibrium, predictions, facts, welfare calculations, full stop.

However, it’s not yet a great finance paper. It’s missing the motivation, vision, methodological speculation, calls for future research — in short, all the BS — that Bob tells you to leave out. I’ll follow my comparative advantage, then, to help to fill this yawning gap.

Volume is The Great Unsolved Problem of Financial Economics. In our canonical models — such as Bob’s classic consumption-based model — trading volume is essentially zero.

The reason is beautifully set out in Nancy Stokey and Paul Milgrom’s no-trade theorem, which I call the Groucho Marx theorem: don’t belong to any club that will have you as a member. If someone offers to sell you something, he knows something you don’t.

More deeply, all trading — any deviation of portfolios from the value-weighted market index — is zero sum. Informed traders do not make money from us passive investors, they make money from other traders.

It is not a puzzle that informed traders trade and make money. The deep puzzle is why the uninformed trade, when they could do better by indexing.

Here’s how markets “should” work: You think the new iPhone is great. You try to buy Apple stock, but you run in to a wall of indexers. “How about $100?” “Sorry, we only buy and sell the whole index.” “Well, how about $120?” “Are you deaf?” You keep trying until you bid the price up to the efficient-market value, but no shares trade hands.

As Andy Abel put it, financial markets should work like the market for senior economists: Bids fly, prices change, nobody moves.

And, soon, seeing the futility of the whole business, nobody serves on committees any more. Why put time and effort into finding information if you can’t profit from it? If information is expensive to obtain, then nobody bothers, and markets cannot become efficient. (This is the Grossman-Stiglitz theorem on the impossibility of efficient markets.)

I gather quantum mechanics is off by 10 to the 120th power in the mass of empty space, which determines the fate of the universe. Volume is a puzzle of the same order, and importance, at least within our little universe.

Stock exchanges exist to support information trading. The theory of finance predicts that stock exchanges, the central institution it studies, the central source of our data, should not exist. The tiny amounts of trading you can generate for life cycle or other reasons could all easily be handled at a bank. All of the smart students I sent to Wall Street for 20 years went to participate in something that my theory said should not exist.

And it’s an important puzzle. For a long time, I think, finance got by on the presumption that we’ll get the price mostly right with the zero-volume theory, and you microstructure guys can have the last 10 basis points. More recent empirical work makes that guess seem quite wrong. It turns out to be true that prices rise when a lot of people place buy orders, despite the fact that there is a seller for each buyer. There is a strong correlation between the level of prices and trading volume — price booms involve huge turnover, busts are quiet.

At a deeper level, if we need trading to make prices efficient, but we have no idea how that process works, we are in danger that prices are quite far from efficient. Perhaps there is too little trading volume, as the rewards for digging up information are not high enough! (Ken French’s AFA presidential speech artfully asks this question.)

Our policy makers, as well as far too many economists, jump from not understanding something, to that something must be wrong, irrational, exploitative, or reflective of “greed” and needs to be stopped. A large transactions tax could well be imposed soon. Half of Washington and most of Harvard believes there is “too much” finance, meaning trading, not compliance staff, and needs policy interventions to cut trading down. The SEC and CFTC already regulate trading in great detail, and send people to jail for helping to incorporate information in to prices in ways they disapprove of. Without a good model of information trading those judgments are guesses, but equally hard to refute.

How do we get out of this conundrum? Well, so far, by a sequence of ugly patches.

Grossman and Stiglitz added “noise traders.” Why they trade rather than index is just outside the model.

Another strand, for example Viral Acharya and Lasse Pedersen’s liquidity based asset pricing model, uses life cycle motives, what you here would recognize as an overlapping generations model. They imagine that people work a week, retire for a week, and die without descendants. Well, that gets them to trade. But people are not fruit flies either.

Fernando and Andy adopt another common trick — unobservable preference shocks. If trade fundamentally comes from preferences rather than information then we avoid the puzzle of who signs up to lose money.

I don’t think it does a lot of good to call them shocks to risk aversion, and tie them to habit formation, as enamored as I am of that formulation in other contexts. Habit formation induces changes in risk aversion from changes in consumption. That makes risk aversion shocks observable, and hence contractable, which would undo trading.

More deeply, to explain volume in individual securities, you need a shock that makes you more risk averse to Apple and less risk averse to Google. It can be done, but it is less attractive and pretty close to preferences for shares themselves.

Finally, trading is huge, and hugely concentrated. Renaissance seems to have a preference shock every 10 milliseconds. I last rebalanced in 1994.

The key first principle of modern finance, going back to Markowitz, is that preferences attach to money — to the payoffs of portfolios — not to the securities that make up portfolios. A basket of stocks is not a basket of fruits. It’s not the first time that researchers have crossed this bright line. Fama and French do it. But if it is a necessary condition to generate volume, it’s awfully unpalatable. Do we really need to throw out this most basic insight of modern finance?

Another strain of literature supposes people have “dogmatic priors” or suffer from “overconfidence.” (José Scheinkman and Wei Xiong have a very nice paper along these lines, echoing Harrison and Kerps much earlier.) Perhaps. I ask practitioners why they trade and they say “I’m smarter than the average.” Exactly half are mistaken.

At one level this is a plausible path. It takes just a little overconfidence in one’s own signal to undo the no-trade-theorem information story — to introduce a little doubt into the “if he’s offering to sell me something he knows something I don’t” recursion.

On the other hand, understanding that other people are just like us, and therefore inferring motives behind actions, is very deep in psychology and rationality as well. Even chimps, offered to trade a banana for an apple, will check to make sure the banana isn’t rotten.

(Disclaimer: I made the banana story up. I remember seeing a science show on PBS about how chimps and other mammals that pass the dot test have a theory of mind, understand that others are like them and therefore question motives. But I don’t have the reference handy. Update: A friend sends this and this.)

More deeply, if you are forced to trade, a little overconfidence will get it going. But why trade at all? Why not index and make sure you’re not one of the losers? Inferring information from other’s offer to trade is only half of the no-trade theorem. The fact that rational people don’t enter a zero-sum casino in the first place is the other, much more robust, half. That line of thought equates trading with gambling — also a puzzle — or other fundamentally irrational behavior.

But are we really satisfied to state that the existence of exchanges, and the fact that information percolates into prices via a series of trades, are facts only “explainable" by human folly, that would be absent in a more perfect (or perfectly-run) world?

Moreover, that “people are idiots” (what Owen Lamont once humorously called a “technical term of behavioral finance”) might be a trenchant observation on the human condition. But, by being capable of “explaining” everything, it is not a theory of anything, as Bob Lucas uses the word “theory.”

The sheer volume of trading is the puzzle. All these non-information mechanisms — life-cycle, preference shocks, rebalancing among heterogeneous agents (Andy Lo and Jiang Wang), preference shifts, generate trading volume. But they do not generate the astronomical magnitude and concentration of volume that we see.

We know what this huge volume of trading is about. It’s about information, not preference shocks. Information seems to need trades to percolate into prices. We just don’t understand why.

Does this matter? How realistic do micro foundations have to be anyway? Actually, for Andy and Fernando’s main purpose, and that of the whole literature I just seemed to make fun of, I don’t think it’s much of a problem at all.

Grossman and Stiglitz, and their followers, want to study information traders, liquidity providers, bid-ask spreads, and other microstructure issues. Noise traders, “overconfidence,” short life spans, or preference shocks just get around the technicalities of the no-trade theorem to focus on the important part of the model, and the phenomena in the data it wants to match. Andy and Fernando want a model that generates the correlations between risk premiums and volume. For that purpose, the ultimate source of volume and why some people don’t index is probably unimportant.

We do this all the time. Bob’s great 1972 paper put people on islands and money in their hands via overlapping generations. People live in suburbs and hold money as a transactions inventory. OLG models miss velocity by a factor of 100 too. (OLG money and life-cycle volume models are closely related.) So what? Economic models are quantitative parables. You get nowhere if you fuss too much about micro foundations of peripheral parts. More precisely, we have experience and intuition that roughly the same results come from different peripheral micro foundations.

If I were trying to come up with a model of trading tomorrow, for example to address the correlation of prices with volume (my “Money as stock” left that hanging, and I’ve always wanted to come back to it), that’s what I’d do too.

At least, for positive purposes. We also have experience that models with different micro foundations can produce much the same positive predictions, but have wildly different welfare implications and policy conclusions. So I would be much more wary of policy conclusions from a model in which trading has nothing to do with information. So, though I love this paper’s answer (transactions taxes are highly damaging), and I tend to like models that produce this result, that is no more honest than most transactions tax thought, which is also an answer eternally in search of a question.

At this point, I should summarize the actual contributions of the paper. It’s really a great paper about risk sharing in incomplete markets, and less about volume. Though the micro foundations are a bit artificial, it very nicely gets at why volume factors seem to generate risk premiums. For that purpose, I agree, just why people trade so much is probably irrelevant. But, having blabbed so much about big picture, I’ll have to cut short the substance.

How will we really solve the volume puzzle, and related just what “liquidity” means? How does information make its way into markets via trading? With many PhD students in the audience, let me emphasize how deep and important this question is, and offer some wild speculations.

As in all science, new observations drive new theory. We’re learning a lot about how information gets incorporated in prices via trading. For example, Brian Weller and Shrihari Santosh show how pieces of information end up in prices through a string of intermediaries, just as vegetables make their way from farmer to your table — and with just as much objection from bien-pensant economists who have decried “profiteers” and “middlemen” for centuries.

Also, there is a lot of trading after a discrete piece of information hits the market symmetrically, such as a change in Federal Funds rate. Apparently it takes trading for people to figure out what the information means. I find this observation particularly interesting. It’s not just my signal and your signal.

And new theory demands new technique too, something that we learned from Bob. (Bob once confessed that learning the math behind dynamic programming had been really hard.)

What is this “information” anyway? Models specify a “signal” about liquidating dividends. But 99% of “information” trading is not about that at all. If you ask a high speed trader about signals about liquidating dividends, they will give you a blank stare. 99% of what they do is exactly inferring information from prices — not just the level of the price but its history, the history of quotes, volumes, and other data. This is the mechanism we need to understand.

Behind the no-trade theorem lies a classic view of information — there are 52 cards in the deck, you have three up and two down, I infer probabilities, and so forth. Omega, F, P. But when we think about information trading in asset markets, we don’t even know what the card deck is. Perhaps the ambiguity or robust control ideas Lars Hansen and Tom Sargent describe, or the descriptions of decision making under information overload that computer scientists study will hold the key. For a puzzle this big, and this intractable, I think we will end up needing new models of information itself. And then, hopefully, we will not have to throw out rationality, the implication that trading is all due to human folly, or the basic principles of finance such as preferences for money not securities.

Well, I think I’ve hit 4 of the 6 Bob Lucas deadly sins — big picture motivation, comments about about whole classes of theories, methodological musings, and wild speculation about future research. I’ll leave the last two — speculations about policy and politics, and the story of how one thought about the paper — for Andy and Fernando!

8 Aug 2020

A Behavioral new-Keynesian Model - Barokong

Here are comments on Xavier Gabaix' "A Behavioral new-Keynesian model." Xavier presented at the October 21 NBER Economic Fluctuations and growth meeting, and I was the discussant. Slides here

Short summary: It's a really important paper. I think it's too important to be true.

Gabaix' irrationality fixes the pathologies of the standard model by making a stable model unstable, and hence locally determinate. Gabaix' irrationality parameter M in [0,1] can thus substitute for the usual Taylor principle that interest rates move more than one for one with inflation.

Gabaix imagines -- after three papers worth of careful math -- that people pay less attention to future income when deciding on consumption than they should.  Making today's consumption less sensitive to future income, means expectations of future income are larger for any amount of today's consumption. Thus, it makes model dynamics unstable.

But just a little irrationality won't do. If you move a stable eigenvalue, say 0.8, by a bit, say 0.85, it's still stable. You have to move it all the way past 1 before it does any good at all.

Thus, Gabaix puts irrationality right in the  middle of monetary policy. If Gabaix is right, you simply cannot explain monetary policy in simple terms with money supply and money demand, or interest rate rises lower investment and inflation via a Phillips curve, as simple approximations that more complex models, perhaps involving some irrationality, improve on. Monetary policy is centrally about the Fed exploiting irrationality, full stop, and cannot be explained or understood at all without that feature.

More in the comments. There are too many equations and figures to mirror it here, so you have to get the pdf if you're interested. This is for academics anyway.

Yellen Questions - Barokong

Fed chair Janet Yellen gave a remarkable speech at a Fed conference in Boston. I have long wanted to ask her, "what are the questions most on your mind that you would like academics to answer?" That's pretty much the speech.

Some commenters characterized this speech as searching for reasons to keep interest rates low forever. One can see the logic of this charge. However, the arguments are thoughtful and honest. If she's right, she's right.

The last, and I think most important and revealing point, first:

1. Inflation

"My fourth question goes to the heart of monetary policy: What determines inflation?"
"Inflation is characterized by an underlying trend that has been essentially constant since the mid-1990s; .... Theory and evidence suggest that this trend is strongly influenced by inflation expectations that, in turn, depend on monetary policy....The anchoring of inflation expectations...does not, however, prevent actual inflation from fluctuating from year to year in response to the temporary influence of movements in energy prices and other disturbances. In addition, inflation will tend to run above or below its underlying trend to the extent that resource utilization--which may serve as an indicator of firms' marginal costs--is persistently high or low."
I think this paragraph nicely and clearly summarizes the current Fed view of inflation. Inflation comes from expectations of inflation. Those expectations are "anchored" somehow, so small bursts of or disinflation will melt away. On top of that the Phillips cure -- the correlation between inflation and unemployment or output -- is causal, from output to inflation, and pushes inflation up or down, but again only temporarily.

What a remarkable view this is. There is no nominal anchor. Compare it, say, to Milton Friedman's MV=PY, the fiscal theory's view that inflation depends on the balance of government debt to taxes that soak up the debt, the gold standard, or John Taylor's rule. In the Yellen-Fed view, "expectations" are the only nominal anchor.

Even Fisher’s interest rates have vanished from the economics of inflation. Nominal interest rate = real interest rate plus expected inflation suggests something linking nominal interest rates and inflation, but that's gone too.

You can see also the implication: don’t worry about energy prices and other “disturbances” to inflation. Don’t even worry about "overheated" real economies, temporary Phillips-curve induced bouts of inflation. With "anchored" expectations, the inflation will melt away.

To be sure, “inflation expectations..in turn, depend on monetary policy.” But just how?

“…we need to know more about the manner in which inflation expectations are formed and how monetary policy influences them. Ultimately, both actual and expected inflation are tied to the central bank's inflation target, whether that target is explicit or implicit. But how does this anchoring process occur? Does a central bank have to keep actual inflation near the target rate for many years before inflation expectations completely conform? Can policymakers instead materially influence inflation expectations directly and quickly by simply announcing their intention to pursue a particular inflation goal in the future?”
The two paragraphs together are an interesting melange of old and new Keynesian economics. In full-on new-Keynesian economics, the answer to my question is straightforward. The Fed announces an inflation target, and a rule following the Taylor principle: for each 1% that inflation exceeds or undershoots the target, the interest rate will rise more than 1%. In new-Keynesian models, this leads to inflation or deflation that spirals away from the target. So, this threat of hyperinflation or deflation “coordinates expectations” around the Fed’s target. It’s a Dr. Strangelove sort of target — do what we want or we blow up the world.

What if inflation is so low that interest rates hit zero, as they have for the past 8 years? Don’t worry, sooner or later a shock will come and inflation will rise all on its own, the Fed can start manipulating inflation again. So, expectations that the Fed will in the future go about this Dr. Strangelove business can still anchor expectations of future inflation around the Fed’s target, and, working back, inflation today.

You can tell that this is a step too far for Mrs. Yellen, and most policy people trained in the 1970s (and me too, but for other reasons). Though “marginal costs” enter her Phillips curve, and though expectations of future inflation clearly anchor that Phillips curve, she clearly does not buy the idea that monetary policy affects those expectations by threatening explosive interest rates. Here she clearly has in mind the old-Keynesian view that higher interest rates lower and stabilize subsequent inflation, not the other way around.

Half her heart goes with adaptive expectations — “Does a central bank have to keep actual inflation near the target rate for many years before inflation expectations completely conform?” Anchored expectations come from the Fed’s painful success in the 1980s, and belief that it will do that again. But half her heart goes with the promise of new-Keynesian models: “Can policymakers instead materially influence inflation expectations directly and quickly by simply announcing their intention to pursue a particular inflation goal in the future?”

You see here some of the debate between the traditional ISLM Keynesians and monetarists at the Fed, on one side, and the promise of these new-Keynesian elements on the other. Both sets of traditional models took their adaptive expectations seriously, and worried that any increase in inflation would raise expectations of inflation and off to 1970s we go. Now both sets of traditionalists are the doves.

How much easier it could be to simply announce an inflation target, everyone believes it, and inflation or lack of inflation follows! It’s the ultimate in speak loudly enough and you don’t even need a stick.

I' skeptical. I think people have heard a lot of promises from public officials, and believe nearly none of them. Every year for the last about half-century the secretary of the Treasury has issued a forecast that the deficit will be eliminated one year after the President’s term ends. How many people in the US know the difference between Janet Yellen and Judge Judy? You have to spend a lot of time inside the walls of the Fed to think that Fed announcements of what their inflation target will be 10 years from now makes a difference to anyone but about 100 bond traders.

Our thesis topic for the week: Is it possible to write down this melange of new and old Keynesian models? You are looking for some model in which higher interest rates lower future inflation, which usually takes adaptive expectations, yet an announcement of a target can anchor expectations, which usually takes rational, forward-looking ones. I guess it’s possible to write down any model, so I should qualify, in a simple and vaguely believable way?

(I should put my horse in the race. I think the “anchor” is fiscal policy. Expected inflation is stable so long as people think fiscal policy is in control. That makes Mrs. Yellen right in a lot of ways. However, higher interest rates might make people quickly realize fiscal policy is not under control, which makes her critics’ nervousness also right. But today is not about my answer or the right answer, it's about Mrs. Yellen's and the Fed's views. I say this mostly so that I don’t get counted as one or the other side of the current hawk v dove debate.)

2. The Phillips curve

"While this general framework for thinking about the inflation process remains useful, questions about some of its quantitative features have arisen in the wake of the Great Recession and the subsequent slow recovery. For example, the influence of labor market conditions on inflation in recent years seems to be weaker than had been commonly thought prior to the financial crisis..."
Translation. Inflation just sat there and did nothing in the face of the hugest unemployment we've seen since the great depression. The Phillips curve, relating inflation to unemployment or output, has completely fallen apart.  This being the central piece of economics in Fed story for how it affects inflation — higher rates lead to less output and employment, lower marginal costs, lower prices — we’re a bit befuddled.

The implications of a vanishing Phillips curve are fun to debate. At a recent meeting at the Fed, I opined it was falling apart because huge variation in unemployment correlated with tiny changes in inflation. No, my counterpart said with a wry smile! It means that we can cure unemployment with only half a percentage point more inflation!

Putting the last two observations together, I think we see where the Fed is going. If inflation is just a trend, battered around by commodity prices, anchored by speeches, and immune to anything the Fed actually does; then that frees the Fed from what used to be its main job -- worrying about inflation -- to just worry about real stimulus with no worry about inflation. Moreover, if unemployment can skyrocket with no huge deflation, as it did, then the Fed can push unemployment way down without worry about more inflation, even in the short run. Instead of the Fed mainly determining inflation, with recessions an unfortunate byproduct, we now have a vision of the Fed mainly worrying about real stimulus, and not needing to worry about inflation. The fact that my first point, inflation, was Mrs. Yellen's last, encourages this reading.

3. Hysteresis. Does demand create its own supply? And vice versa.  (Yes, the Say's law echo is intentional.)

."..one study estimates that the level of potential output is now 7 percent below what would have been expected based on its pre-crisis trajectory, and it argues that much of this supply-side damage is attributable to... the deep recession and slow recovery..... a marked slowdown in the estimated trend growth rate of labor productivity. The latter likely reflects an unusually slow pace of business capital accumulation since the crisis and, more conjecturally, the sharp decline in spending on research and development and the very slow pace of new firm formation in recent years."
It is easy to read this as the latest excuse for dovishness, a new instance of the answer in search of a question. But take the argument seriously. Surely "demand" and "supply" -- poor concepts in the first place -- do leak to each other. If "demand" causes a long depression of investment in human or physical capital, then "supply" will be lower.

"...the natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a "high-pressure economy," with robust aggregate demand and a tight labor market. ...More research is needed, however,.."
I hope the Fed will do that more research before jumping on this theory. Casual investigation of past episodes are not promising. The late 1970s are the textbook case of a "high pressure economy" stimulated by monetary policy and "demand." They did not produce wonders of "supply," either of greater capital or more economic efficiency.

"More generally, the benefits and potential costs of pursuing such a strategy remain hard to quantify, and other policies might be better suited to address damage to the supply side of the economy."
I have noticed a tendency for Fed economists to work hard on issues that have an ear at the top. I  wish Mrs. Yellen had mentioned one or two such "other policies" to reduce the chance that this is interpreted as a throw-away line, not an invitation to write papers proving hysteresis.

4. Heterogeneity.

For nearly a century, the main simplification of macroeconomics has been to gloss over differences between people. "Consumption" and "employment" may be too high or low, but the fact that gains and losses are not spread evenly does not matter, to first order, when understanding the movements of the same aggregates. Note, I do not say they don't matter -- they matter a lot. If one in 10 loses their job, it matters a lot to the person losing the job. The issue is, if you want to know how monetary policy affects average employment or consumption, does it matter that 1 in 10 loses a job and the rest keep their jobs, vs. each of us working 10 percent fewer hours?

Of course it matters, the layman says. But simplification is the key to progress in any science. Chemistry did not get going by working out quantum mechanics. Furthermore, you can see quickly that heterogeneity matters only if economic decisions are nonlinear -- and we know how to model that nonlinearity. Linear decisions add up and behave just like a single household with the average response. Again, the layperson says of course economics is nonlinear. But unless you know just how it's nonlinear, that complication doesn't help. Wrong nonlinearity and state dependence is worse than none at all.

There is a huge new literature on heterogeneity. When a shock hits, some people don't have any savings and have to stop spending, now. Others can dip in to savings. People who lose their jobs are different from people who lose some hours, in big ways.

Watching from afar, I, like Mrs. Yellen, am impressed by this effort, but still scratching my head to understand what it all means for the economy as a whole.

" the various linkages between heterogeneity and aggregate demand [and supply! and equilibrium! Please, Mrs. Yellen, there is more to life than "demand"] are not yet well understood, either empirically or theoretically."
She continues

"More broadly, even though the tools of monetary policy are generally not well suited to achieve distributional objectives, it is important for policymakers to understand and monitor the effects of macroeconomic developments on different groups within society."
That's another sentence that deserves careful study. It is easy to cross the line from "understand and monitor" to target. It's not just easy, it's inevitable. So, the mandate of monetary policy has stretched from price stability to add low interest rates and maximum employment (by statute), to "financial stability," which now means understanding and monitoring, and inevitably trying to control, asset prices, housing prices, debt levels, bank profits (not yet at the Fed, but clearly on the minds of ECB and BOJ policy), and now will be targeting inequality too. I wish for another throwaway line on "other policies." Yes, Fed policy does affect some people more than others. But if the Fed tries to counter the ill effects of other policies -- bad public schools, say -- by monetary policy, it will first do a terrible job of its main objective, and second it can no longer stay independent and a-political.

5. Finance

In light of the housing bubble and subsequent events, policymakers clearly need to better understand what kinds of developments contribute to financial crises. ...
Research on this topic has, of course, been ongoing for some time, and it has expanded greatly in the wake of the financial crisis. But I believe we have a lot more to learn about the ways in which changes in underwriting standards and other determinants of credit availability interact with interest rates to affect such things as consumer spending, housing demand and home prices, business investment (especially for small firms), and the formation of new firms.
I can hardly object to the idea that we need to better understand how finance links to macroeconomics. Since 2008, about 3/4 of the papers at every conference or job market talk are about putting various financial constraints into economic models. I'm interested that Mrs. Yellen is also still looking for something solid to come out of all this.

Again though, one can be quite uncomfortable with the implicit message that the Fed needs to understand everything and try to control -- or at least monitor -- everything. If 8 years of nonstop research have led to so little, is not the program of understand heterogeneity, nonlinearity, inequality, financial "frictions" and linkages, crises and bubbles, and then masterfully address them all, just a little hopeless?

Would the Fed not do better both economically and as an institution to say, "look, our job is the price level. We take care of inflation, we do it independently and a-politically. We are not the master planner of the economy."

6. General comments

As some of the commenters point out, the speech is pretty remarkable for its implicit admission of the fact that the Fed really has very little idea of how its policies work. The jump from cocktail party speculation about, say "hysteresis" or "secular stagnation" or "anchored expectations" to serious consideration of such effects at high levels is pretty short, by scientific standards.

But in defense of Mrs. Yellen and the Fed, Mrs. Yellen is remarkably in touch with the best there is (such as it is) on these questions. I cannot imagine the top-level administrator of any other government agency, from cabinet secretaries on down, anywhere near as conversant with the state and limitations of current research.

Indeed, there is not great academic research answering these questions. And not for want of effort. Saying snarky things about the state of macroeconomics is easy. Coming up with serious answers to Mrs. Yellen’s questions is a lot harder. She is remarkably honest about her, and the Fed’s, limited understanding of the system they are trying to manage.

Compare the Fed here to the rest of the economic policy world -- the FTCs regulation of mergers (about 50 years behind anti-trust economics and legal scholarship), the FCC's regulation of the internet, the SEC's regulation of financial markets, the FSOC (indulging the Fed) regulation of "financial stability,” the CFPB “protection” efforts and so on. Anchoring, hysteresis and heterogeneity are scientific bedrock compared to "contagion," “liquidity," "abuse" and all the other mumbo-jumbo these agencies think they understand and control. And their pretense of knowledge is off the charts greater than Ms. Yellen's humility.

(Thanks to commenters ona previous post who brought up the speech and have active and thoughtful commentary going on.)

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Anies Baswedan

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